PIMG 2022 Q4 Newsletter

The past twelve months were a challenging period for most investors. Almost all asset classes saw a negative revaluation of prices as interest rates moved rapidly higher. As Warren Buffett said, “interest rates are to asset prices what gravity is to the apple”. While no one should be surprised that interest rates didn’t remain at generationally low levels, what did surprise many investors was the speed and magnitude to which they rose. Admittedly, our assessment also underestimated the aggressive monetary path that central banks embarked on throughout 2022. Perhaps consistent with the breadth of unprecedented events that emerged post Covid, 2022 set many more records in financial markets. As we look to 2023, a leading question and guiding factor that will drive our investment strategy will be - will inflation start to moderate as economic activity slows? If so, we expect that central banks will stop raising rates, and recessions, where they occur, will likely be modest and forward returns should be far more rewarding.

For equity investors, 2022 was a tough year but the volatility witnessed was within the range of historical probabilities. For investors seeking capital appreciation, negative performance is to be expected from time to time. Fixed income investors, however, experienced the first significantly negative year in decades. Since the Bloomberg U.S. aggregate bond index was created in 1977, there were only four other instances of negative returns over a calendar year. This year’s -14% decline far exceeds the previous record of -2.9%. This drop in bond prices was a direct result of central banks changing interest rate policy after the unintended consequences of ultra-low rates proved to be far more than just transitory. Ironically, this was rather contrary to Bank of Canada Governor Tiff Macklem’s statement from 2020 in which he stated “interest rates would be low for a long time”. Considering the host of widely followed inflationary data remains elevated, interest rates are likely to trade around current levels for some time.

Most investors that hold fixed income in their portfolios do so because of the diversification benefits. Historically, when equity markets have not performed well, fixed income markets (bonds) have offset much of the volatility and provided a ballast across portfolios. Bonds also provide a steady stream of income which can help satisfy spending needs or fund reinvestment. Last year fixed income provided almost no shelter from volatility as the traditional balanced portfolio of 60% equities and 40% bonds, produced its third worst return since 1950. Thankfully, most of our client portfolios fared much better than these averages as our fixed income positioning was focused on shorter duration holdings (less than 10 years to maturity).

With interest rates likely remaining elevated but likely not moving much higher, we see the year ahead as a good opportunity for fixed income. In fact, fixed income investors should be celebrating the opportunities currently presented. Investment grade bonds, which were yielding a mere 2%-3% only 12 months ago, are now offering in excess of 5%-6%. Remember, the negative return that fixed income produced over 2022 is a temporary drawdown unless securities are sold. Bonds that are trading at $88 will mature at $100, assuming the company stays in business to maturity. The 12% downside that bonds experienced last year will turn into future gains as the discount to par value ($100) narrows. Those with cash to invest or with bonds maturing this year have the ability to reinvest at higher rates and in turn create more income from the same level of capital. Yields are now more attractive than at any time since the early 2000s. The bottom line: despite the pressure on bond prices that the rise in interest rates has produced, markets and investors should welcome the normalization of interest rates as this only creates a more stable economic foundation in which the next expansion can emerge from.

As always equity markets are a little less predictable. The impact of higher interest rates will take some time to filter through the economy. We are already seeing signs of slowing profits and conservative guidance in corporate communications. Earnings over the next few quarters will be integral to equity market direction and where “good” value resides relative to “bad”. From an employment perspective, it is expected that unemployment numbers will move higher as businesses adjust to the new paradigm. This is the baseline expectation that markets have largely discounted at current levels. Assuming we can avoid a more significant economic downturn, the so called “soft landing” that most economists are hoping for should allow the economy to start recovering in the back half of 2023. What could get really interesting is if the economy manages to avoid this “baseline” downturn and actually starts to grow earlier than anticipated. Some potential catalysts for this scenario could be the demand impact of China’s reopening (recall what happened to the economy when the rest of the world ended their lockdowns), a resolution to the war in Ukraine, or unemployment numbers that remain better than expected. On this last point, recent unemployment numbers have indeed proved to be quite resilient. While this is a lagging indicator (looking backwards at what happened already), one would expect the market declines and economic contraction we have already experienced to have shown up in the employment data by now. So far, that has not been the case and instead the data has remained relatively constructive.

Of course, there is always the potential the economy fares worse than baseline expectations and markets could experience further downside. Where we gain comfort is in the widespread expectation that an economic slowdown is happening and will continue into this year. Market sentiment indicators continue to reflect very low levels of investor optimism and these same indicators are some of the best reference points for a pivot in market direction. Simply put, when markets trade down and sentiment is this negative, it has historically been a good time to put capital to work. Investors with time horizons measured beyond the next few quarters should be building a list of investment opportunities while embracing the repricing of high quality assets that are currently available in both bond and equity markets. We have being doing just that as we have become more optimistic these past few months.

As always, your personal financial situation and investment plan should be the primary focus over any short term beliefs about what may or may not happen in the year ahead. Diligently sticking to an investment plan that allows you to stay the course through tough markets, while taking advantage of short term extremes, has been a good recipe for successful investing over time.

This newsletter has been prepared by Plena Wealth Advisors and expresses the opinions of the authors and not necessarily those of Raymond James Ltd. (RJL). Statistics, factual data and other information are from sources RJL believes to be reliable but their accuracy cannot be guaranteed. It is for information purposes only and is not to be construed as an offer or solicitation for the sale or purchase of securities. This newsletter is intended for distribution only in those jurisdictions where RJL and the author are registered. Securities-related products and services are offered through Raymond James Ltd., member-Canadian Investor Protection Fund. Insurance products and services are offered through Raymond James Financial Planning Ltd., which is not a member-Canadian Investor Protection Fund. Raymond James (USA) Ltd., member FINRA/SIPC. Raymond James (USA) Ltd. (RJLU) advisors may only conduct business with residents of the states and/or jurisdictions for which they are properly registered.