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Episode 20: Stubborn inflation, rising interest rates and expensive stocks

Craig Maddock, VP and Senior Portfolio Manager, and Ian Taylor, Assistant VP and Portfolio Manager of the Multi-Asset Management team look back at 2021 – headlines (inflation, interest rates, valuations, metaverses and cryptocurrencies) and performance, MD fund and portfolio takeaways and what lies ahead for 2022.

 

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Thank you again to all the doctors and health care professionals out there for taking care of us at this time. While you’re focused on public health, we here at MD are committed to protecting everything you’ve worked hard to achieve. We are here for you and your family. If you have any questions about topics covered in this podcast or your financial plan, we are here to help.

In the first episode of 2022, Craig Maddock, Vice-President and Senior Portfolio Manager, and Ian Taylor, Assistant VP and Portfolio manager, reflect on the continuing recovery and other headline makers throughout the year including inflation, interest rates, metaverses and cryptocurrencies. Next, we moved on to the state of the global economy, MD Funds and Portfolios and where things are likely headed in 2022.

The equity market recovery has been impressive, albeit a little uneven across geographies and sectors. What were the most outstanding supporters and detractors to performance?

[Craig Maddock 0:59] Well, to start off Alex, portfolio returns ranged from about 4-up-to-13% in 2021, which clearly is exceptional, well ahead of our long-term expectations. What’s equally impressive now is two-year compound returns range from 5-to-11% for portfolios. So, when you consider that we witnessed one of the worst stock market drawdowns in history, at the advent of COVID-19, it's really incredible that portfolio returns have been this good.

And as you mentioned, the force behind these exceptional returns was the strength of global stock markets. The MSCI World Index, which is a proxy for developed market companies, was up over 21% last year alone. Hardly points to an image of a global pandemic.

Now, regional variations, however, shone through, so [the] Canadian stock market was up, pretty strong last year, at 25%. And close on the heels of the S&P 500, up 28% in Canadian dollar terms. So North American markets were very strong, and quite frankly, well ahead of Europe, as well as developed Asia, which were still strong, you know still really good returns and well above their long-term averages with a return of about 11%.

And unfortunately, the bottom of this list last year was emerging markets, running in at minus 3%. That's probably no surprise, given the response to COVID has been very different. It's had different impacts on industries as well as different impacts on countries around the world. China, for instance, has maintained a zero COVID policy. They also cracked down pretty heavily on their big technology companies last year, which really hurt the Chinese stock market, which is a big component of emerging markets.

In contrast, you look at the U.S., been pretty lax with respect to COVID and the U.S. stock market has been a clear winner in that work from home transition. So, you see like technology darlings like Google or Microsoft, or the likes of Amazon, benefiting really strongly and continuing to propel the U.S. stock market well ahead.

So overall, it was a really good year for portfolio returns. And in particular, investors willing to take risk. Risk was clearly well rewarded in 2021.

What happened with bonds and energy prices?

[Craig Maddock 3:04] Bond markets did lag however, they produced negative returns of around 2.5%.

That's not because bonds failed to pay their interest, or that they're really viewed as any riskier now, but interest rates have actually started their slow climb from exceptionally low levels in response to higher inflation.

And then a very notable contributor to performance last year was energy. Oil prices were up significantly, energy stocks had one of their best years in a long, long time with over 50% return for the sector.

We also saw very strong returns from real estate, as prices moved up pretty significantly around the world.

So, the energy move was definitely a help to our portfolios. However, oil companies are a much smaller weight in our portfolios compared to just a few years ago. So, while that was strong, the benefit doesn't have the same kind of impact on portfolios as it once did.

Why is inflation still a problem and what is our base case for inflation?

[Ian Taylor 4:05] As you point out, Alex, prior to the pandemic, the global economy was a fairly well-oiled machine. Decades of globalization and improving supply chain technology made it such that demand could, for many goods, be satisfied fairly quickly, anywhere in the world, be it from inventories or relatively short manufacturing processes.

Now, the nature of the pandemic resulted in a number of significant headwinds to this system. We have asynchronized lock downs of global economies. I've talked about that a lot on this particular podcast, and subsequently, you know, staggered and inconsistent re-openings. We also saw unanticipated changes in what consumers demand and add to that, you know, not even recovery in the labour market and the lagged impact of both central bank and government emergency measures and you have a recipe for a pretty significant challenge that the modern economy has never really had to face, and that is inflation.

You know, our take is that not all is lost when it comes to inflation, you know, there's base effects that are impacting this. And there are these ripple effects from the disruption of the pandemic. And eventually, some of those will clear once we're more confidently through the health crisis.

And then at that point, you're going to have to look back and think where we were prior to the pandemic. And we were living in a world with historically low inflation, which was supported by technological innovation, globalization, and a maturing demographic in developed markets. And it's likely that some of these forces are going to reassert themselves in the global economy.

So, inflation may remain elevated, you know, for the next coming months. At some point, we think, you know, the more secular forces that will pair with a normalisation in the economy, will start to reassert themselves despite some long-lasting impacts from the pandemic.

Quantitative easing is starting to wind down, and it appears that rates are going to start to rise. Where do we see rates going in 2022?

 

[Ian Taylor 5:59] Yea, so Alex, as I just mentioned, you know, we're talking about higher inflation, but paired with the higher inflation is actually higher growth. And along with that higher growth, we are seeing closer to full employment markets.

Now we know certain sectors that have been really battered down by the nature of the pandemic, talking about travel and tourism and hospitality type stocks, for example, or services in the restaurant industry. And there's still challenges certainly within areas of the economy, but the overall picture of employment has improved quite a bit. So as these re-openings occur, we've definitely seen, you know, those statistics improve and continue to be strong.

And that would argue, and rightfully so, that there’s no longer a requirement for emergency policy measures. And we're still sitting at very, from a policy, monetary policy standpoint, very low levels of interest rates. There is still this, you know, the activities of quantitative easing, continuing from many central banks around the world. And it really is time for them to raise interest rates and move away from some of these emergency measures.

So, if you look at what the [U.S] Federal Reserve is projecting, they're basically looking at three rate hikes this year and potentially three rate hikes next year. It's not even across the committee. So, you may see, you know, two rate hikes this year and four next year, or some other combination, depending on how things evolve over the coming months.

I would say that it's very likely that we're going to see interest rate hikes here in the first half of this year, as growth remains strong and inflation remains fairly robust. As we look into 2023 however, you know, the global economy is going to start to decelerate towards the end of 2022. There is prospects for inflation to potentially normalise. And that may call into question rate hikes for 2023. So, it'll be something that we continue to monitor.

But ultimately, long run interest rates aren't going to go much higher than 2-to-2.5% regardless, from a North American perspective, simply because there's sort of secular forces and global forces that are going to downplay on those interest rates.

How will this impact our client’s investment portfolios or their broader financial plans?

[Craig Maddock 8:04] Yeah, we don't believe the long-term impact of this is going to be negative. In fact, the current interest rate cycle and the increase we're going to see here, it's not going to prevent clients from meeting their long-term objectives.

We've just recently updated our capital market estimates. And for bonds, we're projecting about a 2% return over the next decade. And equities are of course higher than that, coming in at around 6%. So, a portfolio that would target about 8% risk overall has an expected return of around 5%. While, that's a little bit lower, like 0.2% lower than our expectations from a couple of years ago, it's still in the same ballpark. So lower, but not meaningfully so.

So, based on that, and very strong recent results, I would say that the estimates look quite reasonable. Now, however, clients who are a little bit closer to retirement, or maybe drawing an income from their investments, that 2% expected return on bonds is lower than maybe it's been historically, and that could impact their financial plans.

But that's a last few years phenomenon as opposed to, you know, the very recent impact of the inflation that we've seen show up. So, I'd say in this case, it's prudent for clients to reassess their risk tolerance, look to see if a higher return portfolio is beneficial to them, and, you know, obviously comes with some higher risk, but they may want to add things like higher yielding bonds, such as those that we'd see in emerging markets, or investments in things like private credit could be an added benefit to portfolios that are highly dependent on fixed income returns.

Equity markets are at all time highs. Is what you're seeing in the recovery, policy decisions, growth and earnings potential supportive of all these lofty valuations?

[Craig Maddock 9:38] I mentioned the U.S. market was really strong last year with returns of 28% in Canadian dollar terms. That was fueled in part by very strong earnings growth. So that's a good thing. We saw earnings in the S&P 500 [Index] grow at over 20% last quarter and over 50% for the year. That was off a low base, so you know, we had seen a major decline in business activity when businesses were shut down at the beginning of COVID and we've seen that recover. And we're now at levels of earnings per share well in excess of where we were prior to COVID.

On top of that, stock market participants have really latched on to some of the fastest growing companies and propelled the Russell 1000 Growth Index, as an example, to a very high price relative to its earnings. Things are expensive. At a price of 36 times earnings for growth companies, investors are paying twice as much for lower growth companies as they are to value companies that are trading at more like 18 times earnings.

Now to be fair, growth companies have been growing much faster, they are reshaping our future and they're enabling all sorts of hopes and dreams. But I'd say things feel like they're a little bit out of touch with reality. I've used this example before, but the automakers is probably the best one to kind of highlight this.

The market capitalization of Tesla is now over a trillion dollars. If they sold a million cars a year, which they're not there yet, that would equate to a $1 million market cap per car sold per year. If you compare that to Ford, with a market capitalization of $93 billion, and global sales of over 5 million cars a year, you get something closer to $20,000 in market capitalization per car sold per year.

So clearly, when it comes to stock market valuations, there's something amiss when a single company can attract so much capital, and a willingness of investors to pay over 300 times earnings for its future potential of quite frankly, a car company.

That's just one example, Alex, of the winner takes all theme. And that's really throughout the market at this moment. And because of that, it's generally difficult for traditional stock picking to do well, when returns are so substantial. Think of the U.S. market, basically anything we bought last year that didn't return over 28% put us behind the market overall.

Another way to look at that is if we started the year, the beginning of 2021, and we found a great company with an exceptional expected return of 20% and we locked down and it worked exactly as we expected, we'd still be behind the market by over 8% last year. So, in a more normal year, finding a company with a 20% return would be exceptionally good.

But as we look forward, and I think you know, we're trying to find attractive ideas that may be accessible at more reasonable prices. We had a recent conversation with Doug Rao. He's a portfolio manager at Janus investments. We're talking about some exciting themes going forward. I think this one's really exciting – he was talking to us about the metaverse, so we obviously know that the company recently changed the name to Meta in a pitch for this and actually today, I noticed that Microsoft bought Activision also in its pursuit of its move towards the metaverse.

You know, what is the metaverse? It's being considered as the sort of third phase of the internet. If you think back years ago, we had personal computers connected to the internet, that was sort of the advent of the whole thing. And we had handheld devices like our phones, which obviously now are, you know, minicomputers that are connected to the internet. And you think of video games and cloud computing and social media or Zoom calls, there's so many things that have allowed us to really connect virtually. And that's the introduction of technology, the speed, the processing power, there's just so many pieces that are connecting the dots to create now what is coming to light is this concept of this Metaverse.

This idea that we could create a 3D virtual world, so not this two-dimensional environment that we're living in. But think of 3D and replicating, the best we can using technology, the real world we live in. So, interacting in a three-dimensional environment, no mute button to stop hearing someone in a chat when you're talking to somebody. And that virtual world can quite frankly, be anything as opposed to just showing up at a Zoom meeting, think of a virtual world where you leave your virtual house and drive to your virtual work and show up there and have meetings and interact. But just like you would have normally done when we weren't in the COVID world, except you're actually doing it and feeling it and living it virtually.

Radically different concept than where we're at today but I think all these technologies are colliding and potentially enabling this for the future.

So, when you think things like that, there isn't just one company that's going to build it. It’s going to be a whole bunch of technology companies coming together, threading this together, and I think you know, the runway for this from a growth perspective is massive. And of course, if we're in it now, hopefully closer to the beginning than the end, the profitability that we can get by owning into this is quite substantial.

The headlines aren’t as noticeable, but the increasing tensions between China and the U.S. didn’t just disappear. How is this situation developing and what can we expect throughout 2022?

[Ian Taylor 14:39] Yeah, so definitely, this is a longer-term theme, Alex. You know it's difficult to understate the relative importance of the ongoing power shift in China and we've talked about it a lot on this podcast. In the 2000s, you know, China gained prominence on the global stage becoming a dominant player in global manufacturing as well as a key driver of economic growth globally, partly through its demand for commodities as it built out its domestic economy.

In the 2010s, China had to begin a journey away from the rapid early growth it had experienced, as it became more prominent on the global stage. And late in the decade, had to start dealing with some of the excesses that had built up as a result of the rapid growth over the prior decade. And then more recently, we've seen a significant political shift that's sort of aligned with that, as power has been taken away and a bit more decentralised and become more concentrated and consolidated once again, by President Xi Jingping.

 

And so, what we have seen over the last 12 months has definitely been a less market friendly, more inward-looking China. For investors who want to benefit from future growth out of China, this raises a number of questions. In particular, as a shareholder, are your interests aligned with those of the Chinese government, and will you actually get to participate in this growth potential?

Our take is that it's a delicate balance for investors and that it will be increasingly selective regarding opportunities within the region, which is why we partner with asset managers who have significant stakes in the region. And just to reiterate, like how big the difference was last year, if you take a look at the peak of the MSCI China Index, which is representative of how investors internationally might otherwise gain exposure to Chinese stocks, they are down 35% from the peak. That compares to the MSCI World Index, which is a measure of the developed markets, which is up 13% over that same period. That spreads 50%, it's a 50% difference. So that's pretty significant, I would have to say.

What about Brexit and the European Union?

[Ian Taylor 16:38] I think one of the reasons, obviously there's a number of competing headlines that can only get so much attention, I think one of the reasons why you're hearing less about it, is that it's definitely more of a domestic situation, a more regional issue than any concerns around a global, you know, potentially global risk-off event at this point in time.

 

So, we've moved past, certainly most of the uncertainty around Brexit, and now it's getting into the details and the execution of it. And this is going to create challenges and long-lasting potential problems in particular for the U.K. But you know, it doesn't all have to be sort of bad, there were certainly a lot of contention at the E.U. level, driven by some of the groups out of Britain. And now that that's less of a, less of an issue, perhaps – perhaps you'll start to see a bit more unity out of the Eurozone. And it has been interesting, because the pandemic has, in some ways, reduced and maybe moved more quickly, the Eurozone towards, something that there is definitely resistance to but ultimately would make a lot of sense, is fiscal consolidation through some of the pandemic emergency responses.

 

You know that's probably not a popular outcome for some folks. But it is one of those things that has basically alleviated and again, if you go back a decade from today, things were much different in the Eurozone and certainly we didn't see that much stability. So as much as there's challenges that are being faced regionally, as a result of you know, what is essentially political strife, there's other offshoots of that that may not be as negative.

Of course, you know, the European Union was set up, in part to overcome some of the challenges that were faced through some of the World Wars. And clearly, there's some pretty significant tensions with Russia at this point in time, and we talked about the potential for an energy crisis. So, at some point and at some level, U.K., and the Eurozone and broader Europe, need to coordinate on those measures, whether it's, you know, through the European Union or in some other way.

But we understand that, you know, some of those linkages will continue long after Brexit is completed.

We’ve had a pretty strong stance on cryptocurrencies in the past. Any new thoughts as we begin the new year?

[Craig Maddock 18:58] Well, we currently have 0% of our client assets invested in crypto and that still seems like the right amount to me. As you know, Alex, we've done a lot of research, a lot of thinking about the role of cryptos in our portfolios, both as a currency as well as a potential investment. Unfortunately, the case for cryptos is still not clear, not at all.

Some suggest it's a digital gold, and it could have utility in the same way as a potential hedge for inflation. So given the fact that we were just talking about inflation, and we're, you know, seeing that it could stick around for a while, maybe you want a hedge for inflation, and if it was one that would be valuable.

Others think it may be a store of value, or that somehow it's rare like gold and that there's only so many of them made. Of course, you mentioned there's, you know, been new ones created. So there's been thousands of cryptocurrencies developed and scarce is not certainly one of their overall features.

The volatility, however, seems to be, so you mentioned the, you know, going up and then coming back down. The recent current is down and we probably seen a number of major cryptocurrencies have dropped, you know, 50% from their peaks, which clearly is not the first time they've done so.

Others would suggest that it's a good portfolio diversifier because it has low correlation to other investments. And while that's true, the history on it's pretty short, so take that for what it is. But it's extremely volatile, and it's uncertain when or why its price will move. So unfortunately, low correlation is just not sufficient to justify an investment. So we still remain at 0%.

What do we see for the global economy in 2022? And how will it impact capital markets? And by extension, investment portfolios?

[Ian Taylor 20:35] Well, this is the $95 trillion question, which is really the size of the global economy, which is down $10 trillion more than it was at the end of 2020, after rapid growth in 2021.

So, as we look to 2022, generally, we still see growth being above long-term potential. And so that's generally a good thing. And most of, you know, that might be a bit more concentrated here in the first half of the year, and certainly into the spring as economies open up more and more. And then with the potential of slowing down later in the year and entering into 2023.

So, from a growth perspective, it's sort of a tale of two halves. You've got, you know, above potential growth, which is good, but it is decelerating. It is decelerating relative to where we've been. And so, when I talk about what the impact is for capital markets and investment products, there are implications.

One, it's not the worst time to be invested from a stock market perspective, or risk asset perspective, but it's certainly not the best time. You know, Craig just talked about valuations, it's unlikely that we'll see valuations continue to rise in this type of environment, especially as we start to see potentially financial conditions tighten through higher interest rates or higher bond yields anyway. And as a result, most of its going to have to come from earnings growth if you're looking at the stock market, for example. And so, the good news on that front is we do expect positive earnings growth in an economy where we see above potential growth.

The other considerations are certainly inflation, which is a risk and you know, if it continues to be elevated, which you know, we don't think is unreasonable in the short term, but it should start to come in throughout the year. But if it does continue to be elevated, you're likely going to see a more significant tightening of financial conditions. You're going to see a capital market start to reflect a higher risk of recession than is currently priced in. And that could create some downside risk as we move closer to 2023 and certainly into 2023.

With that in mind, how are we positioning our client’s portfolios?

[Ian Taylor 22:34] Well, certainly in the short term, we'd like to be a bit more opportunistic. So, when we're looking, and generally the shortest lens we’ll apply to the markets is on a 12-to-18-month framework. I certainly don't think that we are, you know, you'd be able to capture a lot of the short term – like anything shorter than that consistently if you're looking at a, you know, more of a market cycle perspective. And, as I mentioned, although it's not the best time, and it's not the worst time to be invested. So, we continue to maintain a procyclical exposure across most of the portfolio, but on a much reduced risk level than we've been doing in the past. So just taking less, we see it as less opportunity for upside. as a result, our positions have gotten smaller.

And you know, at some point, we may have to make changes to that. So, I think it's really important at this point in the cycle to make sure that there's flexibility in your portfolio to adjust as things evolve throughout the year. And so, when we talk about procyclical positions, that would mean that we still maintain a higher than benchmark allocation to stocks within the portfolio, we are underweight bonds as a result, and we've talked about the potential for interest rates to go up. And as a result, bond yields further out on the curve to continue to rise potentially. So that would benefit that positioning as a result.

We still maintain allocations to corporate credit, which has been very healthy, and even higher yielding corporate credit where the credit ratings are less credit worthy, but we don't see a risk of recession, which is, I think, the key summary point, we don't think there will be a recession in 2022. And most of those asset classes should fare well. But we will need to, you know, keep a close eye on it. And that's why we've certainly introduced some flexibility in the portfolio. Should we need to change our allocation, as we start that 12-to-18-month view, it starts to price in more of 2023 than 2022.

To end, can you talk about the responsible investing trend and our approach to it?

[Craig Maddock 24:34] Well these themes are starting to build momentum in our portfolios. At the same time, we have not done a wholesale shift to, you know, clean and green as an example. As well we talked about electronic vehicle companies which are very expensive, as are many of the associated industries that are linked to the EV businesses. So, lithium as an example was up 400% in 2021. So that transition to the electrification of vehicles is an interesting one but an expensive one.

If you look deeper however, there are some good opportunities and companies that will benefit from the climate change. Our green solutions compared to their global peers, but perhaps can be purchased at much more, I'm going to call it, cost prudent prices. One example of that would be like Daikin, which is a Japanese air conditioning company. They're a leader in green energy and energy efficient refrigeration systems. No surprise, with climate change, there is a growing need for air conditioning, as well as people are looking for greener solutions or more cost effective, more efficient air conditioners to run. So, companies like Daikin can become very interesting, the long-term runway for the growth of a company like that as high, as well as the profitability is good. And of course, it's not priced to take over the entire market like some of the EV companies.

Now I mentioned, we're moving in this direction. Our approach actually started back in the 1960s, back when the Canadian Medical Association, our former parent company, lobbied the government to reduce tobacco use. And as a result, they restricted the MD Funds from investing in tobacco. And that restrictions still exist today in the MD Funds.

And then a few years ago, a very passionate group of physicians made a motion to the Canadian Medical Association to divest of fossil fuels in our portfolios. As I mentioned, we didn't make that decision uniformly across all of our portfolios, because unfortunately, that wasn't actually a view shared by all physicians. So instead, we decided to develop a fossil fuel free set of portfolios, specifically for clients who are passionate about making sure they're not investing in fossil fuel.

Then even since then, we've introduced the investing responsibly strategy at MD. And our objective is to really know what we own, not just from an investment perspective, but also a company's impact on its social and environmental issues around it. And armed with that knowledge, we're now able to engage directly with companies in an effort to influence them better, to make them better stewards of the environment and the social impact that they have. And if we identify companies that are deficient against practices that we think are really important to physicians, we can let them know. We can set expectations for them to improve things through time.

So, our aim now is to use the collective scale of our investments to make a difference. But however, we're going to remain true and committed to delivering strong investment returns.

 

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