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 Fourth Quarter of 2021. You can download the full reports via the links shown below.
Happy New Year and Good Riddance to 2020! That is what we wrote last year at this time and it kind of feels like ground hog day. The good news is the returns were even better in 2021 than 2020. The bad news is that, as we write this, Omicron is reproducing at a rate far exceeding earlier variants and second only to measles. However, cases so far seem to be less severe, resulting in fewer hospitalizations and deaths. We are leaning towards this wave being short-lived.
During the fourth quarter of 2021, the S&P500 total return index gained +10.7% in Canadian dollar terms and the TSX total return index was up +6.5%. This put their annual returns at 27.5% and 25.2%, respectively. Not too shabby.
A continued rebound in economic strength and better-than-expected earnings propelled the markets higher. It also set the stage for the completion of the Fed’s $120 billion per month bond buying program in the first quarter of 2022 and for a higher federal funds rate as early as March 2022. Although the impact of Omicron is not fully known and could influence events, we have gone from pricing in zero rate hikes in 2022 to expecting three of them by the beginning of 2023.
For perspective, the last tapering/tightening cycle took place from December 2013 to December 2018. The S&P500 gained +74.7% through eight rate hikes from the beginning of the taper until September 2018. The sell-off finally came in Q4 2018 when Fed Chairman Powell signaled more aggressive rate hikes to come. Powell remains the Fed Chairman today, and likely does not want to repeat this policy error. If he is successful, we think investors will soon look forward to the 2023 earnings forecasts, which look pretty good.
While we are not a pure play on sustainable investing and ESG is not integrated into our investment process at this time, I would like to mention that we do continue to score materially better than our benchmarks on Environment, Social and Governance (ESG) criteria. We believe that owning high quality, compounding companies led by experienced executives and savvy boards is not only sustainable, but also a beneficial approach to take in the current market environment.
Peter Jackson, HBSc, MBA, CFA
Chief Investment Officer
Portfolio Manager, North American Equities
During the quarter, our overall equity exposure increased by 1% to 97%. Our US equity exposure increased from 47% to 50%, while our Canadian exposure decreased from 49% to 47%. Cash decreased from 4% to 3%. It is important to note that clients invested in our North American plus International Equity strategy will have proportionally lower weights to the US and Canada given the allocation to international companies.
We have continued to position the portfolio toward value-oriented stocks to benefit from the economic recovery that is underway. They now make up 58% of the portfolio, while maintaining exposure to growth stocks for about a third of the portfolio. Staples, which we don’t classify as either growth or value, make up the balance of our equity exposure.
During the third quarter, we added two new stock positions:
Rogers Communications Inc. is emerging from a period of significant underperformance versus its peers, despite strong operational performance, due to a well-publicized boardroom fight, which we thought was nearing an end (a subsequent court ruling has now essentially settled the issue). Rogers has the best operational leverage to a slowly reopening economy relative to its peers, material synergies from its proposed merger with Shaw Communications and an EV/EBITDA valuation discount to its peers at the highest level in over six years.
SVB Financial Group is a fast-growing bank with strong roots providing banking services to venture capital-backed companies resulting in significant exposure to higher growth verticals such as Technology and Healthcare. In recent years, SVB Financial has transformed itself from catering to start-ups only to now providing large companies with traditional banking products that go well beyond the IPO stage. SVB meets our bank scoring criteria given its low Return on Asset variability and high tangible book value growth.
Phil D’Iorio, MBA, CFA
Portfolio Manager, Global Equities
2021 was an interesting year for global equity investors to say the least. Stocks surged on the back of a global vaccine rollout, investors embraced cryptocurrency as Bitcoin soared to new heights, and the Metaverse became a mainstream concept with Facebook changing its name to Meta Platforms in a symbolic move.
Compared to the roller-coaster of last year, 2021 was much steadier and generated very strong returns with significantly less volatility. The MSCI World Index increased by 20.1% and the Euro Stoxx 600 Index increased by 22.3%. Emerging Markets were notable laggards as the MSCI Emerging Markets Index declined by -4.6%. Robust stock market gains were driven by ongoing improvements in the global economy and progress with vaccinations.
In 2021, our research efforts were highly productive in terms of generating new ideas for our portfolios. As a result, we initiated nine new holdings across the Global and International strategies, which are detailed in my full report.
We expect the economic recovery to continue in 2022. However, as we look ahead, we view higher inflation as one of the key risks for the global economy. Economists and policymakers hope that it will be transitory, but if it remains stubbornly high, central banks may be forced to raise interest rates sooner and at a faster rate than the market currently expects.
Instead of trying to predict the future rate of inflation, we have positioned our portfolios for a wide range of scenarios. We believe the best way to do this is to invest in high quality companies, or what we refer to as Quality Compounders. These companies have strong market positions, sustained pricing power, and seasoned management teams that can adapt to changes in the economic environment.
In summary, while we are cautiously optimistic about global equity markets, we are even more optimistic about the companies that we own across our portfolios. Our global and international mandates continue to be constructed with high quality companies that are well positioned to compound the value of their businesses in the years ahead.
Diane Pang, CPA, CA, CFA
Portfolio Manager, Fixed Income
Just as we thought the Delta variant would be our focus, another variant emerges – Omicron. By the way, the CDC is currently tracking 12 variants, with Delta and Omicron being the two of most concern. During the quarter, markets reacted to the surge in COVID-19, as well as a surge in inflation. The result was overall positive.
In the US, crisis was averted as the house and senate voted to increase the debt ceiling by $2.5 trillion to $28.9 trillion just days before the Treasury Department warned it would no longer be able to pay the nation’s bills. This leaves the country with enough spending power to cover its deficits until beyond the November 2022 midterm elections.
On November 22nd, President Biden announced his intent to nominate Jerome Powell to another four-year term as the Federal Reserve chair. Later in November, Powell retired the word “transitory” to describe inflation and indicated that the Fed would end asset purchases earlier than originally planned to help bring it under control.
The Bank of Canada appears to be following suit. It had two meetings during the quarter and wasted no time during the first of those meetings to announce the end to tapering. The Minister of Finance and Bank of Canada also concluded their review and renewal of the monetary policy framework that occurs every five years, confirming the Bank’s commitment to using a flexible inflation target strategy. Details of the framework are contained in my full report.
On December 16th, the Bank of England became the first major central bank to hike its overnight interest rate, citing inflation of 5.1% and anticipating a peak of 6% by early 2022.
It seems clear that by the end of this year, overnight interest rates in most major markets will be higher than they are today. We know from experience that the yield curve will move ahead of actual rate hikes, so we are patiently buying bonds at or near par and of shorter duration in order to preserve capital. As volatility increases, we believe there will continue to be pockets of opportunity to lock-in higher yields as there were during the past quarter.
During the second quarter of 2021, the S&P500 total return index was up +8.6% in US dollars. Adjusting
for currency, the S&P500 returned +7.0% in Canadian dollars, as the Canadian dollar appreciated about 1.2
cents, closing the quarter at US$0.807. The TSX total return in the second quarter was +8.5%, as can be seen
in greater detail in Appendix 2. The biggest performance driver was positive earnings growth in both markets.
While earnings were expected to be strong, actual earnings in the first quarter for the S&P500 rose 52.5%
year over year as compared to an expected gain of 23.7% at March 31st, far exceeding market expectations.
Each quarter, our Investment Management teams publish their key observations and detailed portfolio updates across North American, Global and Fixed Income markets. This is a summary of our views for the First Quarter of 2021. You can download the full reports via links shown below.
Probably the best way to describe the US economy today is “smoking hot.” Corporate earnings continue to beat expectations. The ISM manufacturing index, which surveys purchasing managers at more than 300 US companies, recently recorded its strongest reading since 1983. Meanwhile, a similar index for global markets hit a 10-year high.
The largest vaccine rollout in history is underway. It has been estimated that more than 700 million doses have been administered globally. Despite some worrying trends, the average rate of inoculation is outpacing the rise in new cases.
The combination of record earnings, positive economic data and vaccination progress drove stocks higher. During the first quarter of 2021, the S&P 500 total return index was up +6.2% in US dollars, or +4.9% in Canadian dollars, as the Canadian dollar appreciated about 1.0 cent. The TSX total return in the first quarter was strong at +8.1%.
Between the US Treasury’s US $1,400 stimulus cheques issued to 250 million Americans in March (adding even more fuel to the fire) and the Fed sitting tight on interest rates, the bond market is trying to estimate inflation while the stock market attempts to forecast earnings. Whether that results in a short-term pullback, a more serious correction, or revised earnings expectations, only time will tell.
The bottom line is that the market appears to be pricing in a lot of good news and the risks have now increased. While our outlook remains positive, we have raised a little cash and will pause for the moment to see how this sorts itself out in the second quarter.
NORTH AMERICAN EQUITY UPDATE
Peter Jackson, HBSc, MBA, CFA
Chief Investment Officer
Portfolio Manager, North American Equities
Our US equity exposure decreased from 52% to 48% during the quarter, while our Canadian exposure increased slightly to 46%. Cash rose from 3% to 6%. Many of you who follow our North American Plus International global strategy will have a roughly 20% allocation to international equities, which means the US and Canada weights will be lower.
We now have more than half of the portfolio invested in the value end of the spectrum to benefit from the economic recovery, while maintaining about a third of the portfolio in growth stocks. Staples, which we don’t classify as either growth or value, make up the balance of our equity exposure.
We added three new positions in the first quarter of 2021:
Intact Financial is a Canadian insurer of homes and autos. Company management has a stellar track record both in operating the business and in making accretive acquisitions, including a pending acquisition of RSA Group of the UK, which we believe will prove to be a real winner.
Dollarama Inc. is the largest dollar store chain in Canada, with 1,300 company-operated stores and plans to reach 1,700 stores by 2027. The company has acquired a majority stake in Dollar City, a 240-store chain in Latin America with a market about 4x larger than Canada.
U.S. Bancorp is the 5th largest commercial bank in the United States by assets and one of the most profitable based on return on equity. As the US economy recovers from COVID, we believe the company will experience a rebound in its fee-based businesses and will benefit from an improved credit outlook in 2021.
GLOBAL EQUITY UPDATE
Phil D’Iorio, MBA, CFA
Portfolio Manager, Global Equities
Unlike most recessions, which are typically triggered by economic imbalances or central bank action, the recession of 2020 emerged out of left field. And, unlike most recoveries, where households, corporations and governments typically need time to regain their footing, everyone is flush with record amounts of cash and ready to spend.
As we exit the pandemic, there will be substantial demand for dining out, travel, sporting events, and concerts. There is also a US $2 trillion infrastructure proposal in the United States. We currently see a path to a strong global economic recovery with a level of growth that is likely to be the strongest in decades.
Now let us consider some of the risks. There are new variants of the virus, valuations are elevated, and there are concerns about the potential for inflation. Although each of these risks is significant, we believe they are all manageable.
As you know at Cumberland, the companies we own are profitable across the business cycle, generate strong free cash flow, hold leadership positions in attractive industries globally, and are, in many cases, emerging from COVID even stronger than before. We are confident that they can handle some setbacks that will eventually materialize down the road.
We view equities as the preferred asset class to benefit from the recovery. The US economy has performed well over the last decade and we expect this to continue. However, we believe there is catching up to do in both Europe and the Emerging Markets, which have gone through several years of lacklustre growth. Our global mandates have exposure to these economic regions and are well positioned to benefit as the recovery unfolds.
FIXED INCOME UPDATE
Diane Pang, CPA, CA, CFA
Portfolio Manager, Fixed Income
In January, the Bank of Canada (BoC) signaled its intention to reduce the buying of Government of Canada securities. The expectation from economists is that the Bank of Canada will taper its buying from $4 billion/week to $3 billion/week as early as April, as they gain confidence in the strength of the recovery.
On Feb 23rd, the BoC reduced its buying of provincial bonds in the secondary market from twice a week to once a week and reduced the maximum from $500 million to $350 million. Similarly, the Bank reduced their buying of corporate bonds from $200 million per week to $100 million per week.
This slowdown in bond buying is a signal that Canada’s economy requires less help to emerge from the coronavirus crisis. Indeed, the BoC upgraded its economic forecast in March. Nonetheless, we, as taxpayers will ultimately be left to deal with the ballooning level of federal and provincial government deficits that remain.
With stronger economic growth comes the possibility of interest rate increases, but the BoC has reiterated that they will not increase rates until inflation of 2% is “sustainably achieved.” We believe that we are very likely to see near-term spikes above 2%, and the question will be whether this is sustainable or not. The Bank of Canada kept its overnight rate unchanged in Q1 at 0.25% and the Federal Reserve also kept its rate unchanged at 0%.
At the end of the Q1, 88% of the bonds in the Canadian Bond Universe traded above par, compared to 99.5% at the end of 2020. As a result, the Index yield rose from 1.21% to 1.72%. The market clearly needed to take a breather and we believe there could be a bit more downward price pressure (and higher yields) to come. We are now taking advantage of lower prices to selectively lock-in some yields and reduce the risk of capital losses.
Let’s start with a broad overview of where we are and where I think we might be headed.
Right now, the news is pretty encouraging.
So, things look pretty good and the market averages are reflecting this by reaching new all-time highs.
But, what’s ahead and what could go wrong?
At some point the market will look ahead to where we will be in six months if all this plays out. If the economy is at full throttle, it will start to absorb some of the liquidity that has fueled this market. In a normal cycle, the Fed injects liquidity into the system during a recession. It isn’t initially used by businesses and consequently flows into financial assets. Bond prices go up, interest rates decline and the stock market recovers. But as the economy recovers it eventually needs some of the liquidity to sustain itself. Inventories have to be rebuilt, capital spending picks up and more people are hired.
And where does this money come from? Usually, the financial markets.
So, if the economy is screaming by next fall, as some economists forecast, I’m not sure that will be good for equities.
Furthermore, the market seems to have dismissed Biden’s election agenda as his initial focus is likely to be resolving the Corona virus pandemic. But later this year, the emphasis is likely to shift to his stated objectives which now look to be on the 2022 agenda.
This might include:
Although this might give the market some cause to pause, the reality is that the Democrats don’t likely have enough votes for sweeping change. Votes on significant legislative change will require 60 votes in the Senate where the chamber is currently split at 50 seats by each party. Furthermore, you have some conservative Democrats like Joe Manchin from West Virginia who are unlikely to go along with radical change.
So, the market doesn’t see much to worry about this year.
However, concerns may arise as to how long the Fed can maintain its ultra-accommodative monetary policy. Inflation could and should pick up, especially with a weak US dollar that causes import prices to increase and rising commodity prices. Interest rates in the face of record fiscal deficits could rise causing a steeper yield curve as liquidity is unwound.
An additional concern is whether the Coronavirus will really be gone. What if it mutates to a strain that isn’t controlled by today’s vaccine? Or, worse yet, what if we find that after some time the vaccines have some unforeseen side effects? An Agent Orange reaction might occur.
So, with this as a background, let’s look at what has been happening in the stock market. As I said, the economy is doing well. Globally, the manufacturing PMI’s for December were 60.7 in the US, with new orders even better at 67.9. Europe was at 55.2 and China 51.9. (Anything over 50 signals growth). Not surprisingly, consumer spending on tech hardware and software rose 32.8% in the first ten months of 2020 to a record high. But none of this should come as a surprise. Coming out of a recession there is pent up demand that gets released, especially if the government sends you a free check. Manufacturing has to go into overdrive to keep up with this demand and to rebuild depleted inventories. So, production actually increases faster than final sales initially. However, one has to anticipate pent up demand being satisfied and inventories being restocked which will lead to a slowdown. This is usually about twelve-month cycle and will hopefully be offset somewhat by a recovery in the service sector as the COVID-19 vaccine allows for travel and entertainment.
All of this is good news relative to where we have been. But, when translating it to earnings we won’t get back to where we were in 2019. Right now, earnings growth for last year only shows improvement with Q1 – 15.4%; Q2 -32.3%; Q3 -8.2%; Q4 -6.7% est.. For last year earnings for the S&P 500 are estimated to be $136 while forecasts anticipate $168 in 2021 and $196 in 2022, although some of the benefits of government spending will be given back through tax increases in ‘22.
This leaves the S&P 500 trading at 22.9X forward earnings and at 2.54X revenues which exceeds the “tech bubble” of 1.88X in Q2 of 2000. Right now, 52.9% of the S&P companies trade at over 20x earnings. Bottom line, the market is far from cheap which would appear to limit its upside.
However, as I have pointed out in the past, there is a disparity between the more economically sensitive value stocks and the disruptive technology and stay at home growth companies. So, instead of the market correcting, you could see a rotation from growth to value and in fact, that is exactly what we have experienced.
What is behind this? Well, for sure the overall valuation level of the market is due to the Federal Reserve’s liquidity policy. There is an enormous amount of money around and the economy is not yet fully taking advantage of it with the services industries still shut down. In fact, the reaction to the Covid virus has left a record $4.6 trillion sitting in savings accounts and money market funds.
But there has been a subtle change. On August 4th the yield on the ten year US Treasury note bottomed at .52% and has now risen 63bps to 1.15%. Interestingly, we saw a peak in the relative performance of growth over value on August 28th, with many technology and FANG stocks spiking to highs at the end of the month only to be followed by lower prices as the market made new highs. Conversely, value companies showed extraordinary gains in November after the US elections on the promise of more fiscal economic stimulus. Fundamentally, this makes sense. The performance of growth stocks is highly dependent on the discount rate. Without getting too technical, valuation or price earnings ratios move higher when interest rates decline, and conversely, when they rise as has happened since the end of August. For Value stocks, earnings generally improve as interest rates move higher. For banks which are one of the largest components of value the correlation should be obvious as higher rates make lending more profitable. For others, rising rates usually correspond with higher inflation, which equates to better pricing power by economically sensitive companies.
The question which is still unanswered is whether this shift will continue. Although this is currently undetermined, there are signs that this may be more secular than just transitional. Although bond yields have risen, they are still extremely low by historical standards after a forty year bull market for bonds. Meanwhile, the new regime in Washington has an agenda focused on stimulation and increased deficit spending. Furthermore, the US dollar is declining, which will put upward pressure on import prices. Commodities are also increasing supported by the strength of housing and the emphasis on electrification of autos and solar and wind power, Biden’s Green New Deal.
Stimulus checks on top of $4.6trillion in savings could also put pressure on consumer goods prices which may also face pressure from rising costs and higher taxes. And finally, the trend to reshore manufacturing will add costs.
So, higher taxes and other major Democratic initiatives will be a 2022 problem while economic progress in the second half of this year might start to unwind some of today’s bullish market under pinning. Although higher interest rates will initially be tolerated as they will be considered a good sign of economic recovery, they should also change the complexion of the market in favour of the more economically sensitive value companies.
Join Portfolio Managers, James Nickerson, Jason Isaac and Derek VanGenderen from our Calgary office for their reflections on the market, where they think it is going, asset allocation and valuations. You will also learn how your portfolio is positioned for 2021.
Download the recording by using the three dots on the right to navigate through the sections more easily.
2020 has been a challenging year in so many ways. In our world of investing, in trying to be the best stewards of our clients’ capital, we take great pride in how we have performed. Watch the 30 minute video to gain insight into how we invest, what we are looking at and what we are buying for our clients and for ourselves.
As the Tech Titans and other Technology companies dominate the market, investors can’t help but wonder if this trend will continue – Does a ‘bubble’ exist? And are we about to see it burst?
Last week, Portfolio Manager Phil D’Iorio wrote about US Technology and has now elaborated in a podcast interview, addressing the realities of today’s market, what we have learned from past cycles and what we might see this year and beyond.
Listen to a discussion led by our CEO Charlie Sims and CIO Peter Jackson, on the market impacts of the COVID-19 pandemic in the first half of this year, current market trends and our outlook looking to 2021.
Times of uncertainty allow us to take a step back and then look forward to see new opportunities. We believe that Canada is still a place presenting some of those opportunities for investors.
Read the latest from our Portfolio Managers and Wealth Planners in our Newsletter.