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Q3 2022 Investment Commentary

Inflation has central banks between a rock and a hard place: increase rates just enough to moderate inflation – or tip us into a recession. The answer will be revealed at some point, but in the meantime, opportunity lies in the weeds.

By CWB Wealth Investment Team

In this commentary:

Between a rock and a hard place | Fixed Income | Canada | U.S. | International


Between a rock and a hard place

CWB Wealth Management Investment Team

  • The Fed picks a lane
  • USD is king
  • Volatility to continue

The third quarter of 2022 started strong but didn’t end out that way. Early gains in July to mid-August were partly driven by better-than-feared corporate earnings and the hope that inflation was peaking. Markets started to give back their gains as the quarter went on and September lived up to its reputation as a difficult month for markets.


The Fed picks a lane

Central banks have been caught between a rock and a hard place this year. They need to raise rates to combat inflation. However, if they raise them too quickly or too high, they could tip their economies into a recession.


On the other hand, if they don’t raise rates enough, inflation will become entrenched, leading to the potential for even worse economic outcomes. The optimal result would be to achieve a soft landing, whereby rates increase just enough to moderate inflation without pushing us into a recession. It’s a very fine line.


We’ve seen a persistent message by central banks in their commitment to lowering inflation, but September seemed to mark a more urgent tone – particularly from the U.S. central bank (the Fed). The Fed now expects U.S. policy interest rates will end the year at around 4.5%. That’s up over 4% since the start of 2022 and a full percent higher than projections just three months ago. It’s a stunning amount of tightening in a short period of time.


Federal Reserve Chairman, Jerome Powell, also stated this about raising rates, “No one knows whether this process will lead to a recession or how significant a recession would be.” Although this statement doesn’t mean a soft landing isn’t possible, it does seem to indicate that the Fed is not overly concerned about it. Inflation control is now the only game in town.


USD is king
One side effect of the Fed’s rate increases is a higher-valued currency. Money tends to flow where it receives the highest return, and the U.S. has raised rates more than any other developed nation this year (tied with Canada). The USD also tends to be the currency investors flock to in uncertain times. Figure 1 shows the exchange rates between the Canadian dollar, British pound and the euro vs the U.S. dollar.


Figure 1: CAD, GBP, Euro exchange rate vs USD

Source: FactSet


We can see from this chart that the U.S. dollar has wildly outperformed European currencies and has also moved up strongly versus the Canadian dollar despite the Bank of Canada keeping pace on the interest rate front. Former U.S. Treasury Secretary, John Connally, said in 1971, “The dollar is our currency, but it’s your problem.” This is certainly true today as importers of U.S. goods will now pay a higher price in USD, thus exacerbating their inflation issues, while the U.S. will get some reprieve as imports become cheaper in USD.


Volatility to continue
The interest rate and currency moves outlined above are very unusual – but what’s been usual in the past two and a half years? We expect the remainder of 2022 to be as volatile as the last three quarters. In fact, we’re likely in for a bumpy ride until there’s more clarity on the inflation front. The market will likely flow up and down on incoming economic data as investors try to assess how successful central banks have been in lowering prices.


The volatility does make investors nervous and focused on the short-term. In fact, bearishness (negativity) among investors is very high. In the past, this has often proven to be a great contrarian indicator of an oversold market. Which reminds us of a great Warren Buffett quote suitable for long term investors in times like these, “Be fearful when others are greedy and greedy when others are fearful.”

Sources: FactSet, Morgan Stanley


Fixed Income

Malcolm Jones, MBA, CFA
Senior Portfolio Manager, Fixed Income


Inflation continues to be an issue of primary concern.


The yield curve is currently inverted (short-term yields higher than long-term yields). We’ve seen greater volatility in short-term yields, and an increase in them. Longer-term yields haven’t shown the same level of net movement. Combined, these suggests there’s still substantial uncertainty about the length of current inflationary pressure. Longer term, markets are expecting inflation to return to more normal levels (2 to 3%).


Towards the end of this quarter, we saw a more pronounced increase in corporate spreads at all levels of credit quality. The market seems to be showing a greater fear of a recession.


Figure 2: Sovereign Yields from Sept 1 - 30, 2022

Source: Bloomberg



Markets have changed the opinion on expected U.S. and Canadian bank rates. U.S. rates are seen as peaking between 4.25% and 4.5% by mid 2023. After that, bank rates are expected to decline to 4% by the end of 2023. Canadian bank rates are expected to peak between 3.75% and 4%, and to stay at that level for the remainder of 2023.


We’re seeing greater attention being put on fiscal spending. With central banks using tremendous monetary pressure to subdue inflation, market watchers are increasingly concerned about the inflationary pressure stemming from expansive fiscal policy.


One new item we noticed this quarter is the manner in which U.S. yields have dislocated from Canadian yields. U.S. yields have continued to increase across the curve throughout the quarter. Canadian yields have overall risen less, and in particular, longer-term Canadian rates have shown limited net movement over the quarter.


A number of developing countries have neither government stability, nor central bank credibility. Civil unrest is exacerbated by food insecurity brought about by the Russian invasion. At the margin, this can cause investment funds to flow to the safe of haven of U.S. dollars (and to a lesser extent, Canadian dollars).


Combined, this suggests to us that longer-term rates may have less net movement going forward over the next twelve months. Uncertainly will be experienced in the short end of the yield curve. The market forecast has changed.



We still see value in federal bonds from a risk control perspective. These bonds don’t offer significant return opportunities. We’re maintaining exposure in short-dated federal bonds.


We feel that the bond market’s expectations of a recession may be overdone. Corporate spreads are above long-term trends. We’re comfortable holding an overweight position in credit bonds, but recognize the increased level of risk.


We continue to feel that most of the potential movement in the yield curve is already complete. We’re maintaining a slightly underweight exposure to duration, and did increase duration slightly over the quarter.


Sources: FactSet, Bloomberg



Gil Lamothe, CFA
Senior Portfolio Manager, Canadian Equities 


Q3 2022 was a quarter of realization for equity markets. Canadian economic data is showing that inflation is high and remaining so. The reaction by central banks has been strong and steady, with no hints of when a more subdued stance may be taken. That has led to the markets pricing in a higher probability of a recession. For the quarter, the Canadian equity market as measured by the S&PTSX benchmark index was quite volatile but ended down only 1.4%. 


The largest underperformer in the portfolio was Open Text (-24.2%). Open Text announced a proposed U.S. $6 billion acquisition of Micro Focus International, a U.K-based software company, which they intend to finance with debt. It will be several quarters before it’s known whether value is being added, which increases the risk profile of the company materially. 


There were a number of bright lights in the portfolio in Q3, including Boyd Group Services (+25.6%). Boyd is in the autobody repair business, where much of their revenues depend upon insurance company claims. After many months of negotiating, Boyd announced that they realized an increase in pricing from the insurance companies, which was long-awaited good news. 


Scotiabank also caught our attention. They’ve appointed a new CEO, Scott Thomson. What we find interesting is that Mr. Thomson, while being a Bank of Nova Scotia board member, is actually the CEO of the heavy equipment dealer, Finning. It’s more typical to see appointments at this level to individuals who have operated in several areas of the bank, or the banking industry. We have lower exposure here but will be watching with interest.



For equity investors, the usual driver on the data front is company earnings results, reported quarterly, with results from the previous quarter. The Q2 reported numbers still do not show a material slowing in earnings. The results of our banks are of particular interest, as they have clients throughout the economy. 


Generally speaking, our major banks reported weakness in their wealth management and brokerage businesses. This is somewhat unsurprising as revenues there are dependent upon market levels and market activity. Of more interest were the results of their lending businesses, particularly in Canada, which delivered solid margins and profits. The read through here is that we’re not yet in a recessionary environment. 


The negative reaction to the Open Text acquisition mentioned above is partly due to the nature of the market, which is indisposed to increased risk. The proposed acquisition is very large and will therefore require significant debt. In a rising rate environment, this is a concern. Furthermore, the company being acquired has been performing poorly and will, therefore, have to be turned around before adding value to Open Text, the timeline being in the order of 18 months. 



We added to our position in Canadian Natural Resources, CNQ, as early on, oil stocks were under quite a bit of selling pressure and we felt it was perhaps overdone. The fundamentals of insufficient supply relative to demand still hold in the oil sector, and until we see increased investment in added production, we continue to like the space. 


We’re concerned about Open Text’s proposed acquisition of Micro Focus. A company’s risk profile is a factor we use in determining our weight for a holding in the portfolio. As such, we’ve reduced our target weight for Open Text and will be watching closely to determine if any further action is required.  


Sources: FactSet, Bloomberg



Liliana Tzvetkova, CFA
Portfolio Manager, U.S. Equities

Saket Mundra, CFA, MBA
Portfolio Manager, U.S. Equities 


The Oxford dictionary defines “anxiety” as follows: “the state of feeling nervous or worried that something bad is going to happen.” One needs look no further than the current market to witness what anxious behaviour looks like. 


The common market view suggests that inflation, driven Fed tightening, will inevitably cause a recession. The only unanswered questions seem to be: 1) When is it going to happen? 2) How long will it last? 3) How deep it will be? We wish we had the crystal ball to predict economic outcomes with any degree of certainty, but we don’t. Yet, as stewards of capital for our clients, we weigh risk-reward for every investment opportunity to achieve superior investment outcomes. 


Given recession fears and the rise in the USD, the energy sector has given up some of its gains but remains the best performing S&P sector for the year. On the other hand, communication services, consumer discretionary and technology continue to be the worst performing S&P sectors year to date. 



While we don’t know the answers for the questions mentioned earlier, we do know the answer to what we believe is the most important question in the markets: what is our time horizon? Asked another way, are we “investors” or “speculators”?


While speculators need to worry about the next six months or a year, investors have an unsurpassable advantage of a long time horizon. Investors are aware that recessions and other worries are a part of the markets and, despite these worries, fundamentally sound businesses can generate superior returns when bought at sensible valuations and held for a long time. 


Take, for example, core holdings such as Microsoft and Home Depot. In the last twenty or more years these companies have lived through a tech bubble, a financial crisis, a global pandemic and today’s market correction, yet patient investors have been well rewarded. 


Figure 3: Annualized returns for Microsoft, Home Depot vs S&P 500 

Source: FactSet 


The ongoing correction in the market has provided us with a healthy hunting ground for fundamentally good companies with multi-year runways of sustainable growth and returns, at compelling valuations. Just a year ago, we couldn’t justify owning many of these businesses as their valuations were much higher than we deemed to be a sustainable level of earnings. However, just as we didn’t believe in the commonly held rosy view that the market had for these businesses back then, we’re not buying into the dire narrative that’s prevalent today. 


Instead, we do our own due diligence to uncover the truth and deploy capital in these businesses in accordance with our investment process and philosophy. We’re able to take this out of the mainstream view as we know the answer to the important question asked earlier. We are investors and that, by definition, implies that our time horizon is long. 



During the quarter and the first nine months of the year, our U.S. portfolio showcased resilience versus the S&P 500, leading to relative outperformance in spite of the portfolio’s zero exposure to the energy sector. We don’t give much importance to short-term performance numbers and focus on executing on our investment process to enhance the portfolio for the long run. 


We exited our positions in Jacobs and Booking Holdings during the quarter, as we deemed the risk-reward to be more lucrative in other portfolio opportunities such as Aramark, Nvidia, Microsoft, Gentex, Dollar Tree, Waters and Southern Copper and redeployed the capital in them. Overall, we continue to stay disciplined and focus on the long term by investing in high quality companies at lucrative valuations which we believe will lead to superior returns for the portfolio.



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


One of the key highlights this quarter has been the growing strength of the U.S. dollar, even in comparison to currencies such as the Japanese yen, which are considered to be safe havens in crisis times. The DXY index, a measure of the U.S. dollar against a basket of currencies, hit a new 20-year high at the start of the month and is up ~20% over the past year. In addition to risks emanating from rising interest rates and a potentially slowing economy (credit risk), investors are now starting to pay attention to liquidity risk due to the aforementioned currency moves. 


Various governments and central banks, such as the European Central Bank and the People’s Bank of China, have already intervened to support their currencies or have announced plans to do so as needed. 


The Bank of England (BOE) had to step in to intervene in the longer end of the gilt market to prevent disorderly trading as investors became increasingly concerned about the impacts of the newly announced expansive fiscal policy. While there are signs that some of the newly-announced tax cuts might be rolled back, the market remains concerned about the U.K. government’s unfunded deficits in the context of high inflation. The government’s fiscal easing is at odds with the BOE’s hawkish monetary policy. 


The Bank of Japan (BOJ) also had to step in and spend approximately $20 billion to support the yen in September. This was the BOJ’s first such intervention since 1998. 



Currency moves are important drivers of returns in international markets. However, recent moves even in safe haven currencies highlights that precisely predicting such moves is impractical. Additionally, research shows that currencies move in cycles over time and their impacts tend to average out over the longer term. We continue to stay focused on what we believe is our edge, under our control, and lends itself to more predictability: the continued and disciplined execution of our investment philosophy and process. 


While rising inflationary pressures and hawkish monetary policies continue to remain sources of concern in developed markets, certain emerging markets, like Brazil, have been ahead of the curve in facing such pressures. Consequently, their interest rate cycle is also ahead of the global curve. Brazil has completed the bulk of monetary tightening as it started much earlier and has managed to stabilize its inflation. An imminent rate easing cycle would likely lead to improving economic growth. 


While the Brazilian real has been under pressure for the greater part of the last decade (negatively impacting returns), we think probability is higher now that the real can at least remain stable. Falling interest rates should help reduce the fiscal deficit, as the country’s heavily indebted balance sheet benefits from refinancing its floating rate debt at lower rates. Most of Brazil’s debt is denominated in local currency and Brazil has relatively strong foreign currency reserves. 


The good news is that both corporate and consumer balance sheets are very healthy. High commodity prices should help as well given the country’s status as a commodity exporter. On the political front, the first round of elections results point to neither party obtaining an absolute majority, which removes the tail risk of aggressive right or left leaning policies. Finally, valuations in Brazil are pricing in a very bearish scenario.  


Source: Credit Suisse 



We increased our exposure in Brazil by adding to our holding CCR, one of Latin America’s largest infrastructure concession groups, and reintroducing Banco Bradesco (BBD). BBD is the third largest financial institution in Latin America and a quality bank that earns mid-high double-digit ROEs while trading just above book value. Both companies should benefit from the changing macro regime in the country. 


Sources: FactSet, Bloomberg, Credit Suisse


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