Portfolio Update

Equity markets declined slightly in August as investors weighed the economic risk of further aggressive action by central banks as they strive to tackle inflation. Year-to-date, markets remained in negative territory: the S&P 500 total return was -13.1% in Canadian dollars, the S&P/TSX -7.2%, Bloomberg Euro 500 -19.3%, MSCI World Index -14.8% and MSCI Emerging Markets -14.5%. Returns for our equity, balanced and fixed income portfolios remained notably ahead of their benchmarks over the same period.

Recession or no recession: that is the question

If you are just returning from summer holidays, having navigated packed airports and fully-booked hotels, you may be puzzled by the financial media’s speculation about an imminent recession. Travel, hospitality, and other services are booming, job markets remain tight, and personal incomes are up strongly. There appears to be no shortage of underlying demand in the real economy.

In contrast, financial markets continue to scrutinize daily economic data for signs of recession. Market volatility appears tied to the probability that one of two events will – or will not – trigger a recession. Investors who forecast a global downturn either believe that high and persistent inflation will force central banks to hike rates to levels that kill demand or that geopolitical risk arising from Russia/Ukraine or China/Taiwan will deliver a negative shock to the world economy.

As we will detail in our upcoming Investor Forum webinar, we expect economic growth to slow as central banks hike policy rates to fight inflation. We believe it is premature to conclude a synchronized global recession is in the cards. Europe, which is directly suffering from the war in Ukraine due to its reliance on Russian gas, is likely to experience recessionary conditions. Some emerging market countries may also struggle as they face higher interest rates and a strong U.S. dollar, making imports more expensive and exacerbating inflation. However, the U.S. and Canada are on more solid footing given strong labour markets and high accumulated savings, and China is deploying fiscal and monetary stimulus to boost their domestic economy.

As most global central banks continue to tighten policy to engineer a softening of demand, upward pressure on rates spells further trouble for high-multiple stocks. We have long warned about the interest-rate sensitivity of companies trading at expensive valuations. In our May and June Portfolio Update reports, we highlighted how the selloff in expensively valued companies, particularly in the technology sector, was unsurprising, given the backdrop of high inflation and rising rates. While we believe avoidance of high-multiple stocks is always a prudent investment strategy, the current environment argues for even more caution.

Turning to the questions of whether China is poised to invade Taiwan or more widespread conflict in Europe may derail economic activity, we acknowledge that sound arguments exist both for and against such outcomes. When faced with the potential for an unpredictable shock, the temptation may be great to reduce your equity investments, temporarily shift to cash, and wait for the storm to blow over. In August’s Portfolio Update, we explain that remaining invested through periods of volatility is crucial to long-term success. Our research has shown that being out of the market for even as little as 20 of the best performance days leads to considerably lower total returns compared to holding your investments in down markets. The reason is simple: an investor must decide when to sell and when to re-enter the market. Getting the timing right on both decisions is difficult, if not nearly impossible.

Focusing on longer-term challenges and opportunities

Our emphasis on patience in the face of volatility may appear to some to be a deliberate disregard of looming risks. We would argue the contrary. We keep a watchful eye on all risks, we constantly assess their potential to significantly impair the value of our holdings and we ultimately decide whether action is warranted. Much of the work we do involves looking ahead and evaluating how a myriad of risks, including those arising from structural, demographic or regulatory trends, may impact the industries and companies we invest in. And, importantly, which businesses are creating solutions to respond to these challenges.

One structural force that we are devoting significant time and research effort into understanding is climate change. Our Climate Change Committee is studying how the transition to a lower-carbon economy poses challenges and opportunities to our industries and our holdings. The findings from our work will be shared throughout the year via a series of published reports. We invite you to peruse our first installment, “Net-Zero Research Series Part 1: Understanding the Science”, in which we demystify the science behind climate change and summarize our thoughts on the implications of driving towards a net-zero emissions scenario.

Concluding thoughts

We do not see convincing signs of a synchronized global downturn, although certain regions may face more difficult economic conditions. In the current environment of heightened risks and market volatility, we would like to assure you that our equity portfolios are well diversified by geography and industry, trade at a very reasonable valuation of 9.1 times estimated 2022 earnings and are supported by an attractive 3.7% dividend yield. Our fixed income portfolio is structured defensively for a period of gradually rising interest rates: duration is short and credit quality is high. We are keeping a focus on medium- and longer-term challenges and opportunities, such as, for example, those posed by climate change. We are confident that your capital remains invested in a prudent manner.