Fourth Quarter 2022: From There Is No Alternative (TINA) to There Are Many Alternatives (TAMA) In One Year

Investor Thinking About Return Prospects For Various Asset Classes Has Been All Shook Up

Quarterly Summary and How We’re Positioning for Q1

Since 1920, when looking at the US stock and bond markets, 2022 was the third worst year for a 60/40 portfolio in history and the absolute worst year outside of the Great Depression. A 60/40 portfolio declined 16.9% in 2022. Typically, the worst years are driven by equity market crashes but 2022 was unique in that the decline in the 60/40 portfolio was almost equally due to the decline in both equities and bonds, with both falling more than 15% in 2022. We see this as a positive as if history is any guide, the likelihood is high that at least one of the two – equities or bonds – will rebound in 2023.

One of the market mantras over the past few years is that there were no alternatives to equities because cash and bond yields were historically low and didn’t offer attractive returns. Naturally, “alternative investments” flourished as a true alternative to equities during this period but only a small fraction of investors had/have access to alternative investments. The market weakness experienced in 2022 has shifted thinking from no alternatives to plenty of alternatives.

If we compare the potential returns of each asset class, or the “menu of returns”, relative to January 1, 2022, we see meaningful improvement in the return outlook:

• 10 Year US Treasury bonds now yield ~3.9% (was ~1.5% on January 1, 2022).
• 30 Year US Treasury bonds now yield ~4.0% (was ~1.9% on January 1, 2022).
• Mortgage pools like Capstone and Capital Direct have expected returns (before defaults) of ~7% (was closer to 6% on January 1, 2022).
• Many perpetual preferred shares yield 6%-7% and trade at a 20%+ discount to par versus a yield of 5%-6% and little to no discount to par on January 1, 2022.
• Equity market dividend yields are ~25% and ~9% higher for the S&P 500 and TSX composite, respectively, when compared to January 1, 2022.

While this doesn’t necessarily mean the losses experienced in 2022 will be fully reversed soon, nor that we out of the woods in terms of a potential economic recession and further potential downside, but it does mean that the outlook has improved considerably for a long-term investor holding a diversified portfolio.

Last quarter, we discussed the painfully high natural gas and power prices facing Europe and the possibility of these high prices shutting in large parts of European industry. Thankfully, weather in Europe has been unseasonably warm, breaking many records in fact, and this has alleviated the potential economic and humanitarian disaster that a particularly cold, or even average winter, could have caused. This bit of good luck is great for European households and businesses but also good for the global fight against inflation as well as the financial stability of the world, and is a reason to be a bit more optimistic than just a few months ago.

In late 2022, Chinese lawmakers decided to reverse the draconian zero-COVID policy, boosting the Chinese economic outlook heading into 2023. While there is concern that a rampant spread of COVID could actually be a net drag on economic growth, so far investors have cheered the change in policy and have seen it as a net positive.

Global inflation has been trending lower in previous months and employment remains strong in the majority of economies. Positive signs out of Europe and China are reasons to be a bit bullish to start 2023. While falling inflation is certainly a positive, markets may be a bit ahead of themselves in assuming central banks will soon be friendlier to financial markets. Central banks have noted the war in Ukraine and supply chain disruptions as reasons for high inflation, but they all agree that the key driver, and the greatest risk to an extended period of high inflation, is a tight and unbalanced labour market. Interestingly, although inflation is on the decline in most countries, labour markets remain incredibly tight globally with unemployment near record lows and job vacancies near record highs.

If central bankers start to focus on a normalization in the labour market, rather than a normalization in the current inflation rate, as a reason to maintain high interest rates, investors may be caught flat-footed. In addition, we have yet to fully experience the effect of higher interest rates. Interest rate hikes tend to be felt the most 9-12 months after they occur so we should start to see those negative effects in the first quarter of 2023. The labour market has remained strong so far but may start to crack as housing activity and business spending is reeled in. For these reasons, despite an improvement in some areas, we think a cautious approach to equities remains prudent.

How To Position Portfolios Going Forward?

In general, the portfolios we manage held up well amidst weak equity and fixed income markets in 2022. Defensive equity positioning and material allocations to alternative investments were the primary reasons for outperformance relative to benchmarks. Similar to previous quarters, we continued to trim defensive positions with weak return outlooks and added to stocks with more long-term upside, and will keep leaning in that direction so long as select defensive stocks remain historically overvalued.

We have yet to meaningfully add to international markets but recent energy market developments make these areas even more attractive relative to previous quarters. Opportunities are sure to arise in these markets as we progress through 2023.

GICs are another area we have added to for some clients. One-year GIC yields are now above 5%. For clients in need of income or liquidity in 1-3 years (e.g. RRIF withdrawals, large purchases, etc.), we have begun building material allocations to GICs as this helps protect capital while generating an attractive short-term return. Adding to high interest savings accounts (HISAs), now yielding over 4%, is attractive for those clients with liquidity needs less than 1 year or those with a lack of certainty about withdrawal/liquidity needs.

We remain committed to our balanced investment strategy and will look to capitalize on opportunities when they arise. Given the much improved “menu of returns” to start 2023, we believe diversified portfolios will perform well going forward. Maintaining a diversified approach should help provide a smoother return experience going forward than previous years.

We are here to help you navigate this uncertain environment and help keep you on track to achieve your financial goals. Please feel free to reach out if you have any questions or concerns.

Sincerely,

Steele Wealth Management

The information contained in this report was obtained from sources believed to be reliable, however, we cannot present that it is accurate or complete. Information has been sourced from the RJL Bond Desk or RJ Private Client Solutions, unless otherwise noted. Index and sector returns represented in this commentary are measured using the S&P/TSX Total Return Index and S&P/TSX GICS Sector Indices as detailed in Raymond James Ltd.’s Insights & Strategies: Quarterly Edition. This report is provided as a general source of information and should not be considered personal investment advice or solicitation to buy or sell securities. The views expressed are those of the author and not necessarily those of Raymond James Ltd. (Member Canadian Investor Protection Fund).

This Quarterly Market Comment has been prepared by Steele Wealth Management and expresses the opinions of the author and not necessarily those of Raymond James Ltd. (RJL). Statistics and factual data and other information are from sources RJL believes to be reliable but their accuracy cannot be guaranteed. The performance outlined in the report is net of fees. The client account performance may vary from the model portfolio due to several factors, including the timing of contributions and dates invested in model. The performance reported is that of the account that represents the model, not a composite. Performance calculation for the models may be different than the index used as a reference point. 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 Quarterly Market Comment 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.

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