Fireworks went off in night skies across the globe at midnight just as they did in markets right through the closing bell on New Year’s Eve, capping off a very strong fourth quarter and full year of 2021. The S&P TSX Composite index chalked up a 6.5% total return during the fourth quarter, and 25.1% for the full year. The S&P 500 index notched an 11% total return measured in US$ (10.7% in C$) and 28.7% for the full year (27.6% in C$). The Solactive Laddered Canadian Preferred Share index earned a quarterly total return of 1.5% and 23.1% for the full year. The FTSE Canada Short Term Overall Bond Index lost 0.5% during the quarter and 0.9% for the year, with price declines just slightly more than offsetting interest income in the bond market.
Success in investing demands a mixture of hard and soft skills, with perhaps the most important among those soft skills being the ability to manage one’s own expectations. In that spirit and for context, 2021 marked the fourth best year for Canadian and U.S. stocks in the last 25 years, the best year for preferred shares since the Solactive Laddered Preferred Share index was inaugurated in 2013 and the worst year for Canadian short-term bonds since the turn of the century when the FTSE TMX index was inaugurated. History tells us that a typical or average year over the last quarter century turns out a return of around 11% for U.S. stocks, 9% for Canadian stocks, and between 3-4% for bonds and preferred shares over the shorter lifespan of their respective benchmarks.
Looking ahead to 2022, our expectations are tempered relative to the outsized returns investors enjoyed in 2021, but we are emboldened by the ongoing, dynamic economic recovery, and in the near term encouraged by the markets’ strength in the face of skyrocketing COVID-19/Omicron infections. At the time of writing, both the S&P 500 Index and the S&P TSX Composite are at or near all-time highs, despite COVID-19 infections surpassing all prior peaks. How then do we reconcile the bleak health and wellness situation with the “all clear” signal from stocks markets? Markets are mercenary and are not emotionally tied to the overall health of the general population. Markets look for solutions and rally when they think they have sniffed one out. Such was the case in 2020 when stock markets bottomed in March, but vaccines were not authorized until November. What solution have markets sniffed out since their brief flinch when Omicron emerged a month ago? We don’t pretend to know….it could be booster shot deployment, herd immunity, effective and widely available antivirals…or something else altogether and as yet unforeseen, but we’re inclined to believe the markets at this juncture, as they correctly discounted “solutions” both in the early waves of COVID-19 and in the Delta variant waves last year. In effect, we think the markets have come to view the coronavirus in a fundamentally different light today vs. 12-18 months ago – as an endemic risk, as opposed to a pandemic. The public at large and the media have not yet come around to this view of the coronavirus, and in some ways, the divergent views of markets vs. “the man in the street” recalls the experience of 2011-12, when most people were still talking about “recession”, when in fact the Great Recession formally ended in June 2009.
What is likely to be a more enduring concern on the minds of investors in the year ahead, as we wrote about in a recent e-article, is inflation and the prospect of higher interest rates. Of all the buzzy buzz words of 2021 (meme, supply chain, variant, inflation, etc.), inflation is without a doubt the buzziest, along with its heretofore sidekick, the modifier “transitory”. Canadian inflation is at a level seen only twice briefly in the past thirty years, during the first Gulf War in 1990-91 and then again during the second Gulf War in 2003. Inflation has not held at these levels on a sustained basis since the 1970s and early 1980s – a period which precedes the experience of most professional and non-professional investors alike. U.S. inflation is running at an even more torrid pace, currently printing 6.8%, handily exceeding the brief spikes experienced in both Gulf Wars as well as the spike seen in mid-2008 and is running at levels not seen since the 1970s and early 1980s. Both the Federal Reserve and the Bank of Canada had been until recently willing to overlook high inflation rates in the belief that price pressures were transitory. We too were firmly in the “transitory” camp until as recently as 3-4 months ago, when it became clearer that base effects (i.e. unusually depressed prices in the comparable COVID-19 ravaged period a year ago), supply chain problems and commodity scarcities didn’t fully explain or capture the underlying price pressures in the economy, which now appear to be more deeply entrenched than first thought, with the implication that interest rates are likely to rise.
As for what experts expect and what’s priced into markets, a survey of 27 professional economists conducted by Bloomberg LP shows a median forecast of 3.5% for Canadian inflation in 2022 and 2.2% in 2023, but these forecasts have been rising rapidly, from as low as 2% for next year back in May to the current expectation of 3.5% as economists play catch up with reality. The Bank of Canada itself is validating these private sector forecasts, with its own outlook for inflation calling for 3.4% and 2.3% in 2022/23. And finally, the yield differential between Canada’s 5-year real return bond (which is “indexed” to inflation, much like a government pension plan, for instance) and the maturity matched conventional bond is currently 2.2%, which means investors expect five-year average inflation to come in around 2.2%, somewhat above the central bank’s midpoint target of 2%. Where we stand on the matter, taking the word “transitory” quite literally to mean “non-permanent”, is we expect current high inflation rates to be transitory, but not as fleeting as some, including ourselves expected as recently as a few months ago. What has changed our outlook is the creep of inflation into wage pressures, coupled with widespread anecdotal evidence of labour shortages, particularly in the United States. To a lesser extent, the ongoing robust demand for durable goods (e.g. bicycles, jet skis, cars, patio furniture, boats…a.k.a. “revenge spending” by consumers flush with savings) amidst still patchy availability of services (e.g. travel, restaurants, sporting events) which has created the much discussed supply chain problems the world is now facing has coloured our outlook on medium term inflation, which we now expect to remain elevated into the middle of this year before drifting back towards the central bank target range.
Investors in derivatives markets have priced three quarter-point rate hikes by year end in the United States and five in Canada, which would take the overnight rates in each country to just under 1% and just over 1%, respectively. Some have taken to describing these expected rate hikes as central banks tightening monetary policy, but these descriptions are inaccurate and misleading. Both central banks estimate the neutral level of interest rates, where monetary policy is neither stimulating nor restricting economic growth, to be around 2.5% (Federal Reserve – 2.5%, Bank of Canada 1.75% - 2.75%). As such, raising rates from effectively zero to around 1% is more akin to easing up slightly on the accelerator in a car than to slamming on the brakes. The other important question is whether the Fed and Bank of Canada will balk at their current intentions of normalizing interest rates if either the bond or the stock markets throw a tantrum, as we have seen them do repeatedly since the financial crisis some 14 years ago. While it’s not technically correct to say that stock and bond markets actually set the level of overnight interest rates, it’s a decent functional approximation of the dynamic interplay between traded markets and administered overnight interest rates, as first described nearly 30 years ago by U.S. political consultant James Carville, who coined the phrase “bond market vigilantes”.|
So, with the bond and stock markets on a collision course with central banks inflation fighting charters, and the usual litany of geopolitical risks simmering on the back burner (i.e. midterm elections/the return of Trump/Trumpism, trade policy spats/protectionist domestic sourcing policies, Canadian housing market risk, bad behavior in China-Taiwan, Russia-Ukraine, etc.), we would not be surprised to see at least a garden variety correction in equity markets, or even a minor bear market. Historically, market corrections of 10% or more occur every 12-18 months, and the current bull market has yet to experience one at any time during the last 21 months since the March 2020 COVID-19 lows, so in some sense, markets are “due” for a pullback. Bear markets, where prices draw down 20% or more from recent highs, are less common, but typically are seen every 3-5 years. So while 2022 might be “early” in the economic cycle for a bear market to occur, we can’t altogether rule one out. We don’t fear equity bear markets and we don’t make radical changes to portfolios in attempts to outfox them – this has been proven time and again to be a mug’s game. Instead, we manage total portfolio risk by setting a sound asset allocation framework at the individual client and household level and rebalance diligently to it, whenever bull or bear markets in any asset class take the portfolio meaningfully away from its target asset allocation. In light of very strong equity market returns this past year, as noted in the opening paragraph, and the weakest bond market returns since the turn of the century, in many cases this will entail taking some profits in equity portfolios and adding the proceeds to bond portfolios. We know from numerous recent conversations with clients that after the tantalizing returns in equity markets over the last 21 months, selling stocks to buy bonds will seem about as appealing as trading an ice cream cone for a plate of Brussel sprouts does to a kid, yet this is the essence of managing strategic asset allocation – risk is managed prospectively, not retrospectively.
Whether we do or don’t see a correction or bear market next year, we foresee virtually no chance of a recession ending the current economic cycle. Conditions are simply too stimulative, both in terms of monetary and fiscal policy for the cycle to end. As noted above, normalizing interest rates to sub 1% or slightly above 1% levels does not constitute tight monetary conditions whatsoever, but rather represents central banks merely taking their foot off the accelerator slightly. The same applies for fiscal policy, where governments continue to run large, albeit moderating, budget deficits on both sides of the border, with money flowing to households and businesses and to some extent, “public goods”, like infrastructure. Amidst this ongoing stimulus, not surprisingly, economists are forecasting real economic growth to come in around 4% in both Canada and the U.S. in 2022, which is roughly double the trend rate of economic growth.
Strong expected growth often gets priced into markets in advance and heading into 2022, this is indeed the case. Valuations are full in the United States, with the S&P 500 trading at 22.1x expected earnings, compared to a 20-year average price/earnings ratio of 15.7x, but well below the frothy peaks of the late 1990s. In Canada valuations are somewhat above average, with the S&P TSX Composite trading at 15.8x expected earnings, relative to a 20-year average price/earnings ratio of 14.7x. Accordingly, with valuations on the high side of normal in both Canada and the U.S., our challenge is to pick our spots carefully, finding companies with good prospects to outperform market averages whose overall returns we expect to moderate in the year ahead.
To that end, both our Canadian and U.S. portfolios employ a barbell approach, owning a mixture of growth and value stocks that we expect will be resilient to the vagaries of ever shifting investor preferences for growth vs. value stocks. As the table of portfolio characteristics on the next page shows, both our Canadian and U.S. portfolios have somewhat above average market sensitivity – this is by design, as we expect an ongoing bull market in 2022. Both portfolios trade at lower valuations than their local benchmarks, although the valuation advantage is far more pronounced for the U.S. portfolio and conversely the forecast earnings growth is slightly higher for the Canadian portfolio in the absolute and compared to its benchmark. Both portfolios own companies that are more recommended by analysts than the typical Canadian or U.S. company, and both portfolios are comprised of companies whose latest financial results exceeded consensus earnings forecasts by a wider than typical margin. Finally, both portfolios own highly profitable businesses, particularly so in the U.S. portfolio, despite its modest shortfall to the profitability metrics for the overall S&P 500.
Our fervent belief is that although every portfolio necessarily must have leaders and laggards at the individual stock level, over time the leaders and laggards tend to switch places, and crucially, portfolios with overall characteristics like these stand a good likelihood of faring well in the absolute and relative to benchmarks like the S&P 500 and S&P TSX Composite, both in terms of returns and risks.
While we’re not fond of the expression, “the easy money has been made”, as this phrase is invariably spoken by someone basking in the wisdom of their own hindsight, without regard for how difficult it was to actually make the necessary decisions in real time, the expression does convey a going forward message of tempered expectations, which we do endorse for the year ahead. But setting aside notions of “easy money”, what we can say confidently is that “small money” becomes “big money” with patience, discipline and the power of compounding over multiple cycles and our commitment is to keep clients safely on that journey in 2022 and beyond.
