As we start on a New Year with many questions surrounding the economy, interest rates and inflation and the general direction of markets, we want to outline a few thoughts we have for the calendar year ahead.

1 – Rate Increases to Start the Year

Despite some of the rhetoric around the Bank of Canada and Federal Reserve easing up on hiking rates, we do not believe this is going to be the case. Inflation has fallen, but continues to sit at numbers (6.3% in Canada, 6.5% in the US as of December) far above the target rate of 2%. In order to further combat those numbers, the central banks will have to continue to raise rates, at least twice in our opinion. While rate hikes and high interest rates will remain a headwind, this should not be taken as a negative for the long-term outlook. Markets have likely already priced in interest rate hikes for Q1 2023 and the official announcements should not have a significant effect on the markets as a whole. The work the central banks have done over the last 12 months is working, albeit slower than they likely would have imagined given how aggressive they were in increasing rates, but must continue in order to continue moving towards that 2% target.

As a result of these continued increases, you can expect sectors such as Consumer Staples, Healthcare and Utilities, which have stable earnings outlooks for 2023, to play a defensive role in your portfolio. Our belief is that traditionally growth-oriented sectors such as Tech, Consumer Discretionary and Industrials are still too expensive and will continue to be a victim of higher rates to expect to traditional returns from. Also, an “earnings pinch” may be coming in these sectors, where quarterly earnings may disappoint, continuing declines from 2022. We will go into this more in a following point.

2 – Do Not Expect Rate Cuts

Another common theme I hear/read about is the optimism that come the back half of 2023, the central banks will already be in a position to begin cutting rates. I do not believe this to be the case, at least not in any significant way.

We have lived in a period of quantitative easing since the financial crisis of 2008, where interest rates had to be dropped in order to avoid a global financial meltdown and promote a stalled economy into borrowing and spending. What does not get talked about enough is the fact that these rates stayed below 1% for about a decade. In 2018, the Federal Reserve attempted to raise interest rates and the equity markets quickly turned from green to red.

In order for the intended effects of these interest rate hikes to take hold in the economy, the central banks will not be able to decrease them come year end. Combine that with the fact that the central banks inherently want an interest rate in the range of 2.5%-3%, the central banks will be in no rush to significantly lower rates unless they are forced to fight yet another recession brought upon by inflated prices/wages. Given that US real GDP actually grew by 3.2% in Q3 of 2022 after 6 months of GDP shrinkage, I am not quite on board with the rhetoric that a meaningful recession is locked in for 2023. Given that markets have had a nice start to the year, we could see a pullback of 10-15%, which is far more common than you would think, but I also believe we have seen the worst of this bear market. I don’t think it is time to be buying into high-growth stocks that succeed in a burgeoning market, but I do not agree with the narrative regarding a long, drawn-out recession. What I do see as the most realistic scenario is one where a technical recession occurs where GDP does begin to slow down once more, coupled with a drawdown in markets, focused specifically on the high-growth sectors we mentioned above. But another 20% pullback on the broad markets? I think that’s a long shot.

3 – Bonds Have a Good Year

2022 was a tough environment to find return because in addition to the equity market facing sharp declines, the income sleeve in portfolios was also under siege as rate increases drove bond prices down leading to paper losses on bonds.

For a quick refresher, bond prices move in inverse with interest rates. As interest rates quickly rose in 2022, the price of existing bonds on the market fell. Further to that, the losses incurred by a bond are extended when bonds have either a low yield, commonly seen in government bonds, or a long duration, also common amongst government bonds. So, when you hear commentary surrounding government bonds not acting as the pillow of your portfolio, the quick rate rises combined with the way government bonds are typically structured is why.

So, with these two things combined, the picture below details just how bad 2022 was from a return perspective with this ‘perfect storm’ of economic factors affecting both equity and bond markets.

You’re reading that correctly. Since 1871, 2022 was the worst year when accounting for both bonds and equity, or a 50/50 portfolio.

But again there is a positive aspect to having made it through this. In 2023, bonds should recover during the course of the year and we think that actively managed bond funds are the most appropriate investment. With new bonds representing the higher yields as a result of increased rates, active managers are able to re-position their portfolios to create higher income from bond coupon payments. These bonds may even see paper gains if the narrative from the central banks does change to a more dove-ish (lowering rates) position either late in 2023 or early 2024. You can feel confident that moving forward, your fixed income sleeve will act as that soft landing inside your portfolio when equities are under pressure. That could ring true in 2023 if equity markets do pull back. In that situation, which to re-iterate, I am doubtful we see for any lengthy period of time, money will flow from equity and into bonds, potentially resulting in increases in the price of bonds.

4 – Dividends Continue to Provide Value

In one of our previous posts, I outlined the case for dividend growers as an investment. I think that will continue to ring true throughout 2023. The high-growth/high-valuation companies are priced for perfection and any misstep/unforeseen economic event will continue to push those prices down. Dividend growers on the other hand, look more affordable. Again, linking back to that previous post, we are looking at price versus value for 2023. As a quick reference point, let’s look at the P/E between 2 indexes. The Dow Jones, which I believe is the better overall indicator for market/economic health has a P/E, as of this writing of 7.42. The Nasdaq on the other hand, which contains many, if not all, the high-growth companies I alluded to earlier, has a P/E of 23.73. The Dow is made up of more dividend growing stocks as opposed to the Nasdaq which features many more companies that either do not pay a dividend at all, or a very small one in comparison.

This is to re-iterate that we believe the dividend stocks will hold up better against any future volatility than the non-dividend paying stocks. A healthy, growing dividend with a steady payout ratio represents a healthy business that is continually growing its cash flows on a yearly basis. These businesses will hold up better in a period of volatility, especially in an environment where interest rates will not be going up as aggressively as they did in 2022.

5 – Markets are Down, Then Recover to Finish the Year

Despite the fact that we have had a nice start to the Year (TSX +5.22%, DJIA +3.49% at the time of writing), we believe that the first half of the year should experience volatility with equities moving up and down to reflect uncertainty around company earnings, the central banks’ strategy on rates, the threat of an upcoming recession and how long inflation will be a cause for concern.

To expand on what we glossed over earlier, the biggest concern in our opinion is Earnings report risk. With higher interest rates, companies are paying higher cost on their debt, with inflation are paying higher cost on their inputs and with wage inflation, are paying higher compensation to their workers. Combine that with the outlook of a slower growing economy and we are likely to see earnings shrink, even if relation to the weaker guidance set out in earnings reports last year. When earnings shrink and companies issue “weak” guidance for future quarters/years, the high-growth, high-valuation stocks that provide us with the double-digit returns we have grown so accustomed to experience significant pullbacks. When you hear the term “priced for perfection”, this is what that means. When any news related to company performance/operations is negative, or not perfect, the stock price drops sharply as investors expect that same growth year after year.

As the market adjusts to disappointing earnings in the first half, prices will likely drop to reflect slower growth. The stock market is forward looking however and when companies are pulling through the doldrums come the latter half of the year and issuing stronger guidance for 2024, prices will likely recover and begin a run for what could be a much stronger year as fears over rising rates, inflation and housing prices will likely be things of the past.

Make no mistake here. Buying shares of MSFT or GOOGL at their current prices ($240 and $91 respectively) will not likely be decisions you look back on with regret, but if you’re desire is to preserve capital in 2023, you will likely find yourself shopping in the Dividend Aristocrat aisle as opposed to the Growth Stock aisle.

5 – Timing Investments vs Time in Investments

This is not much of a prediction but rather a reminder. Regardless of how you view certain economic factors, political instability, recessions, different valuation methods, growth vs dividends, you name it… one thing that all famous investors can agree on is the concept of ‘time in the market’ vs ‘timing the market’.

If we date back to the worst days of the financial crisis in 2008 through the recovery of the markets during Covid in 2020 and cherry pick the 10 best and worst days over that period, the result of an investor selling through the bad times and potentially missing out during the good days is staggering. What you’ll notice is that many of the best days over this period actually took place during the times of severe volatility, not long after as one might assume.

Let’s take a look.

If an investor took $10,000 and invested it in the S&P500 on January 1st of 2002 and had held steady through until the end of 2021, the end result would have been a portfolio that had grown to $61,685, an annual growth rate of 9.52%.

However, if in trying to time the market the investor happened to miss the best 10 days of this 20-year time period, the end result would have been $28,260, an annual return of 5.33%. Missing 10 days over a 20-year span results in a reduction of your total return of over 45%. So despite how bad things may look on the market, in our opinion, you only have 2 choices to make.

              Choice A – Continue to ride through the volatility, holding firm on your conviction about your portfolio

                    Or…

              Choice B – If you have it available, using existing Cash to buy more of the stocks you like while they appear to be ‘on sale’.

On Black Friday, everyone rushes out to buy products on sale while prices are low. I am yet to see a person running out to sell their new TV for that lower price. That’s for a $1,500 TV. But for whatever reason, investors can tend to act the in the opposite fashion when it involves their $150,000 investment portfolio.

Always stay strong during times of volatility and if possible, let it be your good friend as opposed to mortal enemy.

For next month, we will take a look at some scenarios for contributions to RRSPs and TFSAs and the taxable implications of both.

This information has been prepared by James Hogan who is an Investment Advisor/Portfolio Manager for iA Private Wealth Inc. and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor/Portfolio Manager can open accounts only in the provinces in which they are registered.

iA Private Wealth Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. iA Private Wealth is a trademark and business name under which iA Private Wealth Inc. operates.