Q2 | 22
Two years after the coronavirus pandemic changed our lives, causing lockdowns beginning in March 2020 and a significant stock market correction, investors are facing a fresh set of challenges.
Central Banks, in the face of rampant inflation (food, energy, shelter), have hiked interest rates at the fastest pace in decades, raising concerns among investors that a recession is imminent. We have entered a “Deflate- Cycle” mode, which has contributed to the worst first half of any year since 1970 for the S&P 500.
The culprit for this pain continues to be the very aggressive upward movement in interest rates by Central Bankers to fight inflation. Early in the year, inflation rose due to many factors including the Omicron variant, China’s zero-Covid policy and Russia’s invasion of the Ukraine resulting in sanctions. This caused the Central Banks to take a much more hawkish stance. The U.S. Federal Reserve raised the Federal Funds rate by 0.25% in March, 0.50% in May and 0.75% in June. The last time the Federal Reserve increased rates 75 basis points at one meeting was in 1994. The expectation is now for the Fed Funds rate to rise to 3.5% by the end of the year, up from an expectation of 0.75% to 1.00% just six months earlier. Despite what many had hoped for, inflation was not transitory! Far from it.
By raising rates aggressively, Central Banks are seeking “demand destruction” for goods and services consumed in the economy and to balance this against what is a constrained supply base. Take U.S. housing as an example. The average rate on a U.S. 30-year fixed mortgage is 5.7%, up from 3.2% at the beginning of the year. This makes it the least affordable time to purchase a U.S. home since before the 2008 financial crisis.
In financial markets, the impact of increasing rates is to increase the “risk-free rate” and make risk capital (stocks, corporate bonds, real estate, infrastructure, etc.) less attractive. Corporate earnings can also be negatively impacted by an economic slowdown. The combination of lower earnings and lower valuation is a headwind for stock prices.
The second quarter 2022 returns reflected the headwind challenges. The broad S&P 500 index fell 16.1% in U.S. dollars, bringing its year-to-date return to -20%. In the second quarter, all eleven S&P 500 sectors were down. The heavy energy-weighted Canadian stock market outperformed the U.S. market in Q2, falling 13.2% in Canadian dollars and down 9.9% year-to-date. The Energy sector was by far the best performing area of the market. In the U.S., year-to-date, energy was the only sector group with a positive return, up nearly 30%. Oil (part of the inflation problem) peaked at U$130 this year and closed the quarter at U$106 per barrel.
In fixed income, U.S. and Canadian bonds posted a negative return in Q2. The U.S. 10-year Treasury Bond closed at 3.0% (after reaching 3.5%), up from 1.5% at year-end 2021 and 0.9% at year-end 2020. In the second quarter, this interest rate increase is reflected in the Canadian Bond Universe falling 5.7% and declining 12.2% for the year. Although the U.S. dollar index is at a 20-year high (vs. Euro, Yen, etc.), the energy-backed Canadian dollar was up 1.7% in the second quarter versus the U.S. dollar.
The first half of 2022 saw negative investment returns and for good reasons – soaring inflation (highest in 40 years), labour shortages, supply chain issues, huge increases in home prices and rents, financial speculation, much higher interest rates and a growing threat of inflation. We expect most of these problems (excess demand and lower supply) to eventually fade, setting the stage for better economic performance. Changes to Policy and a natural machinery of repair is at work, correcting the imbalances. However, this will take time. Unlike the 2020 correction and quick recovery, this time we are not expecting a V-shaped bottom.
At LDIC, during the second-quarter, we played DEFENSE. We raised cash, sold businesses that can be negatively affected in a hostile macroeconomic environment and purchased businesses that can still provide upside in a slowing economy. The real challenge, however, is now that we are defensive, when do these lower valuations fully reflect most of the potential negatives ahead? The answer will really depend on where interest rates go from here, but that will hinge on hitting “peak inflation.” We will be watching for this but there are so many unknowns on this front that we believe it will take time.
The futures market is now discounting the Federal Reserve to stop hiking by January 2023. For the rest of 2022, it appears the rate market is implying +75 basis points for July Federal Reserve meeting, +60 bps for September, +40 bps for November and +20 bps for December. The total is another 195 basis points of higher Fed Funds rate in 2022. The light at the end of the tunnel is that the futures market is forecasting rate cuts of up to 1% in 2023.
This all leads into the bigger picture that we are either going into a Recession or an economic slowdown. The good news is that markets are already forecasting and pricing-in a volatile time ahead for the U.S. Federal Funds rate. Massive inflation with the Federal Reserve behind the curve and needing to hike aggressively. Followed by the Federal Reserve cutting interest rates next year as the economy slows. We believe that we will get a recession/slowdown but it will not be deep. The slowdown is a normal part of the business cycle. Given the uneven supply constraints and heightened geopolitical risks, the weakness in the economy could linger for a while. A lot has been priced in already as we await more inflation data. Almost 60% of the equities in the S&P 500 are down 20% or more.
In summary, we are in a period of many unknowns. The first pandemic in 100 years. The first European invasion in 75 years. The first bout of inflation in 40 years. None of these are unprecedented, but extraordinary that all three are happening at the same time. Given this backdrop, LDIC will be defensive and will look for opportunities as events unfold. We will seek strong management teams, reasonable valuations, strong balance sheets and businesses that can generate cash flow over the next 2 years, not just the next quarter.
If you have any questions, please contact us at 416-362-4141.