Janus was the ancient Roman god of entrances and exits, thresholds and transitions, beginnings and endings, and in some ways time itself. According to mythology, Janus was present when the world was created and even now presides over the change from one year to the next with January as his namesake. Given his role, it is no wonder that Janus had two faces: one looking forward and the other looking backward. In this regard, Janus could also be the patron deity of prudent investors that need to understand the past while continually forming a thesis of the future.
2022 has been a year that has witnessed broad post-pandemic reopening, a spike in inflation triggered by a mismatch of supply and demand, and central banks rushing to extinguish inflation by dramatically hiking interest rates. Indeed, much of the volatility in capital markets this year can be attributed to the rapid pace of interest rate increases which surprised even those very central bankers in charge of setting them. A full cycle of interest rate hikes that would normally take 2-3 years is being compressed into less than 12 months.
With inflation being the primary culprit, and the topic of recent newsletters, our focus this year was to monitor and project inflation’s trajectory. Doing so would inform us about central bank deliberations and the likely interest rate path. Based on our analysis of shifting demand and supply conditions and prices of underlying goods and services, we expected inflation to peak mid-year. As summer transitioned to autumn, additional readings did confirm that the Consumer Price Index peaked in June for both Canada and the U.S. at 8.1% and 9.1%, respectively.
As more time elapses since the June peak, and monthly inflation readings continue to decelerate, both investors and central bankers are gaining confidence that the worst of inflation is behind us. The Bank of Canada and Reserve Bank of Australia have already slowed the pace of rate hikes. The U.S. Federal Reserve recently opined that it is ready to step off the meeting over meeting increase of 0.75% by stating in its November 2nd statement “In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” In simpler language, the Fed has already administered a lot of medicine, understands that it takes time to work, and is ready to slow down. Market participants call this a pivot and a reason to become more confident.
Our inner Janus has a favourable outlook for 2023
The steady recovery in equity and bond markets since mid-October didn’t wait for the Fed to pivot. Rather, it has been the willingness to turn the backward-looking gaze of high inflation and interest rates to a forward-looking period when a reduction of supply/demand imbalances should drive inflation lower and potentially lead to interest rate cuts later in 2023.
Price trends across a wide swath of the economy, including housing, energy, raw materials, and goods/services, combined with the base effects of high inflation rates in 2022, have many economists forecasting a steady deceleration in inflation over the coming 18 months. Indeed, the consensus U.S. inflation forecasts for Q3 2023 and Q4 2023 are 3.65% and 3.10%, respectively (per Bloomberg). These represent dramatic declines from June 2022’s peak rate of 9.1% and the most recent October reading of 7.7%. The path may be bumpy, but we agree with the declining inflation thesis.
As the cumulative impact of higher interest rates impacts consumer demand and supply chains show further improvement, central banks can be expected to not only slow the pace of rate hikes but pause altogether, and eventually begin the cyclical pattern of cutting interest rates. Current interest rate futures are pricing in a total increase of 0.50% by the Bank of Canada. Spread evenly across the upcoming December 7 and January 25 meetings, this would suggest a peak rate of 4.25%. In the U.S., the Federal Reserve is expected to raise rates by 0.50% at its December 14 meeting, followed by 0.25% at each of its February and March meetings, bringing its peak rate to 5.00%. After a pause lasting 6-8 months, both central banks are expected to begin cutting rates by Q4 2023.
The fundamental relationship between interest rates and asset values is well known: they move in opposite directions. The effect of higher interest rates this year on equity markets is more widely recognized than the impact borne by the bond market. In some cases, especially long-term bonds, the decline has been as much or worse than equity markets. Indeed, an ETF holding long-term U.S. Treasury bonds has declined 30% year-to-date as of November 25. As interest rates approach a cyclical peak and potentially decline starting in late 2023, we expect asset values to continue the recovery that started in October. Rather than be confined to the equity market for opportunities, we think the bond market offers a unique opportunity to earn high interest rates and potential capital gains as interest rates eventually reverse course.
While combatting inflation was the objective of raising interest rates, economic activity may be the collateral damage. At this point, we think there is a high probability of a mild recession in the first half of 2023. Why mild and not severe?
By definition, recessions are characterized as two consecutive quarters of negative real GDP growth (real GDP measures economic activity adjusted for inflation). With inflation still likely to hover in the 4%-6% range in the first half of 2023 (per economist consensus tracked by Bloomberg), it’s conceivable that nominal GDP growth (i.e. before adjusting for inflation) remains positive even as real GDP dips into negative territory by elevated inflation. A second reason is that the unemployment in Canada and the U.S. remains well below “full employment” levels, meaning an expected 1.0%-1.5% increase may simply return economies to normal levels. While this is our base case, we intend to remain vigilant for signs of a more protracted slowdown.
Gradually raising equity exposure back to neutral levels, but also favouring long-term bonds
We have continued to be highly responsive to changing market conditions over the past two months. As fully described in the portfolio transaction summary below, we have completely exited international equity markets due to heightened geopolitical risk and better relative valuations in Canadian and U.S. markets. After exiting most of our direct Canadian bank exposure in early 2022, we have re-established an equity position in Bank of Nova Scotia as its relative underperformance and outsized dividend yield have increased its attractiveness.
We have also added a meaningful position in Brookfield Asset Management (soon to be re-named Brookfield Corp.), a Canadian-based owner/manager of global long-lived infrastructure, real estate, and renewable energy assets. We have also continued to increase the weighting of long-term Canadian and U.S. government bonds, making this asset class the largest position in many portfolios. Our overall equity weighting has now been increased back to neutral levels after being underweight in recent months. While we hold a modest amount of cash to facilitate rebalancing transactions, we consider our managed portfolios to be fully invested.
