2022 Q3 Market Commentary

Performance and Management Effect

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Commentary Highlights

Despite energy prices decreasing, inflation remains elevated worldwide, pressuring central banks further.
Yields continue to climb as central banks intensify the inflation fight. The US Federal Reserve faces credibility damage due to a delay in recognizing inflationary pressures.
The 2022 market correction hurt investors but in some ways has opened incredible new investment opportunities from here.
Monetary tightening gets closer to its peak, and central banks monitor required adjustments.
Our Portfolios underperformed the benchmark for the third quarter mainly due to underperformance during the July rally. All our portfolios have outperformed the benchmark in 2022, with much lower volatility.

Market Overview

When looking only into performance this quarter, it feels like it’s been a relatively flat and boring three months. What the current market’s negligible returns hide is how volatile the past quarter has been. Markets rallied in July, with the S&P500 and the S&P TSX Composite delivering respectively 8.71% and 4.66% in Canadian dollars for the month. The remainder of the quarter more than offset July’s gain, with the S&P 500 dropping 1.96% and 4.43% in August and September respectively, and the TSX Composite dropping by 1.55% and 4.26%, ending negative overall for the period.
It has been hard to hide from market volatility using fixed income only. Interest rates in both the short and long-term of the yield curve have been increasing consistently, reducing the value of bonds along the way. Inflation remains the central theme driving market activity.

Headline US CPI ended September at 8.2% after peaking in June at 9.1%. Core inflation, which excludes volitive items such as food and energy, peaked in September at 6.6%, a 40-year high. Do not forget that the core inflation target for the U.S. is 2%. There is a lot to be done in order to converge back to acceptable levels, including a necessary increase in the unemployment rate from historically low levels. Inflation cooled down mainly due to a steady fall in oil prices from the $120 US level in June 2022 to an $80-90 US range. As a result of inflation running hot in Canada and the US, the Central Bank and Federal Reserve continue to increase the overnight rate in an attempt to cool the economy with some of the most aggressive rate hikes in history.

The labour market remains tight, with unemployment at record lows and labour participation below historical averages despite some improvements throughout the year. The US added 263,000 new jobs in just September, considerably above market expectations. You might ask how lower employment and job creation may be detrimental to equity and debt markets. Why is good news bad news for markets? The reality is that the US is in a full employment range, leading to government inference by raising yields to cool the economy. Any decrease in unemployment will create further pressure on inflation and, consequently, additional pressure on interest rates. This relationship is identified in the bellow chart:

Treasury yields rose steadily as unemployment rates fell in the past 24 months. As the labour market remains robust, showing little signs of cooling off, yields increase as fear of higher interest rates consolidated in the market.

We believe that despite the risk of the interest rate hikes cycle not being fully priced in the yield curve, it’s time to move from a defensive position to something more aggressive. We do not claim to be market timers, but we view valuations as being more favourable across the equity and the fixed income universe. While positioning our portfolios defensively in the past 12 months, our Investment Committee is seeing signs of lower valuations in the equity markets and higher yields, which can deliver a reasonable return for fixed income. We will further detail our thoughts on specific asset classes and how we are positioning our portfolios to this sentiment change.

Canadian Equities

Our Canadian equity portfolio underperformed the index for the quarter ending in September. Returns were negative 2.12% versus the TSX Composite, which also delivered a negative return of 1.35%. Return contribution to the Growth and Preservation fund is (-0.22%) and (-0.11%), respectively. Our performance was driven primarily by slightly higher energy exposure which performed poorly in the quarter due mainly to declining energy prices. Our allocation to Canadian Equities has been lower than historical levels, limiting the downside of such volatile markets.
Aggressive monetary actions from the Bank of Canada aiming to control inflation caused a sell-off in the markets, moving capital from equities to safer asset classes, such as short-term bonds and money market securities. The Canadian central bank increased interest rates by 75 bps early in September, raising the target rate to 3.25% and fueling fears that a recession is imminent, if not inevitable. Tiff Macklem, the Governor of the Bank of Canada, indicated that he is not backing down on rate hikes, even as recession fears grow. The Bank of Canada had to increase rates not only to control inflation caused by excessive demand but also to limit the devaluation of the Loonie, which dropped by 7% this year against the U.S. dollar, pushed by a more hawkish US Federal Reserve. More recently, the Bank of Canada made a 50 bps increase to the overnight rate, a surprise to the market that expected another 75 bps. This may be a signal that the Central Bank may be prepared to see how dramatically the economy reacts to the severe rate hiking cycle undergone so far this year.

The silver lining of this mix of higher interest rates and inflation is that valuations became much more attractive than when the year started. Price to earning ratio moved from 18.8 on December 31, 2021, to 12.5 on September 30, 2022. We do expect some degree of earnings pullback caused by higher financial costs and recessionary pressure. Still, we believe such an event is temporary, and valuations look more attractive than nine months ago.

US Equities

It goes without saying that it has been a challenging year for U.S. stock markets. The third quarter of 2022 was vastly different from the previous two quarters, other than a summertime rally quickly fading by the end of September. U.S. stock markets, represented by the S&P500 dropped by 4.89% in U.S. dollars. When considering the performance of the Canadian dollar, this loss turns into a gain of 1.86% due to the appreciation of the American currency. Our U.S. equity holdings outperformed the benchmark, delivering performance in Canadian dollars of 2.6%. We have increased our allocation to US equities throughout the year, but we remain cautious.

As the Fed gets more aggressive in the monetary tightening, the market view is now that recession will be inevitable. The questions remaining are regarding the intensity, duration and timing of such a recession. A recession will likely affect corporate earnings, but that could also correct market anomalies such as extremely low unemployment rates and hot inflation. Markets could even leave this downturn stronger for another cycle of growth. We believe this scenario is feasible but unclear at this point.

Small-Cap Equities

We have been researching North American small-cap equities as a potential new addition to our portfolios. Our Investment Committee believes there is an opportunity as the valuation for this segment looks attractive, and the potential for alpha (return above benchmark) is significantly higher than in the large-cap segment. Capitalization (“cap”) refers to the size of the market capitalization of a company’s equity – i.e. the total worth of a company’s stock. Definitions vary, but in Canada, generally, the following definitions apply:

Micro Cap: <$100 million
Small Cap: $100 million
$500 million
Mid Cap: $500 million
$2 Billion
Large Cap: >$2 Billion

Historically small cap tend to trade at higher earning multiples because they are associated with growing their earnings more rapidly, but recently that relationship inverted as the price to earning for SML Index (small cap index) traded at lower multiples than the S&P 500 (large cap index). We are very excited about opportunities in the North American small-cap segment, and we had material progress in selecting a sub-advisor for this asset class. A formal announcement will come out independently.

Fixed Income

Yields increased consistently this year. The U.S. yield curve is currently inverted, meaning that short-term yields are higher than longer-term yields. Short-term rate levels increased higher and faster than the long term to help fight the 30-year inflation highs. This is a natural, expected reaction, as inflation remains more resilient than initially expected.

As much as we believe that further rate hikes are a real risk, we are finally seeing yield levels that can compensate for such risk.

Investors constantly seek to find the perfect balance of risk and return in their portfolios. However, the reality is that there is no such thing as a risk-free investment. Even so-called “safe” investments, like government bonds, come with some degree of risk. That’s why we believe that risk should be actively managed rather than simply avoided.

As much as we believe that further rate hikes are a real risk, we are finally seeing yield levels that can compensate for such risk.

Investors constantly seek to find the perfect balance of risk and return in their portfolios. However, the reality is that there is no such thing as a risk-free investment. Even so-called “safe” investments, like government bonds, come with some degree of risk. That’s why we believe that risk should be actively managed rather than simply avoided.

One of the most significant risks facing investors today is interest rate risk. This is the risk that interest rates will rise, causing the value of fixed-income investments to fall. To manage this risk, we use a technique called “duration management.” Duration is a measure of how sensitive an investment is to changes in interest rates. By carefully managing the duration of our portfolio, we can help smooth out returns and reduce volatility. We have been underweighted on duration for the past year, which provided positive relative performance, but now we see an opportunity to increase our duration risk on fixed income responsibly.

Regarding credit quality, we believe Investment Grade (IG) bonds remain more attractive when compared to High Yield (HY), as markets are still pricing minimal credit risk for companies with lower credit quality. HY-IG spread remains below the historical mean and median. We believe that a change in the labour market (increased unemployment) and lower earnings level due to tighter monetary conditions could increase the risk, bringing spreads closer to historical levels.

We believe that monetary tightening is getting close to an end, or at least moderating to something closer to more historically normal (25 basis points at a time). We believe that central bankers will soon monitor the impact of such yield increases in the level of inflation in the coming months. Monetary policy changes rarely provide an immediate effect. Much of a central banker’s job often consists of waiting and monitoring rather than making bets on their projections.

Global and Emerging Markets

The U.S. dollar’s growing strength has been impressive compared to many other currencies, such as the British pound, Euro and Japanese Yen. The U.S. central bank has been more aggressive than its counterparts as U.S. inflation remains hot. An expected effect of such movement is U.S. dollar appreciation as investors chase higher yields.

We are seeing an incredible opportunity opening for emerging markets (EM). Valuations look extremely attractive. Price to earnings decreased consistently throughout the year as EM stocks suffered with rate hikes in the developed markets, and now the price to earnings is about 33% below the 5-year average. There are issues that have been driving some of the reasons for low valuations, such as the zero-covid policy for China and the Taiwan-China military tension increase. But there continues to be moderate growth in China and its inflation rate is currently under 3%, way below developed world levels. Of note, India and Brazil have performed reasonably well.

As we previously informed our clients, Foyston, Gordon & Payne, who have managed our emerging markets allocation since inception, closed their strategy. As our conviction remains high for this asset class, we have moved our allocation to Blackrock’s Emerging Markets ETF (Ticker: ZEM) for the interim. Blackrock is the largest asset manager in the world. This allocation gives us market-weighted allocation to emerging markets. We are underway with rigorous due diligence for this strategy, looking for an active manager to take over this portfolio component. Our long-term intention is to have this allocation placed with an active global manager.

Final Thoughts

We understand that this has been a stressful year for investors. We have provided significant positive relative performance, really trying to mitigate the downside for our clients, but the quote “you can’t eat relative returns” explains what many are feeling right now.
The reality is that the current down markets have opened many exciting opportunities, such as emerging markets, North American small-cap and even corporate bonds, to mention a few. We are cautiously optimistic about the future. Many expect that 2023 will likely bring an international recession, but we believe that markets reacted ahead of time and are pricing in such an economic outcome. As opportunities appear, we are inclined to increase our risk gradually, especially for our Growth fund.

We have made some allocation changes throughout this year, and we are excited to see the impact of such changes. We will continue to focus on what we have an edge, which is to construct efficient portfolios for our clients and select the best strategies available in the market.

As always, we want to thank our clients for trusting us. If you require anything at all, please contact our client services team at rwmclientservices@Raintreewm.com.