Quarterly Commentary as of June 30, 2023
Financial markets’ progression since the beginning of 2023 can be explained by an economy that has proven to be more resilient than previously expected. The proof: following a 2-month break the Bank of Canada raised its key interest rate in June and again in July. How do we explain this resilience after 12 increases in interest rates since March 2, 2022 for a total increase of 4.75% in interest rates? Part of the answer lies in the anatomy of Western countries’ economies; between 70% and 80% of our economies are linked to services, that is; financial and professional services, government, education, healthcare, catering, travel/leisure, and the remaining 20%-30% is manufacturing (e.g. cars, natural resources, etc…). Many of us can likely testify that in addition to our grocery bill, services prices have not fallen nearly enough in recent months to allow inflation to return to 2%, as targeted by governments and central banks.
In early 2022, central banks (including the Bank of Canada and the Fed) were willing to tolerate a rise in inflation, but quickly pivoted their stance as prices rose much faster than policymakers had expected at the beginning of the year. The middle of last year is when markets realized central banks were becoming serious about making a dent in inflation and marked the first steps in what would become a series of rate hikes that amounted to the largest in history in such a short period of time.
Given the resilience of both the economy and corporate profits, equity markets have recovered over the past nine months. That said, the question remains whether we are seeing the beginning of a new bull market or the market’s final attempt at a recovery before having to face the realities of restrictive policy? In our opinion, we are in the final stage of the current recovery. In any case, the market is undoubtedly in a different mindset than it was during the September lows. Valuation ratios have again crossed the high bar of 20 times earnings. In addition, confidence indicators have soared to near unsustainable levels (albeit we are not there yet) last observed at the peak of the market a year and a half ago.
As we delve further into our analysis, it is worth noting that over the past 18 months, the US stock market has been running at 2 different speeds. As much as the stock market had battered mega-cap securities in 2022 (Apple, Microsoft, Amazon, Google, NVDA), these same companies have been rewarded since the beginning of 2023. The artificial intelligence theme has come back in vogue as investors attempt to size up the potential contributions that the technology can bring to productivity.
To measure the impact of mega-caps on the indices, let's compare the performance of 2 benchmarks for the year 2022 and the beginning of 2023. One is led by large U.S. stocks with growing dividends (iShares Core Dividend Growth) and the other (S&P 500), is led by the megacapitalizations mentioned above.
In 2022, the return of the iShares Dividend Index was (-7.9%) vs. (-18.1%) for the S&P 500 Index. Since the beginning of 2023, the opposite has occurred. Thus, the S&P 500 index led by megacapitalizations rebounded by +16.70% vs. 4.03% for the iShares Dividend index.
And over 3 years as of June 30, 2023, the average annual return of these two indices is quite close; iShares index +13.6% vs 14.6% for the S&P 500.
It should be concluded that, adjusted for risk, the strategy that focuses on dividend-growing equities has been much more stable during this period.
In the portfolio: strong and profitable companies on solid financial footing
We continue to recommend a neutral weighting of equities for a balanced portfolio, as we believe their growth could continue into the summer months. However, we increasingly believe that investors should limit their stock choices to companies in which they would be happy to hold a stake through a recession. For us, these companies are high-quality companies that are characterized by strong balance sheets, sustainable dividends and business models that are not particularly sensitive to the business cycle.
Performance at June 30th 2023
The results in CAD of the various indices for the quarter ending June 30, 2023: +1.1% for the Canadian S&P/TSX index, +6.5% for the US S&P 500 index and (-0.2%) for the Europe-Asia-Far East index.
In fixed income, the benchmark FTSE TMX Canadian Bond Index posted a negative return of (-0.7%). The depreciation of the US dollar against the Canadian dollar had a negative impact of (-2.1%) on US strategies over the same period. Canadian dollar results for a balanced portfolio are around +0.9% for the last three months.
Balanced portfolio returns over the last twelve months are generally between +6.0% and +8.0% in CAD.
Featured article: Update on inflation and its impact on fixed income portfolios
As inflation remains economic enemy #1, we believe it may be useful for us to summarize our American colleague Thomas Garretson’s most recent commentary, Midyear Global Outlook 2023 – Global Fixed Income.
Public enemy No. 1: inflation
Has inflation been arrested yet? While no major central bank has yet been confident enough to declare it has the suspect in custody, most have cautiously suggested that they believe to have the perp surrounded. As with any standoff, the last thing those in charge want to risk is escalating the situation. The Bank of Canada most recently provided other major central banks with an example of perhaps what not to do. Its rate hike pause early this year lasted for just two policy meetings until an uptick in inflation and economic activity spurred policymakers back into action with another rate hike in June.
But as it is clear to us that the worst of the post-pandemic inflation breakout is almost certainly in the rearview mirror, the question now is how long it will take to fall all the way back to target levels. RBC Capital Markets expects that most major economies will see inflation back toward more normal levels by early 2024, which we think should keep any potential central bank rate cuts at bay until roughly the same time.
Fixed Income Outlook
While the total returns delivered by bonds this year have been middling at best (for the 6-month period ending June 30th 2023), just +2.0% for the Bloomberg Global-Aggregate Bond Index, and +2.4% for the Bloomberg US Aggregate Bond Index, we continue to expect steady performance. We have dialed back our return expectations somewhat from high single digits to something in the 4% to 6% range as we see bonds as likely to deliver little more than the coupons paid for the year. This is largely a function of the anticipated first rate cuts from the Fed being pushed back to Q1 of 2024 from Q4 of this year previously. At the same time, economic risks have perhaps eased as markets are once again pricing in a soft landing for the U.S. economy. As the table below shows, RBC Capital Markets projects the 10-year Treasury yield—which is sensitive to economic growth and inflation expectations—to end this year relatively unchanged from current levels at 3.60%. RBC Capital Markets previously forecast a year-end level of just 3.2%, but as recession risks have faded, so too, in our opinion, have the downside potential for longer-term bond yields and chances of a “flight to safety” in bonds were a deep recession to materialize.
A longer investment window
But the upside for investors of a drawn-out inflation fight by central banks is that the window to put money to work at elevated yields will likely be extended. While we think central banks will take a more cautious approach going forward after a year of brute force, bond investors are in a unique—and privileged— position. Bond yields have rarely appeared more attractive, in our view, while at the same time they should provide strong capital appreciation potential for portfolios should bond prices rally if and when central banks pivot back toward rate cuts as economic growth and inflation eventually cool.
In closing, we encourage you to contact us if you have any questions or comments, and want to take this opportunity to wish you a wonderful summer – thank you for placing your trust in our team.
Mathieu & Anthony
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