Markets, investing and what matters most: Quarter in review Q3, 2022
By ATB Wealth 28 October 2022 8 min read
Written by Daniel Spencer, CFA, CFP and Thang Phung, CIM on behalf of Private Investment Counsel (PIC), ATB Wealth’s discretionary portfolio management team. PIC specializes in working with ATB’s high-net-worth private clients.
Inflation and rising interest rates continued to be the main theme in the third quarter of 2022. Tight global supply chains, Russia’s invasion of Ukraine, a shortage of materials, and a strong labour market have helped contribute to inflation levels not seen for over 40 years. In an attempt to tame inflation, central banks continue to raise interest rates at an unprecedented rate. This is causing market volatility as investors reassess the price they are willing to pay for different asset classes. With future returns on less risky assets going up, investors are paying less for riskier assets to increase future expected returns.
Market performance was relatively flat for the quarter, but that does not mean markets were not volatile. The first half of the quarter saw markets stage a strong rally only to give up those gains in the second half. Canadian and international equity market returns were slightly negative for the quarter, while US equities and Canadian fixed-income returns were slightly positive (for Canadian investors). The end result was relatively flat returns for most portfolios throughout the quarter.
Looking forward, bond yields in Canada are looking much more attractive. Return expectations have not been this high since 2008 prior to the financial crisis. New bonds being issued are paying higher coupon payments, and existing bonds that have seen large price declines this year, will recover to par as they approach their maturity dates.
Company earnings have remained strong throughout the year and have continued to grow despite inflationary pressures in the economy. This shows the resiliency of companies and their ability to pass on their cost increases to the consumers. With earnings growth still strong and stock prices down significantly, equity valuations have not been this attractive in 10 to 15 years. It is still possible that we’ll see a recession and a pullback in earnings over the next few years, but this seems to be priced into current stock prices.
Topics that mattered this quarter
In the US, the Federal Reserve hiked interest rates by 0.75% in both July and September, bringing the federal fund rate to 3.08%. “Reducing inflation is likely to require a sustained period of below trend growth,” said Federal Reserve Chair Jerome Powell in his August press conference. “Moreover, there will very likely be some softening of labour market conditions.”
In Canada, the Bank of Canada raised the target for its overnight rate by 1% in July and 0.75% in September. These hikes brought the key interest rate to 3.25%. Globally, further interest rate increases are needed in most major economies to anchor inflation expectations and ensure inflation pressures are reduced.
- Monetary Policy and Price Stability.” Board of Governors of the Federal Reserve System.
- Policy interest rate.” Bank of Canada.
- Adrian and Natalucci. “Central Banks Hike Interest Rates in Sync to Tame Inflation Pressures.” IMF Blog, 10 Aug. 2022.
According to the Global Supply Chain Pressure Index (GSPI), inflationary pressure decreased in September marking a fifth consecutive month of easing. Year-to-date movements suggest that global supply chain pressures are beginning to fall back in line with historical levels. Inflation expectations are also easing according to the Federal Reserve Bank of New York’s Survey of Consumer Expectations, which shows one-year inflation expectations lowering to 5.4% and three-year to 2.9%. While it may take time for supply to catch up to demand, the easing trend in supply chain pressure and expectations could encourage the Federal Reserve to be less aggressive when it comes to raising interest rates, which in turn may help moderate the US dollar rally.
The upside to the downside
Sometimes bad news is good news, at least it has seemed that way lately. For example, there was a significant decrease in the ISM Purchasing Managers Index (PMI) where new orders dropped from 51.3 in August to 47.1 in September. A reading over 50 indicates growth or expansion while a reading below 50 suggests contraction. With the lower reading, it could be a sign that the interest rate hikes are having the desired effect of reducing inflation.
Credit spreads (the difference in yield between a corporate and government bond with the same maturity) are slowly widening, but still relatively narrow compared to this year's high, and well below the 2020 pandemic highs. Bond credit spreads are often a barometer of economic health where widening is bad and narrowing is good. Lower credit spreads can also indicate that issuing companies are still in good condition to repay their debt obligations.
Breaking down the math behind bond prices
Given that this has been a very eventful year on the bond market, we are fielding more questions about how bond pricing works. The simple answer is that it comes down to math. A bond is a loan to a government or corporation. They are issued and mature at par value, and during the term of the loan interest payments (or coupon payments) are received by the investor.
Here is an example to illustrate how interest rate changes impact the price of bonds.
- Let’s assume that on Oct. 1, 2021 an investor buys $1,000 of a newly issued five- year Government of Canada bond paying a 1% coupon. That investor receives the bond and going forward they will receive a $10 coupon payment each year. At maturity in five years, the investor would receive their $1,000 back plus one more coupon payment of $10. The end result is that the investor received $50 of interest.
- Let’s move ahead one year to Oct. 1, 2022. The investor has received their first coupon payment of $10, and now has four payments left ($40 total) and will still receive $1,000 at maturity.
Let’s also say that interest rates have gone up and a newly issued four-year government bond is now paying a 2% coupon. The newly issued bond would look like this:
If the investor now wants to sell the bond they purchased one year earlier, it would not look that attractive to a potential buyer. The potential buyer could buy a new bond with $80 of interest, so why would they buy the investor’s bond with only $40 of interest payments left?
- In order to sell the bond, it would need to be priced so that the potential buyer would still make $80 if held to maturity. That means the bond would need to be sold for $960. The new buyer would receive the $40 in coupon payments and would see the price appreciate by $40 as the bond would still pay out $1,000 at maturity.
In this example, an interest rate increase of 1% resulted in the bond price dropping by 4% ($40). The key to remember here is that even though the price of the bond has dropped by 4%, this is not a permanent loss as the bond price has to appreciate back to $1,000 by the time the bond matures. From Oct. 1, 2022 onward the future return of the bond has increased as the investor will receive the same coupon payment, with guaranteed price appreciation.
An update on our funds
There have been a few slight adjustments to sharpen the edges of our bond strategies within the Compass Portfolios and the ATBIS Fixed Income Pool. We have been slowly increasing our weight to higher quality and highly liquid credit positions. Should business conditions worsen, and credit deteriorate, these highly liquid securities can be pivoted back into higher-yield fixed income if they present exceptional value to unitholders. In the meantime, the overall bond portfolio including mortgages as of the end of the quarter was priced to yield 5.6%.
In equities, valuations look very attractive as earnings have remained resilient while equity prices have declined. One such measure for stocks is earnings yield, which for global stocks, started the year at around 5%,1 and is now closer to 7% as a result of prices declining close to 20%. From this lens, we have confidence that we are being adequately compensated for holding our bonds and equities right now. We also partner with sub-advisors who invest for the long term in profitable, well-managed companies. Each company is reviewed and our sub-advisors look for companies with healthy balance sheets and strong moats, and they are all stress tested for scenarios just like the one we are in now. It doesn’t mean the companies won’t drop in value, just that there is reasonable confidence these companies can weather the storm. From that point of view, seeing few changes from our sub-advisors in these turbulent markets underscores the conviction in our current holdings.
Compass Portfolios and ATBIS Pools - Series O - Q3, 2022
We are now nine months into a drawdown in the price for both stocks and bonds. In times like these it can be difficult to stick to any investment strategy. Current events and negative news are a distraction to long-term plans and prudent portfolio construction. It is important to remember that the volatility we are currently experiencing will pass, and with valuations of both bonds and stocks looking more attractive, we are confident that investors who stick to their plans will be justly rewarded in time.
What we’re reading, watching and listening to
Comparing the speed of US interest rate hikes - by Visual Capitalist
A look at how fast interest rates are rising in the US relative to recent rate-hiking periods.
Bear market opportunities for every generation of investors - by Ben Carlson
An article that explains the opportunity present in the current markets for each generation.
ATB Investment Management Portfolio Manager’s Commentary Q3 2022 - Read our latest portfolio managers' commentary for more on what happened during the quarter and how markets performed.
ATB Investment Management 2022 Q3 Market Update Video - Experts from the ATB Investment Management team break down the quarter .
Bill Browder on high finance, murder and justice - Bloomberg
MSCI All Country World Index - The earnings yield is the 12-month earnings divided by the share or index price which gives a percentage yield and allows for comparison to interest rates. Source Bloomberg.
This document and all of the content has been compiled by ATB Investment Management Inc. (“ATBIM”) which manages the Compass Portfolios and ATBIS Pools. ATBIM, ATB Securities Inc. (“ATBSI”), and ATB Insurance Advisors Inc. are wholly owned subsidiaries of ATB Financial and are individually licensed users of the registered trademark for ATB Wealth. ATBSI is a member of the Canadian Investor Protection Fund and Investment Industry Regulatory Organization of Canada.
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