As we wrote in our commentary last quarter, we had an inkling that more normal times, that would include nervousness, volatility, and regular corrections would appear in 2022, after a relatively calm, stable, and steadily advancing market from the lows of the pandemic in the Spring of 2020 to the end of 2021. But, as the market often does, it went from one extreme to another, and what a quarter we have just experienced.
The entire world is on edge and in a state of disbelief as the horrific accounts and images come out of Ukraine. Inflation continues to be a headline item as it becomes evident that the residual effects of supply chain disruptions and decades of under investment in our workforce are going to be more than tailings. Covid just will not go away and continues to disrupt life, the economy, and markets. And to top off the list of worries the market is digesting, central bankers are becoming more hawkish and signaling that interest rates are going higher, faster.
The resulting market action was volatile with a capital V. From the beginning to the end of the quarter, the S&P 500 index was down 4.6%. But from the start of January to early March it fell 13%, before recovering 11% into the close of the quarter. The Canadian market’s moves were much more muted, largely because of the relative weighting of the commodity complex. The S&P/TSX Index fell less than 3% to start the quarter before surging 7% off the February lows to finish firmly in positive territory.
There have only been 11 times in the post WWII period where the S&P 500 Index has witnessed an intra quarterly decline AND advance of greater than 10%. The Bespoke Investment Group did some interesting analysis of future market action that can be seen on Table 1 below. Of note is that one quarter later, the S&P 500 Index was higher 10 out of 11 times and a year later it was higher all 11 times.
As mentioned, the Canadian market performed in a more positive and steadier fashion in Q1. After years of playing the laggard, cyclical stocks, and the energy complex in particular, performed well. The S&P/TSX Index advanced 3.8% during the quarter taking the edge off the negative returns put up in the U.S. markets. Bonds suffered in Q1 2022 on the back of rising interest rates. The FTSE Canada Overall Short-Term Bond Index was down 3% during the quarter. Preferred shares also retreated during the quarter. The Solactive Laddered Canadian Preferred Share Index was off 1.7%.
While geo-political events and health scares are serious and command our attention, history shows that they have little lasting effect on equity markets. In the cold world of making money on event-driven issues there is an immediate scramble to position in the “winning” trades, but over time market opportunity dissipates and attention turns elsewhere. The more impactful quarterly headlines concern the actions of central bankers and the bond market’s reaction to rising interest rates. Normally interest rates for short-term periods are lower than those for longer-term periods. This is because of the risks associated with commitments for longer periods and to compensate for the opportunity cost of investing for longer periods. When the yield curve inverts – as has recently occurred -- longer rates are lower than short rates. This is an indication that bond investors are worried about the economy and that they expect rates on longer maturities will fall as the result of economic weakness.
Recessions are always predated by inverted yield curves, but not all inversions have led to recessions. So, it is something to pay close attention to, but doesn’t 100% predict the economy’s path. A recent example of an inversion without an immediate recession was in 2018. There are many strategists who believe the fact that the yield curve has been so heavily manipulated through Central Bank intervention discounts its usefulness in predicting economic outcomes. One theory is that lower long rates are predicting that inflationary pressures will come off the boil. If that occurs, the Fed will feel less pressure to increase interest rates and the expansion will have much longer to go. It was not that long ago that economists were concerned that there was not enough inflation in the system. It is coincidental and curious that a more permanent state of high inflation would occur at the same time as a major economic dislocation caused by a passing (we hope) health scare.
Inflation is taking centre stage as economic public enemy number 1. Consensus has evolved from a belief that inflation was transitory, caused by supply chain disruptions and labour issues causing upward pressure on wages, to a belief that it is more permanent and requires monetary intervention to tamp down demand. Our guess is that it is a blend of factors and that some inflationary pressures will soon begin to abate.
One misconception to address is that moderate inflation is bad for stocks. In fact, stocks do quite well in periods of modest inflation. Companies have pricing power and those who are “price-makers” can benefit greatly. Inflation is a greater concern if central bankers take such aggressive action as to force the economy into a recession. In that respect, the equity market is at an elevated level of risk. In the interim, as the Fed has raised rates, equities have historically performed quite well (see Chart 3 below).
Goodreid’s position on investing in the bond market has been consistent. In this era of extreme monetary accommodation, we have stayed in a “near cash” position with our fixed income allocation, thinking that artificially low rates would pass, and bond prices would fall as rates rose. This is finally happening and Goodreid clients are benefitting.
Something that hasn’t received much attention is that this is an election year in the United States. Mid-term elections call for the entire House of Representatives and one-third of the Senate to stand for re-election. Mid-term cycles normally lead to the Fed taking to the sidelines so not to be seen as influencing voters, interesting in a year of such dramatic change to the monetary setting. Mid-term election years also follow a rhyme that we see taking shape in 2022. Chart 4 illustrates the action of the S&P 500 Index in mid-term election years back to 1950. As can be seen, early corrections are always followed by strong market performance.
The Canadian oil and gas industry is going through a historical restructuring. In the past 15 years there have been 3 major depressions in prices within the oil and gas industry. In 2020, with the price of a barrel of oil falling under $30 as Covid shut down much of the world’s economies, the industry was faced with large losses and heavy debt loads. As Covid started to abate and economies started to recover, the price of energy rose. The energy companies, reacting to shareholder demands, vowed to decrease their debt loads and return a good portion of company profits to the shareholders. The effect of this has been muted drilling activity and limited exploration leading to static output of energy, just as the economies were strengthening and needing more output. Then Russia invaded Ukraine and energy prices got a further boost, resulting in most industry participants recording record profits.
Early in the quarter we added two Canadian energy companies to our portfolio, Suncor and Tourmaline. Both these companies have specific competitive advantages.
Suncor is one of the largest oil sands producers, whose long reserve life and low costs make it profitable under almost any oil price scenario. In addition, it owns Petro-Canada, whose refineries turn the heavy oil into light crude oil, which commands a premium price in North American markets.
Tourmaline, on the other hand, is a major natural gas producer. Over the past two decades it has grown its production from around 20,000 boe (barrels of oil equivalent) to over 500,000 boe, which ranks it as the fifth largest producer in Canada. It has accomplished this through exploration and acquisition while always keeping a very low level of debt. It is in a unique position, in that the price of natural gas in North America is around $5 a bcf (billion cubic feet), while in Europe it sells for $32 bcf. With the present push to provide liquified natural gas to offset Russian gas, demand for natural gas should continue to be very robust for many years to come. The company has also declared a $7.50 yearly dividend (on top of its normal dividend) for the next 2 years which equates to a 25% return on the amount we invested in the company.
We expect prices of oil and gas to be volatile throughout this year. If the Ukrainian conflict ends in a resolution, the price of oil will fall back. However, with worldwide emphasis on security of supply, Goodreid thinks any weakness will be short lived. These companies are trading at historically low valuations (even based on much lower oil and gas prices), throwing off huge free cash flow, have little debt and large holdings of exploration lands.
The financial markets have certainly garnered investors’ attention as we start 2022. As we have outlined above, proper positioning in fixed income and equity markets during periods like these can be rewarding, but we cannot be oblivious to heightened risks. Goodreid continues to employ a diversified approach, holding quality issues that can withstand financial stress and that represent natural hedges. Our portfolios hold stocks that will benefit from a protracted period of inflation and higher interest rates, issues that have stable characteristics to withstand an economic downturn, and companies that are likely to grow regardless of the economic backdrop.
