360 Private Wealth Management-Q4 2022 Investment Commentary: 2023 Investment Factors to Consider
The 2022 Rear View Mirror - 2023 Crystal Ball Edition
Imagine you were sitting at your table the morning of December 31st, 2019 having your favorite morning wake-up beverage and contemplating the New Year gathering later that day. Reading the news on your tablet, you see that unemployment, interest rates, and inflation are all at historically low levels. Looking at your portfolios online, you see that your portfolios did pretty well for the year just past.. What has happened in the three years since you sipped on that New Year’s Eve morning coffee?
- A global pandemic hit. By the end of March, the S&P 500 had dropped nearly 20% in value.1
- Later in the year, scientists announced that they’d developed a vaccine, and markets roared back.
- FAANG stocks soared … before giving up a lot of gains.
- Meme stocks shot way up … and fell back down.
- Bitcoin and other cryptocurrencies reached record highs … and then crashed.
- Inflation spiked to the highest levels many have ever experienced.
- And Russia invaded Ukraine, sparking a humanitarian crisis and geopolitical uncertainty.
We don’t know of anyone who predicted all of this in December 2019 (Not even “perma-bear” David Rosenberg could have painted a picture that foresaw the effects of the pandemic, investment market drama, and the Ukraine war, December 31st, 2019). But what if someone had? What if that someone was you? What would you have done?
As of December 31st, 2022, the S&P TSX (Canada) is up at a 5% compounded rate over three years, and the S&P 500 (U.S.) is up about 10% compounded over that same time frame.
A portfolio of 50% TSX and 50% S&P 500 would have grossed 7.5% compounded annually over those three years. That is after the tough year we experienced last year. Of course, benchmark index returns do not play out as actual investor returns, but I can safely say most portfolios here have been net positive over that 3-year timeframe.
The Rear View Mirror: Looking back, 2022 was ugly!
There is no way of sugar-coating what happened in 2022. Investors experienced a tough year, possibly one of the worst they might ever experience in their investing lifetime. Year over year, 2022 was one of the worst years ever experienced by North American investors since the 1920s and THE worst since the 2008 financial crisis.
By the numbers, here’s what happened with the main stock indexes most North American investors follow, in local currency terms:
TSX Composite (Canada) -8.7%
Dow Jones industrials (USA) -8.8%
S&P 500 (USA) -19.4%
NASDAQ (USA) -33.1%
Canada’s TSX Index and the U.S. Dow Jones Index performed better than the other broader indexes, primarily because they are weighted, at least somewhat, towards larger value stocks (resources, utilities, and financials). The tech-heavy, growth stock-tilted U.S. NASDAQ fared the worst, with a decline of 33.1% in 2022. The broader U.S. S&P 500 index declined 18.1%, affected by the growth stock elements in the index, many that it shares with the NASDAQ index.
There really was no place to hide this year as far as stocks were concerned if one was building a diversified portfolio. The Non-North American MCSI EAFE (Europe Australasia Far East) Index slid 16.8% as well. Energy stocks were about the only asset that went up in 2022.
Usually, declines would be cushioned by stable or rising bond prices in a balanced portfolio asset allocation, cushioning the downside in the stock portion of portfolios. However, in 2022 the rapidly rising interest rates caused bond prices to fall, with the Bloomberg Aggregate Bond index dropping 13% on the year. So, even portfolios that historically have at least partially protected investors when stock markets went down were no haven.
Going into 2022, we were trying to tell everyone in last year’s version of the “Rear View Mirror – Crystal Ball” Commentary that 2022 was likely to be a tough year. I doubled down on what I said at the start of 2022 in the 2022 1st Quarter Investment Commentary we sent out in April. In that commentary, I wrote that some households needed to be prepared to see their portfolio statements show a possible a decline 20% decline from the start of the year values at some point in 2022.
Some might say that if we knew it would be a tough year, why didn’t we take more defensive actions? The operative word there is “knew.” The fact is we can never know for sure what will happen (Hence the “Clouded Crystal Ball” in the title!).
What we can do is make sure households needing to draw income from portfolios have adequate coverage for their income needs in stable cash equivalents (savings accounts, high-interest cash management ETF’s, money market funds and, where appropriate, GIC’s). We then need to depend on the various managers we select to do their best to mitigate the volatility experienced and generate, over the medium term (3-5+ years), the returns households need to earn to realize their Vision, their lifestyle, and other life goals.
Volatility is part of investing. Volatility is great to experience when portfolio statement balances are going up and not so great when statement balances are going down. The trick is to understand this fact and then manage portfolios to the best of our ability, despite the volatility experienced, to get our client households to where they want to go. As I often heard to say, whether markets are up or down, “This too shall pass!”
I have commented on the reasons for the decline in investment markets in 2022 and provided additional reading in our weekly 360 Weekly Digest throughout the year. For those who missed reading some of the Weekly Digest blogs, here is a summary of what was weighing on the markets in 2022:
Inflation. The cost of living remained stubbornly high throughout the year. Inflation peaked in June in Canada and the U.S., hitting 8.1% in Canada and 9.1% in the U.S., driven by higher wages, housing, fuel, and food prices compared to 12 months earlier. However, there are signs inflation is softening, and by the middle of 2023, it could be down by half from the peak numbers experienced last June. While equities will experience some headwinds in 2023, softening inflation could be a boost to equity prices.
Interest rates. The U.S. Federal Reserve (Fed) began its aggressive rate tightening cycle in March to curb inflation along with many of the world’s major central banks, including the Bank of Canada. The Fed indicated it intends to continue to hike rates further in 2023, but there’s a clear sense that they’re close to winding down the cycle. We should expect to stay at peak rates for some time in 2023 to ensure inflation trends towards its target of 2%. However, it will take a significant economic slowdown or even a recessionary environment to move to the next phase of Fed policy—cutting interest rates.
Russia’s invasion of Ukraine. Russia’s aggression in Ukraine and its impact on energy and agricultural commodities have caused significant global economic disruption. Russia’s blockades of Ukrainian ports halted grain exports for months, contributing to widespread food scarcity. Much of Europe is scrambling to ensure energy security in the wake of Russia’s cut of gas supplies to the rest of the continent. In the short term, these issues will pose challenges to the European economy.
China’s reopening. China’s zero-COVID policy put a damper on the Chinese economy and was a cause of supply chain disruptions over the past couple of years. Recent headlines indicated a relaxation of these policies in Mainland China. While this is encouraging, uncertainties remain for investors. In the coming months, vaccination and fatality rates, healthcare capacity, and government responses to a rise in cases will be signs to monitor.
Recession concerns. The recession probability in 2023 continues to rise as we have yet to see the impacts of higher interest rates. Consumers are dipping into their savings to fund their consumption and are likely to face challenges with higher interest rates. However, a tight labour market and strong wage growth will help the consumer remain resilient. Markets are forward-looking; last year’s performance would have factored in a shallow recession. Markets could drop further if we experience a severe global recession, but those odds remain low as of today.
That is not to say that every sector suffered in 2022, although most did. A sector that did exceptionally well was energy, in particular oil and gas company shares, as the world grappled with oil and gas disruptions and price spikes. In fact, if one had cashed ALL their investments and bought an energy ETF like, say, iShares S&P/TSX Capped Energy Index ETF (Symbol: XEG) with all the proceeds on January 2nd, 2022, you would be up more than 50% as at the end of December. Heck, if you had cashed in all your other investments at the start of 2021 and invested 100% into XEG, you would be up about 180% over the two years ending December 31st. That’s not a typo. Of course, no investment manager or advisor would (or likely even could!) advise you to do this, given the risk associated with such a concentrated play!
In fact, to caution households from chasing the story, natural gas prices have already come off the highs experienced last year, largely because of the warmer-than-forecast winter in many parts of the world are experiencing. The lower natural gas and oil prices are having an impact on oil and gas company share prices. What happens from here is essentially a guess, but if an economic slowdown or recession gets traction, everything else being equal, energy prices will fall further.
Home and durable goods sales all plateaued and even declined as the latter part of 2022 wore on. Preliminary figures show that while Christmas buying was nothing to write home about it was up over 2021 and up almost 20% from 2020 figures, suggesting that consumers still had cash (or credit?) to use. Nevertheless, higher interest rates and increases in the cost of living, it seems, are starting to bite.
The situation this time around is that the labour supply remains tight. The Baby Boom retirement wave continues, decreasing the number of employees in the workforce. Outside of the tech sector, many organizations are holding onto people they might otherwise shed for fear of having difficulty replacing them when things turn. This squeezes the unemployment rate, giving employees the ability to bargain for higher wages and salaries in some situations. The result is “wage-push” inflation, one of the underlying forms of inflation the central bankers are trying to reduce. Doing so involves creating so-called “slack” in the labour force, where more people are looking for work than positions to fill. That is certainly not the case at the moment. Economies in North America need to slow more to create that slack.
What are the factors at play for investors in 2023?
Most commentators and pundits are predicting a global economic slowdown in 2023, with many calling for a recession sometime this year. Some are even suggesting we are there already, but some numbers (i.e., employment) indicate otherwise so far.
We can expect central bankers to continue tightening in the first part of 2023, albeit, barring some sort of unforeseen event, at a slower pace than we saw in 2022. Inflation declined again in December in the U.S. and Canada this past couple of weeks. Even so, we see another rate increase by the U.S. Fed Fund rates Committee and the Bank of Canada here in the next couple of weeks. We are with the consensus that both Canadian and U.S. central bankers will raise their core rates by .25% in their next announcement. There is some likelihood that they will pause further rate increases after their next rate increase for the next couple of months to see how the rate increase actions, they have taken to date affect inflation rates and the economies in each of their respective countries.
Expect real estate prices in North America and notably here in Canada, to continue to decline because of the higher rate environment. Homeowners with renewing mortgages and variable mortgages are feeling the effects of higher rates. Potential buyers are sitting on their pens and wallets, waiting for prices to soften more to counteract the higher cost of borrowing on purchases. The “bubble” cities like Toronto and Vancouver will see the most significant residential real estate price declines. There is evidence of softening almost everywhere else in the country as well. If higher rates persist, it will most impact newer homeowners who financed a larger portion of the home purchase price (i.e., high ratio mortgages of as much as 90%). They will feel the squeeze of higher payments on renewals because of higher rates and declining home equity due to declining home values.
Bond investors should take note of the likelihood of higher central bank rates. Bond rates and prices are affected by movements in central bank core rates. Again, increases in core rates will keep a lid on bond prices and could even cause additional volatility in bond markets during the first part of the year. However, we think a good part of what has been anticipated seems to be priced into the bond markets already. Just be aware that the bond element in balanced portfolios will still be soft until there is a definitive turn in central bank policy (i.e., the bank rate does not go up for a couple of months or even starts to decline).
There is a second issue from higher payrolls a few paragraphs back and one that will affect stock prices if it persists. That is the effect on corporate profits of companies choosing to keep more people on the payroll than revenues might otherwise dictate. Higher payrolls, all else being equal, mean less profit for shareholders. Add this to higher interest costs on any corporate debt rolling over and generally higher costs of doing business, and there may be concerns about overall corporate profitability in 2023 until there is a turnaround in economic prospects or central bank rate increase activity. Lower corporate profitability would mean lower share prices to start the year.
Aside from inflation, interest rates, and recession drum beats, there are some systemic geopolitical factors investors need to be mindful of in 2023 and beyond:
The U.S. Debt Ceiling. In the near term, likely sometime this spring, the U.S. Congress will have to vote on raising the debt ceiling to avoid a government shutdown and a possible debt default. The lead-up and the vote will be a very “noisy” period as the Republican-led House of Representatives wrestles with the White House on spending issues to allow an increase to pass. There is a case to be made for some spending restraint after four years of extreme spending by both the Trump and Biden White Houses. The question will be how far each side will go to push its own fiscal agenda before one side or other blinks. If the U.S. government ever defaults (it has not since the war of 1812), it will trigger a financial crisis and be very messy for both stock and bond markets. As loud and anxious as things might get, I do not see the U.S. Government defaulting on its debt. The U.S. dollar would crater with all sorts of follow-on effects and lose status as a reserve currency. Look at any negative volatility during the negotiations as a possible buying opportunity for both equities and bonds.
The Russo-Ukraine War. The war in Ukraine is settling into a stalemate of sorts, with both sides digging in. The unknown is how much of an impact Russian conscripts will have after they are trained and moved to the front lines. 300,000 is a large number of new soldiers. The question, of course, is how well-equipped they are and how well-led they are. Recent news of the successful Ukrainian HIMARS missile attack on a barracks and adjacent ammunition dump would cause some to question the quality of the Russian army leadership if that were indeed the particulars of the target. How motivated are the new Russian conscript soldiers? While numerically inferior to the Russians, the Ukrainians are motivated and continue receiving ongoing equipment and weapon supplies from sympathetic Western countries, many of which are superior in quality to what the Russians are using. Neither side has indicated any desire to compromise to achieve a settlement. This war might go on far longer than either side anticipated when it started some ten+ months ago and longer and more costly to Ukraine’s supporters than they bargained for in making their promises. Barring any extraordinary events (i.e., Russia attacks Kyiv again from Belarus) or Putin is somehow deposed, I think the war will not be a major economic driver in the bigger picture. It will, however, continue to be a sad commentary on modern humanity’s continuing tribal ways and the destructive tenancies of autocrats!
China. China and its autocratic-leaning leader Xi Jinping have finally realized that its Zero COVID policy was depressing its economy. In December, China started rolling back its testing and lockdown policies. Of course, as expected, the country is dealing with an explosion of COVID-19 cases and hospitalizations as it adjusts to life with COVID. The situation is being made far worse because the Chinese vaccines have been ineffectual, and the government there will not use Western-developed mRNA vaccines, which offer at least some protection against several virus variants. Sooner or later, the waves of infection should subside, and some degree of “normalcy” should emerge. This might recharge the economy, which is coming off the worst growth (3%) in 2022 since 1976. China has other issues to deal with, including an aging population slowing productivity growth, and high debt levels at least partially owing to their own residential property bubble. The real estate bubble has affected the solvency ratios of a number of financial institutions there. Another interesting development in China is the impact COVID has had on China’s birth rate. For the first time since 1961, China’s population shrank in 2022. On the flip side, the opening of the economy, from the relaxed COVID measures, will help alleviate some supply chain issues and increase domestic demand for goods and services, which should be good for the greater world economy.
There is also still the prospect that China might move to take over Taiwan, which would be a BIG negative in world political and economic affairs. Taiwan produces a very large number of critical semiconductors. One Taiwanese company, Taiwan Semiconductor Manufacturing Company (TSMC), accounts for around 55% of the world supply of contract chip manufacturing. What does that represent? By comparison, the Organization of Oil Exporting Countries, otherwise known as OPEC controls 40% of global oil exports. As a side note, for fellow Buffet-heads, Berkshire Hathaway disclosed a new $4 billion+ USD stake in the company in November 2022. Back to the potential for a mainland China move on Taiwan, China is building its military strength almost daily. It has been increasingly threatening towards Taiwan, seeing it as a breakaway state of greater China. There have been brushes with Western navies and military aircraft in the Taiwan Strait and the Chinese-claimed Spratly islands.
These are a few of the systemic factors investors need to be mindful of as 2023 unfolds and will cast shadows from time to time over the markets. Fundamentals will still tend to drive investment prices going forward, but the fallout from these situations may impact fundamentals in the short term.
The Bottom Line
As is always the case, the bottom line is that we don’t know how inflation, interest rates, real estate, and investment markets will play out this year. There is the effect of the herd mentality and algorithmic trading systems which will no doubt cause swings, down and up, in investment prices than might not be the case if we all thought more as individuals and didn’t get caught up in the emotional waves that seem to drive short term market moves. I guess that is why I admire people like Warren Buffet. They think for themselves and don’t get caught up in the noise and velocity of trades on the broader investment markets. They are diligent, and they are patient.
They can’t go back and change things, nor can we. We all (including politicians and central bankers!) live life and make most decisions, looking out the windshield with periodic glances in the rearview mirror to make sure nothing is coming up from behind us unexpectedly… In this case, the unexpected are events we have seen or read about, which may be like the landscape we find ourselves driving (living) in. We may reference “maps” drawn (written) by historians and interpreters who can help guide us through the landscape we are experiencing, but in the end, we must live our lives going forward. Potholes, construction zones, and accidents will appear, requiring that we navigate them to get to where we want to go. No one can go back in time and change events and choices to create a different situation than we are living in now. Well, maybe in the movies, but certainly not in real life!
That is the best most people can do, staying focused on what lies ahead and staying in the correct lane (not magically trying to drive someone else’s vehicle!) so we don’t become the cause of any accidents! We want to be mindful of what we know and what we don’t know. We want to control the controllables, in this case, ourselves and our actions. Here at 360 Private Wealth Management, we want to do that for ourselves and our families and help our client households do the same.
We don’t want to confuse good fortune with extraordinary insight or intelligence. We will leave that to the more “hubristic” individuals out there. Almost without exception, their “confidence” will cause an undoing. It’s often only a matter of time.
The question is how much the rate increases already made will continue to slow the economy. There is an element of delayed effect in these sorts of actions.
If I was forced to offer an opinion as to what I see playing out in investment markets as the year unfolds, I would say we are in for a volatile first half of the year (read that a buying opportunity for those with cash!) and then, a bottom and the start of a what I think will be a strong and sustainable rebound in the last half of 2023 with momentum carrying into 2024. That said, no bear market goes straight down, uninterrupted, nor is there a bull market that goes up with periodic corrections along the way. The turn maybe very subtle when it happens. If we are not invested, we may miss the first several percent of upside before emotions tell us it is OK to invest again. Volatility will continue to be a factor in investing whether markets are trending downward or upward. That is the “price of admission” for the potential for higher returns investors seek. Our job here is to tach clients about this reality and provide them with investment options that hopefully moderate volatility over the long term.
Ocean sailors are taught storm sailing tactics. Having had the experience of being in a North Atlantic storm as a sailor on a 45-foot sailboat for two days taught me a lot about sailing AND investing. When a storm descends on your boat, you need to trust your boat’s seaworthiness, shorten your sails, clip your lifeline to the boat, and push through rough seas unless they become un-sailable (then you take the sails down and turn the boat to run with the storm until it passes). Eventually, the sun breaks through the clouds and shines again. You need to be diligent, and you need to be patient, just like some of the greatest investors of all time have demonstrated.
To quote the great teacher and writer John Kabat-Zinn, “Patience is a form of wisdom. It demonstrates that we understand and accept the fact that things unfold in their own time.”
We are trying to practice this here at 360 Private Wealth Management. We want to be diligent in all we do, but we also recognize the need to be patient and let things play out on occasion instead of falling prey to the emotional need to D.O. something in the face of short-term pullbacks in portfolio https://www.manulifeim.com/retail/ca/en/resources/all/others/global-macro-outlook-the-year-aheadvalues. We work hard to make our clients' financial ships seaworthy and storm ready and be their navigators through any rough seas we encounter. We choose the proactive approach to doing things over the reactive approach. It has served us and our client households well over the years. We expect it will do the same in the future.
If you have questions about your portfolios, your specific investment experience last year, what we anticipate going forward, or any other financial life planning and investing matters, call or email our office. We look forward to the discussion.
David J. Luke, CFP, RFP, CLU, CH.F.C., CIM, RIAC | Financial Advisor
360 Private Wealth Management | Manulife Securities Incorporated
 Consumer Price Index Summary – 2022 M05 Results https://www.bls.gov/news.release/cpi.nr0.htm