Points in Time, Q1 2023

In this commentary:

Strong start | Canada | U.S. | International | Fixed Income

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Strong start

Scott Blair, CFA
Chief Investment Officer

Investors often think of October as the worst month for stock market returns, primarily due to two separate Black Mondays. On October 19, 1987, the S&P 500 fell 20.5%. Decades before, on October 28, 1929, the S&P 500 fell almost 13%, and another 10% the following day. Despite these two high-profile selloffs, October has actually been a positive month for the markets as defined by the S&P 500.

In fact, September has proven to be the worst month of the year for stocks. February and May are also slightly negative, but September by far lags the other months of the year. Which makes one wonder why the phrase “sell in May and go away” is so popular. Perhaps nothing pertinent rhymes with September.

Higher yields 

Perhaps the main reason for the market rebound has been the improved outlook on inflation. The Consumer Price Index (CPI), the most followed indicator of inflation, appears to have peaked in June 2022 for both Canada and the U.S. at 8.1% and 8.9% respectively. We’ve seen a steady decline since that time (see figure 1). CPI is now at 5.2% in Canada and 6.0% in the U.S.

Figure 1: Inflation Coming Down the MountainSource: FactSet

Although there’s still a lot of work to do to get inflation back down to 2%—the level desired by the Bank of Canada and the Fed—it is still a remarkable decline in a short period of time. Markets have clearly taken notice, as we’ve now had two strong quarters in a row.

What banking crisis?

There appears to be more going on here than strong inflation numbers. There’s a saying that the Federal Reserve in the U.S. raises rates until something breaks. We hit that moment in March. Two relatively large regional banks in the U.S. failed, causing concern throughout the U.S. financial system and forcing the Fed to take extreme measures to stabilize the system and prevent other banks from failing. To date, it appears that the Fed was successful and that the crisis has subsided.

Expectations for the way forward seem to have changed since the bank crisis, and not for the worse. Some investors are now betting that the Fed will need to soon pause their rate hikes and, in fact, start to cut interest rates by year end. The underpinning thinking is that banks in the U.S. will pull back on lending to preserve capital given the crisis we just had. This, in turn, will slow down economic growth and perhaps dampen inflation. In this way, reduced lending acts as a de facto rate hike. It could also push the economy into a recession, at which point the Fed will want to start cutting interest rates. That is seen as positive for stocks and bonds if the recession is short and shallow.

Higher for longer

For its part, the Fed still expects higher rates this year and doesn’t see rate cuts until 2024. Central banks are scarred by the ’70s and early ‘80s, and it’s not just the questionable fashion choices that induce nightmares. Central banks raised rates significantly in the early to mid-70s to tame runaway inflation. These hikes reduced inflation, but they also tanked economic growth. So, the Fed aggressively cut rates again to stimulate the economy, only to see inflation come back much worse than before in the early ‘80s. This prompted even higher interest rates in an attempt to wrestle inflation back down.

In today’s economy, we’re encouraged by the progress on the inflation front. We’re also skeptical that we’ll see rates fall this year. Central bankers are economic historians who have studied past cycles and policy mistakes. They’re also human and have been somewhat humbled by how sticky inflation has been. In our view, we may be close to the peak of rates. But that doesn’t mean cuts are likely this year. No one needs a reboot of that ‘70s show.

Sources: FactSet, Bloomberg & TD Securities

Canada

Gil Lamothe, CFA
Senior Portfolio Manager, Canadian Equities

Watching

Canadian equity markets have shown resilience in this first quarter of 2023. Overall, the market, as measured by the S&P/TSX benchmark index, was up 4.6%, with the technology sector the leader at 26%. This is somewhat of a reversal of what we saw last year, when technology was the laggard. The earnings recently reported for the 2022 year-end were more positive than negative, although expectations had been reduced in the weeks leading up to those reports.

Overall, it appears as though the expected slowdown in the economy, stemming from higher interest rates, has not yet kicked in, at least to the full extent. In another reversal of last year, the energy sector this quarter struggled, being down 2.3%. The prices of natural gas and crude oil have both been volatile and trending downward throughout the quarter. The anticipated global growth resulting from China’s reversal of its zero-COVID policy has not yet materialized, and concerns regarding a possible recession on the horizon have tempered most commodity prices. The financials sector eked out a small positive gain, notwithstanding concerns surrounding the regional banks in the United States.

Thinking

Many of you are now aware of the collapse of Silicon Valley Bank (SVB), a U.S. regional bank. The natural question then becomes, are any of our banks at risk? Happily, the answer to that is no, at least, they are no more at risk than they were prior to SVB’s troubles. Canadian banks operate in a more conservative regulatory environment than U.S. regional banks, such as SVB. Suffice to say that our Canadian deposits are adequately protected, and that this episode of banking issues south of the border demonstrates why we continue to believe that Canadian banks are among, or are perhaps, the best banks in the world.

With respect to energy, we feel the supply fundamentals are still in place to support higher oil prices in the medium term (especially since OPEC’s recent production cut). Having said that, we don’t feel there is tremendous upside as far as the stock prices are concerned, as much of this is already priced in. We’re happy with our current holdings and exposure in the group. The dividends are expected to be stable, and we would see any strong movement in stock prices to the upside as a bonus.

Doing

Within Canadian equities, we manage two different portfolio strategies with two different types of clients in mind. Our core Canadian equity strategy is designed for investors who are accumulating wealth, and is geared more towards capital growth. Our Canadian dividend strategy is designed to provide growing dividend income to investors who look to their accumulated wealth to provide income for their current needs.

In late 2022, there was an unusual transaction that demonstrates both the similarity as well as the difference between these two portfolios. A diversified financials company, named Brookfield Asset Management (BAM), was held in both portfolios. The company paid a modest but growing dividend, and had exceptional management, which lead to substantial capital appreciation.

In December, the company split into two separate entities. BAM was renamed Brookfield Corporation (BN) and retained all its businesses. The alternative asset management part of its business was spun into a new corporation using the Brookfield Asset Management (BAM) name. The new BAM company has a dividend distribution policy which strongly favours it for our dividend strategy. BN, as before, promises to deliver more capital growth, and is now held in our core Canadian strategy.

Prudent risk management of each of these strategies sometimes results in them sharing the same high-quality stocks. In this instance, we were able to target the distinct objectives of each portfolio, while maintaining the overall quality exposure of each (see figure 2).

Figure 2: Investment Decisions Reflect Portfolio ObjectivesSource: Bloomberg, CWB Wealth

 

Q1 2023 Dividend Performance Summary

 

* Estimate from Statistics Canada, February 28, 2023
** The dividend yield is based on the Leon Frazer Canadian Dividend Fund which includes a target weight for cash
Source: CWB Wealth, March 31, 2023

Sources: Bloomberg, CWB Wealth

 

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

Resilience in the markets has surprised many people, with the S&P 500 rising 7.0% year-to-date amidst widespread calls of an imminent recession. Nasdaq’s performance has been even more impressive, with year-to-date gains of 16.8%. Naysayers of growth and of technology’s demise have been proven wrong so far this year – technology (+21.49%) was the best performing sector. On the other hand, energy (-5.57%) was the second-worst performing sector after financials (-6.05%). The banking sector suffered from the collapse of two U.S. regional banks and strains in the financial system. The performance of both energy and technology sectors highlights the futility of short-term market predictions – both sectors performed completely opposite to prevalent narratives at beginning of the year.

We currently see a real push and pull between bulls and bears in the market. Bears point to earnings estimates coming down, the aftereffects of the regional banking crisis and concerns around commercial real estate issues as reasons to be cautious. Bulls, by contrast, take solace from the fact that high-growth tech stocks have been driving this rally. They see Nasdaq’s 20%-plus rise since its bottom last year as the start of the new bull market. For us, this tug of war between bears and bulls provides opportunity to add value as active stock pickers.

Thinking

Our thought process is deeply rooted in the execution of our investment process, despite various reasons to be bullish or bearish about markets at any given point in time. Our purchase of NVIDIA last year is a great example of this mentality. NVIDIA is the leader in computer graphics processors (GPUs) that are essential for gaming applications, video editing and machine learning, amongst other uses. Like many other stocks, NVIDIA was suffering in 2022 due to rising interest rates, post-COVID demand normalization and the ongoing chip war between the U.S. and China.

In spite of all these factors, we deemed the risk-reward to be highly attractive when we looked at NVIDIA’s business model, future prospects and the valuation. Little did we know that NVIDIA (+89%) would be the best performing stock in the S&P 500 on a year-to-date basis. The key point here? When we execute on our process and mindfully buy businesses that offer compelling risk-reward, we stand to gain over our investment horizon.

Figure 3: NVIDIA Outperforms NASDAQ and S&P 500Source: FactSet

We don’t lose sleep over whether there will be a recession. Why? Because recession, just like expansion, is a part of the business cycle. In fact, fundamental investors like us would argue that recessions serve the essential purpose of removing excesses from the system while benefiting firms with strong business models at the cost of their weaker counterparts. As such, our edge lies in knowing our companies, their drivers and growth prospects, and their ability to navigate different environments successfully.

So, for every reason to be bearish, we must remember that good businesses have survived many recessions and crashes in the past. Patient investors who held their nerves through thick and thin have seen their wealth compound over long periods of time.

Doing

Our U.S. portfolios lagged the S&P 500 slightly during the quarter, and we kept adding opportunistically to our holdings such as Intel, J.P. Morgan and Gentex to take advantage of the attractive prices. This fits with our focus of buying fundamentally strong businesses at lucrative prices and owning them long term, leading to superior returns over time.

Sources: FactSet, Bloomberg

International

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

Watching

We continue to monitor Chinese efforts to stimulate that country’s economy after the COVID-related lockdowns were abruptly lifted. There have been a number of surprise moves worth watching closely. The People’s Bank of China (PBOC) cut its reserve requirements for banks, which released around $80 billion into the economy. As well, regulators relaxed their crack down on the technology and property sectors. And Jack Ma’s public visit to China was followed by a subsequent announcement of Alibaba’s restructuring. These and other factors point to a recalibration of Xi’s government towards boosting economic growth, which should be positive for the economy.

Worries around the stability of the European banking sector dominated headlines this quarter, reviving memories of the 2008/2009 financial crisis. After years of mismanagement, shares of Credit Suisse (CS) – a 167-year old bank – finally collapsed in March when they disclosed material weaknesses in their financial statements. To stave off a crisis and limit financial contagion, Swiss authorities brokered an emergency deal with UBS, which agreed to takeover its long-time rival at a fraction of CS’s prior valuation.

While the emergency rescue assuaged market sentiment on the whole, concerns linger around the potential economic impacts of tighter lending standards, greater regulatory scrutiny, and rising capital ratios among banks. Further problems were encountered in March when Deutsche Bank shares fell after a spike in its cost of default insurance.

Thinking

Alibaba’s restructuring is very interesting. The group will divide its operations into six independently run companies, with the parent company transitioning to a holding company. The subsidiaries may then IPO at some point in time. The markets cheered this comprehensive move. Alibaba stock was up 20% as it unlocks this value.

One of the stated aims of the crackdown on the large Chinese tech firms was to reduce their monopolistic tendencies. We think that the de-agglomeration illustrated by Alibaba points to the path that many firms will take. It’s reasonable to presume that such moves have the government’s blessing. We’ve already seen Tencent spinning off non-core investments, and it could potentially continue further down this road.

A stable regulatory environment combined with economic stimulus from the government is beneficial for our many companies in our portfolio.

While some of the recent market concerns are justified, especially considering the history of the European banking sector, the silver lining is that the region’s central banks have proven tools and experience to deal with adverse scenarios. EU banks are now some of the best capitalized financial institutions in the world, as highlighted by the high Common Equity Tier 1 (CET1) and Tier 1 capital ratios.

Both are important measures of a bank’s resiliency. While figure 4 only shows these ratios to the end of 2021, they continue to be strong. The current situation gives two of our bank holdings, BNP Paribas and Intesa Sanpaolo, opportunities to solidify their market share – as evidenced by strong deposit inflows in March – and come out stronger. Both are large, systemically important institutions with diversified deposit bases.

Figure 4: Tier 1 Ratios by RegionSource: Basel Committee on Banking Supervision

Doing

The past decade of low interest rates and cheap debt incentivized financial risk taking. We are therefore not surprised by the economic dominoes tumbling as rates move higher. Given the high corporate leverage and rising rates, it would not surprise us to see more players caught offside. In this environment, we continue to strongly believe that company fundamentals are important. Thus, our portfolio is favourably positioned because our companies have strong balance sheets, through-the-cycle free cash flow generation capabilities, and low valuations. We continually seek opportunities to improve the fund’s risk-reward profile. During the quarter, we completely sold Want Want, a Chinese rice cracker and flavored milk producer, to free up capital for better potential opportunities.

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

Last year ended with bank rates at 4.5% for the U.S. and 4.25% for Canada, and we suggested at the beginning of this year that volatility would continue throughout 2023. Figure 5 shows market expectations, over the last few months, of where bank rates will end up at the end of 2023.

In December, markets were expecting bank rates to rise to 4.75% and 4.25% for U.S. and Canada respectively. In February, the U.S. reported inflation figures that were not declining as quickly as hoped. Markets interpreted that central banks would have much more work to do, and expectations for year-end bank rates rose significantly. In March, U.S. regional banks suffered a break in confidence. Markets interpreted that a deep recession was imminent and central banks would need to switch to a stimulative stance (lower rates).

Figure 5: Market Forecast for Bank Rate on Dec 31, 2023Source: Bloomberg

Throughout these gyrations, central banks have remained committed to their anti-inflation stance. The Bank of Canada suggests they have hiked sufficiently and now wants to see the effects filter through the economy. The Fed, meanwhile, suggests it may conduct one or possibly two more hikes in this cycle. Notice that neither central bank is suggesting that cuts are anticipated any time soon. We read their statements as saying that if central banks are going to make an error, it will be keeping rates too high for too long rather than cutting too early.

Thinking

Although the U.S. regional bank crisis received lots of attention, the shotgun merger between Credit Suisse and UBS in Switzerland reminded fixed income investors of the importance of due diligence.

After the Global Financial Crisis, AT1 (Additional Tier 1 Capital Bonds) were introduced to transfer risk from taxpayers to bondholders if a bank were to fall on hard times. For example, if a bank’s capital ratio fell below a certain threshold, AT1 bonds would be converted to equity to shore up the capital ratio. These bonds pay a higher coupon because they sit higher in the capital structure than equity, but lower than other forms of capital. Should a bank fail, in other words, AT1 bondholders would only receive part of their capital back after all other debtholders have been paid, but before holders of equity. At least that’s the way it’s supposed to work.

In Credit Suisse’s case, AT1 holders were deemed to sit below equity holders in the capital structure. Meaning holders of common equity will receive some payment on the merger of the two firms while AT1 holders will receive nothing. This was a shock to the market. But it appears that this AT1 structure is unique to Swiss banks and not EU banks (Switzerland is not part of the EU). Canadian regulators also recently reiterated that holders of similar debt in Canada sit above equity holders in the unlikely event something similar happens here.

It can be time consuming and tedious to go through fixed income documents which often seem boilerplate. What happened in Switzerland shows the importance of understanding what you own and doing your own due diligence.

Doing

Given our outlook on the potential movement (or lack thereof) in the yield curve, we have substantially removed our underweight position in duration relative to the benchmark in our traditional bond portfolios. There is no significant change in duration in our more credit-focused fund (CWB M&P Diversified Income Fund).

We continue to be overweight credit in all portfolios. We expect to receive a good boost to interest income from credit this year, and are currently being well compensated for the extra risk taken on.

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. Visit cwbwealth.com/disclosures for our full disclaimer.

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