Market Update – April, 2022
North American equity markets have been abnormally volatile in the first three and a half months of the year. While the Canadian market posted a positive 3% return, it was due entirely to soaring oil and commodity prices. Excluding those sectors, the S&P/TSX index was down over 3% in the quarter. The Canadian dollar value of the US market fell 6% in the quarter. From January 4th to February 24th the S&P 500 lost 14.6% and has recovered 9% since then.
Russia invaded Ukraine on Thursday February 24th. This war is horrific. Seeing innocent people die because of the political hubris of one man is a tragedy we all hoped would never reoccur. We can only hope that it will end soon. Beyond this, the economic implications of the war are significant. The early 2022 economic news has focused on rising inflation and consequently the potential increase in interest rates. Approaching the Russian invasion of Ukraine, the price of oil, certain industrial commodities, and wheat have shot up. For the moment, concerns about rising prices dominate the global economy and financial markets.
People have become addicted to low interest rates that have been the result of declining or negligible inflation. Over the last decade inflation has been around 2% or less every year. However, in the last twelve months prices are up 5.7% — and that does not include the recent spike in gas prices.
In North America, the Bank of Canada and the US Federal Reserve are preparing to combat rising inflation by raising interest rates sharply and shrinking their balance sheets.
Do you remember this? On January 1, 2000, the yield on a 10-year Government of Canada bond was 6.5%! How the world has changed. In August 2020, the yield on the same instrument was a mere 0.56%, and it finished last year at 1.4%. That yield is now 2.4%. Interest rates are rising, and they are rising quickly.
When interest rates rise bond prices fall. The FTSE Russell Canadian Bond Index fell 7% last quarter, the largest quarterly loss in the last forty years. For those who are seeking safety or at least fleeing volatility, investing in bonds has not worked.
The worst may be yet to come in the bond market. Historically the ten-year bond yield has averaged about 2% above the rate of inflation. It is well below that now.
Federal reserve Chairman Jerome Powell stated the case for aggressive rate hikes very clearly “… the economy is very strong, as I mentioned. Tremendous momentum in the labour market. We expect growth to continue. It’s clearly time to raise interest rates and begin the balance sheet shrinkage. As I looked around the table at today’s meeting (March 16th Federal Reserve meeting), I saw a committee that’s acutely aware of the need to return the economy to price stability and determined to use our tools to do exactly that.”
With central banks poised for further rate hikes to combat inflation, further losses in the bond market seem to be inevitable.
Fixed income investments are not the place to be in this environment. If you do need fixed income, short-term or floating rate debt is the place to be.
In a National Bureau of Economic Research working paper, Financial Decision Making in Markets and Firms: A Behavioural Perspective, authors Werner De Bondt and Richard Thaler found that the real rate of return on stocks from 1926 to the early 1990s was 7%; the return on bonds was 1%. These numbers are after inflation but before taxes. Including tax makes the advantage of equities even more pronounced. The return on equities over time more than compensates for their short-term volatility.
At Kingwest, we have always had an overwhelming bias towards equities for this reason. In our opinion fixed income or bonds should be used only for portfolio stability or if there is a cash or liquidity need in the short to medium term (0-3 years). Today the real return on bonds (that is the nominal yield minus the rate of inflation) is negative — much worse than the real return of bonds referred to in the working paper.
And how do rising rates effect equity markets?
Broadly, as the cost of alternate investment opportunities rise it increases the cost of equities as well. Operationally, many businesses face limited ability to absorb higher costs. However, some companies have the ability to counter the ravages of inflation by adjusting prices. The key is investing in companies with pricing power. As well, companies with debt (particularly if that debt is short term and has a low interest rate) face higher costs. We have been concerned about rising rates for a few years and have focused on the possibility of higher interest rates on our investments.
For example, we have a significant investment in financial companies. Banks which have suffered for years as lower rates inhibited their ability to receive a normal spread between their borrowing and lending rate may now be able to earn a reasonable return from that endeavour.
Insurance companies have suffered for 20 years as interest rates declined. That now appears to be reversing. Higher rates benefit insurance companies by reducing the present value of their liabilities and thereby increasing the value of their equity. They should now benefit as interest rates rise.
Real estate, where we are significantly invested, historically does well in inflationary times.
We have attempted to invest in companies with pricing power, enabling them to protect themselves by raising prices without otherwise negatively impacting their business. Investment professionals seem to speak endlessly about competitive advantage, and this is why. If you provide customers with something they value that they cannot get elsewhere that competitors cannot easily replicate, you have a valuable product. Most of the companies we own are in this enviable position.
We have made a few new investments over the past three months. One is Canadian Pacific. CP has made an interesting acquisition of the Kansas City Southern railroad which gives it the only Canada, US and Mexico connected railroad. The CP leadership team has a long history of excellence. It is led by Keith Creel who worked with industry legend Hunter Harrison to transform it in to one of North America’s most prosperous and respected railroad businesses. We believe CP will be successful in cutting costs and building on the unique transport routes resulting from this acquisition. Combining that with the increasing demand for Canadian oil and wheat transported by rail is a recipe for success. We expect CP’s profits to increase significantly over the next few years.
Another new investment is Superior Plus Corporation. Superior is the largest propane distributor in Canada with approximately 38% market share and the fourth largest retail propane distributor in the US. In 2021 Superior completed a five-year transformation into a pure energy distributor with a major US platform, providing the bridgehead for continued growth. The business is particularly attractive in these times because their cost- plus pricing model that provides for consistent, reliable cash flow and protects against rising energy prices.
Additionally, we added Peloton Interactive Inc to our US portfolio. Peloton essentially reinvented the fitness industry by developing a first-of-its-kind subscription platform that seamlessly combines equipment, proprietary networked software, and world-class streaming digital fitness and wellness content. Peloton has over 6.6 million members today and that membership is growing. The company had been a high-flyer during the Covid period. Recently, the business hit a snag as growth exceeded their manufacturing capabilities and the stock was punished. It fell from a high of $129 in July to $24 where we recently bought a position. The new management is focused on the strength of the brand and fixing the manufacturing issues. We believe Peloton will continue to be the leader in the fitness and wellness content industry. While we have no delusions that Peloton stock will regain its once lofty heights, we are confident that the business will continue to build on its strengths, and the value of its connected member base will continue to grow propelling the share price higher.
Inflation has a decided impact on investments. As the former president of the Bundesbank, Carl Otto Pohl said, “Inflation is like toothpaste. Once it is out, you can hardly get it back in again.”
While there is certainly still much to be concerned about, we are focused on this issue and are confident that the companies we have invested in. Having come through the pandemic with a stronger and more resilient economy we continue to be optimistic that our portfolio is well situated for the times we are in.