Craig Maddock, VP and Senior Portfolio Manager, and Ian Taylor, Portfolio Manager, of the Multi-Asset Management Team of 1832 Asset Management reflect on the third quarter and discuss their outlook for the rest of the year. Topics discussed include inflation, the interest rate environment, economic conditions, portfolio performance and more.
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Looking back at the third quarter, markets were as volatile as ever. What happened?
[Craig Maddock 0:52] Well, in technical terms, it was a veritable poop show. By the end of the quarter, equities were down, making it the third consecutive quarter of negative returns for equities. On top of that, there was really no place to hide as bonds and commodities also fell in price.
It wasn't a straight line down. The quarter did start with optimism that inflation was coming under control – central banks will be in a position to pivot away from the tight monetary policy that have been wreaking havoc on the markets for the last little while – and that, of course led to a bear market rally of 18% from mid-June into August.
Now as the quarter unfolded, it was evident that inflation was in fact a little stickier than some people had hoped. And employment remained stronger, resulting in even bigger policy rate hikes and more scheduled to come. Now this of course resulted in markets down about 5% for the quarter. And I have to say, it's starting to look a little bit more like 2008-2009 when we saw, you know six consecutive quarters of declines.
And while the nuances across stocks, sectors, geographies, interest rates, foreign exchange markets are influenced by more than just rates and inflation, at the heart of the long-term value for any asset is based on its risk and return potential, the short-term price moves are based on a change in expectations and even more, a change in sentiment. And we are clearly seeing a tug-of-war now between those that remain bullish, after years of easy monetary policy, leading to low bond rates and high equity returns, and of course, those that are bearish.
Now, aside from holding on to blind optimism or seeing good valuations against a long-term backdrop, the evidence does suggest more headwinds ahead. Surveys on investor sentiment indicate investors are at levels of bearishness we haven't seen since back in 2009. And rates continue to rise around most of the world, and of course, that's because inflation is remaining sticky. I’d say the only real bright spot was that commodity prices declined, and that gave some relief for energy users.
Markets have started October off with a bang, what's happening there?
[Craig Maddock 2:46] With the volatility across all assets at really high levels, it's no surprise that we're going to see wild price swings in both directions, just like the jump we saw at the beginning of October.
When you think of volatility, it's the measure of uncertainty, and I think this is a very important reminder to investors when volatility is high, it's because market participants are unsure of the future. Of course, that means that the recent past, very recent, is a horrible indicator of what might be to come. It could be true, or in fact, the exact opposite could be true. And really, no one knows for sure.
In the second quarter, we saw a rotation in top market performers -- winners becoming losers, and vice versa – has this continued to play out?
[Ian Taylor 3:29] Alex, we’ve absolutely seen a continuation of that theme. But at the same time, what we are seeing is, and I think Craig alluded to this, a broadening-out of the concerns over what's going to happen within the economy over the next 12 months.
So, where at the beginning of the year, you know, we saw certainly some of the euphoria around some of the stocks that did extremely well, through the real height of the pandemic, start to see the price of those stocks fall materially.
And we're talking about some of these really growthy names out of the U.S. That certainly happened in the first quarter. We saw that continue, as I mentioned, so even like Zoom was down. Zoom, obviously one of the bellwether stocks on work from home, down over 30% as more people returned to the office over the quarter. But we also saw stocks, like Alphabet, the parent company of Google and Meta, which is now formally known as Facebook, both those stocks down significant through the quarter. And remember, they get a lot of their revenue from advertising, and if we do get into a pretty sharp economic contraction, marketing budgets are easy to cut, unfortunately, for some.
But, as we look more broadly out of that, we did see other sectors start to participate in the declines, which to me, and I think, to our team, as we look at this and assess, is looking more at less concerns around just the inflation and interest rate picture and now more concerns around growth.
So even real estate stocks, utilities, consumer staples, so really, the decline starting to broaden out a bit more. And we certainly saw a broad base both not just from a sector perspective, but country as well. And I think, you know, obviously that's not a good indication that things are going to rebound from an economic standpoint anytime soon.
Interest rates have risen aggressively, and expectations have also been revised higher in the near term. Is this in line with our thinking?
[Craig Maddock 5:18] Well Alex, if you just look back to January of 2021, Canada 2-year bonds were at 0.2%. 10-year bonds were paying 1.3%. Fast forward to the end of June, we were seeing rates at 3.1% for two years and 3.2% for 10 years. That's a big change in a very short period of time. Over the quarter we've also seen a significant increase in the short end of the interest rate curve where the 2-year rates moved up to 3.8%, the 10-year started to move back down towards 3.2%.
Now this was of course, driven by central banks working hard to fight inflation. We started the quarter with the Bank of Canada policy rate at 1.5%. We saw two hikes in the quarter, one massive at 1%, and another one at 75 basis points. [The] resulting target rate is now 3.25%. This massive shift in bond rates since the beginning of the year, quite frankly, front running central banks, we expected most of that heavy lifting on rate increases was behind us.
And I think generally, that's what we've experienced. The way that the rate increases is such that the yield curve inverted in the quarter, that means you get a higher rate for the short-term bonds than at the long end. It also means that market participants feel the impact of these higher borrowing costs will work to tame inflation, and rates can move back towards normal.
Our current thinking is that normal, you know for long term neutral rate is probably something like 2.5%, which means that interest rates should eventually move back down once inflation starts to moderate.
Regarding interest rates, what can we expect longer term, when will rates stop rising?
[Craig Maddock 6:50] Well, the timing of this is really hard to know for sure. The impact of interest rate moves is typically felt in the economy several months into the future. This has been one of the most significant policy responses to rapid inflation that most people have ever seen.
At the same time, jobs are still plenty, consumers have the willingness and the ability, it seems, to pay higher prices, which continues to drive up inflation. And I suspect central banks around the world are going to continue on their coordinated path of financial tightening, until they, quite frankly, break the will of the consumer. People in aggregate need to change their behaviour for the policy response to stop. And ultimately, they’ll have to change significantly for things to reverse course. And that's going to take several months at least, and of course, it can easily be over a year.
Where is the global economy at, and how will things develop over the next 6-to-12 months?
[Ian Taylor 7:51] The global economy is almost assuredly slowing down at this point in time. And we can see that with some of the incoming data that we watch which is more high frequency. And it's a direct result of the policy decisions that are being made to slow things down to tighten financial conditions. And all these things play into that.
So, you know, when we're looking into 2023 – 2023 is almost absolutely sure to be a very weak year for the economy. And we talked really early this year about the fact that the risk of recession would rise throughout this year. I think at the time, maybe that was a bit more out of consensus, it's certainly not an out of consensus view today. The risk of recession is very real.
And if we look across the globe, clearly, Europe is the one that's in focus. Now, at the beginning of the year, I would have argued a bit more that Europe is probably, from a structural standpoint, a little better positioned than it was last decade, with more stability in its financial system, a little bit more cohesion at the ECB (European Central Bank) level. And as a result, perhaps better able to tackle the coming challenges. But clearly, the energy challenges that are very present and are not going away in the immediate future, are creating a higher risk of recession out of Europe. Clearly, that's well known, but those risks are going to materialize over the coming months.
If we look to the U.S., the U.S. is a bit more resilient. We've seen that, continue to see the economy expanding at this point in time. And even the interest rate increases that we've seen year-to-date, haven't necessarily had the opportunity to play through. I mean, Craig mentioned some pretty stark changes in bond yields. While the implication, and I'm sure for many of our listeners, if you think about it, the U.S. 30-year mortgage rate, and this is similar in Canada as well if you look at mortgage rates here, it's gone from about 3% last year to 7% today. And so, home sales have really only moderated to pre-pandemic levels and prices are still elevated. So, there's lots that still has to be worked through as far as the implications from such a dramatic change in, you know, the cost of borrowing, which has a real impact for the day-to-day lives of individuals and the decisions that they make.
So, those things still have to play through the economy, and we continue to focus, and the biggest focus will remain on inflation, and inflation remains at historically high levels. Expectations for inflation to cool have not materialized. So, if we look at month-over-month readings, and not only is it remaining elevated, but it's more broad based, which means it's becoming more ingrained in the economy. Which means that policymakers probably have more work to do in order to bring that down to a level that's more supportive of sustainable growth longer term. So, this is going to continue to put pressure for months to come and into 2023, which again, will make it a very weak year.
Maybe just if we go beyond, you know, the western world, if you look into China, that would be one area where they're not facing inflation. They're facing more deflationary forces and some of the similar deflationary forces that the western world focused in [on during] the Global Financial Crisis, because there was a property market that used to be red hot and is now deleveraging. So that, on one hand, we do expect China to stabilize over the next 12 months. But they are constrained in the sense that they cannot stimulate their economy to the same extent as they have in previous crises.
So, all of that adds up to a global economy, when you look at the three biggest economies of the world, all facing challenges, from a domestic standpoint, to just an overall slowing growth in the economy and a much higher risk of recession in 2023. You really have to look, start looking beyond that, before we see some optimism at this point in time.
How has our defensive tactical positioning worked out for us over the quarter? Have we made additional tweaks?
[Ian Taylor 11:27] Well, obviously, with the developments in the market, having a defensive positioning has been more rewarding over the last quarter. And that's despite a pretty strong mid-summer rally, as Craig alluded to. But that rally did give us the opportunity to add to some of our defensive positioning and ultimately benefiting, as that rally faded, and ultimately defensive positioning was rewarded. So, we continue to keep that same sort of lens on the portfolio.
But with some of the significant moves we've seen in, not only fixed income, but foreign exchange markets, we have narrowed some of those positions, simply because, you know, they've moved to pretty, I wouldn't say extreme levels, but certainly elevated levels on such things like the U.S. dollar, when we look at bond yields.
And then the stock market – so the stock market was one area where we continue to remain fairly significantly underweight. You know, you could argue that it was overvalued to begin the year, I think the valuations have come in, that's a bit, you know, a bit of a better story. But the cyclical forces of the sort of the downtrend in the economy remain in place. And I think that's not something that's going to go away immediately overnight. And I think that's where investor sentiment, it's going to be hard for it to turn in this kind of environment. So, despite things being, you know, volatility being elevated, and that means you can get some pretty significant rallies, we’ll continue to maintain a defensive positioning.
At some point, when things look the worst, is oftentimes, can be the best time to invest. The outlook, the longer-term outlook for asset prices and for returns, again, if we get beyond this 12-to-18-month period, where there's almost certainly going to be a sharp slowdown in the economy, that's starting to look a lot better. And so, at some point, you're going to want to look at that as a material opportunity. But for now, we continue to maintain defensive positioning.
Bond yields started to climb again, and the U.S. yield curve inverted, what do we need to know about this?
[Ian Taylor 13:16] Yeah, some great jargon for our investors who hopefully don't focus too much on this. But, at the same time, Craig kind of alluded to it.
So, an inverted yield curve, what that means is, generally short-term interest rates are lower than longer-term interest rates or bond yields. So, if you look at a government of Canada, you know, a 2-year bond versus a 10-year bond, the 2-year bond is usually, you know, at a slightly lower level than the 10- year bond, because the 10-year bond has a bit of a what we call like a term premium. So basically, there's some risk of lending to even a government as safe as Canada over a 10-year period. You're just not sure what's going to happen from a growth and inflation period versus what happens over a 2-year period.
That said, the 2-year bond or the shorter time term bond is more influenced by central banks, because policy, they have the flexibility to adjust rates at the very, very short end of the curve. When the yield curve inverts. So, when short term interest rates, again, we're saying like one-to-two years out, are higher than long term interest rates, so say 10 years or more, what that generally means is that monetary policy is tightening and is expected to tighten in the very short term or remain very tight. And so, interest rates are going to be very elevated in the short term.
But what that ultimately does, what it ultimately does, is lead longer term growth and inflation expectations to be a little bit more underwhelming. So, versus when you have the opposite, it's more optimism around long term growth and inflation. Here, the expectation is, is that all the heavy lifting that we were talking about, what central banks are doing at this point in time, are ultimately going to stabilize inflation and return growth to a more sustainable trend, which you know, is lower than where policy rates are today.
That would be the situation where the curve is inverted. And again, it's not something that you expect to remain the case for a very long period of time. So as central banks start to become more dovish at some point in the future, because the economy has slowed, you'll see that relationship change once again. But it is a clear sign, that right now, that we are in a period of pretty significant financial market and policy tightening. And that's reflected in the bond yields.
How did MD portfolios perform? How are they charting versus long-term expectations to achieve client goals?
[Craig Maddock 15:27] Well, given the extreme volatility we've seen in all asset classes so far this year, I'd have to say it's a bit of a relief to say that portfolios held up reasonably well in the quarter.
We had both bonds and equities down in the quarter. So, all portfolios lost, but they lost about 1%, a little bit more, a little bit less than 1%. That leaves year-to-date performance at a range from around a loss of 10% to around a loss of 17%. With most of that coming in the first part of the year.
If you look longer term, which is what our expectations are built around – so 3-year returns are now below our long-term expectations with returns just slightly positive or slightly negative. But for the most part, you'd say 3- year returns on portfolios are flat.
And with the recent sell off in both bonds and stocks, Ian was suggesting this, and I fully agree, that the future is looking quite promising. As the economy will moderate, these things are going to happen, inflation will come back into balance, and that interest rates will come off their peaks. portfolio returns going forward should be extremely good with outsized gains possible for both bonds and stocks.
Of course, it's impossible, as we mentioned, to know exactly when this will happen, or if things will get worse before they get better, it's a great time to be investing if your time horizon is long enough. You think of the rebound coming off market drawdowns, have typically been very large. I think most people can recall the what we called the v-shaped recovery from the drawdown and recovery coming out of the early stages of COVID when markets were up almost 60% off the bottom. If you look back longer term, the average return five years post market bottoms is almost 100%.
So, for me, long enough term going forward, things are looking pretty good for portfolios.
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