At the beginning of the New Year, our team organized a webinar discussing this year’s market outlook. The event was hosted by our portfolio manager, Richard So, and he discussed a variety of topics and areas to focus on. Below are some notes that I took on his key points:

What Happened Last Year?

Most of the damage in the markets was felt in the first half of the year due to many surprises, including:

● Fed increasing rates faster than expected (Expectation was 0.9% but we ended up in the 4.25% - 4.50% range)

● Labor market was tighter than expected, leading to stickier inflation

● China deviated from the rest of the world with respect to an economic reopening

Beyond the midyear, it mostly traded in a sideways (albeit wide) range that was supported by resilient corporate earnings, a buoyant consumer with excess savings, and moderating growth in inflation. However, markets were constrained by the unwavering outlook from the Fed that interest rates would need to continue rising and stay at higher levels for longer

Looking Forward

- Everyone seems to be focused on a pending recession. We have never seen a recession that has been so highly anticipated.

- Not all recessions are created equal – Not all recessions need to be a crisis moment (i.e. financial crisis or covid), it can be part of a normal reset in the economy.

- Even with a recession, it will likely be mild as certain indicators are still showing expansion  (i.e. low unemployment, free cash flow of companies, and a nominal GDP Growth that is greater than the restrictive Fed Fund Rate)

● Government has ample room to bring down rates if a recession occurs. Feds are talking tough right now, but if it is deemed unnecessary, they can revert course. 2 Year yields serve as a proxy for where the government rate will be, and they are already showing the possibility of rate cuts before the end of the year. Although we may not be fully convinced that rate cuts will occur, the overall message we hear from the markets is that the interest hiking cycle is in its’ final innings

- Markets believe the Fed will not extend rates higher as the sources of inflation are diminishing

● Oil and wheat prices are back below pre-Russia invasion prices (oil prices are 21% below the “eve of invasion’ level and wheat prices are 13% below).

● Supply chains at or near pre-covid levels (Cost of Sea and Air Freight have collapsed and signal supply chains are no longer constrained).

● Housing has remained stubbornly high and is skewing inflation higher. Housing accounts for 20% of PCE basket BUT usually operates with a 10-12 month lag. The good news is that “the writing is on the wall” for the housing component of PCE to decline as the real-time indicators for housing have been slowing.

Are we going to have a good or bad year?

- RBC Capital markets predict the deepest quarterly decline in 2023 to be -0.3%. Relative to -2% to -4% declines seen in Non-pandemic & non-financial crisis recessions, any possible economic slowdown should be minor

- Regardless if there is a recession or not, it already feels like there is one. (ie. lost jobs in tech sectors, manufacturing recession, housing recession, and consumers spending down their savings).

- Important to have a balanced approach. Both bulls and bears have valid points. This is not a year to have a bias towards one side.

- Always important to remember that markets are “forward looking” and tend to bottom 6-12months before the trough in corporate earnings. Hence, investors have been historically rewarded by staying invested despite not having an “all-clear” signal from the economy.

Investment Themes

Canada

● BOC downgraded Canada’s growth outlook, but it is still positive.

● Drop in corporate profits has been relatively minor

● A recession in the US does not necessarily mean a recession in Canada due to our unique economy. We have seen 3 instances where Canada avoided a recession that the US fell victim to. Canada’s economy is well supported by elevated commodity prices.

● Canada is relatively cheaper than US markets (12.9 Forward PE to 17.5 Forward PE).

Bonds

● Yields have doubled versus last year.

● Many bonds are selling at a discount to par. Lots of damage have already been done.

● Bond markets have already priced in steep defaults and a recession.

● Seems like yields have already peaked, which will present capital appreciation opportunities.

● Modestly extending bond duration is justifiable.

Energy

● Expect continued multiple expansion for Energy in 2023 due to: a global focus on energy security, less risk of further regulation with democrats failing to secure the House or Representatives, and energy becoming an essential inflation hedge in portfolios.

● Debt and valuations of energy companies are still at record lows with an attractive backdrop of persistent supply and spare capacity issues.

● The energy sector should become a larger percentage of the total index. The sector makes up 10% of the index’s profit but only represents 5% of the market share in the index.

● Reopening of China is a game changer (From 2011- 2020: Emerging Asia made up 80-90% of global oil demand growth)

Banks

● Higher capital requirements and regulations may make it more difficult for banks.

● Slowdown in loan growth and higher provisions for credit losses will reduce profitability.

● Net interest margins to peak out as interest rate hiking cycle comes to an end.

● We are constructive on banks in the long term but would not overweight this year.

Technology

● “Next two years are probably going to be the most challenging” for tech sector…due to “normalization of demand.” The sector will experience a “massive growth cycle after these two years”.  – Satya Nadella (CEO of Microsoft)

● Short-term fundamentals are poor for large cap tech and software companies. Margins are declining, earnings and revenue growth is declining and CEOs shift from growth to becoming more efficient. It can take more than just 1 or 2 quarters for “bloated” tech companies to cut costs.

● However, short-term fundamentals may not matter to investors if inflation falls faster than expected, interest rates decline and overall economic growth remains modest. In these situations, momentum can build back for the tech sector as investors re-focus on the long-term growth potential. Hence, technology should still be present in one’s portfolio.

These are just the ‘headlines’ of certain key topics of the webinar. For the purpose of this blog, we are unable to add the myriad of charts and detailed analysis to further support the team’s outlook. Feel free to reach out to your advisor to dive deeper into the topics discussed above. To understand how to apply these concepts into your own portfolio, you may seek a member of our team to offer an investment review to determine the most suitable portfolio for you in this investment climate.