Craig Maddock, Vice-President and Senior Portfolio Manager, and Mark Fairbairn, Portfolio Manager, look back at the second quarter of 2022 and discuss what’s likely in store for the near term. Topics discussed include market events, economic conditions, portfolio performance and more.
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Markets have transitioned into a more challenging period. What has caused this correction?
[Craig Maddock 0:56] Well, a myriad of events and conditions have led to the bear market we find ourselves in today. This continued volatility we've seen this year, which is a pullback in equities and in fixed income markets, is unique. It's very highly complex but connected series of events.
Of course, the main culprit today is high inflation. But that didn't happen on its own. It was quite frankly, fueled by excessively easy monetary policy, so think of that as low interest rates for years, combined with the more recent global pandemic – of which we're not quite out of the woods on yet, as physicians are acutely aware.
This pandemic led to a stay at home and or work from home culture. And that shifted our spending from services – like food and entertainment, to goods – cars, electronics, home furnishing, homes themselves, and of course, investments. Because people couldn't go to work and their demand for stuff to be made or shipped, you know, real ships, and not just Amazon delivery people, that was going up significantly and I'd say things got out of whack pretty quick.
You got on top of that, excessive fiscal spending. So, $1.9 trillion was given out to U.S. citizens to help them through the pandemic – it’s pretty much no surprise that the price of most things have gone up and quickly as the reopening demands have outpaced any reasonable supply.
And that started to get to normal or some semblance of order, right around the time that Russia decided to invade Ukraine. And since then, it's pretty much all fallen apart. So, we've seen high response to inflation, which has been swift and severe – you think of inflation, it's measured in the price of the goods and services we purchase. But on top of that, we've seen excesses building into things that nobody needs, like cryptocurrencies and NFT's. When I guess people have money to throw at anything, they'll throw it at anything regardless of its purpose, something's really amiss in that environment.
So now we've seen the shift to, from a bubble-ish environment to a bursting of the bubble, as we've now moved from an environment of greed to, I'd say, an environment of more fear.
There has been a rotation in top performing sectors and styles – what do we need to know about that?
[Mark Fairbairn 3:20] Yea there has indeed been a sharp rotation at play within markets so far this year. And in many ways, it's just a reversal of the pandemic period winners and losers. In general, growth stocks had led the market in recent years, and they've gone parabolically higher during the pandemic and are now seeing their valuations come back down to earth, while the more out of favour companies are tending to do better.
An example of this is if you took the pandemic period from December 2019 through to December 2021. In Canada, the biggest contributor to the rise of the [S&P/TSX] Composite was Shopify. It was a big beneficiary of the move to online shopping during the pandemic. At its peak in November 2021, it had gained more than 300% from its pre-pandemic levels in December 2019. However, it is now down more than 80% from its peak and trading well below its pre-pandemic levels, with the bulk of those declines having come year-to-date.
Another pandemic winner from Canada was Lululemon. So, as workers traded in their business attire for trackpants during the work at home period, the stock at its peak doubled in value, but year-to-date, it is also down around 30%.
You're seeing a similar story south of the border. So, Netflix doubled in value during the pandemic because everyone stayed home and watched Netflix. But it's now down 70% year-to-date. And Zoom Communications which at one point was up over 500% from its pre-pandemic levels, is now back to his pre-pandemic levels and down 40% year-to-date.
It's not just these growth stocks feeling the pain. Anything that really benefited from the speculative mania that hit the market, including cryptocurrencies and SPACs, have really come in sharply year-to-date. While energy companies, consumer staples, utilities and other such boring companies, have held in better.
And on the reversal side, energy is the clearest standout of something that went from untouchable to the current market darling. Energy has underperformed for several years as ESG and stranded asset risks have really limited the attractiveness of energy companies to global investors.
However, over the course of the pandemic from 2019 to December 2021, while global equities were quite strong, due in many ways to the strength of large growth names that have come to dominate the benchmark, the MSCI World [Index] for example, which is a benchmark index for global developed equities, returned 20% annualized over that two-year period over the course of the bulk of the pandemic. However, over that same period, the energy sector within the MSCI World [Index] did not participate at all in that bull market. It was essentially flat and USD terms. However, fast forward to current year-to-date, this too has seen a reversal. while the broad global markets as measured by the MSCI World [Index] is now down 20% through June 30 in USD terms, the energy sector within the MSCI World [Index] is up nearly 25%.
Tight oil inventories, under investment and newfound capital discipline within the sector has contained supply, as demand has surged post pandemic. This tight supply demand dynamic was only exacerbated by the Russian invasion of Ukraine, sending energy prices surging higher benefiting the energy sector.
A criticism we've heard in headlines is that central banks have acted too slowly with regards to interest rates and inflation. From our perspective, what's going on there?
[Craig Maddock 6:30] Yeah, it's a true Alex, a lot of people have been criticizing that the Fed, as an example is, you know, been behind the curve, right, so too late to the party. And, you know, I'd say it's pretty normal that the Fed is behind the markets, markets tend to price in what they believe interest rate policy needs to be and the Fed eventually catches up.
I'd say with this one, they were like off the track entirely, right. Like it's, it's an order of magnitude, as far as not really seeing what was happening until it was too late. And to be fair, the Fed was commenting on that they believed it was transitory or inflation was going to be transitory, it was going to be high and that the supply demand imbalances that really kind of, that we’ve been grappling with through COVID, that we've talked about earlier, were really the cause of this higher inflation. And, quite frankly, it was the supply demand imbalance that would eventually fix itself, which would, of course, bring inflation down.
Unfortunately, inflation has been persistently higher than the Fed, or many others actually, thought. So they are, you know, arguably well behind the curve and have to step in this year with much more aggressive policy. In fact, some of the most aggressive policy moves that we've ever witnessed from central banks. And that's mainly because inflation has been on a very steep ascent, following the supply constraints that we've talked about.
So thinking, the likes of Bank of Canada and the Fed accelerating their rate hiking policies in order to bring down inflation and high inflation expectations, there is now the risk of a policy induced recession, right. You mentioned the R word earlier, I think the risk for recession now in the facts of quite aggressive tightening policy, is much higher than clearly it was just short few months ago. So far, the Fed’s raised 150 basis points year-to-date, so 1.5% from essentially zero interest rates. Bank of Canada is up 125 (Note: The Bank of Canada has raised rates an additional 100 basis points since recording this podcast episode).The June hike for the Fed was really the biggest rate increase we've seen since 1994. ECB is also now on board to say they're going to start hiking in July. So clearly, things are getting tighter, right, things are getting more expensive to borrow.
Markets now expect that central banks aren't even halfway done their hikes in 2022. So as much as a lot of work has been done so far, this is the sort of behind the curve part, the market expects that the Fed will have to increase another, call it 170 to 190 basis points by the end of the year. So again, about halfway through the expectation, and you think about what that does to the cost of borrowing, that certainly makes it a painful move as aggressive monetary policy gets reflected into the markets.
So, for us now, we don't think there's a lot more pain to come. We think that that sort of behind the curve has now been caught up and what the markets are anticipating the Fed will need to do within policy rates for the remainder of the year, is likely priced-in. So, unless we see significantly higher inflation, so something to come in that really dislocates things further, or some of these increases to interest rates that we've seen so far not work to try to bring down inflation, it's a pretty good chance that what the curve has priced-in, is going to line up pretty much with what the Fed will likely do.
I think the important thing is the Fed and Bank of Canada and central banks around the world are all committed to bring down inflation. They know that that's not the only thing that has to happen. There's going to be a lot of other things that will need to come together in order for these tighter financial conditions to ultimately bring down and slow down the growth of the economy.
U.S. Federal Reserve Chairman Powell was recently quoted as saying the U.S. economy is in strong shape. How do we feel about that statement and what do we think about the broader global economy?
[Mark Fairbairn 9:59] Yeah, right now the U.S. economy, on many metrics, is in strong shape. The labour market is very tight, low unemployment rates, there's high numbers of job vacancies relative to job seekers, the ISN manufacturing survey level of 53 – that’s still consistent with growth, the services PMI is higher still at 55, reflecting the strong demand for travel and other such services.
Part of the reason for the sharp uptick in inflation and the Feds shift to tight monetary policy is reflecting that the U.S. economy is strong, likely too strong relative to the productive capacity of the economy at this point. And monetary policy is therefore too loose for the current strength of the economy, which has contributed to higher inflation.
You're seeing similar dynamics at play outside of the U.S. as well, Canada, Europe, Australasia, are seeing similar patterns. The one key exception, being China, which due to the pursuit of COVID-Zero policies and resulting lock downs, is lagging behind, but it's showing some acceleration most recently.
However, while conditions right now are strong, that is generally always the case at the end of the business cycle. And many of these indicators that I just described that are used to describe the current strength of the economy are, in fact, lagging indicators. Employment being the most notable of them.
So, when we look forward, financial conditions have already tightened considerably and are likely to tighten further. And the fiscal spending impulse or the rate of change in government spending is slowing. You have high energy prices, high inflation that's eating into disposable incomes, you know it's going to weigh on demand of consumers. And while business surveys still point to growth and are at strong levels, the trend in those surveys is down. And many of the leading components of those surveys, like new orders to inventory ratios are signaling further deceleration.
So, all told, while current conditions do look strong, it is the direction things are going that has us and markets frankly worried.
Absolute performance was challenging in the second quarter, given the performance of broad markets. Focusing on relative performance, how did MD Funds and Portfolios do?
[Craig Maddock 11:53] Well, you're spot on Alex, over the last quarter and year-to-date now, both equities and fixed income have drawn down materially as these tighter financial conditions and attempting to slow down this high inflation is really taking hold.
Now to be fair, periods where equities and fixed income both decline are very rare. That happens less than 10% of the quarter since the 1970s. But of course, they create angst and reduce investor confidence in their portfolios to meet their financial plan because it's very rare, as I said, that both equities and stocks decline at same time.
And part of our role in these environments is capital preservation. And year-to-date, our most conservative fixed income-oriented portfolios have performed well relative to benchmarks and added value coming from our both short duration positions within the domestic bond component, as well as our overall allocations within corporate bonds. Relative to peers, the [MD] Precision Conservative Portfolio would be top quartile year-to-date, and over the last three months, that ranks in the sixth percentile year-to-date.
A similar defensive mandate, the MD Precision Balanced Income Portfolio ranked second quartile year-to-date. Over the last quarters in the income-oriented MD Precision Canadian Moderate Growth Fund is similarly well ranked in the second quartile.
Portfolios with a higher equity allocation have not performed as well. Over the last three months, are aligned with the results of their benchmark as strengths from outperforming Canadian equity exposure was offset by the relative underperformance from an overweight allocation to U.S. growth stocks.
On a pure relative basis, the MD Precision Balanced Growth Portfolio has had a competitive result in the second quartile versus its global equity balanced category. But merely aligning with its benchmarks has produced a third quartile result for others in the last three months.
Fixed income performance has been a focus recently. Are yields still climbing? Has the selloff calmed?
[Mark Fairbairn 13:51] Yes, the selloff has calmed. While yields have moved dramatically higher for much of this year, recently, we've seen yields stabilize and even come back a bit. For example, the 10-year U.S. Treasury yield, it reached a high of nearly 3.5% in June, but at the end of the quarter came back in to 3%. Similarly, the Canadian 10-year yield peaked at 3.6%. This has come back in to end the quarter at 3.2%.
As we've discussed, you know, the sharp rise in interest rates globally has really been about inflation being higher and stickier than expected and the realization that central banks are behind the curve. So, it was really inflation concerns just continually driving interest rates higher. But, higher interest rates tighten financial conditions and that slows growth – and if they rise too much or too fast, they can even cause a recession.
Today, yields on bonds are, you know, at the highest levels they been in 10 years – [they] are much more attractive. We've talked a lot about, in the past about TINA, There Is No Alternative, given low yields. Now there is an alternative and with these higher rates and rising concerns over recession, which is typically a good environment for bond returns. Investors are starting to look back at bonds as more of a defensive asset again.
So, the market has become more focused on growth risks as opposed to solely focusing on inflation risks. And with that, bonds have found support and yields have come back in. That said, it might be a bit too soon to dismiss that the bond volatility is completely over. G10 central banks like the Fed and Bank of Canada have remained that it’s dependent. But they've fallen so far behind the curve on inflation that the credibility is on the line here.
So, we're probably going to need further signs that inflation is firmly trending down likely via several readings of lower or lower than expected inflation, before major central banks really pivot to a more dovish monetary policy stance. So, it might be a bit too soon to ignore inflation just yet, but the situation has calmed substantially from earlier in the year.
Is a recession coming? Is a bear market the base case? What is the most likely scenario?
[Craig Maddock 15:46] Yeah, I'd say we think the global economy is headed towards a technical recession, Alex. That's two quarters of negative GDP growth. So, think two quarters of the world producing less stuff than previously. I think that's likely an outcome of this higher [interest] policy, right. So, no surprise, higher response to high inflation is higher interest rates, tighter financial conditions, that just means the cost of money is more expensive. And that means companies and people will borrow less, spend less, have less to spend and therefore demand less. All those things, which suggests that as a global economy, we need to produce less.
And also, given the years of excesses, people aren't really mentally well prepared for an economic slowdown. We've been living off of very low interest rates for quite a while. It's produced all kinds of different outcomes. And some of them are a bit odd when you're kind of looking at them from the sidelines and wondering why people are doing those things. But I think now you're in this environment where the slowdown almost becomes this sort of self-fulfilling prophecy where things get slower because the financial conditions are tighter. And in and above that, creates more cautious behaviour, which creates more of a slowdown, which again, just starts to feed on itself until eventually, things grind, not quite to a halt, but you know, slow down, and we ended up finding ourselves in a technical recession.
Now, it's difficult to know exactly how investors are going to act against this backdrop. Will they try to front run it and you know, eventually all bad things come to an end, right, when you sort of think these bear markets don't last forever, but with this more expensive debt, the most recent negative performance, both in bonds and equities, you know, the highest risk assets getting just crushed, so basically, all the bubbles that were out there have kind of been burst, maybe the one caveat being housing. I’d say we're definitely in for a more prolonged bear market.
So, bear market think of, that's typically again, similar to a technical recession, a bear market is when markets are down 20%. But I think generally, we're in an environment where the trend for risk assets, and in particular equities, is likely to be down with the headwinds of the, basically the monetary policy response with higher interest rates. It's a pretty good chance that we're going to continue to face that headwind for the foreseeable future.
I think however, the bigger question is, so what? Or what's an investor to do if the odds of a bear market or recession are higher today than they were several months ago? People don't like this, but the short answer is, do nothing. I alluded to it a little bit earlier, but you know, bear markets do come to an end, they do end with the start of a new bull market. And if you went back through history, and even though bear markets can last months, and in some cases years, the bull markets that follow, tend to last for several years and the outperformance in the bull market more than offsets the pain that you endure in the bear market. So clearly, if people have the right time horizon in mind, to stick with it, is the best answer. And it's going to be able to serve them well.
A lot of investors are going to be challenged right now, for instance, to add to their portfolio because of high inflation. So, that high inflation means the cost of goods and services that you buy are higher, your ability to have discretionary income, or quite frankly, savings, are going to be challenged for a lot of individuals. I'd say our physician clients are very fortunate that most of them have sufficient income to withstand the higher inflation and continue to save or add to their investments during this downturn. And let's face it, bonds are cheaper today than they were several months ago, stocks are cheaper than they were several months ago, it's a good time to buy, not to say it couldn't get to be a better time to buy in the coming months. But clearly, if they were to continue to add to investments during this downturn, that's going to serve you very well for the long term.
What are some of the highlights from the recent portfolio adjustments we’ve made?
[Mark Fairbairn 19:53] Yea as Craig noted, we do see a rising risk of a downturn and recession, and this has led us to become more defensive in our positioning. So, as you noted, we moved to be modestly underweight equities, that's the most impactful shift that you'll have at the total portfolio level in terms of controlling the overall volatility. But we've also shored up our defensiveness elsewhere within the portfolios.
So, we've added to our positions to longer term fixed income in our bond pools, as well as the MDPIM Global Tactical Opportunities Pool. We have trimmed our exposure to riskier fixed income investments like high yield bonds in favour of government bonds. Within our relative equities, we have underweighted European equities, seen as the most at risk of stagflation and the geopolitical risk. And we're also underweight emerging market equities, atypically more volatile asset class that doesn't typically do well in recessions.
Finally, within our currency strategies, we've eliminated our long positions in higher carry emerging market countries. And have moved to add exposures to safe haven currencies that tend to hold up better in recessions such as the U.S. Dollar, the Swiss Franc and the Japanese Yen.
However, while our view is that we are entering a period of economic weakness and contraction, we don't see it being a particularly deep or prolonged recession as Craig alluded to. That, together with the declines that we've experienced here today, keep us [from] going max defensiveness in our positioning, as we recognize the market has discounted a fair amount of bad news already.
As such, at this point, we're actually spending about as much time looking for both signs that things will continue to get worse, but also trying to make sure that we don't miss the indicators that it's time to start adding risk back into the portfolio. Because if nothing else, when your equities go up over time, if you're underweight equities over time, that's a losing trade. So, you have to be very cognizant of being aware of, you know, when it's time to no longer be scared and to start dipping back into the portfolios and ensuring you're there to capture the long term return on equities.
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