The Market

Markets started the new year on an upbeat tone after a disappointing 2022.  The optimism was cut short as fears of a policy rate overtightening and the collapse of three US tech-focused regional banks dragged risk appetite down and sent waves of volatility across capital markets.  With regulators stepping in to quell investors’ fears of a systemic financial system collapse (reminiscent of the 2008/2009 Great Financial Crisis), global markets ended the first quarter of 2023 back in positive territory.

The table below shows the market performance as of market close on March 31, 2023, in Canadian dollar terms:

Performance

The table below compares the YouFirst portfolio composites with their respective FPX Benchmarks:

Both YouFirst Growth and Conservative Growth composites underperformed their respective benchmarks for the quarter due to higher cash balances in portfolios relative to the FPX benchmarks.  At this time, cash in portfolios is currently yielding 4.2-4.5% in various Series F high interest savings accounts (HISA) which is a good risk adjusted return relative to bonds.  Holding cash also provides flexibility for us to take advantage of opportunities in the market when they become available.

Portfolio Activity

During the quarter, we purchased shares of Fortis Inc. (FTS:TSX) and Telus Communications Inc. (T:TSX) for clients underweight utilities and telecoms.  We also purchased shares of TD Bank (TD:TSX) and Bank of Nova Scotia (BNS:TSX) on the recent oversold conditions and in our opinion, a market overreaction. The liquidity crisis of Swiss bank, Credit Suisse, appears to have been resolved with the merger with UBS and losses for US regional banks have been backstopped by the US Federal Reserve.  There is further discussion on this topic in the Outlook section of this newsletter, below.

For clients underweight global equity and those with a higher risk tolerance, we added to Manulife (Mawer) Global Equity Class (MMF4606) and Manulife (Mawer) Global Equity Private Pool (MMF4027) as we believe an inflection point in the market may be approaching later this year.  We do believe that overall volatility will continue to be elevated as capital markets are still fragile from the extremely hawkish central bank policy of 2022 and are still facing several headwinds, however, relative strength and confidence will improve when central banks pause and potentially reduce interest rates.

For fixed income, we purchased the new issue of Morguard North American REIT 6.00% convertible unsecured subordinated debentures (MRG.DB.B:TSX) upon the announcement of Morguard REIT redeeming the existing 4.5% convertible debentures on March 24, 2023.  The new MRG.DB.B matures on March 31, 2028.

We sold some positions in Algoma Central Corporation 5.25% unsecured convertible subordinated debentures (ALC.DB.A:TSX) to capture a capital gain as the price of the debenture was trading at an approximate 12% premium to par such that the yield-to-maturity was no longer attractive. 

Outlook

Events over the course of the first quarter of 2023 have strengthened our views regarding the global economy: we see higher odds of an endogenous recession (arising from within the economic system due to rapidly rising interest rates) occurring over the next year, which will likely dampen inflationary pressures as overall consumer spending weakens.

Referring to Figure 1 below, and reiterating statements from our Q4 2022 newsletter, the US leading economic indicators (LEI) suggest that the risk of a recession has now become elevated in the near term with long-term trajectories of the US LEI continuing to worsen.  This leading index has now declined for the last eleven months, and since its inception from 1959, has never failed to signal inflection points in an economic cycle.

All the data in Figure 1 points to doom and gloom in the economy, however there is a light emerging at the end of the tunnel.  Given the weakening economic condition and tighter financial conditions signalled by slowing business and personal loan activity, lower mortgage applications, and higher rates of credit card and auto loan delinquencies, we could perhaps say that the Fed’s task of taming inflation is indeed working.

Surely, the collapse of several regional banks in the US as well as Credit Suisse in Europe could reinforce the decision of central banks to pause their rate hike cycle and consider the ramifications.  Unlike the US Fed, the Bank of Canada reiterated its decision to leave its target rate unchanged at 4.5%.  One factor likely supporting this decision is the elevated level of household debt in Canada (relative to the US) that leaves the domestic economy more sensitive to interest rate hikes.

The banking sector calamities of the past several weeks have certainly added another layer of concern for the health of the economy.  So far, we believe that the contagion to Canada’s financial system appears to be limited, however it’s fair to assume that all global central banks are now more concerned about the potential effect that overtightening can have on certain sectors of the economy than they were just a few weeks ago.

The banking system in Canada is different from the United States in terms of its regulatory regime and its composition.  The Canadian system is concentrated on larger, diversified banks while the US system is more decentralized with a focus on regional banks for everyday banking needs.  We would be remiss for not discussing the impact to our client portfolios from the Silicon Valley Bank collapse in the US.  Based on the information that we have so far, the risk to the banking industry in Canada is low, but not immaterial.  Fortunately, after the Great Financial Crisis, Canadian banks have implemented several policies to backstop liquidity events.

• For our clients, Fidelity Clearing Canada is protected by the Canadian Investor Protection Fund (CIPF), a copy of the CIPF brochure is attached. If FCC were to go insolvent, the following coverage applies:
  1. $1 million for all general accounts combined (such as cash accounts, margin accounts and TFSAs), plus
  2. $1 million for all registered retirement accounts combined (such as RRSPs, RRIFs and LIFs), plus
  3. $1 million for all registered education savings plans (RESPs) combined where the client is the subscriber of the plan.
  4. Note, CIPF does NOT cover losses as a result of a drop in market price and does not guarantee the value of your investment. Refer to the attached brochure for more information.
• For deposits up to $100,000 in each type of account (TFSA, RRSP, non-registered), there is deposit insurance called CDIC backed by the federal government. Since 1967 since the CDIC inception, there has been no loss of money under insurance coverage.  We manage the exposure to each individual bank by keeping a maximum of $100,000 in high interest savings accounts within the limits of CDIC coverage.
• To control portfolio risk, we allocate no more than 5% to an individual bank stock (or any stock for that matter), such that if the bank equity were to go to zero, the maximum loss is only for the amount invested
• There are minimum capital limits and loan loss provisions that banks are required to hold. When the risk of default increases, loan loss provisions go up which protects the liquidity of the banks.  There are also several early warning indicators that the bank must report to their regulator if there is anywhere near a potential liquidity scare.

For clients with an income or conservative risk stance, we believe that high-quality, dividend paying equities and cash held in HISAs over bonds will continue to bear fruit even if short-term aberrations in the market do not reflect the strength of these companies’ operations and consistent dividend payout.

We continue to closely monitor developing economic conditions and will adjust portfolios accordingly should changes to our investment thesis have a material effect.  Please let us know if you have any questions about the material contained in this newsletter.

Doug Garner, P.Eng., CFA
President, Portfolio Manager

Jane Garner, BA, EPC
VP Operations and Client Experience

Simon Chun, P.Eng., CFA
Director, Portfolio Manager

Sources:

1. Adapted from Manulife Capital Markets Strategy, Q2 2022 and Bloomberg Capital Markets Strategy.
2. The Conference Board US Leading Indicators. March 2023 (https://www.conference-board.org/topics/us-leading-indicators)
3. US Department of the Treasury (https://home.treasury.gov/). January 10, 2023
4. ISM Report on Business (https://www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business/). March 2023.
5. Board of Governors of the Federal Reserve System, FOMC Minutes (https://www.federalreserve.gov/monetarypolicy/) January 4, 2023.
6. Trading Economics US Housing Starts (https://tradingeconomics.com/united-states/housing-starts) March 2023
7. Koyfin Global Economic Data (https://www.koyfin.com/data-coverage/global-economics/).