The second quarter of 2022 was very challenging for markets around the globe as concerns surrounding inflation weighed heavily on investor sentiment. After holding up relatively well in the first quarter, the Canadian market fell 13.2% in the second quarter while the S&P 500 and MSCI EAFE indices declined 13.6% and 12.0%, respectively. Bond markets also came under pressure as interest rates continued to rise during the quarter.
The economic backdrop has become more uncertain as central banks have communicated their intentions to aggressively combat inflation. The US Federal Reserve has drawn a line in the sand saying they need to see clear and convincing progress on inflationary pressures before changing course on rate hikes. The Fed is prepared to cause a recession to bring inflation back into line if that is what is necessary. In our view, the expected interest rate hikes should be enough to bring inflation under control, but time is needed for the higher rates to work. It is unclear if Central Banks will be able to hold their nerve and hike as expected, as markets have and will react dramatically. Our investment style is not heavily reliant on predicting the outcome for inflation or interest rates. Instead, we place our confidence in companies who we feel can do better than their peers, however things unfold. We prefer preparation over prediction.
Coming into the quarter the economy was already slowing, but it could be explained in large part by trade distortions resulting from supply disruptions while underlying demand remained resilient. We are now seeing weakness in other areas including consumer confidence which is reflected in downward revisions in real personal spending over the last few months, which brings into question the resilience of the consumer. Given this backdrop, market expectations for the probability of a recession in the US. have increased markedly. Canada has not been immune, although there appears to be a lag with the US. We are seeing a rotation in Canada from housing being the primary growth driver to strength in the resource and services sectors, which has been supportive. As we head into the second half of the year, we expect to see the lagged effects of the rapid tightening in financial conditions on households emerge, which will likely dampen growth at home.
It is worth noting that first quarter GDP growth was negative in the US – which is technically halfway to a recession. We very well could be asking the wrong question: it is not when the recession will start, it is when did it start? We did not have a recession when the global economy shut down in 2020, to the surprise of many at the time. It is possible we just delayed it with all the stimulus that was pumped into the economy. As emergency stimulus programs are winding down, we may be getting the recession we would have had two years ago. On a positive front, labour markets remain strong, savings have been stockpiled and there is no stress in the banking system as of yet. Longer term interest rates have also fallen, indicating that the bond market expects inflation to moderate over the medium term. This likely means any recession would more likely be shallow rather than sharp and deep, should it occur.
What does this mean for your portfolio? The worsening economic outlook and higher inflation environment is already being reflected in markets. While stocks have declined across the board, certain sectors have been hit harder than others. Areas of the market that had been popular during the pandemic – and were expensive in our view – have had a very difficult 2022. Two years ago, we commented that “…Shopify has entered a realm beyond any reasonable valuation framework.” You heard us many times describing a case of not if but when this situation would revert; the stock is down over 80% from its high. While our portfolios are down, they have weathered the storm better than the overall market due in large part to our companies being attractively priced heading into 2022. The Royal Bank never exceeded a price to earnings ratio of 13.5x over the last several years; it is more attractive now, trading under 11x earnings with a dividend yield of 3.8%. Bond portfolios yield close to 4%, levels not seen since prior to the Financial Crisis in 2008/2009.
The current period of uncertainty will create opportunity for long term investors, and we will take advantage. Whereas it was becoming more challenging to find value after a very strong year in 2021, many areas of equity and bond markets are now more interesting. After many years of growth stocks out-performing in an overstimulated (low rate) environment, a return to more normal interest rates bodes well for our relative performance as value managers.
After generating positive returns and escaping the weakness that hit other developed equity markets in the first quarter, the Canadian equity market fell into correction territory during the second quarter as investors worried that aggressive interest rate hikes to combat high inflation would send the economy into a recession.
The S&P/TSX Composite Index (TSX) declined 13.2% over the quarter, with all sectors delivering negative returns. Information Technology was among the worst performing sectors once again, falling 30.7% as the continued rise in interest rates punished tech stocks with higher valuations. Shopify (SHOP, Financial) extended its losses, with shares down 52.4% in the second quarter, bringing its year-to-date decline to 76.9%.
Elsewhere, the uncertain economic outlook weighed on the Materials (-23.6%), Financials (-13.1%), and Industrials (-12.7%) sectors. Within Materials, the gold sub-sector declined 22.9%. On the other hand, the Energy (-1.9%) sector fared better, as oil prices rose early in the quarter amid supply concerns stemming from the Russia/Ukraine war and lower output from OPEC members.
While the Canadian Equity Fund also fell 11.0% after fees and expenses in the second quarter, it outperformed relative to the TSX. The primary drivers of outperformance were our exposures in Information Technology and Materials – specifically, not owning Shopify and gold stocks, which both experienced significant declines. Relative performance was partially offset by weakness in Financials, and an underweight in Energy.
With the market sell-off over the second quarter, we have added selectively to existing holdings, including Royal Bank (RY, Financial), CN Railway (CNI, Financial), Enghouse (TSX:ENGH, Financial), Brookfield Infrastructure (BIP, Financial) and Saputo (TSX:SAP, Financial).
Our experience managing investments through different cycles has taught us to stay focused on the long term, as predicting what will happen to markets quarter to quarter is a difficult task. We believe our process of investing in quality businesses, with sustainable competitive advantages, strong balance sheets, and capable management teams able to navigate through different environments, will continue to benefit client portfolios over the long term.
Canadian Dividend Fund
The Canadian Dividend Fund declined 11.9% after fees and expenses in the second quarter. The Fund modestly underperformed the TSX Dividend Index which declined 11.1%, with all sectors delivering negative returns. Performance was helped by our exposure in Materials – specifically, not owning gold stocks, which declined significantly. Relative performance was partially offset by weakness in Industrials and Financials, and an underweight in Energy.
With the market sell-off over the second quarter, we have added selectively to existing holdings, including Royal Bank, CN Railway, Enghouse, Brookfield Infrastructure and Saputo.
Carbon Constrained Canadian Equity Fund
The Carbon Constrained Canadian Equity Fund (CCCE) follows the same investment process as our core Canadian Equity Fund, where environmental, social and governance issues are addressed in our bottom-up stock analysis. The CCCE Fund adds an additional layer of analysis where companies with more than 30% of their revenues tied to fossil fuel-related activities are screened out of the portfolio. More specifically, investments are excluded if they derive more than 30% of their revenues from:
- The extraction and sale of fossil fuels, or from royalties earned from third parties performing such activities
- Services (including transportation and refining) provided to companies involved in the extraction or sales of fossil fuels
- The sale of power produced by the consumption of fossil fuels
While the Carbon Constrained Canadian Equity Fund also fell 12.7% after fees and expenses in the second quarter, it outperformed relative to the S&P/TSX 60 Fossil Fuel Free Index (TSX FFF) which declined 13.8%. The primary drivers of outperformance were our exposures in Information Technology and Materials – specifically, not owning Shopify and gold stocks, which both experienced significant declines. Relative performance was partially offset by weakness in Financials, and no exposure to Energy as the TSX FFF holds pipeline companies which were helped by the rise in oil prices early in the quarter amid supply concerns stemming from the Russia/Ukraine war and lower output from OPEC members.
With the market sell-off over the second quarter, we have added selectively to existing holdings, including Royal Bank, CN Railway, Enghouse and Saputo.
US Equity Fund
The S&P 500 Index continued its 2022 sell-off over concerns of rising interest rates, inflation, and the potential for an economic recession. Weak performance was broad-based as all index sectors were negative. While the US Equity Fund was down 9.4% after fees and expenses in the second quarter, it outperformed the S&P 500 Index which was down 13.6%, mostly due to strong stock selection with sector allocation also providing a positive contribution.
By sector, outperformance was due to stock selection in the Consumer Discretionary sector, led by Dollar General (DG, Financial) (+14.1%) and not owning Amazon…