Articles

Market Overview

The first three months of 2023 saw much of the financial drama we have grown accustomed to coming off a volatile few years. Stock markets continued their momentum from the end of 2022 into January but pulled back in February on renewed fears of a recession and concerns markets may have got ahead of themselves. The real drama came in March with the failure of three U.S. regional banks and one Swiss bank resulting in heightened anxiety about what that means for the stability of the banking sector as a whole and the future path of interest rates. Despite all this, investors largely shook off these concerns and pushed markets higher to end the quarter.

In this quarterly review we will be discussing these key developments, what that means for investment decisions moving forward, and what actions we are taking to benefit client portfolios. Key themes discussed include:

• The interest rate increases that began in Spring 2022 finally began to reveal cracks in the system, particularly with mismanaged U.S. and European banks.
• Stock markets rallied in the first three months of the year, but this growth was largely focused on only a handful of large companies.
• There continues to be fears that central banks will raise interest rates too much or too little.
  • Recent enthusiasm that our U.S. counterpart would be nearing their peak may be short lived in light of a historically low unemployment rate and stubbornly high inflation.
• The global economy is slowing and we are likely to see measures of economic health get worse before they get better.
• Earnings season is here and investors will weigh concerns over a recession while the health of the consumer will be in the spotlight.
• Canadian economic growth has remained resilient while the U.S. is decidedly weaker.

Year to Date Market Returns

The Return of Growth Stocks?

2022 was an extremely difficult year for growth stocks – those companies anticipated to grow significantly above the average growth rate of the market. This was evidenced by the technology heavy Nasdaq declining over 30% for the year and largely resulted because of the sharp rise in interest rates and associated uncertainty of a pending recession.

To begin 2023, a handful of growth stocks have dominated stock market returns causing many to ask the question if this is the recovery we have been waiting for after so many months of negativity.

As can be seen in the year to date market returns chart above, the S&P 500 is up 7% but interestingly the average stock in this index is up just 1%. It’s fair to ask how this is possible and without getting into overwhelming detail, the S&P 500 is a market capitalization weighted index. What that means is larger companies account for a greater share of the overall index. In fact, the largest 10 companies in the S&P 500 account for 25% of the index. Removing just these 10 stocks of the total 500 in the index would see the year to date return be negative. Apple alone accounted for 1.6% of the total growth for the S&P 500.

The disconnect between the few and the many has several key implications for investors.

• Narrow leadership tends to signify a shakier rally than one with a broader group of stocks participating.
  • Notable outperformers include Amazon, Tesla, Apple, Google, and Meta.
• It remains to be seen if these companies will be immune to a possible recession or, at the very least, a slowing global economy.
• A growing stock market doesn’t always indicate a healthy economy. If the economy was strong, would energy and financials be negative?
• We will need to see a broader rally in stocks before getting excited about this recent recovery.

We continue to be focused on adding long term value for client portfolios and refuse to be swept up in short term gains we feel may not be sustainable. Risks remain and we favour those trading at discounts to fair value and providing a nice dividend while we wait for better times ahead.

Bank Failures

Investors have spent months pondering whether the impact of rising interest rates, which began in March 2022, would finally reveal cracks in the system. A full year later and we have now seen the 2^nd and 3^rd largest bank bankruptcies in U.S. history as well as Credit Suisse, once a staple in world banking.

While the failure of these banks has been well covered there are some interesting take aways:

• Silicon Valley Bank (SVB), which kicked off these troubles, was a regional U.S. bank heavily exposed to the deposits of their also risky clientele. This coupled with management’s reckless decision to invest these deposits in long term bonds resulted in a significant drop in value when interest rates began to rise.
• Regional banks in the U.S. are subject to less strict regulations when compared to federally regulated banks and those in Canada.
• Officials in Europe and the U.S. took quick action to reassure depositors and the general public in an effort to prevent contagion.
• Canadian banks continue to be globally recognized for their stability and benefit from strict regulatory oversight and diversification. On March 15^th we spoke to the differences of the U.S. and Canadian banking sectors: TriDelta Financial – Response to U.S. Banking Concerns
• History appears to be repeating itself. Canada’s banks provided a safe haven in 2007-09 as U.S. and European peers’ profits collapsed.
  • Canadian bank earnings are expected to consistently grow in 2023 while U.S. bank profits are forecast to decline.

A frequent question we receive is how no one saw this coming. Many will be pleased to learn that we did act on both of our equity funds to reduce our exposure to the financial sector one week prior to the collapse of SVB. We did this on several indications of weakness in the sector. While no one could have known a bank failure was right around the corner, we were able to take advantage of this and remained highly active in the following weeks to the ultimate benefit of our clients.

An Update on the 2023 Federal Budget

While a detailed breakdown of all points laid out in the recent Federal Budget is outside the scope of this commentary, there are key takeaways worth discussing.

Canada’s Alternative Minimum Tax (AMT) is applicable to high income earners and is used to limit tax deductions available to taxpayers who benefit from certain incentives. The Budget proposes several changes to the calculation of the AMT – including to expand the base on which the tax is calculated, raise the AMT exemption to $173,000 (from $40,000; indexed to increase with inflation) and increase the AMT rate to 20.5% (from 15%). It is estimated that under the AMT reforms, more than 99% of the AMT paid by individual Canadians would be paid by those who earn more than $300,000/year.

One frequent tool we use with high income taxpayers is Flow Through Shares. The proposed changes, beginning in 2024, would still allow for Flow Through Shares to be used, but at a lower amount.  Where before the rule of thumb was 35% of income to avoid triggering AMT.  With the new rules proposed, in 2024 the rule of thumb might be 25%.  We encourage those with incomes of $250,000+, to speak with your TriDelta Wealth Advisor to ensure that you can maximize the tax savings in 2023 and beyond.

The First Home Savings Account (FHSA) is an exciting addition to assist those Canadians looking to purchase their first home. The FHSA will allow for tax deductible contributions up to $40,000 and can be used in combination with the First Time Home Buyers Plan of an RRSP. This account officially became recognized April 2023 but is not yet available on many platforms. While we know many of our clients own their own home, you may have someone important to you, like a child or grandchild, who this may be relevant to. In any case we would be happy to share more details about strategies for how this may benefit those looking to purchase their first home.

What we are doing and why

Stocks

There was enthusiasm among investors stemming from the March banking issues that led some to believe it could be enough for interest rates to finally relent. Although interest rates and inflation remain key drivers of market volatility, the uncertainty over a potential recession has garnered renewed attention as investors look to company earnings and what business leaders are indicating for what to expect moving forward.

Both the TriDelta Pension and Growth Funds were positive year to date returning 0.62% and 3.28%, respectively. While positive, both funds returned less than the broader indices due to the broader market growth being driven by only a handful of growth stocks. Our funds have always been different than the broader indices which served us especially well in 2022. Key considerations include:

• Our funds remain defensive with the continued use of tactical allocations to cash to allow us to benefit from swings in the markets.
• We do not believe investors should become complacent with narrow market gains concentrated in only a few companies. Our funds remain highly active and continue to find exceptional value we anticipate has not yet been recognized by the broader markets.
• The Toronto Stock Exchange underperformed to begin the year due to declines in the financial and energy sectors, which are two larger weights in the index.
• Growth expectations have slowed below historic norms. Our emphasis is on high quality businesses with exceptional leadership, and positive cash flow.

Risks remain and, although volatility is expected to continue, we take great pride in knowing the opportunities we see today should create long term value for client portfolios.

Bonds

Bond returns to begin the year were positive and our focus remains on high quality investment grade bonds with an emphasis on short term maturities. Coming off what was the worst year in history for bond returns, we see an opportunity for both elevated income yields and capital gains if (when) interest rates decline. Key considerations include:

• The Bank of Canada has signaled that rate hikes are on pause as it assesses the impact on the economy and inflation.
• The U.S. Federal Reserve have renewed their commitment to raise rates higher despite the recent banking disruption discussed earlier.
  • On March 13^th we discussed the differences between the U.S. and Canada: TriDelta Financial – Interest Rates – what is happening, why it is happening, and what we are doing about it
• Bond markets do not expect further interest rate increases and have predicted rate declines in both Canada and the U.S. later in the year. We disagree with this prediction and find it more likely that the U.S. continues to increase rates as originally intended.
• Inflation is expected to trend lower throughout the year but gone are the days of persistently low inflation. Inflation will continue to be a more meaningful component of future interest rate decisions and a pain for consumers and businesses.

We continue to prioritize quality and remain active as the interest rate dynamic changes. At higher income yields, bonds present a much more attractive investment opportunity than pre-pandemic.

Preferred Shares

Preferred shares had a strong start to the year as end of year tax-loss selling in 2022 reversed. Since then, shares have held up well in both rising and falling interest rate scenarios and the primary reason for owning this asset class remains to be the shrinking issuances of new preferred shares.

Presently, preferred shares have an average income yield of 6.3%.

Alternatives

Alternative investments, those not publicly traded, have continued to provide steady income and diversification benefits for investment portfolios. To the end of February, the TriDelta Alternative Performance Fund is +1.41%.

Alternatives have proven a valuable source of income and diversification in the face of volatile markets elsewhere. Our clients have benefited from this allocation as we continue to do further due diligence on several funds for inclusion in client portfolios, but the asset class is not without risks.

• Private real estate has not been immune from rising interest rates. Rising rates have brought down real estate values globally but some areas have been better able to weather the storm more than others.
  • Many of our partners refinanced in 2021 at the low rates previously available. Many are locked into those fixed rates until the mid-2020’s.
  • Rising rents and continued increases in demand have helped provide support.
  • Regardless of near term impacts to real estate due to increases in interest rates, the fundamental reason for investment has not changed. There is simply not enough affordable housing for people to live.
• Our private credit partners have continued to manage the new interest rate environment well.
  • Rising interest rates have provided an opportunity for greater income for investors.
  • The pool of opportunity has materially expanded due to many small and medium sized businesses no longer qualifying for traditional bank lending.

Conclusion

In our 2022 year end review we discussed the struggles of traditional balanced portfolios and the need for active management moving forward. No one can be sure what the future holds, but if we are entering a period where markets trade sideways rather than the persistent up trend we grew used to pre-pandemic, those who can remain nimble should benefit the most. We believe strongly that active management will be at a premium for managing investments moving forward and encourage thinking beyond the past decade. Times have changed. We have entered a period of higher interest rates, stubborn inflation and we caution against letting the belief that “what worked before will work again” drive decision making.

If you would like to discuss your financial plan or investment portfolio, please give us a call or send a note.

Market Overview

2022 was a rollercoaster year that saw war between Russia and Ukraine, fears of an energy crisis, surging inflation, and central banks raising interest rates at a pace not seen in decades.

While it’s impossible to summarize a year in just a few sentences there are several points from 2022 worthy of note:

• Stocks had their worst year since 2008. Bonds had their worst year on record.
• Market movements continued (and will continue) to be driven by the expectations versus realities of interest rate changes.
• Inflation rates in Canada and U.S. appeared to have peaked and have continued, albeit slowly, to come down.
• Recession concerns will continue to be top of mind as we wait on whether central banks can avoid inflicting additional hardship.
• The conflict between Russia and Ukraine, while tragic, has become less of a concern for the market in the latter half of the year.
• Economic activity has been slowing, and some countries are likely in a recession today, but others remain reasonably healthy.
• Commodities remained one of the few bright spots for the year, helping the Canadian market outperform many peers.

While some of these worries will continue to drag markets, no one can know for sure how exactly 2023 will look when it’s all said and done. Our views continue to be cautious, but we are increasingly seeing long-term opportunities when looking at all the volatility being experienced globally.

Year to Date Returns

How did you do?

Do-it-yourself investing became a well talked about phenomenon during the early days of COVID lockdowns. Established financial news outlets found themselves reporting on the success of “meme stocks”, NFTs, cryptocurrency, and the larger than life individuals behind these risky endeavors.  Have you ever wondered how these same investors did in a year when not everything went up? We did, and fortunately, we were not alone.

According to data compiled by Vanda Research, the average active amateur investor suffered losses of approximately 30% in 2022. JPMorgan Chase & Co. was even more downbeat about these amateur traders, estimating they saw losses of 38%. (Retail Traders Lose $350 Billion in Brutal Year for Taking Risks – Bloomberg)

Even the traditional balanced portfolio of 60% stocks/40% bonds was down over 15% at its lowest in 2022 and finished the year down over 11%.

While no one likes to see the dollar value of their portfolio decline, we think these figures and the ones in the market returns chart seen above pose an important reminder of what value working with an experienced team can provide.

While each individual portfolio is unique and depends on many different factors, we have been very happy with how our clients have fared in 2022. Our outperformance relative to the broader markets can largely be attributed to:

• Our continued focus on active risk management,
• Taking emotion out of the decision-making process,
• Exposure to energy markets in most portfolios,
• Developing a well-diversified portfolio that can withstand the ups and downs of the market, and
• Our inclusion of alternative investments with less correlation to public markets.

Why the next 10 years won’t look like the last 10

The last bull market was 13 years in the making and born out of the Great Financial Crisis of 2008/09. This recession was a difficult time for many reasons outside the scope of this commentary but what is important is what came afterwards:

• Consumers significantly lowered their debt to disposable income (unless you were Canadian).
• We saw persistently low inflation and slow economic growth. This allowed central banks more leeway to stimulate the economy and drive asset prices higher.
• Markets enjoyed strong and steady gains. Companies were able to borrow at next to nothing and investors bet on companies they assumed could grow exponentially in this new normal.

For years investors, economists, and bankers speculated when this bull market would come to an end, but no one foresaw a global pandemic as the underlying reason. A pandemic that drove the excesses of the previous decade to new highs, buckled supply-chains, and finally showed that inflation would not be low forever. We have discussed several times this year that while we believe inflation has likely peaked and will continue to come down from its highs, it is likely to remain well above the central banks 2% target to which they have become accustomed.

What does this mean moving forward?

• Central banks won’t be able to act as freely. Interest rates will rise and fall but are not likely to reach their previous lows any time soon.
• Households and companies will need to rethink their spending.
• The market should still trend higher over the long run, but the highs and lows will be more abrupt.
• The “winners” of the last decade are not certain to be the winners of the next decade. You can’t drive a car looking in the rear-view mirror. Buying something simply because it is down 30+% does not mean it is a good investment.
  • Technology stocks provide some history. Prior to 2022, tech stocks grew to become 30% of the S&P 500 and every time an industry has been 30% of the S&P 500 it has then underperformed the next 10 years.
  • We analyzed a winner from the early 2000’s tech bubble earlier in the year: TriDelta Financial – Market Commentary for June 2022

Much of this probably seems ominous, but if anything, it has only made us more excited for what’s to come. Will there be difficult years like 2022? Yes. But with each period of volatility there is far more opportunity for the long-term investor than the short-minded trader. We think the value of working with an active manager will be increasingly important moving forward. We are not only investment managers, we help to manage emotions so the households we work with can keep their long-term goals in focus. The risk of a market correction in our mind is not that portfolios have declined but that a client sacrifice achieving their goals in favour of short-term comfort.

The value and importance of financial planning alongside investment management

These days, it can be downright depressing watching the news too closely.  Depending on which news source you watch, it is hard not to get despondent.  Often, the cure for this is to step far back and look at your personal situation, your immediate world, and not get so worried about the global issues that you can’t control.

We find that financial planning becomes even more important in times like today as it allows you to focus on your world much more than the big, bad world.  Just like stepping away from the online news, to focus on your smaller world, a financial plan review allows you to get a better handle on how you are doing, and any adjustments you can make in your world to better align with your goals.

By looking at your taxes, debt, income, estate planning and insurance, it allows us to put your investments in context with your overall picture, goals and plans.  This can help us to manage not just the ups and downs of the investment market, but the risk required to meet your overall goals.

What we are doing and why

A couple of weeks back, Ted Rechtshaffen, President & CEO of TriDelta Financial wrote a featured article in the Financial Post discussing his thoughts for what’s to come in 2023.  It provides an overview of the world as we currently see it, and we think may come about in the year ahead. In case you didn’t see it, we are providing a link here.

23 investing and personal finance thoughts for what’s to come in ’23 | Financial Post

Stocks/Equities

Worries remain that central banks will raise interest rates too high, and a severe recession will follow. On the other side, worries are central banks will not do enough or governments will introduce stimulus too soon which will prolong the issues and do little to bring down inflation. Both scenarios will have material impacts to investment portfolios but there’s a case to be made that a recession could be the optimal outcome in terms of facilitating a sustainable path towards long-term growth.

Historically speaking, a central bank induced recession is easier to rebound from than a structural failing like what we saw in 2008/09. If a short and mild recession gets the economy back on its low-inflation track, that could be preferable to a world in which high inflation persists for years.

We have mentioned all year that markets are not likely to sustain a prolonged uptrend until we have greater clarity around the path of interest rates. Heading into 2023, the path of markets hinges, as always, on economic growth, corporate profitability, and — most importantly — whether inflation abates, and we can stop raising interest rates.

As we have already written, the last 10 years are very unlikely to simply be repeated when markets finally recover.

• The last cycle centered around growth-oriented stocks (i.e., tech) while the next cycle is likely to be focused on high-quality companies with stable and growing cash flows, often paying a dividend and trading at a much more reasonable level than some of their high-growth peers.
• With inflation being more elevated, the winners and losers in this environment will depend on those that can better contain costs.
• We continue to expect Canada to perform well in comparison to global peers. Canada was a relative stand out in 2022 with economic growth likely finishing in the 2.5%-3% range.
• We are not simply looking for companies trading at discounts relative to their pre-2022 highs. Some companies are justifiably down. Companies with poor debt management, inexperienced management teams, and slim cash flows should likely be avoided.
• Both TriDelta equity funds continue to use cash tactically to take advantage of significant price swings as we expect to remain cautious in the first months of 2023.
• Areas we like moving forward include:
  • Healthcare – the population isn’t getting any younger. Healthcare is the third-best performing industry of all time, and it has just come off a three-year period of underperformance.
  • Energy – despite the recent volatility there remain a lot of strong fundamental reasons to be confident in energy. There are also a lot of uses of oil and gas for which there is no substitute such as plastics, vitamins, fertilizer, drug ingredients, flavors, and fragrances.
  • Globally (outside of North America), markets have seen meaningful selloffs and are often trading at much better valuations than their U.S. peers, creating an attractive entry.
  • Emerging markets pose an attractive entry point at current levels. A potentially weakening US dollar, new optimism around a Chinese reopening, and valuations at extreme lows all bode well for these companies in the near term.

The TriDelta Pension and Growth Funds performed exceptionally well in 2022. The Pension and Growth funds were -1.09% and -6.96%, respectively. Following a strong 2021 where the Pension and Growth funds returned +16.4% and +28.5%, 2022’s performance is evidence to the risk management strategies we employ within the funds and why capital preservation is always an important consideration.

Bonds

As mentioned earlier, bonds had their worst year on record and because of this decline have become a much more attractive space for both income and capital gains. That said, not all bonds are equal and active management will be key to ensuring we take advantage of this asset class in 2023.

Some important aspects to note include:

• There is a broadening belief there will only be one or two more interest rate increases occurring in the first half of 2023 and then subsequent declines in rates as early as the latter half of the year.
• Central banks have been adamant that they disagree with this assessment and do not forecast cutting rates in the second half of the year.
• Key to the future of interest rates will include inflation continuing to fall and a weakening labour market in North America.
• As we saw with the United Kingdom in 2022, government decisions to use fiscal spending to spur growth would likely force central banks to raise interest rates higher than expected.
• Globally, we expect currency changes to be volatile. Much of this change will be influenced by government decisions in the face of declining economic growth. Fundamentally we see the Canadian dollar as lower than what it should be.
• Limited Recourse Capital Notes (LRCNs) have been an important addition to our inclusion in bond portfolios. With yields currently averaging around 7.5% on new issuances, we foresee further issuance into 2023 at potentially even greater yields.

Preferred Shares

Preferred shares ended a difficult 2022 down 20% on the year. Pressure from Limited Recourse Capital Notes and tax loss selling into year-end were significant detractors to close the year. Preferred shares continue to be a space we monitor closely as income yields have continued to rise, yielding 6.3% on average, and investors have benefited owning preferred shares that have been redeemed in 2022 with 15% of the Canadian market being redeemed by issuers.

Alternatives

2022 was a year where alternatives demonstrated a lot of value in client portfolios. Private credit and real estate returns remained broadly strong and have been one of the lone positives in portfolios. We continue to have regular conversations with our managers and have continued to add new funds to our offering.

• Private debt stands as a beneficiary of rising interest rates as they are able to pass along these rates to borrowers and expand their pool of opportunity as more companies are no longer able to seek traditional bank financing.
  • Rates on these loans are up 4% in most cases and referrals continue to come from the banks themselves.
• Private real estate has performed much differently than their publicly traded peers. While the impact of rising interest rates is being felt across the space, not all types and geographies of real estate are the same.
  • Many of our managers operate in niche markets which has provided insulation from these changing rates while rent increases have continued to climb as the long-term case for rentals persists.

In Conclusion

In five years’ time we see it as a very real possibility we will look at 2022 as a year people look back on as having been a great opportunity for investors. Stocks in 2022 had their worst year since 2008 while bonds had their worst year ever recorded. We know first-hand that there is no one on our team who would say they wouldn’t go back in time and put everything they could in the market in late 2008 but we also know hindsight is 20/20. We still think there will be ups and downs in 2023 and beyond but having a long-term focus will be what ultimately protects your portfolio and helps you succeed.

If you would like to discuss your financial plan or investment portfolio, please give us a call or send a note.

Market Overview

Coming off a difficult June, markets were optimistic heading into the early stages of the third quarter. By mid-August markets in Canada and the U.S. were strongly positive on several good news stories. Recession fears eased on the back of improving economic data and inflation showing early signs of having peaked, and company earnings from the second quarter were not nearly as bad as many expected.  Some believed we had found our bottom in June amid several indications the market had grown too pessimistic.

As quickly as the market had seemingly reached a turning point, markets reversed course. The bounce off the June lows ran out of steam due to persistent inflation and indications the central banks of the world were going to continue aggressively raising interest rates. This was coupled with further escalations in the conflict between Ukraine and Russia, an ensuing energy crisis forcing European countries to begin rationing ahead of what is likely to be a very difficult winter, and a struggling consumer in China.

Central banks raising interest rates is worth further attention as it’s one of the primary drivers impacting markets today. It’s important to note that never in all recorded history have central banks all raised rates at the same time. While all central banks will act independently of each other, the U.S. Fed is ultimately the driver behind a slowing global economy and will not stop until its goal of bringing inflation down shows signs of life.

September, in particular, was a very difficult market for stocks which put the TSX and S&P 500 back down to their June lows. Bloomberg has coined this the “Everything Selloff” which is in direct contrast to the Covid rebound in 2020 termed the “Everything Rally”. With inflation at 7% in Canada, interest rates meaningfully higher, and major stock and bond markets negative, it’s true there have been very few places to hide this year. The question we need to ask ourselves; is it really all bad?

In this quarterly review, we will look at why there is opportunity in the face of extreme negativity and what we are seeing in the market today and moving forward.

Year to Date Market Returns

Global markets are meaningfully lower and while each offer an interesting reference point, a traditional balanced portfolio has fared just as poorly. To the end of September, a passively managed 60% stock, 40% bond portfolio is down 15.1%. This has provided further evidence to the value of active management as our portfolios continue to outperform and protect on the downside.

Finding Optimism in a Bear Market

“In the real word, things generally fluctuate between “pretty good” and “not so hot”. But in the world of investing, perception often swings from “flawless” to “hopeless” – Howard Marks

There is no valuation metric or sentiment score that marks the bottom of a bear market. The end of such a market is always identified in retrospect and the reasons are not always clear. That said, there are indications we can use to help identify long term opportunity despite the near-term uncertainty.

Sentiment (investor attitudes) has reached extreme negativity, which can be a positive indication markets have become oversold. The latest AAII Sentiment Survey showed bears (those seeing stocks lower in six months) topping 60%. This poll has been around since 1987 in which the last time we saw these extreme levels we were nearing the bottom of March 2009 during the Great Financial Crisis.

Readings at these levels tend to imply a strong market advance during the following 12 months.

Valuations offer another point of optimism for investors. While it’s true whether the S&P 500 or TSX is trading at a 15x or 20x price-to-earnings ratio will never, by itself, mark a bottom, as prices fall and valuations improve, the downside risk declines as upside potential rises. For example, we look to include high quality companies whom we have long term confidence in their ability to outperform the market. If we believe the appropriate price for a company is $100/share and it falls to $80/share, it may continue to fall but $80 still represents a better opportunity for a long-term investor. After all, we are not trying to catch a falling knife, we are investing in companies we believe will have a positive impact on client portfolios.

We tend to caution against drawing comparisons to past bear markets because no two are the same. The financial world is in much better shape than 2020 and even 2008/09. It’s easy to forget that during the late 2000’s there was very real concern the entire financial system would collapse. Major institutions either failed outright or required government assistance. Insurance companies were at risk of not being able to pay out policies and houses were being abandoned because speculators couldn’t afford payments on third houses they never should have bought. Today is not without its challenges, but we are increasingly seeing higher wages, companies continue to hire albeit at a slower pace with unemployment still at record lows, and banks and large institutions have had the eyes of regulators on them for over a decade to ensure the stability of the financial system.

No two bear markets are the same and although the future remains uncertain, it is uncertain regardless of whether the market has fallen 20% or has risen 20%. What’s most important is to take emotion out of the decision-making process and maintain a long-term perspective despite short term negativity.

The worst thing you can do in a time like today is turn temporary declines into permanent losses.

Yields on Investments Now Versus One Year Ago

The surge in bond yields and rise in interest rates are giving investors options they haven’t had for some time.

This is not to say that stocks don’t present an attractive long-term opportunity, but that our options for how we construct portfolios and make allocation decisions for individuals has increased. In fact, today is a great time to review why it pays to remain invested in difficult times. The following chart demonstrates what a $100,000 investment in 1990 until the end of September 2022 would look like if: you had remained invested for the whole time, had missed just the best 5 days of the market, and had missed the best 10 days of the market.

Clearly, patience pays off in the long run.

What we are doing and why

Equity

The factors weighing on markets during the first half of the year persisted into the third quarter and are expected to continue for the remainder of 2022. We reiterate from earlier in the year that markets are not likely to sustain a prolonged uptrend until we have greater clarity around the path of interest rates, and we remain highly active in our decisions to take advantage of near-term opportunities.

Moving forward, we foresee equities trading in response to what is happening elsewhere in the markets. Rising bond yields have had the dual effect of making bonds and cash an attractive alternative for income investors seeking stability and decreasing the valuations of public companies.

Here in North America, Canadian markets have continued to outperform much of our global peers. Canada’s reliance on commodities have benefited from a stronger USD and the supply disruptions happening abroad. Historically Canada has been more sensitive to global recession fears rather than inflation which is why the TSX was one of the best markets earlier in the year, before fears started migrating from inflation to recession.

The U.S. have continued to see strong employment numbers and wage gains. The markets have been especially hit hard due to their higher exposure to growth companies in relation to Canada and are expected to remain volatile with a highly polarized midterm election taking place in November.

Abroad, Europe has struggled in response to the conflict and associated sanctions on Russian energy. Europe’s energy infrastructure has failed in entirely foreseeable ways as policymakers have increasingly made short-sighted decisions and failed to adequately diversify their energy needs towards renewables.

In Asia, China has struggled amid slowing growth and a troubled real estate sector. Covid restrictions in the country also remain, with as many as 20 cities facing some form of lockdown in the past three months. This has hurt consumer confidence and economic activity.

Into the last three months of 2022, the TriDelta Funds continue to be highly active to take advantage of attractive opportunities.

• Bond yields declining in the months ahead should have a positive impact on equities and an indicator we continue to watch closely.
• We expect Canada to continue to perform well in comparison to markets globally and predict a potential recession in Canada would be mild as the Bank of Canada reaches a peak interest rate before the U.S.
• Global equities have felt the brunt of poor policy decisions and the ongoing conflict but pose an increasingly attractive long-term opportunity for investors willing to tolerate near term volatility.
• We have added to the cash positions in the funds as a defensive measure and to take advantage of near-term price swings.
• Future company earnings releases will be of key concern as the market gets a closer look into how today’s challenges are impacting companies bottom lines.

The TriDelta Pension and Growth Funds have performed well in the quarter and year-to-date relative to the broader markets. For the year ending September 2022, the Pension and Growth funds were down 9.00% and 16.01%, respectively. Presently, the yield on both funds is greater than 5% which marks the highest since the funds inception and poses an attractive opportunity for income investors.

Preferred shares

Preferred shares continue to see much of the volatility being experienced in the stock and bond markets as the yields have not yet increased enough to attract sufficient activity in the space.

Our preference is still towards rate-reset preferred shares but see the market trading in line with broader stock markets into 2023, limiting their ability to act as a diversifier in a portfolio despite the added income.

Limited Recourse Capital Notes (LRCNs)

We have recently shown interest in the market for Limited Recourse Capital Notes (LRCNs) for use in client portfolios. This is a relatively lesser-known investment that shares characteristics of both preferred shares and bonds.

There is now over $18 billion worth of these bank notes in Canada, but only recently have the banks come out with LRCNs paying 7+%. These bonds are technically higher risk given that they are secured by preferred shares in the issuing bank and are typically much longer term than we would include in portfolios.

An example of one of these notes technically is not due until November 2082, but it includes a rate reset feature based on the 5-year Government of Canada bond rate plus 4.10%. This will reset in 5 years, and we believe it is very likely that the note will be redeemed at $100 in 5 years.

We see these bonds as relatively low risk and offering an attractive yield for income seeking investors while also providing daily liquidity and the opportunity to gain in value if/when interest rates come down in the next 5 years.

Bonds

Typically, one would expect with stock markets lower, bonds would at least be holding their own but that has not been the case this year. Instead, bond markets have experienced their own bear market when the Bloomberg Global Aggregate Total Return Index of government and investment-grade corporate bonds fell 20% in August from last year. In fact, bonds are having their worst year since 1949 and instead of acting as a diversifier, bonds have been a driver of lower returns.

• Central banks, most notably the U.S. Fed and Bank of Canada, have recommitted to raising rates to bring inflation under control and the market is finally starting to take them at their word as economic activity slows and likelihood of a formal recession grows.
• Inflation is still of key concern, and we don’t believe it’s a matter of if inflation comes down but when. Inflation will recede but likely not quick enough to avoid policy rates in the mid 4 to low 5 percent range into early 2023.
  • Presently, inflation in Canada and the U.S. sits at 7.00% and 8.26%, respectively.
• We continue to watch the inverted yield curve as an indication the market believes the inflation fight can be won. Our hope would be to see a more sharply inverted yield curve in the near term.
• Our focus heading into this year towards short term and high-quality investment grade bonds to provide insulation from interest rate increases have helped to insulate portfolios from the losses seen in long-term, low-grade bonds.

We remain selective with bonds we choose to include in client portfolios and have actively sought out attractive opportunities. As prices have fallen, we increasingly see the value in including bonds in client portfolios as a source of income and future return.

A Note on Currency

Fueled by rising global uncertainty, the U.S. dollar (USD) has been a notable outperformer in 2022. This has rewarded Canadian investors with bigger dividends and an offsetting boost for their investments held in U.S. dollars or simply through owning companies which derive profits from the U.S. consumer.

An example of this can be seen in the last three months alone where an investment in U.S. dollar assets have helped returns for Canadian investors.

While large swings in the dollar — in either direction — adds to uncertainty in the market, a strong U.S. Dollar is predicted to help many countries boost growth as their exports become more attractive. It may also be a positive for the U.S. to bring down inflation as cheaper imported goods cause disinflation. U.S. companies may also find it harder to compete with global companies whose prices are in other, cheaper, currencies. This isn’t great for the companies in question but is a positive for bringing down inflation in the near term.

Alternatives

Alternative investments, those not publicly traded, have offered support for portfolios. To the end of September, the TriDelta Alternative Performance Fund is +3.22%.

Our real estate partners have benefited on multiple fronts.

• Rising interest rates have made home ownership less affordable for many. This has added further demand for rentals which continue to see increases in average rents by 10-20%.
• Canada is not on pace to achieve affordable housing for Canadians. In Ontario, the CMHC estimates 1 in 3 people will be forced to rent in the next 10 years. An already tight supply for rentals represents a significant opportunity for investors as demand continues to rise across North America.
• Many of our partners refinanced in 2021 at the low rates previously available. Many are locked into those fixed rates until the mid-2020’s.

Our private credit partners have also seen positives.

• Rising interest rates have translated into higher returns on the loans they provide to small and medium sized businesses in Canada and the U.S. We have seen yields rise this year as the loans tend to be structured with variable rates and/or short term in nature.
• As rates have risen it has been difficult for these small and medium sized businesses to receive traditional bank financing due to the strict stress testing enforced by regulators. Our partners are seeing a greater pool of opportunity because of this.
• Our partner funds use little to no leverage as part of their fund’s strategy. This has put them in a good position to act opportunistically as their indebted peers may be less nimble to take advantage of attractive loans.

Alternatives have proven a valuable source of income and diversification in the face of volatile markets elsewhere. Our clients have benefited from this allocation as we continue to do further due diligence on several funds for inclusion in client portfolios.

In Conclusion

Market behavior this year has thrown a wrench in the traditional 60/40 strategy — the idea that if stocks are down, then bond performance will offset the losses, and vice versa. This traditional 60% stock and 40% bond portfolio is down over 15% to the end of September.

We believe strongly in the value of active management and have seen firsthand our ability to protect portfolios on the downside. Our portfolios have outperformed the traditional 60/40 portfolio and broader markets because of this active management and allocation to Alternative investments which have served investors well as a source of income and diversification in the face of volatility elsewhere.

The final quarter of 2022 is likely to continue to see heightened volatility. Seasonality, midterm elections, inflation, slowing economic growth, negative earnings revisions, and higher interest rates are all factors we will have to face.

Ultimately, we are confident that markets will recover regardless of near-term volatility and what the upcoming interest rate decisions may be. Central banks are not raising rates and reversing stimulus because they don’t like investors or are trying to wreck your home’s value – it is in response to inflation.

When, (not if) inflation comes back down, we think both stocks and bond markets will rally. This, on its own, may very well mark the end of the bear market, even if a recession or earnings recession looms on the horizon. After all, stock market bottoms rarely coincide with the bottom in economic activity as the markets are always forward looking.

As always, we are here to help. If you have any questions, please don’t hesitate to contact your Wealth Advisor.

Overview

While it’s undoubtedly been a difficult first six months of the year, there are still positives. A strong job market, companies buying back their own stock, signs that pessimism had gone too far, and strong bank balance sheets have helped provide some support. The consumer has also largely continued to spend, helped by rising wages.

On the other hand, investors are particularly focused on rising interest rates and the possibility of a recession. Central Banks globally have continued with their interest rate increases. That shift has pushed bond yields higher and squeezed stocks. Earnings estimates have held up for most individual stocks and sectors, but the concern is that with Central Banks raising rates, it could spur an economic downturn, forcing earnings forecasts to fall and pushing stocks lower.

In this quarterly review, we will look at:

• Bear Markets
• Inflation & Central Banks
• TriDelta’s current view on stocks, alternative investments, bonds, and preferred shares

Year to Date Market Returns

The unavoidable reality of investing is that markets do drop. Bear markets arrive. There is nothing any of us can do to control this so we must focus on what we can control. While we can’t force the economy and stock markets to be any better than they are, we can control how we respond in times like these.

After all, panic is not an investment strategy. To overcome these periods of stress, we build investment portfolios directly tied to your time horizon and specific circumstances which leads to a diversified portfolio of stocks, bonds, preferred shares, and alternative investments. No one likes to see the value of their investments declining but it helps when you have been here before and can look back at history as a guide for what may be to come.

So, what is a bear market? A bear market is typically defined as a period where prices have fallen 20% from a recent peak.

The S&P 500 officially entered a bear market June 13^th and while it may be tough to see any positives when stocks are falling, a look at past bear markets shows there is good news and bad news for investors once the S&P 500 has crossed that largely symbolic threshold.

This year’s declines have marked a quicker-than-average descent into bear territory, at 111 trading days since the S&P 500’s January 3^rd record high, according to Dow Jones Market Data. Among the past 10 bear markets, only the 1987, 2009, and 2020 versions took fewer trading days to achieve a 20% drop. The S&P 500’s average bear market peak-to-bottom decline has been almost 36% taking about 52 days to bottom after reaching this 20% threshold. That would put the bottom in roughly late August. The key word is roughly.

No two bear markets are the same and while no one knows when we will reach a bottom, history suggests the long-term returns after reaching a bear market are quite positive. In bear markets since 1950, the index has been higher 75% of the time three months later, by an average of 6.4%. A year after falling into a bear market, the S&P 500 has been positive 75% of the time and climbed 17% on average.

While we don’t know what the next few months hold, we do know that bear markets don’t last forever and often offer the most attractive opportunities for those looking long term.

Inflation & the Central Banks

It remains our view that the inflationary pressures will begin to fade later this year, but we don’t expect it to be smooth. Central banks have continued to raise interest rates globally to fight inflation with Canada’s benchmark rate presently 1.50% and the US Fed at 1.75%. To the end of June headline inflation in Canada stood at a multi-decade high of 7.7% and 8.6% for our neighbors to the South.

The higher cost of borrowing is now starting to slow economic activity, but the subsequent slowing of inflation can take even longer.

One question we receive frequently is how long these interest rate increases will go on for and how high will they get. While it is nearly impossible to predict with perfect accuracy, the below chart shows us that in the past 30 years there has been six tightening cycles and, in each case, rates came right back down within two or three years.

Source: Bloomberg

The key takeaway is that over the past 30 years, Canadian rate hikes have not been a one-way street.  There has usually been a corresponding decline to each period of rate hikes and people should not be fearing long term significantly high interest rates. History suggests that we may have a relatively short window of ‘high’ rates.

Central Banks continue to walk a very fine line. Too much too quickly can trigger a recession while too little too slowly can propel inflation out of control leading to even more aggressive action. This is an area we are watching closely and are beginning to see a possible opportunity in bonds, but also believe the stock markets of the world cannot see a bottom until Central Banks begin to ease the reins of the current rate increase cycle we find ourselves in.

What we are doing and why

Equity

The market stress in the second quarter was focused on global Central Banks’ ability to achieve a so-called “soft landing” or raising interest rates just enough to slow inflation without triggering a recession. June was particularly difficult for equities as the markets expectation for a recession has grown and while, in some areas, stocks still do not look cheap, they are becoming increasingly attractive despite the potential for near-term volatility.

The one-year forward price-to-earnings multiple, an estimate to gauge future relative value, for the S&P 500 dropped from 21 times at the start of the year to around 16 times last month. (Since 1990, the median multiple is 15.4 times.) This doesn’t mean equities are cheap, but value has improved.

Despite the uncertainty surroundings businesses, a report from BMO determined earnings expectations have largely held firm, with 2022 profit growth for S&P 500 companies expected at just under 10% compared to 9% at the start of the year.  One of the keys moving forward will be examining the impact Central Bank tightening has on earnings forecasts potentially forcing stocks lower.

Global stocks have fallen for many of the same reasons we are seeing in North America but amplified because of the conflict between Ukraine and Russia. One of the bright spots have been China. In June China posted one of its best months since July 2020 as the government eased COVID lockdowns and eased their extended crackdown on the tech sector.

While we acknowledge it has been a difficult year investing in equities, we remain focused on owning high quality businesses we feel are well positioned to perform regardless of how their stock price does in the near term. During COVID some businesses saw their revenues more than cut in half yet rebounded very quickly. We would argue the businesses we own are even better positioned today to weather the economic storm clouds above.

Into the last half of 2022 TriDelta Funds continue to be highly active to take advantage of attractive opportunities.

• We echo other market commentators that the market likely will not see a bottom until we have greater clarity on when interest rates will peak.
• Contrary to the start of the year, commodities struggled in the second quarter and while we still see value in this asset class. we had trimmed some of the top performing energy names in favour of other areas which had been oversold.
• We have continued to reduce exposure to cyclical stocks and throughout the quarter increased exposure to the US while decreasing exposure to Canada.
• Defensive companies and those with the ability to pass along rising costs to consumers have provided some support.
• We have remained flexible with the amount of cash in the Funds to allow us to take advantage of opportunities in the markets. We began the second quarter with 8% cash which increased to 12% in April and is presently at 5%.
• Our team is closely watching company earnings reports to better gauge company health, inventory and supply chain issues, as well as gain a better picture of the resilience of the economy as a whole.

Bonds

Uncertainty remains around bonds, but if the focus shifts away from interest rate increases towards weakening economic data, we would expect this to provide support for bonds and potentially equities if markets view that the current interest rate hiking cycle is fully priced in.

• Our view is that bond markets have priced in the current interest rate hiking cycle, even more than what the Central Banks have indicated.
• Presently, we see government bonds being traded close to fair value while, for corporate bonds, we prefer high quality investment grade bonds. Concerns remain over potential defaults in light of weakening economic data and because of this we have stayed away from low quality investment grade bonds in danger of credit downgrades.
• We continue to keep a close eye on credit spreads for corporate bonds and see a wider spread from where we are today as a positive indicator to increase portfolio weightings to bonds.
• High yield bonds have done very poorly as lower grade credit has been heavily hit with higher rates and a slowing economy.
• We remain focused on short duration bonds to provide insulation from rate hikes as we stay patient for an attractive entry point.

Bond prices have fallen dramatically this year, which means their yields have risen sharply. These higher bond yields are becoming increasingly attractive following the selloff in the first half of the year.

Look no further than Apple as an example on the corporate bond side. It’s one of the most creditworthy U.S. companies — sitting on loads of cash — and its bonds are trading for 70 cents on the dollar, down from around 100 last fall. Yielding around 4%, compared to 2.7% when Apple issued them last August, this is one of the increasingly attractive opportunities in the asset class.

Preferred Shares

Preferred shares have remained volatile since our last quarterly commentary but, on a relative basis, have held up slightly better than broader equity and bond markets.

The asset class has benefited from continued redemptions of existing preferreds. So far in 2022, $6.7 billion have been redeemed which equates to 10% of the entire market. We see this as one of the key factors for why preferred shares have performed well.

• Rate Resets, which should be more attractive as rates rise, have yet to perform as we would expect.
• Institutional participation has shown little enthusiasm this year and some investors are opting for conventional asset classes at cheaper levels (bonds and equities). This has created liquidity issues in the market.
• We continue to hold our allocation steady with a focus on picks we believe may be redeemed in the next six months. Along with the income component, we see this as a significant value add in taking advantage of the market dynamics which are pushing the asset class to shrink.
• The rate pressure is the greatest challenge for Fixed Rate Preferred Shares.

Alternatives

Alternative investments have been one of the brightest spots for portfolios this year and have helped to reinforce why they are an important component in a diversified portfolio. Our primary focus has remained in Real Estate and Private Credit.

On Real Estate,

• High quality apartment buildings continue to see strong demand. The lack of supply in Canada and abroad remains which has made this an increasingly attractive space for investors.
• Broadly speaking, rents are rising everywhere in North America as people are priced out of homes and increases in interest rates have made mortgages out of reach.
• Despite rising interest rates impacting individual homeowners, large real estate managers continue to be well positioned for the inflationary environment we find ourselves in.

On Private Credit,

• Private Credit returns remained favourable and, in many cases, have offered protection from rising interest rates. Loans in this space tend to be shorter term, and in some cases floating rate, which helped returns.
• The borrowers engaged with these lenders often work closely with each other, which provides these managers unique insight into giving strategic business advice to assist companies in a variety of market environments. To date, we have not seen any notable increase in defaults.
• Rising interest rates can make it more difficult for small and medium sized businesses to borrow from the large banks which have helped to increase the pool of potential borrower’s credit managers have access to.

TriDelta Recognized as Top Wealth Manager

We were pleased to be selected as one of the Top 10 Wealth Managers in Toronto for 2022 by AdvisoryHQ. AdvisoryHQ has a strict selection process that is designed to identify the best financial advisory firms in multiple cities across Canada.

In conclusion

Since WWII there have been 12 different bear markets, all with specific reasons or fears around what was happening at the time. While no two bear markets are the same, the biggest mistake people have made time and time again is letting emotion take control over logic and reasoning.

Panic is not an investment strategy, and you would not drive your car looking out the rearview mirror. Our focus remains on looking forward and building portfolios suitable for each individual and family we work with. Managing risk in good times and bad is one of greatest value adds we can provide but almost more important is helping keep emotion at bay and focusing on the things we can control. No one can say what tomorrow will look like, but we do know the current bear market, like all others, will come to an end.

History has shown repeatedly that in the long run there will be more good days than bad and, in our experience, the best days in the market often come right after the worst.

Source: S&P 500 Index, Bloomberg.

As always, we are here to help. If you have any questions, please don’t hesitate to contact your Wealth Advisor.