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17 min read

Points in Time, Q2 2023

Some analysts are calling this year’s strong start a new bull market, believing that a soft landing – not a recession – is in the cards this year or next. While we think a severe recession is unlikely, we know there’s more uncertainty than usual and would like to reiterate the importance of diversification.  

In this commentary:

Soft landing | Canada | U.S. | International | Fixed Income

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Soft landing

Scott Blair, CFA

Chief Investment Officer

 

The strong run of returns that began in Q1 continued through Q2. Equity markets across the globe, with the exception of China, have posted solid gains year to date. Bonds were also solid in the first half of the year, with the Canadian bond market up after a very weak 2022.

 

Some analysts are now calling this year’s strong start a new bull market, believing that a soft landing – a slowing of the economy but no recession – is in the cards.

Inflation moving in the right direction

Inflation in Canada, as measured by the Consumer Price Index (CPI), peaked in June 2022 at 8.0%. Since then, it has fallen rather spectacularly down to 3.4% as of May 2023. While that may sound great, if we look behind the curtain the picture isn’t so rosy. The real reason for inflation’s downturn centers around food and energy.

 

In May, gasoline prices fell 18.3% from a year ago while natural gas prices dropped 3.5% over the same period. Food prices also ticked down. Central banks, however, pay much more attention to inflation measures that exclude food and energy when considering interest rate policy, as these prices are volatile and big changes are often temporary. For instance, a poor crop year could cause food prices to rise, only to then fall the next year as things normalize.

 

As we can see from figure 1, although the inflation rate excluding food and energy rose rapidly, it peaked well below 8.0%. It’s now falling at a slower pace. Overall, the Bank of Canada (BoC) wants to see this measure of inflation back at around 2%. While progress has been made, there’s a long way to go.

 

So, falling food and energy prices have been a big driver of lower inflation even as we’ve seen ongoing strength in many key economic factors. That’s why the total picture is slightly different from how it may otherwise appear.


Figure 1: Canadian inflation rates – including/excluding food and energy

Canadian inflation rates – including/excluding food and energy

Source: FactSet

Rates continue to rise

Earlier in the year, the BoC paused increasing interest rates. At the time, Governor Tiff Macklem stated, “this pause is conditional, it depends on whether the economy develops as we think it will and whether inflation continues to fall.” In June, the Bank raised rates again by 0.25% to 4.75%, with indications that another 0.25% increase is still to come. If inflation is moving in the right direction, what caused the Bank to rethink its pause?

 

We think there are three main reasons. First, the Canadian economy grew 3.1% in Q1 of this year, much hotter than what was expected. Second, the job market remains very tight. The unemployment rate is 5.2%, which is low from historical standards. Third, the housing market, a big driver of our economy, is rebounding despite a huge surge in mortgage rates. Taken together, these three factors will make getting inflation back to 2% difficult.

 

What's next?

To achieve a soft landing, the economy has to slow. That means higher unemployment, a greater number of insolvencies, a slowdown in housing and less consumer spending. The Bank isn’t seeing enough progress here yet and will keep raising rates until they do.

 

The issue here is that each rate increase heightens the chances that the Bank has gone too far. Rather than a soft landing or mild recession, rates that rise too high could cause a deeper slowdown. That’s why, from our perspective, it’s too early to call the strong start to the year the next bull market.

 

While we think a recession sometime late this year or early next is likely, we still doubt it will be severe. That said, we know there’s more uncertainty than usual and would like to reiterate the importance of diversification, especially the role bonds play in a portfolio. With higher rates, bonds are now offering nice yields that are attractive should we manage a soft landing. If the landing is hard, rates will likely get cut and bonds will offer capital gains along with the yield, while equity markets could be challenged. It’s a great insurance policy in an uncertain world.


Sources: FactSet, Bloomberg

Canada

Gil Lamothe, CFA
Senior Portfolio Manager, Canadian Equities

Watching

One of the more attention-grabbing events this quarter was the increase of 0.25% by the Bank of Canada (BoC) in its overnight lending rate, bringing it to 4.75%. Many thought the Bank would be on hold in its fight against Canadian inflation, though indications were that inflation was falling more slowly than expected. There’s now an expectation that the Bank will continue with another 0.25% increase.

The larger question of whether we’ll have a recession has yet to be answered, but recent commentary from transportation companies may hold some clues. The movement of goods is like the pulse of the economy, whether it’s raw materials moving to manufacturers or finished goods moving to retail outlets for sale to end consumers. Both TFI International, a trucking firm, and CN Rail have indicated there’s a slowing in their volumes that may well persist into next quarter, and perhaps until year end. There’s also been a pullback in many commodity prices over the past few months. This suggests that demand is waning, or that anticipated demand isn’t materializing as expected.


Thinking

The economy might be slowing, but Canadian banks appear well positioned for a downturn. OSFI, the Canadian bank regulator, has increased yet again the minimum capital requirements for banks. This is a safeguard against banks being overextended should we move into a period of extreme economic stress.

There’s been much discussion about the mortgage market, with variable rate mortgages and mortgage renewals being affected by significantly higher rates. We believe our banks will work with borrowers through this adjustment period, and that the tailwind of immigration that we continue to see in Canada will support housing prices. The banks themselves, while reporting persistently higher costs this quarter, have increased their dividends. This underscores their confidence that the overall economic environment is manageable.

 

Beyond the banks, we’re also paying close to attention to onshoring, which is the movement of manufacturing from “riskier”, low-cost overseas centers back to more predictable North America. This macro trend bodes well for firms in many sectors, including engineering firms, transportation companies and even utilities providers. Companies such as Stantec, TFI International, CP Rail and CN Rail all stand to benefit from onshoring (figure 2).

 

Figure 2: Manufacturing jobs in onshoring and foreign direct investment (FDI) per year.

Chart showing rapid growth of jobs announced per year due to onshoring and FDI

Source: Bloomberg, CWB Wealth

Doing

Having identified an opportunity within the Canadian technology space to get further exposure to the changing global trade picture, we’ve added Descartes Systems (DSG) to our core Canadian strategy. With the recent supply chain disruption experience, combined with the need to better manage the increasing cost of inventories, companies are paying more attention to efficiently managing their flow of resources, whether inbound materials or outbound finished goods. Descartes helps companies plan and manage the movement of goods domestically and internationally. They maintain an international database of regulations and forms that allows clients to ensure they’re complying with all relevant rules and restrictions. They also provide real-time tracking as shipments progress and modes change from sea to rail to truck through various third parties.

Late in the quarter, Brookfield Renewables (BEPC) announced the acquisition of Duke Energy’s Commercial Renewables business, for US$1.05 billion. These solar and wind assets generate approximately 3,400 megawatts, and this announcement brings BEPC’s generating capacity to nearly 35,000 megawatts. The development pipeline of projects associated with the acquisition will contribute to Brookfield’s stated growth targets of 10% cash flow growth from operations annually. This bodes well for further dividend growth from this company in the years ahead.

 

Sources: Bloomberg, CWB Wealth


Q1 2023 Dividend Performance Summary

Canadian Dividend Portfolio
Number of companies in the equity portfolio 31 
Number of companies that declared an increased dividend 21 
% of companies that declared an increased dividend 67.7% 
Weighted average of dividend increase 3.5% 
Consumer Price Index increase (YoY*) 53.4% 
Equity portfolio dividend yield** 4.5% 
S&P/TSX dividend yield 3.2% 

Top 10 Dividend Growers 

MANULIFE FINANCIAL CORP 10.6%
CCL INDUSTRIES INC 10.4% 
NUTRIEN LTD 10.4% 
INTACT FINANCIAL CORP 10.0% 
CANADIAN NATIONAL RAILWAY 7.8% 
TELUS CORPORATION  7.3% 
CANADIAN NATURAL RESOURCES LTD  5.8% 
METHANEX CORPORATION 5.7% 
BROOKFIELD RENEWABLE CORP
5.4% 
RUSSEL METALS INC 5.2% 

* Estimate from Statistics Canada, May 31, 2023
** The dividend yield is based on the Leon Frazer Canadian Dividend Fund which includes a target weight for cash

Source: CWB Wealth, May 31, 2023

 

U.S.

Liliana Tzvetkova, CFA
Co-Head of U.S. Equities & Portfolio Manager

Saket Mundra, CFA, MBA
Co-Head of U.S. Equities & Portfolio Manager


Watching

The U.S. stock market pivoted in Q2 from concern over the U.S. financial system and bank failures to a new focal point: artificial intelligence (AI). The excitement surrounding AI has propelled technology stocks, resulting in significant gains for companies involved in AI such as Nvidia (+47%) and Meta Platforms (+33%), as well as the technology-weighted NASDAQ index (+11%) this quarter.

The emergence of the AI narrative has sparked debates about its potential: whether it constitutes a bubble, what industries will be helped and hurt by it, and just about everything in between. We’ll refrain from adding more to this extensive discussion. Instead, we again emphasize that market narratives can shift or reverse rapidly so it’s critical for investors to maintain a long-term focus and not be overly swayed by today’s headlines. Regardless of market conditions or news, our team remains focused on identifying promising businesses with strong management teams and growth prospects, trading at reasonable valuations.

 

Thinking

Markets experience cycles of concern ranging from anxieties about numerous issues to periods of extreme enthusiasm. Last year, amidst worries about rising interest rates, inflation, economic slowdown, geopolitical conflicts, and other concerns, we dedicated time to think about what does not change. In doing so, we examined one of our core holdings, AutoZone.

 

AutoZone is a retailer of automotive replacement parts, catering primarily to “do-it-yourself” (DIY) customers. We looked at AutoZone’s operating performance since 2001 – a period that includes the 9/11 attack, war in Iraq and Afghanistan, U.S. financial crisis, Euro debt crisis, U.S.-China trade war, and a global pandemic, just to name a few. If that weren’t enough, some people have also been calling for the demise of the DIY auto part market for decades, despite the industry’s ongoing growth. Throughout all these events, we observed AutoZone’s consistent revenue growth, robust and stable margins, and capital-light business model that generated substantial free cash flow. Notably, the company used a significant portion of this free cash flow to repurchase its own stock. All this contributed to AutoZone’s strong stock performance, which markedly outperformed the S&P 500 in the last three, five, 10, 15 and 20-year periods (figure 3).

We’ve often written about our investment philosophy, outlining the aspects we consider when managing U.S. equities. We don’t try to predict when recessions will happen, how much the last Federal Reserve rate hike will affect unemployment rates, or where and when the next bubble or crisis will be. Rather, we know with certainty that economic booms and recessions will come and go, as will bubbles and crises, but we don’t know exactly when and what form they’ll take. Instead, we prioritize identifying businesses with a potential to flourish across various economic landscapes, and we dedicate significant thought to understanding the growth and profitability drivers of our portfolio companies.


Figure 3: AutoZone vs S&P 500 compounded total returns

AutoZone vs S&P 500 compounded total returns
Source: FactSet

Doing

During the past quarter, our U.S. portfolios slightly outperformed the S&P 500. We made several adjustments, reducing our position in TJX and completely divesting from Cintas. We used the proceeds to add to our existing holdings in Amazon, Intel, Accenture, Home Depot, and Gentex. Additionally, we initiated a new position in Pool Corporation, the leading distributor of swimming pool materials and products in the U.S. Overall, we maintain confidence in our portfolio, comprising a diversified set of high-quality businesses trading at attractive valuations, and believe these investments will generate favourable returns over the long-term.


Sources: FactSet

International

Ric Palombi, CFA
Senior Portfolio Manager, International Equities and Alternative Income

 

Watching

So far in 20231, European equity indices have been amongst the best relative performers, many of which showed some healthy returns. In Canadian dollar terms, the Euro Stoxx 50 has returned 13.1%, the CAC 40 (France) returned 11%, the DAX (German) returned 13.4% and the FTSE MIB (Italy) returned 15.2% since the beginning of the year2. This may seem surprising given the negative financial headlines the region has been generating. But after a tough year in 2022, investors are now seeing good value in European stocks.

Looking to Asia, we watched Alibaba Group announce some management changes during the quarter. Daniel Zhang, the outgoing CEO and Chairman, will become the CEO of Alibaba’s cloud computing division in September. Two of the co-founders of Alibaba – Joe Tsai and Eddie Wu – will now run the core e-commerce business. Both were instrumental in Alibaba’s successful growth and are considered to be close to founder Jack Ma. Their return to the company marks a return of part of the dream team back to Alibaba.

 

As of June 27, 2023

Source: Bloomberg WEI (World Equity Indices) function

 

Thinking

Seeing good market returns amid negative headlines can highlight that returns are driven by multiple factors, including valuation and earnings revisions. Earnings revisions that are positive, for example, refer to rising expectations among market participants of future earnings. In our view, positive earnings revisions in cyclical sectors such as banking, industrials and consumer discretionary were significant factors in driving market performance (see figure 4).

 

On the other hand, Alibaba’s shares have struggled in line with the broader Chinese market, which has suffered from high expectations on reopening from the pandemic. Returns have also been hampered by the higher competitive intensity spurred by the regulatory measures the company faced. The shares trade very cheap (at 8x P/E), and it’s our view that the market is not giving the company any credit for even the slightest improvement in earnings.


Figure 4: Change in earnings expectations as of May 31, 2023

Chart showing change in earnings expectations across different sectors
Source: JPM International Market Intelligence

 

Doing

A notable feature this month has been the underperformance of European chemical stocks, with a few players issuing profit warnings for the year. Demand weakness in end segments, along with over-stocked inventories in the supply chain, have been cited as the culprits. Although this is clearly a sign of a weakening economic backdrop, we believe that the short-term volatility that such events create, results in a favourable risk/reward skew for long-term investors.

Our holding, German-based Lanxess, has not been immune to this weakness and there are concerns around their debt. However, we think the company’s balance sheet is in a healthy place with no covenants on their debt, no immediate refinancing needs, ample liquidity and positive cash flow. We have a high regard for this management team and their track record of guiding the company through various crises. Their incentives are strongly aligned with shareholders. And, in our opinion, the CEO’s capital markets acumen and relationships with various stakeholders are competitive edges for the company.

We sold some Heidelberg Cement, as the company is likely not immune to the construction weakness being cited by the chemical sector. The firm has performed strongly so far this year and we were happy to take some profits. We also completely sold Maersk shipping, which was a beneficiary of pandemic supply chain issues. As shipping returns to normal, the cyclical return in the sector may turn negative in the coming years.


Sources: Bloomberg, FactSet

Fixed Income


Malcolm Jones, MBA, CFA

Head of Fixed Income, Senior Portfolio Manager

Ric Palombi, CFA
Senior Portfolio Manager, International Equities and Alternative Income

 

Watching

Early this year, the Bank of Canada (BofC) announced a pause in rate hikes. It made mention of expectations for slowing Gross Domestic Product (GDP), possible weakness in labour markets, and a subdued housing market. Over the course of the second quarter, economic data came out showing that GDP had not significantly slowed, labour remained tight, and housing markets looked strong. The pace of inflation slowing seemed to be waning. Out of a preponderance of caution, the Bank made an additional hike in June and further hinted that future hikes are possible. The U.S. Fed has similarly telegraphed that this rate hike cycle has not yet ended.

In light of all this, we feel that these two central banks are still committed to getting inflation down to 2%. The path to that 2% inflation may have more twists and turns than was originally expected, and the time to get to that level may also be more flexible.

Thinking

Corporate bond yields are reaching highs not seen since the global financial crisis. The combination of rapid interest rate hikes and a weakening economy are causing investors to demand higher returns on corporate credit.


Taking a step back to look at the relative attractiveness of fixed income versus equities, figure 5 compares the dividend yield on the S&P 500 with the yield-to-maturity on a 5-year Treasury note. Currently, the yield-to-maturity on a 5-year Treasury is roughly 200 basis points (bps), or 2% higher than the dividend yield on the S&P 500 Index. This differential is wide relative to the 20-year average of only 35 bps. Over the past two decades, when this differential has been considerably higher than longer-term averages, subsequent performance for fixed income asset classes has generally been better, on average.

 

Figure 5: Dividend yield on S&P 500 vs yield-to-maturity on 5-year Treasury note

Dividend yield on S&P 500 vs yield-to-maturity on 5-year treasury note
Source: Bloomberg

Doing

We currently have the most inverted yield curve since the 1980s. One approach we’re pursuing in our more credit-focused fund (CWB M&P Diversified Income Fund) to optimize yield (and income) is a credit barbell strategy. The strategy involves investing opportunistically at both the shorter and longer ends of the yield curve.

The long side of the barbell (bonds maturing twenty years out for example) shows investments in bonds trading at $0.70 - $0.80 on the dollar. Over the coming years, these bonds will start grinding towards par ($1.00 on the dollar) as the interest rates normalize, producing equity-like returns with much lower risk because of the bonds’ maturity profile.

 

The short side of the barbell (bonds maturing in the next few years) involves taking advantage of higher yielding (and therefore higher income-producing) shorter dated bonds. The short duration of the bonds makes their interest sensitivity low, while the inverted yield curve provides higher yields. These bonds provide a ballast for the portfolio while maintaining stabile income generation.

Combining these short and longer-term approaches in our barbell strategy provides the best combination of income generation and capital gains. It also optimizes the risk/reward in the Diversified Fixed Income strategy to enhance our clients’ purchasing power in this difficult interest rate and inflationary environment.

We expect to maintain a duration near benchmark for our more traditional bond portfolios. We also expect to generate stable returns from longer-dated bonds, and we see some trading opportunities in shorter-dated bonds. While we expect month-to-month volatility to be high in this strategy, we feel that the yearly return will be in the low to mid-single digits.


Source: Bloomberg

Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of CWB Wealth or its affiliates. CWB Wealth does not assume any duty to update any of the information. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk. Nothing in this content should be considered to be legal or tax advice and you are encouraged to consult your own lawyer, accountant or other advisor before making any financial decision. Quoted yields should not be construed as an amount an investor would receive from the Fund and are subject to change. Investors should consult their financial advisor before making a decision as to whether mutual funds are a suitable investment for them. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus, which contains detailed investment information, before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. CWB Wealth uses third parties to provide certain data used to produce this report. We believe the data to be accurate, however, cannot guarantee its accuracy.

CWB Wealth is a business name and trademark of CWB Wealth Management Ltd. (CWB WM). CWB WM is a subsidiary of Canadian Western Bank and a member of the CWB Financial Group.

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