Quarterly Commentary as of March 31st, 2023

For many, turmoil in the US regional financial sector at the beginning of March brought on difficult memories associated with the great financial crisis of 2008-2009. Investors understandably became very nervous upon hearing the words “bank failure” – although, as we stated in our Q4 2022 commentary, the historic rise in bond yields in 2022 gave the asset class enough breathing room to resume its role as a diversifier in times of stress. This is in fact, exactly what happened – equity markets sold off and bond prices rose to cushion the blow.

As some of our colleagues at RBC Wealth Management so eloquently put it: a crisis for a few banks is not a banking crisis (detailed in our March 15^th special commentary on the US banking sector). The events leading up to the Great Financial Crisis of 08-09’ exposed careless lending standards across most of the financial industry that eventually created losses so large that some large banks became insolvent overnight. Today, the issue is very different: the losses are temporary in nature and are a result of the rise in yields and the temporary loss in market value of otherwise safe investments, that is US Treasuries backed by the full faith and credit of the United States government. For some banks, this liquidity issue morphed into a solvency issue due to potentially questionable risk controls – but, in our opinion this was the exception and not the rule.

When central banks hike rates, especially as much as they did throughout 2022, risky management practices begin to come to light; debt service costs increase, losses begin to materialize, and something eventually breaks. And perhaps that is precisely the point; to rid ourselves of the inefficiencies that stimulative monetary policies bring about. Although this does not occur without some discomfort it does come with a silver lining: allowing well-managed businesses with exceptional business models (like the ones we look to include in your portfolios) to emerge stronger and move onto the next cycle.

Performance at March 31^st 2023

The results in CAD of the various indices for the quarter ending March 31^st 2023: +4.6% for the Canadian S&P/TSX index, +7.2% for the US S&P500 index and +7.4% for the Europe-Asia-Far East index. In fixed income, the benchmark FTSE TMX Canadian Bond Index posted a positive return of +2.9%. The depreciation of the US dollar against the Canadian dollar had a negative impact of (-0.3%) on US strategies over the same period. Canadian dollar results for a balanced portfolio are around +3.2% for the last three months. Balanced portfolio returns over the last twelve months are generally between (-1.0%) and (-3.0%) in CAD.

To start the long-awaited spring season, 2 themes capture our attention: What is ChatGPT and why it is so important, and the concept of De-Dollarization, which implies a changing of the guard for the US dollar in the world economy.

What is ChatGPT and why it is so important?

• As opposed to traditional artificial intelligence (AI), which utilize pre-existing data to generate predictions or responses (ex. Apple’s Siri or Amazon’s Alexa) , generative AI models (GAI) are an improvement that can create original content
• One of the leaders in the development of generative AI is Open AI, a non-profit research organization whose mission is to ensure that artificial intelligence benefits humanity. OpenAI’s work has a wide range of applications, from language processing to robotics and everything in between
• One of OpenAI’s most well-known achievements is the development of GPT-3, which is able to generate incredibly accurate human-like language. It has already been used for chatbots, virtual assistants, content creation and language translation with great success.
• Why is ChatGPT so important? ChatGPT sports incredibly powerful AI under the hood, but its interface is conversational and easy to use, which democratizes the use of AI for the first time ever.
• While a more advanced version has already been announced in ChatGPT-4, the current public version of ChatGPT (version 3; ChatGPT-3) is a “free research preview” that has managed to impress millions of people, as well as meaningfully surpass previous expectations of where artificial intelligence would be today. The future of AI looks promising.
• AI has finally moved from the analytical stage to the learning and creation stage, and ChatGPT’s ease of use has opened up more use cases than initially imagined.
• Some examples of AI uses: ChatGPT has passed law school and business school exams, written official speeches for politicians, and even more impressively: there is currently a COVID-19 drug undergoing clinical trials that was entirely designed by generative AI
• What are the societal implications? For one, it is expected to disrupt every major industry. While traditional automation was focused on replacing manual labor, we believe GAI will be able to complete tasks traditionally done by office workers. While that may sound scary to some, we believe the greatest impact will be to productivity; workers will be able to automate some tasks while being able to focus on others, effectively increasing productivity.
• Relationship building becomes even more important. Arguably, at the top of many professions, be it law, banking or consulting, relationships are one of the most important ways to distinguish from the competition.
• The companies that do not have a strategy around utilizing AI will be left behind, and those that do will enhance the business itself through better relationships, better productivity, etc…

Source: RBC Capital Markets

De-dollarization: A changing of the guard for the US dollar?

• The US dollar is the world’s reserve currency, and so it has many advantages that other currencies do not have, namely being a safe haven in times of stress through access to liquidity.
• The first decade of the century was difficult for the USD as global investors questioned the US dollar’s reserve currency status, and the Euro appeared to settle in as a possible rival
• By 2011, a cheap valuation on a purchasing power parity (PPP) basis helped start a dollar bull cycle that lasted until the end of 2022, when the USD was pushed to more than 25 percent above its fair value level as indicated by PPP

• It’s important to note that currencies do not trade in isolation, they are all quoted relative to other currencies. If one currency depreciates, another one appreciates. The drivers of a nation’s currency depend on the strength of its economy and finances relative to its trading partners.
• Three major factors drive currency valuations: interest rates, budget deficits/surpluses and the global market price of a country’s exports relative to its imports. It has been reported that the US government printed 38% of new currency in two years, devaluing US dollars that other countries hold. Consequently, some notable recent global trade headlines: 1) France Buys 65,000 Tons of Liquid Natural Gas From China in First Ever Yuan, 2) BRICS (Brazil, Russia, India, China & South Africa) Countries keen on having common currency to replace US dollar, and 3) Saudi Arabia open to trading in currencies besides the US dollar (Source: alphaMountain Investments, Brooke Thackray, Volume 17, Number 4, April 2023)
• The largest of these drivers is interest rate differentials; all else equal, as a country’s central bank increases its overnight rate, more capital moves into the higher yielding currency, therefore increasing the valuation of that currency
• The COVID-19 pandemic triggered a sharp rise in inflation, and the Federal Reserve’s response consisting of steep interest rate hikes (faster than other countries’ central banks) allowed foreign investors to convert their currencies into dollars and park the funds in short-term accounts with a higher interest rate than they could achieve in their own currency. In RBC Wealth Management’s Global Portfolio Advisory Committee’s opinion, this was the last leg of the dollar’s rally.
• Several of these long-term drivers of the dollar’s strength now seem to be reversing. Global central banks are catching up with their own rate hikes and this will erase the advantage of holding US dollars
• Another implication is that international equities (outside of the US) tend to do well as the US dollar weakens since US investors can capture the outperformance of foreign markets on top of the benefit of stronger foreign currencies when translated into dollars
• US large caps typically tend to outperform in such an environment as they generate a higher proportion of revenues outside of the US, denominated in appreciating foreign currencies
• While we can’t say definitively that the dollar bull cycle is over, in fact it may still have several quarters to go, what we can say is that we are probably closer to the end of the bull cycle than we are to the beginning.

Source: RBC Wealth Management

How have we positioned portfolios for this trend? As you may have already guessed from the above points, favoring well-established large-cap companies with an internationally diversified revenue stream allows us to be more defensive in an environment where central banks continue to impose more restrictive monetary policy as well as protect against a depreciation of the dollar.

We wish you a wonderful beginning to the spring season. Please contact us should you wish to discuss your portfolios, or have any questions or comments.

Thank you for placing your trust in our team.

Mathieu & Anthony