The Market

Global markets in the third quarter of the year began on an upbeat note in July with some markets recovering over 50% of the year’s losses on optimism of peak inflation.  However, the bear market rally was cut short in the last few weeks of September as US inflation numbers did not weaken as expected in the August reading, dragging the S&P500 down to the lowest level in over two years.

Quoting the Bank of Canada, central banks are “resolute” in their fight to tame inflation and will continue with aggressive tightening until the long term inflation target of 2% is met (we are currently hovering around 8% in Canada).  Investors should prepare for continued market volatility in the near-term as policy makers are now waiting until the last possible minute to announce rate decisions and are no longer providing forward guidance. 

The table below shows the market performance as of market close on September 30, 2022, in Canadian dollar terms:

Performance

Given the current market environment, we are still holding higher than normal cash balances in accounts and remain slightly overweight equities and underweight bonds compared to the benchmarks.

The YouFirst Growth and Conservative Growth composites have performed better than their respective FPX benchmarks on a year to date basis.  Refer to the following table:

Portfolio Activity

Over the quarter, we focused on companies exhibiting persistent dividend growth history, quality financials, and relative value. For clients underweight Canadian value, we purchased shares in Bank of Nova Scotia (BNS:TSX), Enbridge (ENB:TSX), CP Rail (CP:TSX), Telus (T:TSX).  We believe that these aforementioned companies hold strong economic moats and pricing power while bottom-line earnings will continue to support the long-term viability of their dividend payments.  While no equity is protected from downdraws even in the best of times, the dividends from these companies will compensate investors for being patient while waiting for long-term capital appreciation.

We sold some positions in Mawer Global Small-Cap (MAW150) and bought units of iShares ESG Aware MSCI USA Small-Cap ETF (ESML:US) with a four-pronged objective: to capture some capital losses to offset 2022 realized capital gains, to maintain our allocation to small market capitalization stocks, seek market-level or better performance, and to lower MERs (management expense ratios).  Further, ESML tilts the portfolio weightings to small-cap US stocks with favourable environmental, social and governance (ESG) ratings and screens out companies that have exposure to civilian firearms, controversial weapons, tobacco, and thermal coal.  We maintain that companies screening favourably on these metrics will outperform their peers in the long run as consumer sentiment and capital are rapidly shifting towards products and services that avoid the above controversies.

Outlook

In the September 2022 US FOMC report, median projections of committee participants are pricing in a further 1.5-2% increase in interest rates in the US over the next three months terminating in a fed funds rate of 4.6% by 2023.  Canada is largely expected to follow aggressive interest rate increases in a similar vein and has already driven borrowing costs to a 16 year high; pre-Great Financial Crisis 2008/2009 levels.  An unfortunate corollary to rising interest rates to tame inflation expectations are a direct slowdown in economic growth and an increase in unemployment.  This begs the question – are we headed towards a recession?

Over the year, we have been closely watching macroeconomic signals of a forthcoming North American recession, which is now becoming apparent.  The US leading economic indicators (LEI) suggests 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.  Coupled with a persistently inverted yield curve over the 2y-10y maturities in Canada and the US (N.B. inversion is seen across all maturities in Canada relative to the 2-year yield) and other signals worsening, we believe that a recession in North America is imminent (or coincident). 

Figure 1¹: Typical macroeconomic signs of a US recession are becoming apparent with conditions continuing to deteriorate.

Financial markets are forward-looking.  In other words this means that rational market participants are looking years ahead and discounting cashflows of investments based on rapidly changing information, today.  Sentiment in capital markets right now is at multi-year lows and due to this, we are taking a contrarian approach by slightly increasing overall equity asset allocations for clients based on their Investment Policy Statements, while holding excess cash in high-interest money market funds yielding >3%.  We are using money market funds in place of new fixed income investments, remaining nimble to move back into growth opportunities as they become available.

Markets will likely suffer through the remainder of 2022 and investors should brace for further weakness in capital markets.  We’ll end this newsletter with an excerpt from a recent opinion piece from the Globe and Mail about what not to do when markets are testing investor fortitude (our emphasis in italics):

“In moments of heightened financial peril, it’s a reliable reflex for retail investors to want to reduce their exposure to risky assets. After all, if you can see the storm approaching, why not get out of town?

Unfortunately, this can be one of the worst mistakes an investor can make. Selling into a falling market locks in losses that, up to that point, exist only on paper. And it sets up the hopeless task of trying to time the market rally once conditions improve.

For investors who panic sell and liquidate their equity holdings, the consequences can last a lifetime…

…Those who do return to the stock market, unless they time the bottom perfectly, will miss out on the early days of a new bull market…If you miss those, you miss a lot of the game.”⁸

Of course, if you would like to discuss your portfolio performance and re-evaluate your appetite for risk, please don’t hesitate to reach out to us.

You may notice below that Simon has graduated from Associate Portfolio Manager to a fully accredited Portfolio Manager allowing him to make independent portfolio decisions.  This is a strong boost to YouFirst Financial’s business continuity plans.

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. August 18, 2022 (https://www.conference-board.org/topics/us-leading-indicators)
3. US Department of the Treasury (https://home.treasury.gov/). August 19, 2022
4. ISM Report on Business (https://www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business/). Sept 2022
5. Board of Governors of the Federal Reserve System, Monetary Policy Report (https://www.federalreserve.gov/monetarypolicy/) September 2022.
6. Trading Economics US Housing Starts (https://tradingeconomics.com/united-states/housing-starts) August 2022
7. Koyfin Global Economic Data (https://www.koyfin.com/data-coverage/global-economics/).
8. It’s a dangerous moment in the stock market. Why it’s probably not time to bail. (October 9, 2022). Globe and Mail.  https://www.theglobeandmail.com/investing/markets/inside-the-market/article-investors-dont-succumb-to-the-cardinal-sin-of-panic-selling/