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Market Update – January, 2023


Investors had an awful time in 2022. For the first time in 90 years both global stock and bond markets had double-digit negative returns. In fact, it was the first time in over 50 years that both global stock and bond markets had negative returns. 2022 was indeed a terrible year for the markets.

We do not make economic or market predictions, as we have reiterated many times. However, we are students of the present. We do try to understand where we are in the economic cycle and the main drivers that will affect economic and market prospects.

In our last letter we said that “inflation remains the number one, two, and three most important data point. The market is fixated only on inflation, no other economic developments seem to matter in the near term.”

Just about every country in the world has grappled with soaring prices in 2022, the global rate of inflation will be roughly 9% for the year. In Canada, prices will have risen about 6.8% (excluding food and energy will be about 5.4%). In the US, consumer price hikes increased 6.5%. Even in Germany, inflation will be close to 10%, the first bout of double-digit inflation since 1951, although the pace of price hikes is diminishing there as well.

However, that does not tell the whole story. The chart below clearly shows the rate of inflation in North America (smoothed by averaging three months at a time) peaked in June and has been receding thereafter. For the past few months, inflation has been running at a 2% to 3% annualized rate, which is in line with the targeted inflation rate of both the Fed and the Bank of Canada.

Consumer Price Index — 3 month moving average

Source: Bureau of Labor Statistics, Statistics Canada, Kingwest Research

One of the major consequences of higher inflation is higher interest rates. The central banks in both Canada and the US delayed taking action even after it became clear that inflation was rising. By the fall of 2021— six months after President Biden’s stimulus — the US economy was rapidly heating up, yet the Federal Reserve left interest rates untouched. It is hard to escape the fact that Jerome Powell’s term as Fed chair was set to expire at the end of the year and Biden had not yet announced his re-appointment. Had Powell initiated interest rate hikes sooner, the president would probably have replaced him as chair.

By playing catch up to the accelerating market interest rates, the central banks sent worrying signals to financial markets.

US Federal Funds rate vs US Treasury yields

                                                                                                                                 Source: Federal Reserve Bank of St. Louis, Kingwest Research

After most Fed meetings this year, markets collapsed. Powell’s hawkish tone shook investors. In each of the five worst weeks for stocks in 2022, shares plunged by about 5%. Each occurred immediately before or after a Fed meeting. With inflation rising, market interest rates climbed, and the central banks followed belatedly, doling out four consecutive monster rate rises. The fierce tightening of monetary policy was the trigger for much of the turbulence that rocked the financial world in 2022.

Today, administered interest rates have finally caught market rates. According to the December Fed minutes, “a restrictive policy stance would need to be maintained until the incoming data provided confidence that inflation was on a sustained downward path to 2 percent, which was likely to take some time.”

Central bankers are saying that they will raise interest rates above 5% in 2023 and leave them there. That does not tally with investors’ expectations. Despite Powell’s warnings, investors are betting on a shallower peak and continue to think that a rate cut may come as soon as this summer.

An examination of the historic relationship between interest rates and inflation suggests a different conclusion. When inflation is under 3%, interest rates have historically been 2% above that. When inflation exceeds 3%, the interest spread widens. Where we are now only time will tell, but the history suggests that interest rates are not bound to decline anytime soon even if inflation remains at the lower levels seen in recent months.

As we enter 2023, times are uncertain. Will there be a recession in 2023? If so, when will it start? Surging inflation has had profound social and political consequences. Consumer confidence is low. Confidence among chief executive officers is at its lowest level since the Great Recession, according to a recent survey from the Conference Board. Wage inflation seems sticky due to a shortage of skilled workers.Yet even as wage rates rose, higher inflation has pushed real wages lower. And employment is still surprisingly strong. The Fed is projecting economic growth to slow within a range of 0.4% to 1% in 2023, with inflation around 2.9% to 3.5%.

Of course, we do not know exactly how this will eventually play out. For the moment we are remaining cautious. With stock prices at very cheap levels, we are well positioned. But the uncertainty around interest rates leads us to be a little more cautious than might normally be the case.

The positive case has equal merit. The stock market peaked on January 3rd last year, so it has been down for 12 months, slightly longer than the 11-month average duration of declines over the past 50 years.

The important thing is that the companies we own are continuing to do well and are consistent with our investment theses. The stocks that have weighed heaviest on the portfolio recently continue to see their businesses improve. So, while a slowdown will certainly cause earnings to suffer, these businesses are resilient and are gaining as competitors suffer even more.

Over the past several weeks we have had occasion to talk with a number of very successful real estate developers and investors, both public and private. Almost to a person, their story remains the same. “We have had the opportunity to pick up properties at 5% or even a 6% yield (20 times or 17 times cash flow), with rent increases that average around 1% per year. These are great opportunities.”

If those are great opportunities, what are Canadian bank stocks today? The Toronto Dominion Bank yields 4.4%, and CIBC and Bank of Nova Scotia an even more generous 6.2%. In each case, the dividend is about 40% of earnings. The balance of those earnings are re-invested in the business, in each case generating a return of about 16%. So, earnings should grow 10% per year for each of the next five years. This implies a 15%+ return per year for the stocks, without a valuation change.

But bank multiples are currently depressed. TD trades at 9.6 times earnings; CIBC and Scotia at 8.3 times earnings. And bank earnings are being propelled by a much more profitable banking business as higher interest rates allow for wider spreads between the bank’s borrowing cost and lending rate.

That being said, there are two reasonably probable positive surprises. One is that bank earnings may improve even faster than anticipated pushing the stocks higher still. The other, the average multiple may rise from the depressed present level. A return to past norms will drive the return for the group to over 20% per annum.

As we listen to some people talking about where they can find good investments, the stock market is unquestionably the place to be. The average return over the past fifty years has been close to 10% per annum. Stocks are currently depressed, so if the trend continues, returns from here will be even higher. There aren’t a lot of investments that you can buy at a discount today and that incorporate inflation protection. So long as you are prepared to look out a few years, many stocks today offer exceptional potential returns, with low risk.

These kinds of opportunities abound. We are working hard to ensure that your portfolios will do exceptionally well over the next few years as the economy improves and the interest rate turmoil settles.  Nonetheless, we continue to be cautious but remain very optimistic into the new year and beyond.

We wish you all a happy, healthy, and prosperous 2023.