Q4 2022 and Year End Strategy & Market Reviews

Each quarter, our Investment Management teams publish their key observations and portfolio updates across Global Equity and Fixed Income markets. This is a summary of our views for the Third Quarter of 2022. You can download the full reports via the links shown below.


We have just concluded another year of tremendous volatility, although it finished on a positive note. The S&P500 total return for the fourth quarter was +7.6% in US dollars or +6.3% in Canadian dollars. The fourth quarter TSX total return was +6.0%. For the year, the S&P500 total return index was down -18.1% in US dollars or -12.5% in Canadian dollars. The TSX total return was -5.8% for 2022.

While it’s never fun to have a down year, the previous two years featured strong gains. Between 2020, 2021 and 2022, the average annualized total return for the S&P 500 was approximately 9.6%, which is close to the average of the past 50 years.

The losses of 2022 were almost entirely comprised of a forward price/earnings (P/E) multiple contraction of -22.07%, and were slightly offset by a positive contribution from dividends (+1.33%) and positive forward earnings per share of +3.37%. In other words, most of the decline was a result of people willing to pay less for every dollar of earnings in 2022 than they had been previously, mainly as a result of higher interest rates and perceived risk.

Two-year stretches of P/E multiple contractions are rare, and 2021-2022 ranks as the greatest two-year P/E multiple contraction of the past 38 years. Meanwhile, earnings themselves have not collapsed. Current forward earnings growth is still positive for 2023 and 2024 at +5.1% and +10.1% respectively, such that the forward P/E multiples are starting to look reasonably attractive at 16.7x and 15.2x compared to the historical 10-year average of 17.3x. Our experience is that the market begins to look forward to the next year (2024) usually by the second quarter of the current year.

While there are no shortages of negative economic forecasts for 2023, we think there is a reasonable chance for the Federal Reserve to tame inflation and for the economy to remain resilient. Even if we are wrong and we do experience a mild recession, our best guess is that long term interest rates will fall, which would lead to P/E expansion and support for market valuations – potentially reversing the historic P/E contraction of 2022. 

Peter Jackson, HBSc, MBA, CFA

Chief Investment Officer

Portfolio Manager, North American Equities


During the quarter, our overall equity exposure decreased by 6% to 96%. Our US equity exposure increased from 37% to 38% while our Canadian exposure increased from 53% to 58%. Cash decreased from 10% to 4%. It is important to keep in mind that many of our clients’ portfolios are invested in equities globally, through our North American plus International Equity strategy, meaning that the actual weights of US and Canada within their equity holdings will be proportionately less than this given the 15-20% allocation to international companies.

We have continued to position the portfolio toward value-oriented stocks. Value stocks now make up 63% of the portfolio. Our exposure to growth stocks was trimmed by about 1% to 29% of the portfolio. Staples, which we don’t classify as either growth or value, make up the ~8% balance of our equity exposure.

During the quarter, we added a number of new stock positions, including: 

Enghouse Systems Ltd. acquires and integrates technology companies. After a brief lull, it’s most recent quarter showed stronger revenue and EBITDA growth. This Canadian company also announced two acquisitions that should re-accelerate growth.

Arthur J Gallagher & Co is one of the leading insurance brokerage, risk management, and human capital consultants in the world. We like this business and consider it defensive, as most insurance purchases are non-discretionary. 

Eaton Corp. PLC is a power management company that benefits from the shift to renewable power. New orders and backlogs have accelerated, and secular tailwinds should support prolonged revenue growth at mid-to-high single digits.

Elevance Health Inc. is one of the largest health benefits companies in the United States. We like the demographic-driven stability and growth characteristics of health care, and believe the company is well positioned to benefit from this trend. 

A more detailed review of each company can be found in the full report per the link above.



Phil D’Iorio, MBA, CFA
Portfolio Manager, Global Equities

Download Full Commentary


Inflation was percolating at the start of 2022, and the war in Ukraine served as a catalyst to drive it even higher. In response, central banks aggressively hiked interest rates as you have seen. Against this backdrop, both stock and bonds lost money. Since 1926, there have only been two calendar years when stocks and bonds were both down.

We believe that a changing of the guard may be unfolding in terms of stock market leadership. During the fourth quarter, the MSCI EAFE and MSCI Emerging Markets Indexes both outperformed the MSCI USA Index. This trend may continue after 15 years of outperformance by the United States, thanks in part to a fading US dollar.

We are cautiously optimistic about 2023. Inflation is showing signs of cooling, which means we may be getting closer to the end of rate hikes. We believe that the companies we own, with stable earnings, low leverage, and pricing power, are well positioned for 2023. And history suggests that forward returns are typically strong in the aftermath of a bear market.

We recently added several new stock positions, including Arthur J Gallagher & Co and Eaton Corp, which are highlighted on the previous page. We also added:

Avery Dennison is a materials science company specializing in labeling and functional materials with dominant market share, pricing power and economies of scale.

FinecoBank is one of the most established online banks in Italy and stands to benefit from the wealth transfer to younger generations and higher interest rates.

Keyera Corp is an integrated energy infrastructure business with extensive interconnected assets and a generous dividend yield.

Keysight Technologies is a global leader in testing and measurement equipment with exposure to several themes that we like, including electrification and reshoring.

A more detailed review of each company can be found in the  full report per the above link.



Owen Morgan, MBA, CFA
Portfolio Manager, Fixed Income

Download Full Commentary


During the last quarter of 2022, fixed income also markets continued to wrestle with three things: inflationary data, ongoing interest rate hikes and elevated recessionary risks.

In December, The Bank of Canada made two statements that highlight recent uncertainty. First, the Bank noted that “its Governing Council will be considering whether the policy interest rate needs to rise further,” potentially signaling that the rate hike cycle is close to an end, then noting that the “annual run rate inflation is still too high, and short-term inflation expectations remain elevated,” leaving the door open for further hikes.

Like Canada, the headline economic story in the US was inflation. The market currently expects another 50-75 bps of overnight interest rate hikes in 2023, and for the rate to peak at 5.0% in June. We anticipate that, like the Canadian situation, the Fed will pause and watch the state of the economy in the second half of 2023 before making further moves.

Subtle shifts in the Bank’s commentary and five consecutive months of declining inflation in both countries have us feeling more positive than we have in months.

Firstly, we believe we are near the end of the rate hike cycle, and therefore the impact of higher rates on fixed income securities should soon end, barring any unforeseen shocks. Secondly, there is a risk of a recession in our view, but we believe it will be mild. Consensus forecasts of Canadian and US GDP expects positive growth in 2023 and the labour markets in both countries remain tight.

With a rate hike or two still likely, we maintain a shorter duration than the benchmark. Some of the investment opportunities in the 2-3 year range offer yields that are almost as attractive as those maturing 7-10 years out, and we don’t believe the relatively minor additional yield of longer bonds compensates us adequately for the additional maturity risk or remaining interest rate risk.

We believe the current yields are more compelling than they have been in many years. As a result, we are looking for opportunities to lock in investments for the benefit of our client portfolios. To get a deeper understanding, you can read the full report via the link above.

Fourth Quarter Fixed Income Strategy Review

During the last quarter, fixed income markets continued to wrestle with
(i) inflationary data and expectations,
(ii) global central banks’ attempts to tame inflation through ongoing interest rate hikes and reducing money supply
(iii) the elevated recessionary risk concerns for the economy, both domestically and globally.

Fourth Quarter 2022 Global Equity and International Review

2022 was a challenging year for investors. Inflation had been percolating in the background when the year began and then the onset of the war in Ukraine served as a catalyst to drive inflation even higher. In response to inflation reaching levels not seen in 40 years, central banks in various parts of the world started hiking interest rates. Against this backdrop, both stocks and bonds lost money in 2022. It is very unusual for this to happen. Since 1926 there have only been two calendar years when stocks and bonds were both down. Those years were 1931 and 1969. According to Ned Davis, 2022 marked the first time on record that both stocks and bonds fell by more than 10%.

Fourth Quarter 2022 and Year End North American Equity Strategy

2022 was another year of tremendous volatility, although we ended the year with some positive recovery as the S&P500 total return for the fourth quarter was +7.6% in US dollars. Adjusting for currency, the S&P500 returned +6.3% in Canadian dollars, as the Canadian dollar appreciated about 1.5 cents, closing the quarter at US$0.7381. The TSX total return was +6.0% in the fourth quarter. For the year, the S&P500 total return index was down -18.1% in US dollars or -12.5% in Canadian dollars, as the Canadian dollar depreciated -5.3 cents. The TSX total return for the year was -5.8%. To put this negative performance for 2022 in context, recall that in 2021, the S&P500 total return index was up +28.7% in US dollars or +27.5% in Canadian dollars, while the TSX total return for the year was +25.2% and that followed positive returns in 2020 even with the large COVID-19 drawdown in March of that year. As well, the North American Capital Appreciation strategy has managed to do better than the markets over these past two years.

An Arbitrary Grading of Our 12 Themes for 2022

One of our more popular reading materials for the 2021 year was our “12 Themes of 2022” piece that we published just prior to the Holiday Season. As we have been working very diligently on publishing our 12 themes of 2023, we thought it would be an interesting exercise to go back and look at the potential themes we identified and see how they turned out. With the benefit of hindsight, we will be giving each theme a grade (completely arbitrarily) based on the relevance and the accuracy of the theme with respect to what transpired over the past 12 months. Keep your eyes open for our 2023 themes which should be published over the next few weeks.

1. Favour Companies with Pricing Power

Grade: A

Inflation continued to dominate headlines for the majority of 2022 and while markets were difficult throughout the year, companies and industries that could not raise prices for their goods/services were hit very hard relative to those that could. This theme was illustrated by the Healthcare Sector (with its pricing power) outperforming the Consumer Discretionary Sector(no pricing power) by nearly 20% year to date as of this writing. By focusing on investing in businesses with pricing power, we sheltered investors from a lot of potential downside.

2. Don’t forget about Copper and Oil

Grade: A-

This theme really looked good for the first half of the year and, due to that strength within commodities for those six months, which is why the grade is so high. As of November month end, commodities have been the best performing asset class in 2022 with the BCI ETF having outperformed the S&P500 throughout 2022 by 32%. A few marks are docked because all of this outperformance was felt in the first 6 months of the year. Commodities peaked as of June 8th and have underperformed the S&P500 by nearly 13% since.

3. Short Duration Bonds for the Win

Grade: A+

Absolute home run with this prediction as 2022 was a lesson for bond investors about the potential downside in long duration assets. For the first time in over 40 years, yields went up and went up A LOT and if your bond portfolio was exposed to long duration bonds you most likely experienced losses that you have never seen within fixed income before. The most widely used ETF for long duration bonds (TLT-US) and as of this writing, it is down nearly 30% on the year. While unprecedented, the TLT has serious interest rate risk as it is shown with a duration of over 17 years, as opposed to our Kipling Strategic Income Fund that has a 2 year duration and has seen a return of -1.8% through the first 11 months of the year.

4. Capital is at Risk if you Hold to Maturity

Grade: A+

Another dead accurate prediction when it came to bonds. This fall, we saw the US 10 year bond hit its highest yield since 2007 at 4.37%. This was preceded by a 3-year period from 2018-2021 where that same 10 year bond went from a high of 3.25% to a low of 0.52%. Essentially, nearly every bond that had been issued from 2018-2022 was trading at a premium to par and then that premium was erased to a point where many of those bonds began trading at a discount (below issue level or par).

5. Single Family Housing Strength Doesn’t Stop

Grade: D

Our worst prediction for 2022. So, where did we go wrong? Well, the thesis was driven around the fact that the fundamentals for housing were very strong. Structurally we had underbuilt new housing communities since the Financial Crisis until 2019. Mix in the underinvestment with the demographics of the Millennial generation beginning to reach average “first time home buyer age,” it suggested that the strength in housing would continue. However, we did not see interest rates going up nearly as much as they did, which tempered mortgage demand. US mortgage rates went from nearly 2% in 2021 to 7% at one point in the late summer, which caused mortgage applications to plummet. While wrong for 2022, the underlying fundamental argument is still holding true. November saw an increase in mortgage applications of nearly 13% from October as mortgage rates fell nearly 0.5%. Due to this bounce back in mortgage demand homebuilders have seen a recent bout of outperformance after seriously struggling through the first 6 months of the year.

6. Liquidity continues to dry up

Grade: B+

While accurate on the fact that we continued to see liquidity dry up, we were only talking about 3 rate hikes throughout 2022. In hindsight this is almost laughable as November saw the Federal Reserve raise rates for the 13th, 14th and 15th time all at once. December appears as if we will see another two rate hikes bringing the total of rate hikes to 17 for 2022. Liquidity within the financial system dried up faster and more rapidly than we could have imagined.

7. Tail Risk Protection

Grade: C+

While the argument for Tail-Risk protection was primarily revolving around the fact that, in our view, traditional fixed income instruments were not going to buffer investors’ portfolios in a potential down market (A+ on this), tail-risk protection didn’t help either. While painful at times, the bear market that we saw in 2022 was very orderly and the VIX (volatility or fear index) never spiked to levels that would see any kind of Tail-Risk Protection strategy buffer losses in portfolios.

8. Non-profitable Covid Beneficiaries Will Continue their Disappointment

Grade: A+

The pain and suffering continued. While Goldman Sachs Non-Profitable Tech index saw a return of -38% in 2021, the first 11 months of 2022 we saw that downward trend continue with that same index seeing a return of -58%. Worse than the index, major 2020 winners such as Zoom, Peleton and Roku followed their lackluster 2021’s with returns of -59%, -67% and -74% in 2022. What is perhaps more interesting is that the pain felt in the unprofitable sector expanded to include a lot of the profitable tech businesses and punishment for any new project that wasn’t profitable right away experienced downwards pressure in their stock prices (looking at you META). Investors mindset about profitability and growth has done a complete 180 over the last 24 months.

9. T.I.N.A -> There is No Alternative

Grade: C

While true at the beginning of the year, and why we were so weary on the majority of fixed income, this acronym was no longer relevant by about June. With the central banks on a historic rate hiking cycle TINA has transformed into TARA (There Are Reasonable Alternatives). Interest rates in GICs, Money Market Funds, Corporate Bonds and Government Bonds have gotten to a point that is generating a positive real rate of return for the first time in nearly 15 years. Equity investors are going to need to have a higher hurdle rate to justify the risk associated within equity markets going forward.

10. Diversification beyond the Traditional Balanced Allocation is the Key

Grade: A+

The traditional balanced 60/40 portfolio has had one of its worst calendar years on records as equity and fixed income became nearly perfectly correlated. A balanced portfolio made up of the MSCI World Index and the Canadian Aggregate Bond index would have seen a return of nearly –9% through the first 11 months of the year. Alternative assets and alternative strategies have buffered losses and done wonders for diversification within portfolios.

11. When it comes to Shorting, Fundamentals will Matter!

Grade: A

While possibly a very obvious theme, one must go back and think of the environment we were exiting at the end of 2021. Liquidity and support was the main theme and, as we had just experienced in 2020 and through the majority of 2021, stocks just went up. A rising tide lifts all boats and the least seaworthy rise the fastest. The reversal of liquidity that we saw in 2022 has reversed this phenomena and has led to a resurgence in fundamentals mattering.

12. Increased Participation in cryptocurrencies

Grade: B-

While the direction of the price doesn’t suggest it, major cryptocurrencies did continue to see an increase in participation. Globally the number of exchange traded crypto products has increased nearly 70% in 2022 going from 111 products at the beginning of the year to 186 products by the end of September. Interestingly enough, it is not North America that is leading the way of growth in product, but global banking capital Switzerland. All of this adoption in the face of a 70%+ drawdown.

Overall Grade: A-

As Yogi Berra famously said “It’s tough to make predictions, especially about the future” but we will happily take our arbitrary honour roll grade of A-. It has been a wild ride, but 2022 has proven to be a year where a lot of investors should be going back to the drawing board and adjusting the way they view the world. To our clients that have entrusted us with their hard-earned wealth – thank you for that trust. Keep your eyes peeled for our 12 themes of 2023 piece coming up in the next few weeks.

Big Tech Meets Big Government

As companies mature, they increasingly look to M&A to find new markets for growth. The big cap technology stocks¹ (“Big Tech”) have used M&A to (1) develop new markets and, (2), to ward off new entrants competing for market share. Regulators have been increasingly hawkish towards approving these mergers which may slow growth in the future. The relative outperformance of small and mid cap technology companies² (“SMID Tech”) in 2022, despite being more expensive at the beginning of the year, could be a signal that the market is pricing-in a more difficult growth environment for Big Tech in the future.

For the five years prior to 2022, the largest technology stocks (“Big Tech”) was the best place to be for US investors, with +34% compound annual return over the period. Small and medium sized technology companies (“SMID Tech”) performed well relative to the S&P 500 (+20% vs. +16%) but Big Tech outperformed them both.


Figure 1 Large cap technology stocks outperformed SMID cap technology and the S&P 500 from 2017 to the end of 2021.

That strategy broke down in 2022 as the S&P 500 outperformed the technology sector and SMID Tech outperformed Big Tech.

Figure 2 Year to date, large cap technology stocks are down more than SMID cap technology and the S&P 500.

The shift from growth to value (or expensive stocks to less expensive stocks) helps to explain the lagging performance in technology, but it doesn’t explain why smaller technology companies outperformed Big Tech in 2022. On a price-to-earnings basis, SMID tech was more expensive at the beginning of the year and remains so today. Being more expensive, SMID Tech was more vulnerable to the markets shift to value over the course of the year. Yet, on a year-to-date basis, Big Tech stocks are down 41% while SMID Tech stocks are only down 33%.

Figure 3 SMID Cap stocks were more expensive than large cap technology stocks on a price-to-earnings basis at the beginning of the year and remain more expensive today.

Big Tech’s price-earnings multiple has contracted 26% while small cap technology’s multiple has only contracted 17%. Generally, Investors are willing to pay a higher price-to-earnings multiple if earnings are growing. The obvious inference is that investors are becoming concerned about Big Tech’s ability to grow earnings in the future.

One source of concern could be the increasing attention big technology is garnering from competition regulators. Over the last decade, Big Tech used acquisitions to establish new areas of growth and to entrench their competitive position in new markets. The usual competitive advantage for these large technology companies is a network effect – where a digital platform becomes more powerful as it gains more users, content, and developers.

In past years, regulators were less likely to interfere with network reinforcing acquisitions. One prevalent example was in 2012, when the Federal Trade Commission (the “FTC”) cleared Meta’s[3]  acquisition of Instagram without objection. Meta had the dominant social media platform on the web, but Instagram was gaining momentum with mobile users. The acquisition crystalized Meta’s virtual monopoly on the web and with mobile devices. The FTC didn’t think much of the acquisition at the time. Instagram was just a small company with 13 employees.

Meta recently announced an acquisition of Within Inc., looking to entrench its early lead in virtual reality. Within Inc. is the application developer of Supernatural, the dominant dedicated fitness app for Meta’s virtual reality platform, Quest. Meta doesn’t currently compete in the dedicated fitness category. However, the FTC is challenging the acquisition on the basis that Meta has the size, resources, and capability to potentially compete in the dedicated fitness virtual reality app market.[4] If the potential competition challenge is successful, it could prevent many big technology companies – all of which have size, resources, and capability to potentially compete in any market – from entering newer markets through acquisition.

Regulators are also cracking down on “strategic” acquisitions intended to protect market share. Last year, Visa walked away from acquiring Plaid, who is building a competing payment network, to avoid a protracted legal battle with the Department of Justice.[5] Similarly, Adobe just announced the acquisition of Figma for 50x its annual recurring revenue – a price only a cornered incumbent would pay.[6] The DOJ is preparing to launch an investigation and it would not be surprising if the Adobe-Figma deal meets the same fate of the Visa-Plaid deal.

Many of the other Big Tech companies have an outstanding file with regulators to challenge an outstanding merger or for a potential breach of antitrust laws. For example, Microsoft is being challenged by the FTC and the UK’s CMA over its acquisition of Activision.[7] Alphabet is being sued by the Department of Justice for “unlawfully maintaining monopolies through anticompetitive and exclusionary practices in the search and search advertising markets.”[8] While not all these challenges will be successful, they slow down the M&A process and often result in concessions to the regulators.[9]

It’s no wonder that investors have preferred SMID Tech over the last year to avoid the uncertainty of regulator and political interference. SMID Tech companies often have robust organic growth that can drive stock price appreciation, without the need for M&A.  At Cumberland Private Wealth Management, we still believe some of the larger technology companies are good investments, but we are careful to choose only those that have less growth priced in and those that continue to have organic growth opportunities available to them.

Never Look Santa’s Gift (Horse) In the Mouth

Every gathering, regardless of whether it is with friends or strangers, the question always arises “Is now a good time to invest in the market?”. Market timing is always difficult and has nuance depending on the time horizon being considered. If you have decades until retirement, the answer should always be yes, near fully invested. However, what people are really asking is, “If I buy today, will I be disappointed within the next couple of months?”. There is never a perfect answer, but we can highlight certain times when, on average, the probabilities are more in your favor for purchasing a long-term investment.   

Here are four points to consider – Momentum, Seasonality, Sentiment, and Inflation.  

  • Since 1980, there have been 19 times where the price of over 45% of stocks made a new 30-day high together. Of the 19 times that this happened, 73.7% of the time you have a positive return exceeding 3% over the next two months (the median return was 7%). This indicator just occurred on the 10th of November 2022 (per Ned Davis Research).  
  • Seasonality has a real effect on when returns on average occur during a calendar year. The typical strongest point in time begins in October and extends all the way into the end of the year, sometimes into earlier next year. This is the well-known Santa Claus rally.  
  • Sentiment is currently more negative than normal. The AAII Bull vs Bear Sentiment Survey has a larger than normal tilt towards fearfulness. In addition, the futures market commitment of trader’s report has its lowest reading since 2016 (The report analyzes how negatively tilted money managers are positioned in futures markets). Remember the old adage, buy when there is fear.  
  • When inflation’s rate of change expands upwards, the price [or valuation multiple] investors pay for a business falls. Fear increases around the potential damage inflation will wreak on business profits. Conversely, when inflation’s rate of change peaks or begins to marginally decline, investors collectively heave a sigh of relief and become more willing to pay higher prices for businesses that have been previously beaten up.  

To summarize:  When there is bearish sentiment in the market, when inflation’s rate of change has potentially peaked, when we are in the seasonally strongest part of the year, and with many stocks having made a new 30-day high together, we just might get to enjoy some positivity over the coming months.  

So, the next time you hear someone ask, “When is best time to buy the market?”. Tell them it always is, but typically, it works a little bit better a few months before Christmas.  

Second Quarter 2022 North American Equity Strategy

The S&P500 officially entered a bear market on June 13th after it fell -21.8% from its January 3rd high. Any decline over -20% is considered bear market territory. For the second quarter ending June 30th, the S&P500 total return was -16.1% in US dollars. Adjusting for currency, the S&P500 returned -13.5% in Canadian dollars, as the Canadian dollar depreciated about 2.3 cents, closing the quarter at US$0.7768. The TSX total return was -13.2% in the second quarter. The main cause of the decline was probably the May CPI inflation data pressuring the Federal Reserve (Fed) to increase the federal funds rate by 75 basis points in June shortly after the inflation report.

Bottom or a Bounce?

I find it hard to sort out what is really going on in the market from all the noise unless I systematically work through it. There’s the war in the Ukraine, gasoline prices over $5.00 per gallon, the Fed being behind on the yield curve and the economy is probably already in recession. When I step back, the news is pretty negative and forecasters seem to be competing to report the worst possible outcome. The S&P 500 is down 20.6% in the first half, the worst six months since 1970, while the NASDAQ, home to many of the technology companies, is off 29.5%, the worst first half on record. Furthermore, stock market sentiment is worse than what we saw at the COVID bottom in 2020 or the bottom of the Great Financial Crisis in 2009. You can usually take some comfort from this type of peak sentiment and what may be the most anticipated recession on record. For a bounce, you probably don’t need things to reverse. They just don’t have to be as bad as expected. But, for a bottom, there has to be a change for the better and when I look at some of the longer term trends, I don’t see it. But let me take you through both scenarios. And, the best way to do this is to focus on a couple of time-tested principles of liquidity and regressions to the mean.


We’ve always contended that liquidity will trump economic statistics when it comes to predicting the stock market. Recessions end after stock market bottoms once the Central Banks start to loosen monetary policy. Unfortunately, the inverse is also true. The Federal Reserve has embarked on a tightening cycle, which is being reflected in the market’s averages even though the economic statistics and earnings estimates are still hanging in there. If you want to understand the market, I’m reminded of an old President Clinton campaign slogan, ‘It’s the economy, stupid’. It was a reminder to his entire campaign staff that there was a singular issue to focus on. For the current market, I’d revise the message to ‘ It’s valuation stupid’. Companies, in many cases are reporting good earnings and analysts’
estimates are still rising, but the stocks are going down. Investors are frustrated with the declines and believe it’s an over reaction. But, I can tell you, having lived through the ‘70’s, you might be surprised at how far price earnings valuations can fall if liquidity doesn’t improve.

Obviously, the key to this issue is held by the Federal Reserve and other Central Banks. So, it’s worth understanding how they operate and then I’ll give you my best guess on how this all plays out. The Fed has two methods of implementing monetary policy. The first is through stated intentions or moral suasion. This is done through ‘forward guidance’ when it indicates future policy moves. It is intended to get a reaction from the financial markets and to have the markets do some of its work. It is pretty apparent in this cycle as 10 Year Treasury bond yields have moved up from last year’s lows of about one half of one percent to a recent high of almost 3.5%. It’s caused mortgage rates to escalate and is shutting down new home acquisitions. Yet, the Fed’s actual implementation of tighter monetary policy has only just begun. Rates were raised a mere 25bps in March, another 50bps in May and finally 75bps in June. That gets us to 1.5% – 1.75%, not a particularly high bar. But Chairman Powell’s rhetoric is pretty hawkish and his hero is now previous Fed Chair Volcker who took government interest rates to 18% to cap
the inflation cycle of the ‘70‘s. Forecasters now expect him to be more aggressive and anticipate two more bumps in the Fed funds rate of 75pbs in each of July and September, which will get the rate between 3.0%-3.25%. Whether this is actually being more hawkish or just shorting the cycle and getting to the same objective sooner remains to be seen.

In my opinion, Powell is no Volcker and has some other unstated objectives in mind. He has pivoted from stated policy several times in the past. Remember, his original goal was focused on employment and being willing to accept higher than normal inflation for a period of time to balance the extended period of low inflation. Now, his focus is on rising prices and bringing them under control at the expense of employment, and he acknowledges the possibility of a hard economic landing. Not what the market wants to hear. In my opinion, he has probably been intentionally aggressive to give himself some maneuvering room. Hike more now to cut expectations later. I think inflation is on the verge of moderating, but secular trends will leave it higher than acceptable. I’ll come to these shortly. Nonetheless, it will leave the Fed compromised. Do they push further to bring inflation down to target (Volcker)? They can only affect demand and employment, not supply. Or, do they declare a victory at higher than normal inflation levels to save jobs? My bet is that Powell pivots and backs away from aggressive tightening.

As I said earlier, things don’t have to get better to cause a market rally. They only need to be not as bad as expected. Inflation coming off the peak and Powell taking his foot off the monetary breaks would constitute the conditions for a bounce. Furthermore, this would not be inconsistent with other Fed tightening cycles where the central bankers backed off to preserve growth and employment. My challenging the government’s resolve already has a real case example. The European Central Bank (ECB), even before they have started to raise interest rates, has had to relent on Quantitative Tightening by providing a new, yet to be unveiled, bond buying program to prevent government bond spreads from widening and impairing the borrowing ability of certain countries such as Italy. The ECB feels that it needs to continue to intervene.

Furthermore, I think there are some things that the Fed isn’t telling us. First, it will require significantly higher interest rates to cause the kind of demand destruction that is required to bring demand and inflation down to their stated goal. Second, I think they are willing to suffer stagflation to save jobs and avoid a serious economic downturn and bear market in an over leveraged economy. Financial Repression could be the undeclared goal to deal with the bloated size of government debt to GDP. This has been practiced in the past, most recently after WWII, to reduce the debt burden by holding interest rates below inflation to create a high nominal economic growth rate, but one that is low after accounting for inflation. When revenues and wages go up they are taxed, but bonds, after inflation, get devalued. In the 70’s nominal GDP kept climbing from the economic peak of the cycle in November, 1973, to its trough in March, 1975. But in real terms from peak to trough GPD dropped by 3.1%.

Regressions to the Mean

Most of the market’s decline can be attributed to the rise of interest rates, which causes an increase in risk premiums and higher discount rates. That’s analyst-talk for lower valuations. Price earnings ratios, a measure of valuation, have collapsed for the S&P 500 from about 22.5X at the beginning of the year to roughly 16X. That’s a 27% decline, and it is even worse for some of the big cap growth companies such as Amazon and Facebook.

This isn’t unusual for a market correction. What is generally required for a Bear Market is a recession and earnings deterioration. So far, you’re seeing softening economic data but not a collapse and no declines in earnings estimates. If a downturn isn’t coming, this market is a buy as a recession is now being factored in.

My problem is that I see a number of secular issues and trends that are regressing back to the mean, which I find troubling and will result in an extended headwind for the market. Let me take you through them.

1) Profit margins are still near all time highs. They reached current levels in the 1960’s and then were eroded from roughly 12% to 7% by the 1980’s as companies couldn’t pass through cost increases.

2) Risk. Low interest rates have required investors to take on more risk to achieve the same return objective. Investors have moved out of their safe GIC’s into longer dated bonds. Or they have moved from government bonds to corporates and even out of fixed income to equities. But to get a reasonable rate of return one has had to take on more risk. And some of this is benign. Even if you stayed with bonds, which did well in a declining interest rate environment you might not have appreciated that as the coupon rate approaches zero, the volatility risk gets transferred to the principal amount of the bond. The first quarter of this year saw the worst bond market on record even though interest rates went up only modestly. As investors come to grips with this new volatility and experience some negative results, they may be inclined to step back a little and look for safer returns and move away from equities.

3) Credit Spreads. One of the hallmarks of a Bear Market and distressed conditions in the financial markets is a widening in the interest rate spreads between government issues and those issued by corporations. These spreads have started to widen, but have not reached levels seen in past recessions. If the economy slides, this will be another negative factor for the market.

4) Earnings. As I said, earnings forecasts are still close to their highs and don’t reflect the worsening economic conditions. Consequently, valuations may be understating how much lower this market could go. Second quarter earnings releases could give us some insights as managements will get a chance to provide earning and business guidance for the balance of the year. But, I would be surprised if the current estimates hold up.

5) Liquidity. From 2009 until recently, we have seen an unprecedented amount of liquidity pumped into the system. Initially, it did not make its way to Main Street, but instead flooded into the financial markets resulting in an extended bull market in stocks and bonds. Recently, that excess funding has found its way into residential real estate. The Fed is now embarking on Quantitative Tightening that will remove $1.14 trillion dollars from the system over the next twelve months. We’ll see if they actually follow through, but if liquidity is key to a bull market, this is not a good sign and in my opinion will effect Wall Street more than Main Street not unlike what we saw in the 70’s.

Secular Inflation

There are other trends that I see reversing that are more specific to inflation. If I’m right on these, they support the case of stagflation.

1) Wages. Labour’s share of GDP has historically averaged about 66% and it has dropped to around 59% and they want it back. Demographics say we have run out of workers with almost two job openings for every unemployed person. With baby boomers retiring, we face a continued shortage of workers.

2) Housing. Over the last couple of years, the price of a median home has appreciated roughly 33%. With higher mortgage rates, home ownership is out of reach for many and they have turned to the rental market, which has seen the rent for a one bedroom apartment rise by 20%. This is getting fed back into homeowner’s equivalent rent which is about 42% of the Consumer’s Price Index (CPI).

3) Energy. The price of oil has been aggravated by the Russian- Ukraine War but is hardly the underlying cause. It is due to a colossal miscalculation of governments and environmentalists in transitioning from carbon-based fuels to renewables.

4) Globalization. China has provided the antidote of cheap labour and cheap goods that has offset loose monetary policy for years. Now trade wars and unreliable foreign sourcing and security issues are causing manufacturers to re-examine their supply chains. It’s resulting in manufacturing moving out of China and in some cases returning to North America while others are adjusting their inventory levels from just-in-time to just-in-case. Either way costs are going up.

5) Regulation. I haven’t mentioned this one before but regulation, besides monetary and fiscal policy, is one of the ways the government can control the economy and the role of regulation is reversing. Deregulation, tax cuts and free trade are good for corporate profits and bullish for the stock market.

Policies that promote income redistribution, higher taxes, industrial re-regulation, organized labour and
protectionism are bad for economic growth and stock prices. (Please accept these as over-generalizations as even I would argue that the capitalist system has some excesses that need to be addressed.

Pro-growth government policies dominated by supply side reforms, free market capitalism and globalization from 1980 to 2010 are beginning to reverse. The Trump Administration started the process with a trade war with China. Biden wants to tax and spend while pursuing an aggressive green agenda and continuing trade protectionism. As an example, it is estimated that California’s new restrictions on driver classification will take tens of thousands of truck drivers off the road according to the Wall Street Journal. Meanwhile, President Xi is aggressively regulating China’s platform companies, centralizing power, marginalizing private business and pursuing ‘common prosperity’ by forcing the rich to pay more.

Global geopolitical tensions are rising. Europe is already in a war. China – US tensions continue to rise and Western Europe is re-arming while Japan plans to spend more on defense.

Unfortunately, I don’t see any easy solutions for some of these issues and I don’t think they will favour the financial markets.

Stock Market

When I look at some of my individual portfolio holdings, I’m impressed by how cheap they are. On a one-off basis, there are a number of companies that I’d buy because they seem too undervalued, and eventually that’s what will put in a market bottom. But liquidity and valuation may be the headwinds for a general market advance.

The market has already discounted higher interest rates and is now discounting a recession, which my secular factors would suggest is likely. Nonetheless, a lot of damage has been done to the market. If the trends are cyclical, then we’re probably getting close to a bottom on a stock-by-stock basis. We’re oversold and due for a rally, which could be triggered by some relenting of inflation and the Fed backing off from its aggressive posture, my not as bad as expected scenario.

However, if we do enter a recession there will probably be another leg down as earnings get revised. If it results in stagflation, the earnings drawdown may not be as great, but higher interest rates and limited liquidity will continue to erode valuations as we saw in the 70’s. Back then, we endured a decade long bear market where stocks made little progress, but earnings expectations were met most every quarter. From 1970 to 1989 corporate profits grew 4.7 fold, which equals an 8.4% annualized rate in a period of high inflation and rising inflation. From 2000 to 2019, corporate profits expanded 3 fold, equal to 6.1% annualized in a period of low inflation. Inflation in the 70’s depressed PE ratios as the average multiple for the S&P was only 12X. Multiples expanded by 85% since 2010 even though the US economic growth had been weaker than the previous decade.

Another differentiating factor is what we refer to as the Fed Put. This has been the Central Bank’s response to falling or troubled financial markets. In the last two decades, the Fed has been able to dramatically lower interest rates and provide liquidity at any sign of trouble because inflation was in a secular decline. In the 70’s, there was no such option and the Fed in fact raised rates even during economic slowdowns to fight inflation. Similarly today, it is highly unlikely that Powell could justify a reversal of his tight monetary policy because of a weak stock market. It will no doubt require a financial accident to cause a sudden reduction in rates.

So, there’s a realistic case for a bounce, but a bottom may be a bit more elusive and when it does come a new bull market will require a pivot to monetary easing.

In the meantime, remember this market is all about valuation and liquidity. With unemployment at 3.6% headed to 4.2% (Fed’s est.), we’re not likely to have much of a recession. Earnings, however, could suffer from margin compression as this monetary policy cycle hurts Wall Street more than Main Street.

Second Quarter Fixed Income Strategy Review

The second quarter of 2022 echoed many of the themes evident in the first quarter. Inflation in both US and Canada exceeded already lofty expectations and climbed to levels not seen since the early 1980s. The Federal Reserve and the Bank of Canada hiked rates sharply and aggressively in response. Oil, a primary driver of inflation, hit multi-year highs as well, as the conflict in
Ukraine entered a new, possibly more protracted stage, roiling energy markets. The impact to financial markets, although not as severe as the first quarter, was steeply negative across most asset classes.