Into the Home Stretch of 2022

We head into the final quarter of a turbulent 2022, but opportunities abound

Quarter in Review

Global financial assets rallied off their June lows through the back half of June and into July but gave that back through mid August to the end of September. The continued concerns over inflation and the path forward for interest rates being the driving factor.

There remain very few places to hide overall, with equities globally remaining weak as valuations continue to reset given the move higher in interest rates, which is also causing global bonds to sell off. While the nature of drawdowns in fixed income are different than those in equities due to the ability for bonds to mature at par at their maturity date provided the issuer remains solvent, it has nonetheless been a very turbulent year for global investors.

Commodities have been a good place to be in 2022, although these gains have leveled off since the initial rise due to the Russian invasion of Ukraine. Commodities broadly selling off in June was a major catalyst for the bounce off the lows in global equities to start the quarter. We continue to maintain a moderately bullish stance on certain commodities globally given the medium to long-term knock-on effects stemming from the Russian invasion of Ukraine, as well as the overall lack of investment into new production of key commodities in the global energy complex and energy transition complex.

Canada continued to exhibit some relative strength detailed in Chart 2, given their weighting to energy, which has been the best performing equity sector by far this year, as seen in Chart 3.

The US Dollar continues to strengthen globally given the overall risk off sentiment in global markets, and we will touch on the potential implications of this later in the letter.

The Path Forward for Interest Rates

While the conflict between Russia and Ukraine continues in the background, the major force affecting global financial markets is the current inflation rates globally and the continued increase in short term rates by central banks globally in response.

As mentioned previously, rising interest rates affect both equities and bonds. For bonds, rising rates means investors require a higher yield on existing bonds in the market, which equates to a lower price demanded on these bonds, and a higher resulting yield to maturity.

For equities, higher interest rates provide more compelling alternatives to equities in the global marketplace, as cash offers a yield, and bonds offer higher yields to maturity. This results in less aggregate demand for equities, and a lower multiple on earnings. The second part is as rates rise; the risks of financial recession grow. A recession would affect the growth rate of earnings for equities, resulting in a change in the expectations for earnings, which can also be a catalyst for downside in equities. As yield curves in North America remain inverted, the yield curve is providing the signal that they believe rates will be lower in the future, signifying that a recession is probable to drive rates lower.

US Fed Chair Jay Powell continues to put forward that the stance of the US Federal Reserve is to remain committed to fighting inflation, at the risk of economic growth. This stance has been echoed by the Bank of Canada, and both central banks again raised rates 75 basis points during the quarter. The two major economic areas we are watching when evaluating the likelihood of continued interest rate increases are inflation readings and employment data. As the Fed has a mandate to target a 2% inflation level and managing towards full employment, a significant change in either of these areas would certainly give central bankers in North America reason to re-evaluate more increases.

Currently, the US employment situation remains strong and inflation persistent, so Jay Powell’s continued rhetoric around more increases seems warranted. In Canada, we are seeing employment data begin to show some weakness, along with weakness in housing prices, which could put the Bank of Canada in a more precarious position with more rate hikes given the importance of housing to the Canadian economy and the wealth effect of households. As we have stated in previous editions, we maintain that the Canadian economy and average household was more sensitive to rising rates than their neighbors to the south.

The issue facing the US housing market is more focused on the market for buying and selling drying up, as the 30-year fixed mortgage rate has risen from 2% to over 7% in 2022. Thus, there is a strong incentive for current homeowners who locked in mortgage rates under 3% to remain in their home and not look to trade up or move. For buyers, the affordability of housing has changed dramatically given the move in rates, and this environment of a lack of activity would affect GDP and consumption. In both the US and Canada, as the younger generation is looking to own a home continue to feel that they cannot, this continues to provide dissatisfaction and anger that has manifested and will continue to in multiple ways.

The US Dollar

The US Dollar has been extremely strong this year as uncertainties in Europe and Asia continue to cause strong demand for the relative safety of the USD amidst the backdrop globally of risk-off financial markets. In fact, the US Dollar Index is at the highest levels since the peak of the dot-com market in 2000 and has risen over 17% in 2022 at the time of writing. The Canadian dollar has not been immune, even with strong energy markets, and is down over 8% against the US Dollar this year.

This relative strength has implications across the global economy, from a statement of the overall risk sentiment by market participants, to the costs of trade and financings for emerging economies, to the competitiveness for US based companies in the global marketplace.

Winter in Europe

The fallout from the Russian invasion of Ukraine continues to affect food and energy markets globally, but Europe is facing a potentially severe energy crunch this winter if it is a cold one. While Europe has done an admirable job sourcing natural gas from other partners in the form of LNG, there remains a significant chunk of current Russia imports that has not been replaced.

This has already resulted in significant increases in energy costs across the continent, contributing to the inflationary pressures in the economy, and is likely to result in the continued curbs on demand to balance the system. There remains a risk that the people in Europe put pressures on their elected leaders to ease the burdens on them, which would likely involve some easing of restrictions on Russia and President Putin. This outcome would likely not be beneficial for the people of Ukraine. Nevertheless, the European people and economy will be tested in their resolve this winter, and this area of the world bears watching in Q4.

Portfolio Considerations

While it has been a difficult year for investors, yet we continue to hold conviction in the strength of the assets, themes, and businesses that comprise our portfolios. We believe that these businesses will come out the other side of this period with strength. We also continue to evaluate and reposition capital to introduce new ideas that given the events that have transpired in 2022 have strong investment thesis’ behind them.

Globally, we continue to view the US as offering the most breadth and quality in equity markets, while certain Canadian sectors offer a promising outlook, namely in the commodity complex. Europe is beset by multiple issues as discussed above, including the risk of a severe energy crisis. Asia is still grappling with China and their zero-Covid policies causing rolling lockdowns and hurting manufacturing as well as consumer demand.

Within fixed income, there are an increasing number of individual bonds that are offering an attractive return profile given the re-pricing that has occurred, and that this is a long-term positive for investors who need steady income from their investment portfolios moving forward. Our bias remains to keep duration short given the potential for further rate hikes.

We continue to favour a strong allocation to the alternatives sleeve in portfolios, given its ability to hold direct real assets and strategies that can mitigate some of the volatility in public markets.

Overall, while we are seeing more attractive entry points to add capital than we have in a few years, we are remaining prudently cautious and selective, while awaiting a more concrete change in central bank policy or macroeconomic forces that would allow us to have more conviction that we are at an inflection point.

While this has been a difficult year for investors, and there are continued areas of concern relating to inflation, geopolitics, and the economy, we wanted to end this investor letter on a positive note. Below is a table showing the long-term returns in the S&P 500 after a decline of 25% or more since 1950. Our message is this is not the time to make major changes to a strategic asset allocation, and that investments in high quality businesses that will come out the other side in a position of strength can and will do well when financial markets recover.

_{Table 1: Data Sourced From Ycharts}