Q4 | 22

Last year proved to be a tough year for financial assets because both equities and bond prices fell. We had three major shocks to the system: a global pandemic, a major war and inflation. The war helped create a 42% year-over-year increase in energy prices which pushed inflation to its highest level in 40 years. To combat inflation, the U.S. Federal Reserve hiked interest rates from 0% to 4.25%, the steepest rise since the Great Financial Crisis of 2007-2008. In addition, we now have Global coordinated tightening at the Bank of England, Canada, Europe and potentially Japan. The Bank of Canada raised its interest rate for the eighth consecutive time to 4.25%, its highest level since 2008. The final push toward sustainable inflation levels will require a longer period of sustained higher rates.

As we begin the year, The University of Michigan’s Index of Consumer Sentiment is lower than it has been 96% of the time since 1978. Despite this negative investor sentiment, many problems that we faced in 2022, could be resolved in 2023. With the significant changes that have already occurred in interest rates and asset prices in 2022, we look for better days ahead.

Macro recession fears continue to be the primary driver of asset prices. Earnings have not declined anywhere near the stock price declines. For 2022, S&P 500 earnings are expected to be down only 7%. In other words, the majority of the down move in stock prices can be explained by rising bond yields which had a dramatic negative effect on valuations. High growth/long duration/high valuation stocks were the hardest hit. Energy was the only positive sector in the S&P 500 in 2022, up 59%.

In the fourth quarter (Q4) of 2022, the S&P 500 rose 7.6% in U.S. dollars, breaking the streak of negative returns for Q1, Q2 and Q3. Year-to-date, the index is down 18.1%, the worst performance year since 2008. The heavy energy-weighted Canadian stock market outperformed the U.S. market, up 6% in Canadian dollars in the fourth quarter and down only 5.8% for the year. Oil (part of the inflation problem) started the year at US$75 and peaked at US$120 in March.

In fixed income, U.S. and Canadian bonds posted a negative 2022 return. The U.S. 10-year yield started the year at 1.5% and hit 4.2% in October. Mortgage rates more than doubled relative to where they were a year ago. As a result, the Canadian Broad Bond Universe fell 11.4% in 2022. In the currency world, the U.S. dollar index is close to a 20-year high (vs. Euro, Yen, etc.). In 2022, the energy-backed Canadian dollar was down 7.2% versus the U.S. dollar.

Consumer confidence may move sideways or improve in 2023. Job growth is likely to be much slower and an upward drift in the unemployment rate would be viewed as a positive. Year-over-year inflation is continuing to fall, and gasoline prices have returned to acceptable levels. Countries are showing continued signs of moving beyond the pandemic. However, we must crawl before we can walk. There is still uncertainty about the outcome of the Russia/Ukraine war. How well will China transition from a zero-Covid policy? How quickly will Central Bankers end their tightening cycles, even as inflation fades? Will Saudi Arabia and OPEC+ restrict production to support oil prices? In the midst of all these uncertainties, investors should realize (big picture), that the majority of interest rate hikes have already occurred, and stock valuations have already been hit.

At LDIC, the general theme of our investment strategy in 2022 was to own energy and play defense. Our cash levels are elevated, our European exposure is low, our high valuation exposure is limited, and we continue to focus on the quality of management, proven earnings and cash flow resilience, mission critical businesses and stable and growing dividends. Looking forward, we are preparing for a pause from the Central Banks, but at a restrictive level. We expect inflation to continue to fall at a steady clip, but as we approach a Consumer Price Index reading of 4% from a peak of 9%, it may be a slow process to move to the Federal Reserve 2% target.

As we enter 2023, investors are positioned defensively. This will diminish the risk of substantial negative developments. In 2022, interest rates and inflation were the main topics. In 2023, we believe earnings and the labour market will be the focus.

Although we maintain a cautious view, with all the dramatic movements that have occurred in 2022, LDIC has a wide range of investment opportunities that need to be explored. Who might benefit from supply chain easing? Who might see improvements in fundamentals as cost headwinds peak? Will energy companies hold back on growth and return capital to shareholders? What is the post-covid normalization of earnings for each of our companies. Will fiscal policy impact 2023 earnings, given U.S. Congress has passed nearly $1 trillion in new stimulus in the last 2 years? Will others like China follow? When will the market look through this period of negative earnings revisions and look to the green hills beyond focusing on secular growth trends, good pricing power and higher free cash flow? Much to consider as we prepare for a Fed-pause.