Craig Maddock, VP and Senior Portfolio Manager, and Ian Taylor, Portfolio Manager of the Multi-Asset Management team chat about what happened in a somewhat volatile first quarter. Topics discussed include the return of stock market volatility, inflation proving more stubborn than anticipated, the path for interest rates and the impact of Russia’s invasion of Ukraine.
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At the beginning of the year, we were talking about stock markets being at all-time highs, since then, we've seen downside volatility strike back. What happened?
[Craig Maddock 00:49] Well Alex, it kind of reminds me of my last trip to Canada's Wonderland sitting at the top of Leviathan. We were at the top of the roller coaster in the beginning in the quarter and it's been quite a ride so far. But you know, brace yourself, I don't think it's over.
A lot has happened in a very short time period. At the beginning of the quarter, we were we were cautiously optimistic that [the] Omicron wave would subside, spring would hopefully bring a renewed sense of positivity that would keep stock valuations high, supply constraints would probably ease and although, you know, monetary conditions were a bit tighter, things were looking pretty good.
We've been monitoring central banks around the world, in particular, the U.S. Fed, trying to figure out when and how much they would hike interest rates. It seemed a little bit benign at the beginning of the year, perhaps they were of the belief that inflation would be transitory and they wouldn't have to do too much.
And then, of course, geopolitical risks were rising with Russia advancing on Ukraine at the beginning of the year and the world believed that the impending attack on Ukraine was likely just an enhancement or advancement of the invasion that started back in 2014 in the Donbas/Crimea region. Of course, to our shock and surprise, the action turned into a full-scale invasion back on February 24th.
So, the good news is that Omicron and COVID, apparently, or looks to be, abating. The world is coming back towards something that resembles normal. There are still some flare ups in areas like China and other regions in the world that are, you know, a concern, but I'd say globally, it's definitely not the risk that it once was.
Maybe the bad news is that the U.S. appears to be, well the U.S. central bank appears to be a bit behind the curve. I'd say they waited maybe a little bit too long for the data to show that it was time to tighten. Now the fear is that the U.S. Fed might have made a policy mistake and that now is going to have to act more aggressively with higher rates faster, in order to slow the quite overheating economy. That's having a major impact on markets so far this year. We've seen bond rates jumped significantly in anticipation which is also causing corresponding markets to fall in value. And it's brought stock markets down with that as well.
And as I mentioned, this full-scale invasion of Ukraine by Russia has certainly elicited one of the most severe global sanctions to ever be placed on Russia, effectively shutting its economy off from the rest of the world. And this is added to the already uncertain economic backdrop and has therefore increased volatility across assets even further.
On the market level, you know, we saw the S&P  sell off about 13% in the quarter. However, it did manage to recover a lot of that ground to be down only 5% by the end of the quarter. So, if you just looked at that headline number, you'd kind of miss the volatility that's been masked within that. You'd also miss the change of leadership that took place over the quarter. Oil prices surged 35% in the quarter, making energy the best performing sector by far. And the Fed hike took the wind out of the sails of many non-profitable tech stocks, along with a number of others, which gave growth stocks one of their worst quarters in quite a while.
With these events in mind, what were the biggest supporters and detractors to performance?
[Ian Taylor 3:59] Well Alex, there was a lot of dispersion across asset classes throughout the quarter, across global capital markets. And perhaps not surprisingly, when we reflect on the developments Craig just outlined, commodity markets and Craig, you know, alluded to oil, but more broadly, you know, all were sort of strengthening through last year as the global economy was moving closer to being more fully recovered and reopened as the pandemic situation improved.
Commodity prices leaped higher even further this quarter, eventually, as the reality of Russia invading Ukraine set in. Wheat and corn prices were up more than 25% – the region is a very significant exporter of these commodities. Natural gas prices in some regions were up more than 60%. Brent crude oil was up just over 30%. Aluminum prices were up more than 25% and nickel prices up more than 50%. And if we extend just beyond the quarter and incorporate those gains that I mentioned over the past year, some of these commodities are up more than 100%. So more than double in just one year period of time.
And all this materialized in an environment, where we already had elevated inflation. So, this creates an increasingly challenging environment for central banks globally. Price stability mandates are now being heavily questioned and as a result, bond yields rose significantly over the quarter. The Canadian 10-year bond yield, for example, was up close to 1% in the quarter. And then due to the increased uncertainty around the economy that associated with all this as well, corporate bond yields even rose further up close to 1.5%. And it's very rare to see an environment where you see government bond yields rise, and the spread of corporate bond yields to government bond yields, rise at the same time, and this created an environment for one of the worst quarters for bonds since the 1970s.
Now in the stock market, Craig mentioned the S&P 500 ultimately being down 5% for the quarter, although it was down further at some points in the quarter. Other markets fared quite well. In particular, markets like here in Canada that have a higher allocation to commodities and financials. The TSX was actually up more than 3% as energy companies within the index rose more than 27%, further highlighting the dispersion across markets.
International stocks, though, which are more exposed to the geopolitical risks that materialized throughout the quarter, were down more significantly. The MSCI EAFE, so Europe, Asia, far east and emerging market indices were both down close to 9% in the quarter.
And then when we looked at currency markets, the U.S. Dollar which had been strengthening, benefited further as uncertainty increased and was up 3% against the broad basket of currencies. Actually, within that though, the Canadian Dollar performed even better, and marginally outperform the U.S. Dollar as well. So, all told, it was an eventful quarter indeed.
How did all that translate into performance for MD Funds and Portfolios?
[Craig Maddock 6:46] Given the plethora of risks facing markets in the first quarter, it's not a surprise, this was not a great environment for our portfolios. Returns ranged from a loss of about 4% for conservative portfolios to a loss of just over 6% for portfolios with higher allocations to equities.
[The] best performing fund in the quarter was the MD Dividend Growth Fund, which is a Canadian equity fund. So, it was up 3.5%. However, most other funds would have lost money in the quarter. MD Bond Fund was down 5.9%. So, Ian's comments around how troubling the bond market was and how it was the worst since the mid-70s, no surprise with a negative return of almost 6%, that was not really helping portfolios, especially as those that are viewed to be more conservative in nature. And then, of course, international growth [mandates] and MDPIM Emerging Markets [Equity] Pool were actually down over 14%. So that international effect plus growth on top of that certainly was not favorable to those two mandates.
Now, good news I guess, is over the quarter, we saw our value funds perform better than growth. So [MD] American Value Fund outperformed its growth counterpart by about 6%, although both did lose money in the quarter. And that is in stark contrast to what we've seen over the last several years where growth had been significantly outperforming value.
Our best absolute performing strategy in the quarter was our small cap Canadian mandate. So, think of, you know, materials and energy prices rising rapidly, and it has a higher exposure to that. So, it was actually up 2.25% over the quarter.
And while the quarter was volatile, it does come off the back of several years of very strong performance. So, investors have had a longer-term track record to reflect on – they should feel pretty comfortable that even with the most recent sell off in markets, their portfolios have been growing at a healthy rate. And for most investors, they're still well ahead of their long-term expectations. Quite frankly, that means they should still be in great shape financially.
What is our position on Russian assets and what is our stance there?
[Craig Maddock 8:49] Well, first off, I'd like to recognize the humanitarian impact from Russia's invasion in Ukraine. I'm just completely appalled with the actions of [President] Vladimir Putin, and I do hope that as a global society, we can do more to help the people of Ukraine.
Notwithstanding that, you know, we want good things to happen for them. We had made investments in Russian securities prior to the invasion. We've actually long held investments in Russian oil and material companies as well as large Russian banks. And quite frankly, up until the Invasion of the 24th of February, they've been pretty good investments.
Putting aside the very visible and negative geopolitical atrocity that we're seeing unfold every day, business in Russia had actually been improving for many years. Russian oil companies were highly profitable, they were paying large dividends and they were trading at deep discounts to their global counterparts. So, they were pretty good investments.
Part of that discount, however, was due to the state-owned involvement of many companies. Of course, the corruption that's well known within Russia and previous sanctions. And these discounts in the stock prices, however, we're more than compensated for investors for the risks and the reality of that time. Unfortunately, that reality has changed very quickly and we along with all other global investors in Russian securities who are stuck, as those stock markets closed.
So, we still unfortunately hold our Russian positions today, as the markets are closed, we do not have a reasonable way of exiting our positions. Additionally, they're worth, you know, small fraction of what they were worth at the time we purchased them. And of course, they're worth a small fraction of what they will be worth, if things move to some form of a settlement.
So financially, we'd probably be irresponsible to sell them right now at a small fraction of what they could be worth, even if we could. From a social perspective too, I believe we are best to hold on to our Russian securities for now as well. By holding on to them, I'm confident we are not providing any benefit to Russia, or [President] Vladimir Putin. Whereas if we do sell them, we wouldn't know who would buy them. And who would benefit potentially from the future change in value. It is a tough decision, but I do feel it's the right one.
We hear about tighter financial conditions all the time now, what are we talking about and what does it mean?
[Ian Taylor 11:02] You know, as an industry, we certainly use a lot of jargon. So, I really actually appreciate your question, Alex. So simply put, you know, tighter financial conditions really refer to an environment where money begins to flow less freely throughout the financial system, and as a result, the economy.
So, financial conditions can become tighter deliberately, for example, when central banks raise interest rates, as the Bank of Canada and U.S. Federal Reserve are doing currently, in an attempt to prevent the economy from overheating. And of course, interest rates, it's the cost of money, so as interest rates go up, people will borrow less, so there's less flow of money there. And in fact, it entices people to save more, because you know, the savings generate more interest, and therefore less money flowing through the financial system.
But financial conditions can also sort of tighten on their own due to stress in the financial system, from geopolitical risks, or, you know, other events that cause investors to be skittish. And you know, what we witnessed in the first quarter was sort of a combination of both these scenarios. And when that happens in the financial system, when you get stress in the financial system, the stock market can become a bit of a casino – but on the other side, there are legitimate credit channels through bond markets, that all of a sudden, you know, issuance is down, and that really has an impact on the economy directly.
So more recently, some of that tightening is absolutely warranted. The employment picture in most developed markets has improved markedly. And there are signs that inflation expectations amongst businesses and consumers are becoming more entrenched. And higher inflation can be problematic for the economy. It makes it more complicated to make business decisions as companies struggle to pass through cost increases to consumers. And it can influence consumer behavior, who may choose to put off purchases if prices unexpectedly rise too quickly.
And you have to recognize that even my whole generation, we're not used to inflation. So, it makes it, you know, it is an uncertain environment, it does create uncertainty, and certainly central banks are becoming increasingly concerned about price stability, and now they're embarking on a more meaningful plan to raise interest rates in the coming quarters.
Quantitative easing/tightening and the rising of interest rates – where are things likely headed this year?
[Ian Taylor 13:20] Talk about more financial jargon. Certainly, quantitative tightening is an interesting concept to try to explain. But, at the beginning of the quarter, and I think Craig alluded to this, we felt like we had a pretty good handle on what central banks would do throughout the year as inflationary pressure from the economy, you know, moving closer to full capacity, was going to be somewhat offset by the clearing of supply chains and a rotation of demand from goods to services. And we thought that, you know, would help bring the economy back into a more healthy balance as the pandemic receded. And so, you could have this balance between interest rates going up at a gradual pace and sort of inflation coming down at a more gradual pace.
Unfortunately, a number of events through the quarter have made the inflation picture much more complicated. So, we've talked about the outbreak of war in Europe, and the resulting sharp, really sharp rise in commodity prices across the commodity complex. And it's not just oil, it’s you know, materials that are key to manufacturing. It’s agricultural prices and things like fertilizer, that's all going to lead to higher food prices.
And then at the same time, what we're seeing now as well is more lockdowns in China as it confronts the very contagious Omicron variant of the virus while still pursuing a COVID Zero policy. And this once again, may have an impact on supply chains. So overall, what that means is that central banks are going to raise rates more aggressively, they're going to reduce the size of their balance sheets more quickly, which means they're literally selling bonds and therefore, interest, yields across the curve, and that can influence housing prices – we’re already seeing, you know, mortgage rates move up materially – and they're unlikely going to get any data in the near term because of these new inflationary pressures that are combined with what was already present in the economy. They're unlikely going to get a significant sign that we're getting meaningful deceleration in inflation in the coming months.
And all that means is that there's a heightened risk of a policy mistake. And what is that? That's when interest rates have risen so high, that you end up slowing the economy more sharply and likely recession risks will begin to build through that period and it’s certain that recession risk are going to rise. It doesn't necessarily mean that there will be a recession within the next 12 months, but as you look beyond that, the impact of the decisions they make over the coming months is going to have a significant impact on the economy when it comes to 2023.
One of the big changes that we saw towards the end of the first quarter was we moved from an overweight equity position to an underweight in our portfolios. What was our thinking there?
[Craig Maddock 15:51] Yeah, and given the conversation to date, Alex, I don't think it would be a surprise. I don't think he and I have talked this negatively or dire in any of these calls in the past.
When you think of our tactical position, time horizons, typically looking out 12-to-18 months, and we're trying to figure out where we think things will go. And, as Ian mentioned, you know, the long end of our, sort of, vision for tactical views right now is well into 2023. And there's a lot of risks to the global economy that we're dealing with today. And we expect we're going to be dealing with for a while, and they do have the potential to further deteriorate equity returns. We saw some of that happen in the first quarter. Saw a bit of a bounce back. But you know, we've been overweight equities for a while. I like to look at, you know, to say time to stop and read the writing on the wall. And it's all the things are saying there's risks, right, there's, you know, flags popping up, there's things that are of concern. Things aren't as positive as they once were. And it's probably time and therefore we have started to take a defensive posture.
And we say, we've started to, we've really just moved from an overweight to a slightly underweight equity [position]. We're not saying, you know, go to cash now, it's, you know, we still have most of our equity risk within a portfolio being exhibited today. So, it's as I say, a small move in that direction, as things are just not as good as they once were, right.
So year-to-date, financial conditions have tightened. That's true. We've also seen, fiscal and monetary policy become more restrictive. And of course, seen the Russian invasion of Ukraine. Inflation doesn't look as good. Rising commodity prices, just all of these things we've just sort of outlined, creates a very challenging environment for policymakers, and therefore makes a very challenging market for us from an equity, fixed income perspective.
As Ian mentioned, we're not predicting a recession at this time. But let's face it, the risks have risen. The possibility that we face a recession in the next, whatever coming years, is much higher than it was perhaps just a few months ago. And as a result of that, we are now underweight, very small position. But we will continue to monitor this as we move through the business cycle, and of course, continue to adjust portfolios accordingly.
Within the equity weights, the only overweight is still to U.S. equities, why is that?
[Ian Taylor 18:14] And really, that is the change in this quarter. So, we came into the quarter with a more optimistic view on, actually European assets, relative to actually more assets in Asia. And clearly the picture in Europe has changed. But you know, clearly the thesis around that, the reopening theme was stood to benefit Europe, more so than the U.S.—Europe had stricter lockdowns, so it had more room to recover from the reopening theme. Obviously, tourism is a big industry in Europe as well.
So, it was a number of factors that looked like they were going to benefit Europe entering into this year. But obviously the potential for, and what is legitimately, an energy crisis, in some respects, creates a lot of risks to the economy in Europe. And then with our, you know, our broader picture changing a bit more, we feel that U.S. equities are well positioned, they definitely got some companies that are much higher growth, and much higher quality in the sense of their balance sheets. So, they can withstand multiple potential scenarios that could be evolve over the coming 12 months.
So even if we avoid, you know, if we do avoid a recession, it is going to be a sharper slowdown. And so, not looking to add too much cyclicality into the portfolio. But do want some of these companies that are going to do well, maybe on a longer-term basis, more of a secular basis.
So that's really the rationale for that positioning, Alex.
On the fixed income side, we remain interest rate risk neutral, and we continue to target a flattening of the U.S. yield curve – what does that mean, and why are we pursuing this?
[Ian Taylor 19:44] Well, we've had a more of a flattening bias. So, and I'll explain what that is because, again, it's good to understand what that is, but really, the research that we've done shows that at this point in time, when we get into an environment where there's higher inflation and central banks are compelled to raise interest rates that the yield curve flattens. And that's definitely what we've seen. It's flattened significantly and even in some parts of the curve, have inverted.
So, what does that mean? Well, let's take an example. It's basically short-term bond yields, so shorter term, so they mature sooner than longer-term bond yields, short-term bond yields rise more quickly, you know, and there's other ways that it can flatten, but in this scenario, if we take a look at Canada, the 2-year bond yield was up 1.4% over the quarter. And what does that reflect? Well, it reflects a greater, it's more closely tied to what the central bank is likely to do, because you could think, you know, it's a 2-year period, it's fairly short term, what the central bank does within the next few years is going to have a big impact on what happens to that bond.
The 10-year [bond], however, which is more anchored in growth and inflation expectations, but still influenced by policy, it rose, but it only rose 1%. So, 1.4% is greater than 1%. And as a result, we would say that curve, from the 2-year, if you looked out to the 10-year, has flattened. And really that reflects that the economy is later in the cycle, it's closer to full capacity, markets are starting to anticipate that central banks are going to raise rates more meaningfully. And when I talk about growth, inflation, that generally means that growth and inflation won't be as robust as you thought it was going to be a year or two ago because now you have to start pricing in tighter monetary policy, tighter financial conditions, as we've explained, that in effect dampens what your average growth will be over that 10-year period, for example.
Can you give us an update on inflation?
[Ian Taylor 21:33] Well by far it's the most important focus for financial markets over the next 12 months. You know, if you look at the last decade, huge disinflationary pressure and even deflationary pressure coming out of the global financial crisis. Consumers were restoring their balance sheets. The financial system had to be repaired. And that took a number of years, and it was a slow economic recovery in that context, if you look at unemployment and how long that took.
Now, we're in this period where we've got high inflation, it's something we haven't had to face for a long time. And if the central bank starts to raise rates, but inflation still stays at high, high levels, then that's going to compel them to have to raise interest rates even further. And ultimately, if inflation continues to push higher, right, then you're basically, you almost need to induce the economy into a contraction in order to bring down inflation.
So, on the one hand, you know, many of the expectations we have coming to year may still ring true. There are signs supply chains are easing, there are signs that consumers are rotating from goods purchases towards more services. And this is helping to balance out supply and demand. And there are signs inventories are starting to rise, for example. So, all of these indicators would confirm that a better balance is more likely to be achieved. And as a result, inflation should come in.
And when you think of some of the components of inflation that really move higher, I don't know if you've looked at used cars lately, but certainly if you were shopping for a used car 2 years ago, or 3 years ago, you'd be quite surprised at the prices of used cars today. But there's lots of room for them to actually fall. So instead of seeing this significantly high positive number, and we're talking 30, or 40% increases in some areas, you could actually see a negative number next year at this time. And that would be the counter argument that at some point, as central bank raised rates, you know, we expected that they would start to see inflation come in and come in more meaningfully.
The complicated part is the situation in Ukraine and the situation in China. Commodity prices are an input to all sorts of things. So, whether or not you're looking at inflation, outside of commodity prices, it still has an impact. And then we have the nature of these lock downs in China, which we're not sure how long that's going to last. And these all add to inflation dragging out. So, we're not going to have a really clear picture and inflation is going to be high in the near term. So, that creates that risk that the central banks will raise rates too high. And then the only way really, at that point, you know, the economy will react, and inflation will have to come in, but it's not really a good scenario, because the economy will come in along with it, then you end up in a recession.
What is our current base case for the global economy? What's realistic in terms of market performance and, by extension, MD portfolio performance for the rest of this year?
[Craig Maddock 24:14] Well, as you've heard already, our proprietary business indicators place us firmly in the tightening phase of the business cycle, talking about high inflation, positive but declining [Purchasing Managers’ Index]. PMIs are sentiment indicators for how optimistic businesses are and still shows that businesses are growing but at a slower pace than they were previously. And of course, gross domestic product, which is high compared to history, but it's also trending down, and all those things suggest that you know, things are slowing and we're in a tightening phase of the economy.
And in that environment, equities can be positive or negative. And I'd say this is where the issue we're challenged with right now is they’re likely to skew a bit lower. Hence, we've taken a slightly more defensive position. As well, interest rates typically rise, but as we mentioned, a lot of that work seems to have been done in the first quarter of this year with this massive rise in interest rates, so it may be hard to figure out whether there's much room left to grow, to go with interest rates, or whether they've sort of hit where they need to go.
I'd say that's actually pretty good news for long term investors, while there's definitely some volatility. So, you know, it's, it's going to be harder Alex to give you a confident prediction of what will happen in the next 12 months. But the good news is for our long-term investors, which quite frankly, I hope is all of the clients that are listening to this, rates are now higher than they were just a few months ago, that is better for long term returns in portfolios.
Additionally, we've seen some of the excesses come out of equity markets, which do make them more attractive in the long term. I've been doing this now for over 30 years and this is one of the most difficult markets to have a lot of confidence in right now. There's just so many variables. And I know there's going to be some extreme winners, and there's going to be some extreme losers as things move forward. And quite frankly, knowing which one is the right one in advance is impossible.
So, for me that reinforces the benefit of our well-diversified portfolios. You think of them, they're diversified by asset class, investment style, sectors, currencies, and the experts that are actually making decisions on our behalf – all diversified. And I'm confident that that collective wisdom is what will achieve the most suitable outcome for clients, no matter what we experience next.
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