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Episode 27: Reflecting on 2022 and discussing what kind of performance will we see in 2023

Craig Maddock, VP, Senior Portfolio Manager and Head of the Multi-Asset Management Team of 1832 Asset Management, and Wesley Blight, Portfolio Manager, look back at the key drivers of investment performance in 2022, discuss their outlook for 2023 and describe how we’re positioned to take advantage of opportunities and avoid risks to start the year.



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From an investment performance perspective, it's fair to describe 2022 with the word volatile. What were the key drivers of investment performance in 2022?

[Craig Maddock 0:58] Well, thanks Alex. And, you know, certainly after a decade of above average annual returns for balanced portfolios, I think 2022 was a big surprise for investors – it really wasn't very good. Most portfolios were down, you know, 10% or more from the peak that we saw in markets back at the end of 2021.

And of course, stock markets around the world sold off as central banks tighten monetary policy, sort of think of that as secret code for increased borrowing costs. I think a lot of our clients will have felt the impact of that personally. And this is, of course, in response to exceptionally high inflation. Major markets like the S&P 500 [Index], were down in excess of 20%, at some point in time in the year, and there was a general negative trend across equity markets. And we would call this a bear market environment. Of course, within that, there were very few places to hide, because last year, not only stocks but also bond investments declined in value. And this rapid rise of interest rates wreaked havoc on bond prices, meaning that even the most conservative portfolios did lose some of their value in 2022.

Now there were many contributing factors to this decline that we saw in 2022. Part of it was, you know, strong returns that we had seen in portfolios for many years, that had driven both stocks and bonds to very high prices, and interest rates to historic lows, and negative in fact, in some parts of the world. Actually, if you look back at the end of 2021, you could say that both bonds and stocks were priced for perfection. And in reality, in 2022, things were clearly far from perfect.

High inflation was the key driver of this reset in prices. However, things like high energy prices, which of course contributed to the high inflation, supply chain disruptions, significant demand continuing from the reopening after COVID shutdowns – all of this was the perfect storm for markets. You add on top of that, geopolitics, top of the list with Russia's war in Ukraine, and of course, the resulting global sanctions that shut the Russian economy off from the rest of the world and ultimately, you end up with what we saw in 2022.

Every market setback is different. I mean, I can think back through many in my career, like the I.T. bubble of the late 90’s, the global financial crisis in 2008-2009. While the cause is always different in the cycles, things get priced to perfection and typically get reversed, and often, very painfully.

I'd say the good news, so looking forward, is that the progress that we saw to reset market prices. And that setback often sets us up for some of the best returns for investors following these biggest declines.

We talked throughout the year about the rotation of performance and big differences in returns across asset classes, sectors and geographies. What drove this behaviour?

[Wesley Blight 3:30] Thanks, Alex. I think a lot of what Craig mentioned, played out throughout the year and had a direct impact on capital markets. And really rare, but cash was clearly the king in 2022 with short duration exposure, so lower interest rate risk, providing the most material protection in the past year. The FTSE Canada Universe Bond Index, which represents all Canadian investment grade bonds fell by 11.7% over the year. And all of that decline came in the first half of the year compared to positive performance in the second half of the year. And that was as a result of bond investors having, really correctly, predicted that monetary policy around the world would dramatically tighten in 2022.

And even though those key lending rates from policymakers, central banks really, around the world, even though they've continued to increase through the end of the year, and even through until now, the pace of bond yields rising slowed, and that's slow down happen on expectations that central banks were unlikely to continue rocketing their key lending rates higher in future years.

On the equity side, a lot of what Craig mentioned, also had a significant influence in that we did have geopolitical turmoil with Russia's invasion of Ukraine, causing energy prices to soar. And in turn, Canadian energy stocks dramatically outperformed the Canadian equity index (S&P/TSX Composite Index) and that Canadian energy stocks rose 24% in the year when the broad Canadian equity index fell 6%. And then within energy itself, there was definitely some winners and some losers in that energy companies and energy stocks performed really well, but energy consumers like you and I got squeezed. Western Canada Select rose 78% From the start of the year to march, and it remained elevated through the first half of the year. And then it started to decline in the back half as expectations for global economic growth and energy demand started to slow. For the full calendar year, Western Canada Select ended down 15%.

Global oil prices, so brent crude, and WTI were up 7% and 4% respectively, following a similar pattern. Natural gas was up 6% After increasing a whopping 153% between the start of the year and August. Now that same phenomenon played out in our pockets. In Canada, year over year, energy inflation peaked at 39% in June, and it’s since come down, but it's still at year-over-year 13.9%. That's extraordinarily high and polar opposite from the dramatic deflation we witnessed in the first half of 2020, as demand collapsed. And that happened because we were slowing our economy down. And that was in the middle of the early days of the pandemic where we were staying at home, and we weren't necessarily spending as much capital or consumer spending had shrunk.

Looking across the globe, the same phenomenon really played out. In Europe, it was the first time since 2011 that the European Central Bank raised rates. They were emerging from negative key lending rates for the first time since March 2014 and their rates had been held at negative 50 basis points, so negative 0.5%, since late 2019. And they're now increasing at a historic pace with the Euro area having experienced 10% year-over-year headline inflation with gas prices up over 67%.

Similar story in the UK with year over year inflation being 10.7%. And the difference here is the Bank of England was more proactive in raising rates earlier than what the ECB did. Now usually the UK market doesn't have a big impact on global markets, but policy proposals from the short-lived Liz Truss premiership had a profound impact on bond markets with their mini budget, including significant spending and unfunded tax cuts. Now that policy decision that they had proposed was intended to be stimulant. It was intended to support consumer spending, and spending generally, to try and help the economy recover in the UK. But financial conditions were already tight, and they'd already tightened so significantly that the market response was quick, profound – bond yields spiked, caused bond prices to plummet so much that UK pension schemes became forced sellers to raise liquidity and ultimately the Bank of England had to step in with a purchase program. That mini budget was ultimately quashed and as we know now, the Liz Truss premiership ended after only 45 days.

Now supply-side economics have generally improved since the end of the pandemic but this has been a disproportionate improvement across the globe. China's reopening is certainly going to help further ease pressure but that's going to continue to be slow as COVID’s spread is rampant with lockdown policies in China having eased only recently, vaccinations are proving ineffective, and hospital capacity is proving insufficient thus far to handle the increase in hospitalizations that are certainly happening as a result of COVID's rampant spread through China.

Within China manufacturing production has been volatile, but it's actually increased, whereas consumer spending, amidst those lock downs, has clearly slowed. When you think back to the experience that we had in Canada, when we weren't able to get out of our homes, and go out and spend money, that same thing has happened in China. And that's really been a larger impact to consumer services versus consumer goods. Now, we are anticipating that there's going to be a rebound, but that's going to occur in fits and starts, as spending is likely to slow with export orders contracting on the back of lower economic demand globally, and liquidity at the same time is being tightened by the central bank in Canada, even though support from authorities has been increased to property developers in China. And if you think back to the bond payment issues that happened earlier, that support is required. But it's really hard for central banks and policymakers to act because debt levels are already so high.

Now the reopening of China I think is much more positive for China itself than the rest of the world because the boost is coming from, for services and consumer spending, whereas the rest of the world is more exposed to China's industrial economy.

Now it doesn't mean that that all areas of the world have gone through an incredibly tough time. India has actually been performing quite well. And they've been a beneficiary of the uncertainty in China with multinational companies becoming more keen on turning to India as an alternative for their international expansion. And as they look to gain access to what's been a growing middle-income consumer in India. India itself is on track to be the third largest economy in the world by the end of the decade. And those same supply chain disruptions that I was talking about earlier in China, that's boosted the appeal for other global businesses, like Apple as an example, having warned that their COVID restrictions in China were going to interrupt the primary assembly facility in China, and that they were moving some of their production over to India.

Now, I mentioned Apple, and I should mention that growth-style equities underperformed quite dramatically. And it was an offset similar to what Craig mentioned, the discrepancy between the experience we had in the pandemic and now the experience that we're having outside of the pandemic, valuations played a role here in that growth-oriented stocks were bid up, the valuations were growing as their outperformance was so outsized relative to their value peers.

As the pandemic has evolved, and our consumer habits have changed, that positive boost that growth stocks were receiving in the past, is starting to unwind and you layer on top, that financing costs have increased, the underperformance of growth stocks was quite profound. And that was really concentrated in I.T. stocks and then tech-oriented stocks, like consumer services, or tech-oriented consumer services like Meta, Facebook, Netflix, Disney, Alphabet, or Google, all underperformed their value peers in the last year.

Given all these considerations, how did our portfolios perform in 2022? Also, what adjustments did we make throughout the year to better position our clients?

[Wesley Blight 11:53] Our portfolios generally experienced some challenges in 2022, alongside broader markets. The tough thing is that both stocks and bonds declined. That's extremely unusual for that to happen at the same time, and usually what we would expect to happen and usually what has happened in the past, is bonds act as a countered equity market drawdowns.

But given this year, there was such a profound focus on combating that inflation that Craig mentioned, interest rates rose at a historic pace, and that pushed bond returns lower. At the same time, the rise in interest rates pushed the cost of capital higher, so it was pushing the cost of capital higher for all companies to much higher levels. And in turn, that corresponding fear of an economic recession or at least a slowdown in earnings caused investors to sell. And that happened predominantly in the first 6 months of the year.

So, heading into the year, we were cautiously optimistic with a defensive position for our fixed income allocations via lower weight, lower allocation to interest rate risk because we thought that inflation was going to be high, but transitory.

On the equity side, we were neutral to modestly underweight versus our strategic allocations. And as it became clear that inflation was not going to be a transitory phenomenon, and that market conditions would worsen, we became increasingly defensive with an underweight equity allocation.

Now, stepping back, I mentioned strategic asset allocation, and this is our positioning for the long term. And that's based on our forward-looking capital market assumptions for risk-return correlation. So how different asset classes move together or don't move together. In all of the allocation decisions we make, risk management is our primary focus, and our portfolios are anchored on a required amount of risk to realize our client's long term investment objectives.

Our portfolios are designed to be robust rather than optimal. And what I mean by that is we recognize our long-term assumptions aren't going to be perfectly correct, and that it's better to have a structure that's going to be robust in multiple investment environments, as opposed to having a portfolio that's only mathematically derived. It's also an acknowledgement that we don't know exactly what's going to happen and are focused on maximizing the probability of realizing our client's investment objectives through time. Now over a reasonable investment time horizon, we found that this results in very attractive investment performance.

And then additionally, we have the capacity to deploy tactical decisions, and we used that extensively throughout 2022. We don't make giant swings in our asset allocation, but we will make tactical moves from time to time, to take advantage of shorter-term trading opportunities. And we did that throughout 2022. Most significantly by reducing some exposure to equities and moving into cash. So, while 2022 wasn't the best year for our portfolios overall, we're confident that this measured approach and focus on the long term will provide performance prospectively that's a lot better than what we've just gone through in 2022.

Does our investment process allow us to be nimble and opportunistic?

[Wesley Blight 15:21] It does Alex and it lets us react quite quickly, when we see unusual volatility coming. We are able to do that without changing the long-term makeup of our portfolio. While we do embed some timing into the decisions that we're making, we don't want to try and time the market aggressively because one, it's extraordinarily hard to do. And two, we don't want to impose such a significant change on a short-term basis that pulls the client away from their ability to realize their long-term objectives. I think that's critically important.

Volatility often challenges investor discipline. How should our long-term investors think about the performance of their portfolios in 2022?

[Craig Maddock 16:11] I think it's natural for people to think in terms of, you know, quarters or calendar ends, let's face it, our lives rotate around the Gregorian calendar, which incorporates the earth’s travel around the sun and the moon around the earth. And this is interesting, because it gives us patterns that we can use to create year ends and month ends and quarter ends. And to some degree, they influence our behaviour and the performance of investments, they really mean very little over the lifetime of an investor.

And Wes alluded to this already, you know, what's really important for us long term, and really what's important for our clients is can you meet your long-term goals? And when it comes to an investment portfolio, investors often worry about short term periods of weak performance, like last year. But we know from long periods of history, both stocks and bonds, they do fluctuate in value, and Wes mentioned that, you know, we know that they will also go up generally over time. And while most major indices have declined in 2022, if you measure over long periods, in fact, they're up.

Look back to every calendar year since 1960, balanced portfolios have declined 20% of the time. But if you look out over three-year periods, they've only declined 2% of the time. And there has not been a five-year period since 1960, where a balanced portfolio had a negative return.

So, while it never feels good when markets decline, we understand that it is going to happen from time to time, and that is anchored into those long-term expectations that Wes just spoke about. It is uncomfortable, but it generally works out fine over the long term. And I think that's the key is we have to think over the long term. Now in terms of the different quarters within 2022, it's true though that the worst of the losses were earlier in the year, and the markets regained some territory in the fourth quarter. And while there are some reasons to be a bit more optimistic, as we head into 2023, we believe that volatility will continue, there are going to still be some economic ups and downs in the year ahead. And for that, we have of course planned and are managing our portfolios accordingly.

As we kick off the new year, higher inflation and higher interest rates remain key concerns. What are our expectations for 2023? Also, what are the themes that we watching that will impact markets this year?

[Craig Maddock 18:24] Well Alex, that was a huge deal last year. Inflation spiked, as you mentioned, for a variety of reasons. And importantly, the world's major central banks had an incredible response, increasing interest rates faster than we've seen in decades. We’re talking, you know, 400 basis points or 4% increases in both Canada and the U.S. in a very short period of time. And after years of low inflation and low interest rates, now that was the shock to markets for sure.

Of course, central banks have made it very clear that they're planning on bringing inflation back down, they will keep interest rates elevated, you know, as long as it takes or as high as it takes, and we've certainly seen some progress on the inflation front with inflation starting to ease over the past few months. Now the CPI, which peaked in June has come down. And as these rate hikes from earlier in the year are now starting to make an impact on spending habits and behaviours of consumers. And so, while inflation is still a concern, and interest rates will likely continue to climb or at least, you know, remain elevated through much of 2023. I think there's also a real probability that we'll see, you know, either rate cuts later in the year or at least a view that the heavy lifting on the rate rises will start to decrease, especially if we do see a recession into this year.

[Wesley Blight 19:35] All of that activity that Craig just described made for a pretty dramatic year for bond investments. But on a go forward basis, it puts us in a pretty interesting place. And because bond yields are so much higher now, bond investments are a lot more appealing than they were a year ago and quite frankly, they're a lot more appealing than they were at this time in 2021 and 2020 and 2019. And that's because we were in this environment where yields kept just moving down, down, down, down as policymakers became more and more accommodative.

Now that we're in this environment where policymakers have moved to a more restrictive monetary policy that has boosted bond yields higher, which means on a forward-looking basis, because the starting yield of bonds are so strongly correlated with the total return that we get from bonds, that makes fixed income investments a lot more appealing now than they have been in the recent past.

What are some of the opportunities we see for 2023? And how are we positioned to take advantage?

[Wesley Blight 20:53] From my perspective, what I just mentioned around bond investments, I think that is the one area where we are seeing a significant opportunity for added value. And we're always evaluating things, but one of our processes is an annual review of our upcoming capital market assumptions. And these are our long-term capital market assumptions. And as a result of that analysis, what I just mentioned about bonds, we are expecting higher investment returns across the board on a go forward basis. Now, this is long term, so think 10 years, and at that higher portfolio return is largely being driven by the more compelling bond yields that we're now experiencing.

But it's also true for equities, and that last year is poor performance has led to some more attractive valuations. And we recognize that the economy may experience some challenges this year, or in any year for that matter. But the cheaper entry point that we now have, provides a little bit more wiggle room and it provides a little bit of a greater opportunity for us to realize a stronger return from equities going forward as a result of valuations now being lower than where they were at this point last year.

Any final words for our clients?

[Craig Maddock 22:08] Well Alex, hopefully, you've heard that we're on top of things with respect to managing our portfolios as we move into 2023. While we do expect continued volatility, we also are optimistic that things will start to settle down, that the ability for us to generate better returns out of our total portfolios in 2023 will be certainly better than 2022. But of course, we always encourage our clients to work with their advisors* to make sure their policy and portfolio fits with their long-term needs as we continue to navigate through, what could be a bit of a volatile 2023.

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