A Return to Normal?


A year of normalization provides optionality

Quarter & Year in Review

We turn the page on 2022, a year that will be remembered as a very difficult year for investors in financial markets. Persistent inflation, slowing economic growth, a war in Europe, and an aggressive change in monetary policy from central banks globally caused most financial asset classes to experience negative returns in 2022. This year was especially difficult for the traditional 60/40 equity and bond portfolio, as rising rates (chart 1) led bonds to have one of their worst annual return years ever. This was accompanied by slowing economic growth and a strong valuation reset in global equities. As can be seen in Chart 2 below, commodities were by far the strongest asset segment. The final quarter saw some relief in financial markets, as October and November saw markets recover some ground, before giving some back to end the year.

The rapid change in monetary policy regime globally as seen in Chart 1 below, brought on by persistently high inflation throughout the global economy, is one of the more impactful things to come out of this year as we move forward. We will discuss in more depth later in this letter as to why this is the case and the repercussions and considerations for portfolios as a result.

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A More Robust Investment Universe Provides Opportunity


As mentioned above, the major storyline for global investors in 2022 was the rapid rise in interest rates. This change comes off the back of more than a decade of ultra-low interest rates in developed economies. This rise in interest rates led to major re-ratings, not just in equity markets and valuations, but also in bond prices, especially in longer duration bonds.

This low interest rate operating environment led to many inefficient outcomes and unproductive behaviors in both the global economy and in financial markets. When the cost of capital is negligible, unproductive businesses can stay solvent and suck up capital that would have been better allocated to more productive endeavors. Growth becomes the dominant driver in a low growth world, and businesses that do exhibit growth are valued at extreme valuations. The value of fixed income in the portfolio is not in the income it provides, but in the trend of lower rates persisting and return derived from capital appreciation. At its peak, there was around $18 trillion dollars in debt globally that was negatively yielding if held to maturity. This was not a sustainable operating environment.

In much the same way that 2022 was dominated by the changing interest rate policy, it is likely that going into 2023 and beyond, the storyline will be the consequences of this change.

In the near term, the key macro risks remain that inflation stays stubbornly high, although the recent economic data suggests this could be changing, as seen in the figure below. The other risk is how much damage this rising rate environment has and will inflict on global economies, particularly consumption-based demand, and corporate earnings. We have seen signs of softening retail demand, as well as decreasing home prices and housing investment. However, the labor situation both in Canada and the US remains firm. Should more recessionary forces materialize, there is also risk to credit spreads widening as risks increase to borrowers. Therefore, credit selection and business quality become very important in the fixed income sleeve of portfolios, as it is for equities.

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There are also consequences that are decidedly positive for global investors. Much of the pain felt in equity and bond markets in 2022 can be viewed as part of a needed reset within the global economy and financial markets. Valuations in many areas of the market were too frothy, negative yielding debt needed to be wiped out. The cost of capital for businesses needs to matter, so that businesses are forced to make decisions more prudently with respect to where to invest capital, as well as maintaining a viable capital structure. For investors, the fact that there is a meaningful return on cash savings again has major repercussions to portfolio construction. A year ago, major financial institutions were offering 1-year GICs for 90 basis points (0.90%). Today, those same institutions are offering 5%!

In a world where the risk-free rate is around 4%, this shifts the decision matrix throughout the portfolio allocation process. If cash can earn an investor the risk-free rate, then to invest in an investment grade corporate bond and take on some form of credit and payment risk, they require to be compensated for that risk in the form of a return expectation of say 5%. To then look at the risk associated with a high yield bond, where there is a higher risk of payment, then they may require 7%. To then look at an unsecured claim on earnings, such as equity, then they may require 8 or 9%. All of this is to say that the competition for investor capital is far more balanced and compelling today than it was a year ago.

The toolkit available for investors today is far superior. A functional cash and fixed income universe providing real income again is a welcome normalization to the global financial ecosystem. This enables investors requiring their portfolios to generate income for them to not be forced into chasing dividend paying equities for much of their income requirement. This fund flow pushes valuations of those types of equities higher and leads to a cascading effect down the income and risk spectrum. By requiring investors to source income predominantly from equities and certain high yield bonds, investors ultimately had to choose between accepting a higher overall portfolio risk profile to achieve a level of return or accept lower returns, a difficult position for many investors to choose between.

We believe that we are entering into a market environment where our core values of owning quality businesses with strong balance sheets and measurable cash flows is well suited. A focus on owning businesses and strategies that pay us, as this normalization takes place in financial markets has the potential to result in a consolidation phase where there is not a strong trend in markets overall one way or the other.

An outcome that in our view remains under discussed is the possibility that while interest rate policy may be getting close to concluding their hiking phase, interest rates themselves may be higher for longer. This would represent a significant regime change for interest rates, and positioning for this outcome is prudent. It remains to be seen if inflation moves back towards the 2% target of many central banks in the developed economies, especially if trends of geopolitical risk, de-globalization and reshoring continue to pick up steam, which are inflationary impulses in the global economic system.

In Summary

As we turn the page on 2022 and look ahead, our view when looking at portfolio construction in 2023 is that the opportunity exists to take advantage of a more functional investment universe to construct global multi-asset portfolios. Our focus remains on finding and investing in high quality businesses and strategies that can continue to show operational strength in a higher for longer interest rate environment.

While risks to global financial markets stem from economic contraction, earnings growth deceleration, and credit spreads widening, there remains a case to own equity and credit of high-quality businesses with strong balance sheets and cash flow profiles. We continue to favor owning investments that pay us to wait as the economic uncertainty resolves itself in a potentially sideways to slow growth market environment. Within alternatives, we continue to look to allocate and source investment ideas that provide non-correlated return and risk profiles, and that own productive real assets such as real estate and infrastructure.