In this commentary:
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Chief Investment Officer
One advantage of writing a monthly commentary on financial markets and the economy is that you end up with a library of real-time thoughts that you can later return to and learn from. In reviewing our 2020 year-end commentary, here’s what we found interesting.
Lessons learned in 2021
The commentary, An optimistic eye on 2021, reflected (as the title implies) that we liked the outlook. Economists were calling for strong global growth, rates were low, and the view on corporate earnings was very robust. All great signs for equities and, indeed, the forecasts were correct. It was a great year for many global markets, and the best of times for Canadian and U.S. stocks in particular, which gained well over 20%.
Despite the strong year-end results, 2021 was full of surprises. For instance, economic growth was very robust (likely around 4.5% in Canada) but fell well short of forecasts at mid year, which called for over 6% growth. The COVID-19 vaccines were effective, but we still ended up with three waves and are now at peak case counts due to the Omicron variant (something few predicted, including us). Inflation spiked above most forecasts and supply chain issues became front-page news. The list of surprises goes on.
Our takeaway from 2021 is that the news flow is endless and easy to get caught up in. We’re bombarded with data points, most of which are not very useful. Staying focussed on the big picture instead is key. In 2021, the big picture was that strong economic growth coupled with low rates would lead markets higher. The precise numbers didn’t really matter.
Different year, same optimism
Although 2021 will be a hard year to beat for equity markets, we’re still positive going into 2022 but know there are more clouds on the horizon.
On the positive side, economic growth is forecasted to be very robust again in 2022, with economists seeing 4% growth in developed economies like Canada and the U.S. This compares very favourably to the 2% growth rate we were experiencing pre-pandemic. Most economists believe 2023 will be a stronger-than-usual year, with Canada forecasted to grow close to a 3% rate. It’s hard to be pessimistic when looking at these growth numbers.
Perhaps the biggest potential headwind (outside of the pandemic) is inflation. Pre-pandemic, we were used to fairly stable prices with the annual inflation at or below 2%. Several factors have pushed prices up (supply chain issues, low rates, and government spending programs to name a few), and the debate is whether this is temporary or has become more structural.
Figure 1 shows quarterly inflation numbers from the start of 2021 to mid 2022. The first three quarters of 2021 are actuals (A) while the rest are estimates (E). Current forecasts predict that inflation will more or less peak this quarter before starting to fall back towards more “normal” levels by the end of 2022. We agree with this view and if estimates are correct, inflation will be a fading concern. We’ll be watching it closely.
Figure 1: Consumer Price Index (YoY%)
One reason for optimism with regards to inflation is that interest rates are going to rise back toward more normal levels after being cut to record-low levels at the start of the pandemic. This should take some of the froth out of the demand side as consumers start to deal with higher interest payments on their debt.
Higher rates could also cool down the torrid rate of price increases in the housing markets. We expect to see three rate hikes from the Bank of Canada this year, with the first being just months away. We think the economy and stock market can handle rates going back to a more normal level without too much pain.
Pandemic year 3
The pandemic is truly the worst of times. COVID-19 continues to be the biggest wildcard in the economic outlook. As shocking as the Omicron case count increases are, there’s reason to believe year three may be the last year of the pandemic.
The contagiousness of Omicron means that more deadly variants (like Delta) are being replaced by this less deadly variant. Some experts believe the combination of high infection levels, booster shots and new medications will turn the pandemic into something more like the flu or common cold. In other words, something that’s still there but manageable in the context of normal society. We hope they’re right. We think the feasibility of lockdowns is starting to wane, as each new one is more difficult to implement.
Although 2022 may not bring us fully back to normal, it should be another big step towards normalcy which is positive for the economic outlook. We continue to advocate for diversification in our client portfolios, focussing on strong and resilient businesses that can weather any storm.
Malcolm Jones, MBA, CFA
Senior Portfolio Manager, Fixed Income
In response to the COVID-19 pandemic, central banks in many developed nations took dramatic steps to increase liquidity in financial markets, and to lend support to a temporarily shuttered economy. As we moved through Q4 2021, many central banks declared that their job was either done, or near to being done. The extraordinary bond purchases are either stopped or soon to be stopped. The market is, reasonably, expecting that actual bank rate hikes will occur in 2022 from Canada, the U.S., and the UK. Increased bank rates are expected to raise yields, with an emphasis on shorter term rates.
Inflation remains a concern. An argument can be made that this is simply transitory, reflecting various disruptions in the supply chain. A contrasting view is that this is more permanent, reflecting disenchantment with globalization and increased geopolitical tensions. Increased inflation is expected to raise yields.
A number of countries continue to have a challenged economy. The European Central Bank, for example, continues to see the need to provide support to the European economy. This is expected to keep their local yields suppressed, and this, in turn, can serve to limit the increase in yields in North America.
Overall, we’re expecting yields to increase over the course of the next twelve months. At the same time, we expect a great deal of volatility in yields. Vaccination rates are increasing throughout the world, but there remains distinct pockets of low vaccination, and, of course, various COVID-19 mutations are arising.
Uncertainty remains a key concern in both COVID-19 and inflation.
We expect yields to move upwards over the next twelve months. As such, we’re maintaining a low duration to reduce our exposure to interest rate movements. We’re starting from higher yield levels as of January 2022, so coupon yield should be higher this year than last.
We are expecting greater volatility in yields. Inflation and COVID-19 progression are difficult to forecast, and interpretations are likely to change dramatically as inflation flows in. This may present an opportunity to trade back and forth in some circumstances.
National governments have issued a large amount of debt, and are expected to need further issuance. Sub-nationals (such as our provinces) have shown less need to issue debt. A number of sub-national governments have shown better-than-expected budgets lending support to their ability to pay their existing debt. While credit spreads on sub-nationals are low, there’s little to suggest these spreads will increase in the near future. We continue to like sub-national debt.
Corporate debt has also seen a lot of issuance. With strong earnings, these corporates have strong ability to pay. Indeed, some of the issuance is being used to pay back higher interest debt taken on at the height of the pandemic. Corporate credit spreads are historically somewhat low, but again, we don’t see evidence of an imminent increase in spreads. We continue to like corporate debt.
In the U.S., there’s an attempt to legislate an increased spending bill, and an attempt to legislate an increase to the debt ceiling. We expect a lot of drama and exciting headlines (with a commensurate ebb and flow in market sentiment). At the end of the day, we expect neither Democrats nor Republicans will get everything they want, and neither will walk away empty handed. Depending on your political affiliation, there will be plenty of credit or blame for all parties. We do expect some increased market volatility, and this may lead to some opportunities for trading.
With expectations for continuing upwards pressure on yields, we are underweight duration (exposure to interest rates). In particular, we’re very under-duration in Canada government bonds. We’re willing to hold longer dated bond in corporates and provincial bonds, so that we’re able to collect a higher coupon. Further, we think credit spreads are unlikely to surge higher.
We decreased duration during the fourth quarter, as we felt that bond yields had moved lower too quickly and by too much.
Figure 2: Canada Curves - December 2021
Gil Lamothe, CFA
Senior Portfolio Manager, Canadian Equities
The Canadian equity markets had another great quarter in Q4 2021 with the key benchmark (S&P/TSX Composite) up 6.5% on a total return basis. The quarter capped off a fantastic year where the market gained 25.1%.
The strongest performing sectors in Q4 were Materials and Financials. In the Materials space, our holding in Nutrien was up 16.4% in Q4. The strong global demand for fertilizer is continuing and looks to extend into 2022. Within the Financials sector, the Canadian banks had a very strong showing in the quarter. Bank of Nova Scotia and Toronto Dominion led the way, up 17.5% and 16.7% respectively. Another contributor within the Financials was Brookfield Asset Management, which was up 12.8% in Q4.
One positive event for the Financial sector was the restriction removal on Canadian banks and insurance companies from increasing their dividends or repurchasing their shares. One may recall, at the outset of the pandemic, the Office of the Supervisor of Financial Institutions (OSFI) implemented this restriction as a capital safeguard in what was a very uncertain environment. Our larger financial companies have since demonstrated their resilience and quality, and the restrictions were lifted in November. As a result, we saw dividend increases from all of our banks and insurance companies. While the average increase was in the 10-12% range, BMO surprised with an increase to its dividend of just over 25%. All announced the intention to continue repurchasing their shares in the amounts of 2-3% of outstanding shares.
CP Rail (CP) has received the approval of the Kansas City Southern (KSU) shareholders for its purchase of that railway. After a back-and-forth battle with CN Rail (CNR) throughout 2021, the deal has finally closed. Provided the company gains approval from the U.S. regulator, CP Rail will have an end-to-end north-south corridor through North America.
Also of note, the new COVID-19 variant, Omicron, came to the forefront in this quarter. Market reaction in late November was decidedly negative. However, as it became clearer that this variant was less harsh than Delta, the market recovered somewhat into the end of the year.
At a high level, our thinking hasn’t changed very much over the past six months. We still believe the pandemic will continue to subside through 2022. This latest Omicron variant may actually help speed up that process, as it’s both more transmissible and milder than the Delta variant. This, combined with the wide availability of booster vaccines, has had a positive effect on the stock market’s outlook. We still view the recent inflation increase as transitory in nature, being largely driven by accelerated consumer demand following the strict lockdowns earlier this year. As demand normalizes, there should be an alleviation on prices as well as less pressure on manufacturing and supply chain capacity.
The outcome of the KSU battle going in CP Rail’s favor wasn’t altogether surprising. This asset gives CP the opportunity to grow its railway network volume, perhaps significantly, over the coming years. On the other hand, the strategy at CN Rail is to increase its operating efficiency going forward to become more profitable. They’ve been attempting to do this for several years. From an investment perspective, we like the opportunity presented by CP versus that of CNR.
Another important development in the quarter was BMO’s purchase announcement of Bank of the West from BNP Paribas. Bank of the West is headquartered in San Francisco, with branches in the central and western United States. At US$16.3 billion, this is a large transaction for BMO, greatly extending their presence in the U.S. from Illinois westward to California, and virtually doubling the number of branches they have in that country (Figure 3). This is a bold move in the bank’s U.S. growth strategy, and one which we like the look of. It remains to be seen whether the price tag was too high, given the opportunities.
Figure 3: BMO greatly extends their U.S. presence through Bank of the West purchase
During the quarter, we added Brookfield Renewable Corp. (BEPC) to the portfolio. This limited partnership within the Brookfield family of companies owns and operates hydro, wind, and solar electric generation facilities globally. The company currently has over 20,000 megawatts of capacity from these sources, with development plans for a further 30,000. Renewable energy has continued to gain importance worldwide from consumers, governments, and investors. We feel that Brookfield Renewable is a best-in-class operator in this field.
As previously mentioned, we like what we see from CP Rail, and have changed horses from CN Rail to CP in the portfolio. This is a long-term decision, and we look forward to seeing how management integrates the Kansas City Southern assets into their operation.
One other addition has been Intact Financial (IFC). Intact is a property and casualty insurance company, specializing in home, auto and commercial. The company has been successfully consolidating this industry in North America and Europe. Intact is an advanced user of data technologies, analyzing trends and thereby efficiently pricing its products. In conjunction with the purchase of Intact, we’ve exited our Manulife position. We continue to hold Sun Life Financial. This insurance company is well managed and has shown good market performance over the years. We feel that having exposure to Sun Life is sufficient in the life insurance space.
We’re looking forward to 2022 in the Canadian equity markets. As always, there will be challenges and opportunities aplenty. Maintaining a high-quality, well-diversified portfolio will see us through the former, and let us take advantage of the latter.
Liliana Tzvetkova, CFA
Portfolio Manager, U.S. Equities
Saket Mundra, CFA, MBA
Portfolio Manager, U.S. Equities
U.S. equities finished the year strong, outperforming most global markets with the S&P 500 up 10.7% in Q4 and 26.7% for 2021. These returns are even more impressive considering the uncertainty around the impact of Omicron, multi-decade high inflation, supply chain disruptions and the expectation of the Fed’s monetary tightening. That aside, we saw an unabated strength in the U.S. consumer, improving labour markets and very accommodative monetary policy continuing during the quarter. U.S. corporations also managed to post another strong earnings season with year-over-year (y/y) earnings growth of nearly 40%, exceeding expectations once again and surprising the market with resilient margins despite persistent inflation.
Omicron was the biggest negative surprise during the last quarter. What we know so far is this strain has a higher rate of transmission, but it also appears to be less severe than its predecessor. Preliminary data also suggest that it might be able to evade immunity more easily. Another hot topic in Q4 and in 2021 was inflation, which remained high with supply issues persisting, while demand did not abate. Headline CPI rose 6.8% y/y in November, the highest annual increase in decades, putting into question the transitory nature of inflation and evoking bad memories of the 1970s inflationary period.
From a sector perspective, we saw a wide divergence in performance but the only sector to decline in Q4 was Communication Services with weakness across the telecom, media, and entertainment industries. After Omicron emerged later in the quarter, there was a flight to safety and more cyclical sectors such as Energy and Industrials underperformed. Financials was also a laggard hurt by falling yields. REITs were the best performing sector, followed by Information Technology with strength across the board.
The recent increase in COVID cases and associated restrictions will surely have a negative impact on growth in the short term, especially in certain areas like travel. Looking past that hurdle, we see a strong case for a continued economic recovery in 2022 supported by strength in both consumers and corporations with the Fed being the wild card, as usual. Consumers are flush with cash saved during the pandemic and there is still pent-up demand especially in the service industries (Figure 4). Businesses are ready to replenish inventories and invest in capital spending now that supply chain disruptions are easing, and the labour market is improving. All that should support the ongoing recovery, despite the pace of growth slowing. Inflation is also not necessarily bad for equities, especially for certain sectors and for companies with pricing power. As for valuation, we think the U.S. market looks fairly valued at a benchmark level, but we still see lots of good opportunities within the market.
Figure 4: Consumers are flush with cash saved during the pandemic and there is still pent-up demand, especially in the services industry
That said, the most recent developments in the markets and the economy have been another reminder to investors to expect the unexpected. Shortly before Omicron emerged, it seemed as though the market had almost forgotten about the risk associated with COVID, hence the initial selloff. Today, it seems that the market is pricing in a quick resolution partly due to the supposedly less severe outcome from this variant and partly due to the high transmissibility, meaning it would pass the population quicker and lead to herd immunity. But the reality is this scenario might not play out (Figure 5).
For instance we could have another more deadly variant or maybe Omicron proves to be more severe than currently thought. We, as investors, are not willing to bet on any one outcome. Rather, we prefer to invest in a balanced portfolio of high-quality stocks exposed to different drivers so that the portfolio can fair well in the variety of scenarios that could play out in 2022.
Figure 5: Global COVID-19 new cases & deaths
Our U.S. equity strategy had a very good year, posting strong absolute and relative performance to the S&P 500. While we are aware of the quarterly and annual numbers, we do not give much importance to short term numbers and focus on executing on our investment process to enhance the portfolio for the long run.
As has been the trend during the year, we further concentrated the portfolio by exiting a few of our positions wherein our thesis either played out or the risk/reward wasn’t as lucrative as other opportunities. During the quarter, we exited our positions in Disney, Nike, and CarMax and redeployed the capital in several high-quality businesses that were trading at attractive valuations and offered better risk/reward. We added to our positions in Amazon, Costco, Home Depot, MasterCard, Visa, Booking, and TJX. Our thesis on these names is based on continuation of revenue and earnings growth, which is not yet being fully priced in by the market. With respect to the names that we exited, we will continue to monitor them and should the risk/reward become lucrative again, we will not hesitate in taking a position.
In our U.S. portfolio we focus on long-term investing in high quality companies with strong returns, healthy balance sheets, and stable cash flows. While different factors may work during different periods, we believe that buying fundamentally strong businesses at lucrative prices and owning them over long periods will lead to superior returns for the portfolio.
Ric Palombi, CFA
Director of Research, International Equities
If there’s one word that would describe 2021 best, it would be volatility. The year started off with cyclical areas of the market outperforming as we recovered from the pandemic-induced downturn, supported by vaccine rollouts and Central Bank policy. As the year progressed, performance of various factors (e.g. quality, growth, defensives, value) was impacted which led to back and forth market rotations, based on the rhetoric related to the emergence of COVID variants and confusion around the change in direction of monetary policy.
One of the poster child sectors for this volatility was shipping. Shipping prices were driven to decade highs. Supply side constraints in the sector (too few ships) due to years of under-investment were exacerbated by the emergence of COVID variants which caused limited availability of port workers. The global economy re-awakening from the downturn drove demand for goods through the roof and the industry just could not keep up (Figure 6).
Figure 6: Jumping Ship – Ocean freight rates have surged for more than a year on strong demand
While net shipping rates have risen, they have not been immune to periods of volatility. We have exposure to this sector through Maersk, one of the largest container shipping companies in the world and one that fits our process and investment philosophy (the healthy balance sheet is worth mentioning in a sector that has historically been over indebted). The volatility story is similar when we look at how the Maersk share price has performed over the last year (Figure 7).
Figure 7: Maersk Share Price
This is an area we will continue to follow closely, not only because of our investment in this niche area of the market, but also as it has broader ramifications for the global economy and inflation.
Despite the sizeable gains in most global markets in 2021, not everything worked. In fact, for Hong Kong’s Hang Seng index (HSI) it was a year to forget. The Hang Seng trailed the S&P 500 by a staggering 41%, the most since the 2008 Global Financial Crisis. Fundamentally, with a trailing price-to-earning (P/E) of 9.3x, the HSI is trading at a 65% discount to the S&P 500, the cheapest since 1998. Furthermore, the HSI’s price-to-book (P/B) is 0.97x (Figure 8). The index has never started a January with a valuation below its book value.
Figure 8: Hong Kong's stocks’ price to book ratio falls to historical lows
Two of our holdings, which are large weights in the index, Alibaba and Tencent are down around 57% and 43%, respectively, from their peaks in 2021. A triple whammy of higher regulatory pressure, weak domestic macroeconomic conditions, and high competitive pressures led to an investor exodus from the sector and from China in general.
Looking ahead for the year, the signals coming out of China currently indicate that the incremental regulatory pressure should be lower, and that the government is more focused on macro-stabilization and growth. Additionally, companies in the e-commerce sector, like Pinduoduo and Meituan, have indicated that they will reduce the level of user subsidies/incentives. Tencent fully offloaded their holding of another e-commerce company, JD.com. These measures should improve profitability for the entire e-commerce sector as the competitive pressure reduces. The combination of these moves means that the “triple whammy” of 2021 should have less of an impact this year. In fact, it’s possible that some of the headwinds actually become tailwinds in the coming year. These factors combined with the all-time low valuation for companies like Alibaba should put them in a position to outperform over the coming few years.
In keeping with our process, we added to Alibaba on multiple occasions over the last year. The stock currently trades at 13x forward P/E, which is the lowest in its history. Once adjusted for the net cash on the balance sheet, we believe Alibaba trades at closer to 11x. This is astounding for a company with multiple growing streams of business and around US$15B of annual operating profit, which will continue to compound at >10% annually over the next several years.
Also in 2021, we took some weight off Maersk to manage valuation risk. Having said that, the company continues to remain an above average weight, as in our opinion, a 1.8x P/B is not egregious given what is going on in the end market. For reference, Maersk traded well above 2x prior to the 08/09 downturn.