2022 SO FAR…

 

The New Year has gotten off to a poor start. The main culprit has been government bond yields which have moved to highs not seen since before the pandemic. Good if you are looking to buy bonds – not great for values of bonds you hold already. There continues to be some angst among investors that central banks may be aggressive in tightening monetary policy. Investors should get some confirmation on this front in short order as the Bank of Canada and U.S. Federal Reserve are set to make announcements within a week.

 

A good portion of the equity market weakness so far has been focused in the technology sector and other so-called growth pockets, where stock prices can be particularly vulnerable to swings in bond yields and interest rates. The other important factor of late has been the fourth quarter earnings season which is now underway. Some of the high fliers of 2020 and 2021 that came out of nowhere are coming back to reality.  Let’s discuss why earnings may play a more important role going forward in driving equity returns.

 

There are two forces that typically drive stock prices: valuations and earnings. The former can be described as the value that investors are willing to ascribe to the earnings, cash flows, and dividends that are expected to be generated by a business in the future. Basically, we are you willing to pay now for a series of future cash flows.  As expectations change, and factors such as interest rates rise and fall, so too can the valuations that investors are willing to pay. Not surprisingly, valuations have moved higher for global stocks over the past decade as interest rates have declined.

 

Today, global equities are not cheap. Some markets around the world are trading above historical averages when looking at various commonly used metrics such as the “Price to Earnings” ratio. But, that was the same case a year ago and returns proved to be quite strong last year. So, elevated valuations do not imply an imminent risk, nor do they suggest that returns can’t be reasonably attractive in the short-term.  Eventually things return to some form of normal but you can leave a lot on the table waiting for this to happen.

 

Nevertheless, higher valuations do have important implications for investors and are not something that you want to rely on long term.  It seems to me that investors may have to lean on earnings growth to drive positive equity returns going forward, rather than an increase in the valuations.  Prudent investors should moderate their return expectations going forward, and pay increasing attention to potential earnings growth.  You may have noticed that we have had a good few years but we are still maintaining conservative return assumptions in your financial plans. 

 

The coming year should be reasonably good on the earnings front, barring any unforeseen headwinds to global growth. Consensus expectations are for close to 7% earnings growth for the world stock market this year. That is a meaningful decline from the nearly 50% growth in 2021. But, last year was skewed by the sharp recovery from the earnings decline witnessed in 2020. Earnings growth should moderate from the incredibly strong levels seen last year, but should still be close to or above historical trend. And, there is upside potential should inflation moderate more than expected later this year, supply chain pressures ease, inventories get restocked, and restrictions be lifted more quickly.

 

The tailwinds of very low interest rates and bond yields are shifting. This presents a headwind to asset valuations and will create bouts of volatility as the markets reposition for a changing monetary policy backdrop. We are being patient deploying new portfolio dollars and have confidence in the economic outlook and the prospects for earnings over the months to come.

 

INFLATION

 

The number one topic on people's minds these days is inflation.  To be clear, I do not have a new strategy to deal with inflation.  The strategy that I have employed to invest the money as per your financial plans has had inflation as a key component.  This has been in place for the past two decades so no need for something "new" to deal with it.  Even when it is not a headline, I think the erosion of one's purchasing power over a decade or two can have a huge impact.  That's why we like investments with growing cash flor.  Unfortunately, "safe" investments like bonds and GICs are actually far from safe over the long term because they 1) do not have increasing cash flow, 2) are expected to have a negative rate of return when tax and inflation are factored in and 3) can actually lose value in the short term in a rising rate environment (which is exactly what happened in 2021).  Bonds are held to meet short term cash flow needs and to reduce the volatility of the overall portfolio.  

 

I don't wish to get into what makes up inflation and why the number can be a bit misleading in today's diary - we can save that for our next meeting.  What I do wish to highlight is what I like in an inflationary environment.  

 

COMMODITIES

 

Energy/ Oil - Historically, the best sector in terms of performance during inflationary environments is oil due to the ability to pass along price and cost increases to the consumer.  Fundamentals in terms of oil supply and demand bode very well for the sector today.  

 

Materials - Many materials are an important part of the CPI basket or are direct inputs into the production of many goods we consume. As a result of this, there should be a good relationship between inflation and commodities over the short term, with commodity prices often leading broad inflation trends.

 

REAL ASSETS 

 

REITs - Real estate investment trusts.  Rental income can rise as inflation rises which also leads to increased property prices.  We like the industrial space which typically has longer leases and less control on rent increases.  

 

Infrastructure - see Warren's quote above.  Revenue streams are often explicitly linked to inflation.  Does it get any better?  Many infrastructure assets, including the majority of contracted power and utility investments, have an explicitly link to inflation through regulations, concession agreements or contracts, providing natural inflation protection.  Infrastructure assets have long-tern (10-20 years) revenue contracts that are derived from contracted or regulated pricing regimes and are based on subsidies or corporate power purchase agreements (PPA), which may be tied to inflation indicators such as CPI and PPI.  

 

Stay warm, 

Todd