Before we get into this quarter’s Quarterly Compass Newsletter, I want to congratulate Kyle and his wife, Devon, on the arrival of their son Landen!!!
May 27th also marked our first anniversary at Wellington-Altus Private Wealth. I would also like to take a moment to thank each of you for joining us and for and your continued trust and confidence – we are honoured to serve you and your family!
As we move forward, we remain steadfastly committed to continual improvement. In this spirit, we have introduced a new way of setting a time to communicate with us. Going forward, when you receive an email reminder of an upcoming Wealth Road Map Review Meeting or Wealth Strategy Call, we will include a link to a feature called Calendly. Calendly allows you to directly book a convenient time slot for your meeting or call without any back and forth. Bookings can be made anytime, and we hope that introducing this option will make the process more convenient. If you prefer to book directly with us by phone or email, we are happy to help.
If you have any questions about the Quarterly Compass Newsletter or anything else in your financial life, please use the below link to set up a time to talk or reach out to Jordan or Scarlett, and they will be happy to set up a time!
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For those that believe “brevity is the soul of wit”, here is the Quarterly Compass Newsletter in five key points:
- U.S. Equities outperformed in the quarter, led by large cap technology
- Inflation continues to fall in both Canada and the U.S.
- No recession yet despite warning signs. Economic slowdowns do not need to result in a recession.
- A.I. is not something to ignore. See below for a link to a great primer on A.I.
- The outlook remains positive. Despite dire predictions, client portfolios have risen steadily since October 2022.
Quarterly Compass Newsletter – June 30, 2023
Q2 2023 saw mixed equity markets. In North America, the NASDAQ and S&P500 led markets with appreciation of 15.38% and 8.68% respectively (in USD). The Canadian S&P/TSX Composite was up by 1.1%. International markets were also positive, with the MSCI EAFE Index up 3.25% (in USD). The overwhelming theme of Q2 was the continued leadership of equities whose earnings are weighted toward the future (Growth) vs. stocks whose earnings are more weighted to the present (Value). Unsurprisingly, Growth tilted markets, such as the S&P500 and NASDAQ, led while Value tilted markets, such as the S&P/TSX, and MSCI EAFE lagged. Even within Value tilted markets such as the S&P/TSX Composite, Growth sectors such as Technology dramatically outperformed value sectors such as Energy and Financials.
Per Refinitiv, key global Fixed Income benchmarks, such as the U.S. 10 Year Bond, saw yields rise somewhat vs. the end of Q1. Even with the uptick, yields are still well off their October 2022 highs. In Canada, the Bank of Canada (BoC) raised rates by 0.25% after being on pause for most of the year. The bump in rates was a bit curious as the economic/inflation data coming in was not particularly strong and Canadian debt to GDP is amongst the highest in the G7. This has led to some speculation that the hike was to either build more room for future cuts or to counter some of the deficit spending being enacted by the Federal Government.
During Q2, commodity markets were ~3% lower as per the Bloomberg Commodity Index. Furthermore, as per Refinitiv – market-based expectations of inflation remain well-contained with longer-term inflation “break-even” rates ranging from 5 to 30 years, all remaining below 2.50% at the time of writing. One-year inflation break evens closed out the quarter at approximately ~1.82% well below their March 2022 peak.
Based on questions from clients I have collected a few thoughts. As always, the focus of the Kluge Wealth Advisory Group is on preparation and not prediction. Irrespective of any views, we always acknowledge and prepare for a wide range of events and outcomes. That said, the picture painted by my Risk Dashboard remains cautiously optimistic about the path forward. As a result, we recommend that investors consider reducing cash and buying both high quality equity and fixed income, where risk tolerance and objectives allow.
First, we continue to see inflation come under control. In Canada and the U.S., the year/year nature of the data means that there will be a big drop in reported inflation once the June 2022 numbers come out of the data. In the U.S., this means that absent other changes, the year/year rate will likely fall from the ~4% rate we see today to ~3%. Furthermore, based on an analysis done by Fundstrat – U.S. inflation driven primarily by housing and used cars. Looking at each of these in turn, it appears likely that reported inflation will fall further because the housing and used car data is lagged and reflects “catch up” from the past. More timely indicators of housing and used car prices tell a different story. Jeremy Schwartz from Wisdom Tree Investments has an ongoing calculation of CPI inflation using real-time housing data – it shows core CPI inflation at a 2.2% year/year rate. You can also see the declining trend in U.S. inflation from looking at the U.S. core inflation ex-housing which has dropped to 2.5% year/year. Finally, the moderation in prices can be seen in the make-up of the inflation figures. As of May, 42% of the prices in the CPI basket used to calculate inflation were down year/year, much higher than the 50-year average of 30%.
The picture is broadly similar in Canada with inflation declining to a 3.4% annualized rate in May vs. the 8.1% annualized rate, which peaked in 2022. In its most recent report on inflation, StatsCan reported that the biggest single source of inflation was higher mortgage interest costs followed by travel services. Excluding the increase in mortgage interest cost (rising rates causing inflation), inflation fell to a 2.4% year/year rate in May.
I also continue to see a lot of questions around the possibility/probability of a recession. Waiting for the recession to appear seems to be the economic equivalent of “Waiting for Godot”- we talk about it showing up, but it has not. To be clear, several historically accurate forward-looking indicators that forecast a slowdown – they must be seriously considered. That said, not all slowdowns need to be recessions. Slowdowns have included past instances of “soft landings” where economic growth slows down, but the economy does not slip into contraction; instead, it slips into another expansion. In considering all the research and views I consume – it seems to me that the key point of whether we slip into expansion or recession is going to come down to how the U.S. Federal Reserve (The Fed) reacts to the slowing of the inflation data we have seen, and will likely see, over the next few quarters. If The Fed continues to raise rates, the cumulative impact of interest expense taking money out of the economy and the negative impact to confidence will likely catalyze a recession (Godot shows up). On the other hand, if The Fed begins reversing course, it seems likely that the positive boost to confidence and the prospect of moderating interest rates will allow us to slip into an expansion (Godot stays at home to watch Netflix). Co–incidentally, this course of action would have the benefit of helping to fix the problems currently plaguing U.S. regional banks.
There have also been a lot of questions on A.I. (Artificial Intelligence) and investment opportunities. My focus so far has been on the “picks and shovels” of A.I. – the large software and chip makers that will sell the tools needed for A.I. enterprises to develop applications. A.I. is a fascinating space with many fundamental aspects that are still undecided (e.g., the debate of open vs. closed sources) and there will be a lot of winners and losers. This is not a technology that can be ignored, but at the same time, there is no need to invest “on the bleeding edge” of the space. Unlike much of the blockchain (i.e., cryptocurrency) sector there are many ways to gain substantial exposure via companies with real products, real innovative track records and REAL profits. As with the internet or any other technology revolution, humans will likely overestimate the impact in the short term and underestimate it in the long term. I recently shared a link on my LinkedIn profile that gives a great primer on the current state of A.I.: https://www.visualcapitalist.com/sp/artificial-intelligence-the-journey-to-a-thinking-machine/
I remain optimistic about the outlook. By and large, both individual and institutional investors remain underinvested and generally negative on the markets despite recent positive returns. Examples of this negativity include: data from the recent Bank of America Fund Manager Survey showing that allocations to stocks continue to be at very low levels vs. historical averages and that sentiment remains at levels last seen during the financial crisis in 2008/09. Furthermore, as reported by Evercore ISI, short positions (i.e. bets against) against the S&P500 remain at elevated levels vs. history. This negativity has been and remains a significant contrarian positive – history is clear that extremes in sentiment and positioning in either direction usually resolve in the market moving in the opposite direction vs. expectations. The steady (albeit choppy) advance of markets since October 2022 has allowed us to see this phenomenon in real-time. In the face of multiple stress events and a plethora of dire predictions, we have witnessed that markets (and your portfolio) have “bent but not broken” and then resumed their uptrend.
This resilience, coupled with the continued leadership of sectors that tend to do well as the economy is strengthening (technology, transportation, homebuilding etc.), an improvement in ex-energy earning expectations, falling inflation and a continued drop in the U.S. dollar index (a rising USD vs. world currencies is usually a sign of serious stress), all point to the probability of further strength in stocks. Finally, amongst a multitude of other technical indicators, BMO Capital Markets, points out that in the post WW2 era, that if the S&P500 has been up 10-15% in the first half of the year, then the last six months return 11% on average. Again, any single statistical analysis can be wrong, but collectively they present a pattern that has had a powerful tendency to repeat throughout many different historical circumstances.
Finally, it is important to remember that the economic and market cycles do not necessarily align, so although the current situation feels unsettled, it would be totally normal for the market to begin its recovery before the economy. This has the potential to create some scary headlines but since the markets are forward-looking vehicles, there would be nothing unusual about it occurring. Maintaining an investment discipline in the face of “the herd” is very difficult, which is why most investors do not do it, despite its historical profitability. In all the noise we have been hearing, it is easy to forget that since October 2022, we have seen portfolios rebound on the back of strength in both equity and bond markets. No one knows the future but the best chance of success is to understand and make the types of decisions that have proven successful. Again, to paraphrase Warren Buffet – we want to be greedy when others are fearful and fearful when others are greedy.
We have taken several actions in the portfolio entrusted to us since our last update. First, we have conducted our routine quarter-end review of all holdings and have adjusted the names in the portfolio to ensure that each one reflects our desire to hold a diversified basket of high-quality stocks in an uptrend. A key part of our process involves profiting from our successful names and looking at the worst-performing stocks with an eye to reduce or remove them in favour of stocks with a better fundamental and technical profile. Secondly, late in Q1, we increased our weighting in U.S. equities as the U.S. markets have a better selection of high-quality technology, consumer discretionary and industrial stocks vs. International or Canadian markets.
These are uncertain times, but I firmly believe that by maintaining a disciplined approach, maintaining a long-term view, and focusing on proven behaviors, we can continue to profit from the current moment.