Every year brings a unique set of challenges and opportunities for the financial markets and our economy. The start of 2022 has been especially challenging. We’re currently dealing with the war in Ukraine, Covid-related lockdowns in China, inflation at multi-decade highs, rising interest rates and uncertainty in the path of corporate earnings. However, the unemployment rate sits at the lowest level since 1976, global economies continue to recover from the induced recession of 2020, Covid infections appear to be on the decline or at least manageable in most parts of the world, and the Blue Jays’ encouraging start to 2022 has them atop the A.L. East. There is reason to be optimistic.
It is important to point out what some of these challenges mean for the investment results of our client portfolios, as well as the expectations for future results. With any significant market influence, our role is to assess its impact and make changes to our strategy as necessary. In some cases, little change is the best decision. If we believe that the businesses we own are the best in their sector and they have an advantage over their competition that will be proven by market out-performance over time, we will choose to own those businesses through most market conditions and collect our share of the profits. In some other cases, we need to make adjustments to avoid sectors or industries, or to capitalize on strengths in certain areas or asset classes. The objective is to achieve pleasing results over time and to meet the specific goals of our clients. The noise and volatility of some short-term outcomes will always create anxiety and concern, but we remain committed to our process of assessing both the challenges and opportunities of the markets and to getting it right over time.
Q1 Results
For the first time in a while, March 31 brought disappointing results for an entire quarterly period. Very little worked in our favour from an investment perspective, something we haven’t experienced since Q4 2018. Recall then that the U.S. Federal Reserve remarked that the economy was on strong enough footings that hiking interest rates was prudent to attempt to build some policy buffer to help absorb future shocks. The markets disagreed and the result was relatively steep declines for both the equity and bond markets through the end of 2018.
This year began with the markets reacting negatively to central banks forecasting higher interest rates again. With inflation already high and rising, and an economy having recovered sufficiently from the Covid-induced recession of 2020, higher rates were to be used to achieve what bankers call neutral policy – neither stimulate nor restrict the economy. The results for the markets have been somewhat predictable. Bond prices fall with the expectation, and eventual reality, of higher interest rates. This has hurt our fixed income investments. Equity markets react to higher rates by applying a greater discount to future growth of company earnings, effectively paying less for profits in future years. The result of both asset classes being negatively impacted by interest rates rising made it a challenging first quarter overall.
The war in Ukraine that began midway through the first quarter has further compounded the market challenges. With any geopolitical conflict, there is significant uncertainty that is created. This is especially true with the current conflict given the implications on a global scale. The war is further squeezing supply chains given both Ukraine and Russia’s role as key providers of inputs and raw materials, energy and commodities to Europe and the rest of the world. Through broken transport networks and Russian sanctions, we are experiencing shortages and delays that are only increasing prices and inflation data, creating additional pressures for higher interest rates.
Fixed Income
There were very few places to hide in the bond market over the first quarter of 2022. The dynamics have changed over the past several weeks with rates stabilizing and the expectations “baked in” for future interest rate hikes that will be needed to manage inflation. The bond market challenges didn’t begin in January although the effects from inflation began to be felt then. At the onset of the Covd-19 lockdowns, central banks provided unprecedented support for the economy and financial markets, taking measures to push interest rates and bond yields to extremely low levels. It made borrowing money – for households and businesses – extremely cheap. Since then, a robust economic recovery has led to strong employment levels and rising inflation, and therefore, a potential problem for central banks and their policies. Central banks have two levers at their disposal they are expected to use to manage the current environment.
The first is control of short term interest rates. Both the Bank of Canada and the U.S. Federal Reserve have increased rates with an expectation for multiple rate hikes over the next 12 – 18 months. The reality of a rising interest rate cycle is the reason for the recent decline in bond prices. Recall that higher interest rates and higher bond yields lower the market value of existing bonds. The second lever is the use of the central bank’s balance sheet. In a supportive function during Covid, the balance sheets grew via bond purchases and providing significant liquidity to the market. This is now reversing with central banks unwinding those purchases and letting the bonds they own mature without replacing them.
The intended outcome of these two levers is to dampen inflation with higher short-term interest rates and avoid a yield curve inversion, a potential precursor to recession, with longer term rates rising as the central banks’ balance sheets decline.
Our strategy with fixed income allocations hasn’t changed materially. We have used core actively managed solutions to gain broad, diversified exposure to high quality government and corporate bonds. We have also used select credit and alternative solutions that have actively used shorter duration and reduced interest rate exposures that act to complement the core positions.
While our core positions have been negatively affected by the current environment, we continue to hold them with expectations for higher future returns. As the bond market prices in higher future interest rates, we will be able to reinvest the interest that our current bonds pay at these higher yields. The following illustration shows the path of returns for a sample bond portfolio under a rising, falling and flat yield scenario.
Our non-core/satellite positions may be more subject to change going forward. We will be monitoring these positions to ensure they remain actively managed to capitalize on this dynamic market. There will come a time when we will want them to extend duration and increase the yield of their portfolio as future interest rate expectations become reality. And there may come a time when exposure to corporate credit will have to be reduced as we prepare for the next stages of the economic cycle.
Equity
While equity markets have been faced with the headwinds of geopolitical uncertainty and the effects of inflation on future growth rates, there have been select bright sectors of the market that have helped offset price declines. The Canadian market has held in relatively well over the first quarter of 2022, and in particular, the commodity sectors. As a result of supply chain constraints, the war in Ukraine, and years of under investment, many commodities and raw materials are seeing prices at decade-high levels. We are positioned to benefit from ongoing strength in prices through our exposures to the biggest and best Canadian energy companies – Canadian Natural Resources (CNQ), Cenovus (CVE) – select mining and materials companies, and agriculture inputs – Nutrien (NTR).
I addressed the effects of higher inflation and higher interest rates on equities earlier, particularly high growth companies. While this has created some outsized volatility and impacted the current value of portfolios, it hasn’t changed our investment strategy and our thesis. We have made some changes in select portfolios, upgrading positions, adding to positions at depressed prices, or raising cash to capitalize on future opportunities. Our core equity holdings have been under selling pressure along with the broader equity markets, but we don’t believe there are material impairments to any of the businesses we own. We continue to believe our companies are the best in a diverse range of sectors and industries across the Canadian, U.S. and global economies.
CargoJet (CJT) is an example of a Canadian company we own in many client portfolios that has declined in value over the past several months. CargoJet commands 95% of the domestic overnight airfreight market and is growing their revenue at a double-digit rate. The company’s largest customers – Amazon, Canada Post, UPS, DHL Express – are contracted out to 2025 and are likely to sign long-term extensions this year. Barriers to entry for new competitors are substantial. It would require a fleet of aircraft, pilots, and matching a track record of on-time and efficient scheduling in the 14 major centres across the country. The next phase of growth for CJT is international cargo. Dedicated airfreight is proving to be a better alternative to gridlocked sea freight and better service levels than the belly of passenger planes. CargoJet has committed capex spending to new planes dedicated to expanding internationally. Investors initially balked at these plans, however, much of the fresh capacity has been de-risked via a significant long-term partnership contract with DHL Express. We liked CargoJet when it was trading at $180-200 per share. We really like it at current prices of $153-154.
Given the current environment, there are also specific sectors of the markets we have been focusing on that we believe will be overall winners over the medium term. Financials typically do well in a rising interest rate environment. I mentioned previously the commodity sectors, specifically energy and metals/mining, which should benefit from higher prices due to under supply and under investment. And those sectors with the ability to pass on rising costs to end users, such as contracted utilities and select consumer staple companies, will continue to be areas we are willing to commit new money to.
The economy appears to remain on solid foundation and markets will benefit once some of the near-term headwinds subside. Low unemployment, stable growth expectations and a continued commitment from governments of support spending on specific projects and initiatives should keep that foundation intact. Provided those is charge are able to navigate a ‘soft-landing’ with interest rate policy effectively dousing inflation while avoiding a recession, building on this foundation looks promising.
We have been encouraging our clients to connect with us over the past several months. We recognize periods of heightened market volatility can be cause for concern, and a discussion can be effective at easing some of those concerns and providing some perspective. If you want to discuss some of the broader market influences, or your personal accounts and/or positions specifically, we encourage you to reach out and we’ll make the time for you.