2022 was a very challenging year as investors faced multiple shocks.  Stocks and bonds both sank as inflation spiked, stimulus was withdrawn, bond yields and the USD$ climbed, China implemented strict lockdowns of its two major cities (Beijing and Shanghai), Britain blew up its government, and Putin launched a war against Ukraine.  Canadian investors fared better than their global peers, as strength in commodity prices and a decent outing from most Canadian banks flattered the return of our benchmark index, the S&P/TSX Composite.  However, the 9.9% drop in the national average home price in Canada hasn’t helped the mood.

Long term relationships of ours are used to us reinforcing the merits of exercising discipline and sticking to a long term plan, but they continue to serve us all well during good times and bad.  While these strategies don’t make for exciting cocktail party stories, they are essential to long term wealth creation.  Rebalancing investment portfolios back to one’s target asset allocation, implementing strategies that are not proxies for the market as a whole, sticking to your budget and saving regularly, being conservative with your modelling (whether for your long-term financial plan or for an investment opportunity), and taking the time to meet with management and reflect on why a position, manager or strategy is not performing up to expectations rather than abandoning them wholesale; these are strategies that should add incremental value over time and lead to steady wealth generation for you and your family. 

Looking forward, the long term outlook is decidedly brighter than it was a few months ago, though there may be a few further bumps to weather in the months ahead.  For the first time in over a decade, the ballast of a balanced portfolio, the humble bond, offers an attractive return profile.  North American government bonds now yield 4-5%, Investment Grade bonds yield 5-6%, while more esoteric securities with higher default risks in the event of bankruptcy like high yield bonds and leveraged loans yield 8-10%.  Admittedly, the returns from these asset classes will lag inflation in the short term, but assuming inflation returns to its long term average of 3.65% (per the chart below), the “real” return from bonds should move into positive territory, which is a region it has felt uncomfortable in for most of the past decade.

 

 

In North America, stock market valuations have compressed sharply over the past year and are now approaching long term averages for the first time since the lockdowns of March 2020, which should limit downside risks if earnings deteriorate further from here. U.S. Small and Mid-Cap Stocks are particularly cheap. Meanwhile, while earnings may continue to fall if financial conditions remain tight and the global economy slips into recession territory, many of the headwinds of the past year are beginning to dissipate.  Inflation is already showing signs of peaking, and supply chains are normalizing after the shocks of the past two years.  Weakness in the USD$ as the Federal Reserve approaches the end of its tightening cycle as the European Central Bank and Bank of Japan continue to hike borrowing rates should also flatter the earnings of big U.S. multinationals like Microsoft and Apple.  Finally, the U.S. consumer, who comprises 68% of U.S. GDP, remains in excellent financial shape thanks to the USD$2 Trillion in excess savings they amassed during the lockdowns of 2020 with USD$1.0 Trillion in savings left to spend and relatively low levels of debt, as you can see from the table below.  While the start of corporate layoffs will likely dampen the mood, the twin taxes of rising borrowing costs and pressures at the pump are starting to level off after sharp jumps over the past year which should keep the U.S. consumer doing what it does best: spending.

 

 

 

Looking further afield, International and Emerging Markets offer particularly attractive value.  The recent re-alignment of power in China has been followed by a rapid policy reversal towards real estate, tech and COVID.  Restrictions in these arenas have been a huge drag on growth for the country, and President Xi is clearly keen to get his economy back on track. This should bolster not only key exporters to China like Japan, the Asean trade block (Indonesia, Philippines, Thailand and Vietnam), South Korea, the EU and Taiwan, but also should stabilize global supply chains after two years of disruption.  This recovery in underlying earnings power is occurring at a time of very depressed valuations relative to North American stocks, which is an optimal set up for above-average returns.    

In the short term, we should be prepared for a few further surprises as investors digest the prospects of slowing growth and the impact of the rapid rise in rates over the past year.  Illiquid assets that have seen inflows of capital like real estate, private loans, and private equity are already showing some signs of strain as institutional investors rebalance their portfolios to take advantage of low values in stocks and bonds.  To date, this has been very orderly, with a few large real estate funds slowing or halting redemptions.  But there is the risk that there is a larger bump in the night that spooks markets.

Looking longer term, there are clearly a few major issues that came to a head in 2022 that will take markets some time to digest.  First, the conflict in the Ukraine and Chinese threats towards Taiwan have highlighted rising political risks that are forcing many companies to reflect on the resiliency of their supply chains.  Re-shoring and “friend-shoring” are trends that are not going away, particularly as the cost advantage of manufacturing in China is starting to erode, as illustrated in the chart below.  Expect us to be writing more on this subject in the new year, which should tell you that we have already positioned portfolios to benefit from this trend.

 

 

Second, the conflict in Ukraine has made clear how important secure and diverse energy supplies are to a well-functioning economy.   We wrote about this extensively in our blog posts this spring, but we are confident that major investments in climate-friendly energy solutions will be required going forward, as well as a reconsideration of the value of low impact non-renewables during the period of energy transition.

Finally, as a result of the tensions above and those that emerged during the Trump Administration’s time in office, the concept of globalization as a force for positive change has been called into question.  Offshoring led to a flood of cheap goods in the developing nations, but also contributed to the stagnation of job growth and productivity in developed nations from 2000 – 2010, leading to the “jobless recoveries” after the recessions of 2000 – 2002 and 2007 – 2009.  This, in turn, contributed to the rise of populist movements, protectionism and rising tariffs that came to characterize the end of the last decade. What these movements conveniently forgot about were the beneficial aspects of globalization, including steady growth in the trade of manufactured goods as well as the flow in data, services and well educated human capital across borders.  Most importantly, it highlighted an intrinsic lack of understanding on how interconnected our global economy is – no region, nor one single nation, is close to being self-sufficient.  Perhaps the silver lining of the lockdowns of 2020 is that it reminded us that we all rely on one another to move forward.

 

 

(Source: McKinsey, “Global Flows: The Ties That Bind, December 2022”)

As we enter the holiday season, we hope that you will reflect on how lucky we are to reside in a country with such ample resources and stable institutions.  Peace, order and good government, indeed.  We should dedicate ourselves to standing on guard for them for the generations to follow.

On behalf of all of us at the Greenwood White Group and our partners at CIBC, we’d like thank you for your continued business and support of our growing practice. 

 

Sincerely,

 

Calvin, Emily, John, Lorena, Marc, and Peter.