Markets delivered positive performance in the first quarter of 2023, yet significant investor concerns continue. On our latest podcast, Greg Sweet, Scotia Securities Director, chats with Craig Maddock, Vice President & Senior Portfolio Manager, and Wesley Blight, Portfolio Manager, both from the Multi Asset Management team. They discuss the highlights of Q1 2023, and their views on how best to manage the current market environment.
GS Gregory Sweet
CM Craig Maddock
VO Voice Over
GS Welcome again to our listeners. I'm Greg Sweet, a Director at Scotia Securities Inc. Today, we'd like to bring you a new podcast to help empower our customers when making important financial decisions. The first quarter of 2023 continued to give us ups and downs. We saw some volatility but generally we've seen solid performance in both equity and fixed income markets.
Right around now, Canadians are receiving their first quarterly statement. After another exciting quarter, it's once again a natural time to reflect on recent events as well as look ahead. We know that customers want and benefit from advice. This is true at all times but particularly in times of volatility or fast-moving markets.
Today, our special guest is Craig Maddock, Senior Portfolio Manager and Head of Scotia's Multi-Asset Management team, as well as Wesley Blight, a Portfolio Manager on Craig's team. The past quarter was an interesting one for investors. Performance was good but some significant questions remain about where we're going throughout 2023. What are the key drivers that impacted markets in the first quarter?
CM You are correct that the first quarter of the year was very good and performance was strong across most asset classes. That also means that portfolios we manage were also off to a good start as well. We saw conservative portfolios up around 3.5% and long-term growth portfolios up around 5%. I'd say the returns we achieved were similar to what we'd expect through almost a full year of investing.
And for conservative portfolios, they have a higher allocation to bonds. Canadian bond investments were up over 3% in the quarter, with a number of our bond mandates approaching 4%. In fact, we saw the largest quarterly drop in interest rates since early in 2020 at the start of the pandemic.
Why did rates drop so much? Market participants really believe that the significant shift up in interest rates that was done to tame inflation is actually starting to work and therefore central banks around the world will be able to stop raising interest rates and eventually be able to move back down a little bit lower.
In addition, the belief that inflation is starting to moderate propelled investors back into stocks, hoping to catch the bottom. The best performance for Canadian investors actually came from international markets, as Europe did particularly well, and that's off the back of a warmer than expected winter in Europe, as well as a reopening of China after lengthy COVID lockdowns.
However, North American stocks were strong too, with the S&P/TSX Composite Index, which represents Canadian stocks, up 4.6% and the S&P 500 Index up 7.4% in Canadian dollars. And with the decline in interest rates, investors who pushed the technology and communications and consumer discretionary stocks to excessive valuations back in 2021, well they seem to be lured back into the market.
So, if you lift the hood on the S&P 500 Index, you'll see that only these three industry sectors outperformed the S&P 500 in the first quarter. All other sectors trailed the index and six of them actually had negative returns for the quarter. So, while on the surface things looks pretty rosy, lurking beneath we're still working through some challenges.
The biggest challenge that showed up in the quarter was the banking sector, which moderated returns at the end of the quarter and, for those who follow style-based investing, the clear winner for the quarter was large-cap growth with both small and value trailing significantly.
GS It seems that after a year of rapid interest rate hikes we might see something different this year.
WB The banking crisis that happened in the US earlier in March and the policy reaction to stem that contagion might have worked. It might have actually stopped the contagion from transpiring in the way that it could have but the market is now pushing back, recognising that central bank policy is starting to become too tight for the economy to be able to handle those tightening in financial conditions.
Easing inflation, it's clearly happening. We're starting to get some deflationary pressure coming from some segments of the economy but it's not happening as fast as what we had assumed before and central banks are now pushing back against that perspective that they'll be able to cut rates in the near future. But the market is coming out and saying that, well, because they've tightened so much, it takes time for that tightening to work.
We've had this regional bank crisis show up in the US. We had it come over to Europe a little bit. Maybe they're going have to start cutting rates? And the market's expectation that cuts are going to happen in the next few months is the key reason why interest rates and bond yields have moved down so significantly thus far this year.
There is a very big dislocation between the market's expectation of where rates are headed and what central banks are assuming. So, central banks, taking the US Federal Reserve as an example, are actually expecting and guiding that there is going to be tighter monetary policy over the next couple of months before staying flat through to the end of the year.
And that has caused bond yields to move meaningfully lower than where they were at the beginning of the year and that has felt fantastic as a bond investor and that if you look over the last year in Canada, probably well ahead than anyone really would have expected. If you look at the year-to-date performance, it was 3.2, short-term bonds were up 1.8%, mid-term bonds were up 3.9%, then long-term bonds were up 4.7%. But to Craig's point earlier, that's more what you would expect to happen in a year as opposed to in a quarter.
GS The tumultuous situation that happened in the financial sector in Q1, what impact did this have?
CM Well, Greg, as I mentioned, it did mute returns in the quarter. Prior to the flare-up on banking, by mid-March things were on track for an even better quarter. However, the US financial sector ended down the quarter about 7%. Now, this was on the back of the failure of two US regional banks. Silicon Valley Bank and Signature Bank failed in the quarter.
Now, the financial sector overall traded down as a result. However, and I think it's important, it certainly does not feel like this is going to lead to a systematic banking problem. Silicon Valley Bank was a very small bank, about $200 billion in domestic assets. That sounds like a lot of money but when you compare that to the $19.8 trillion in the US banking system, it's a pretty small bank overall and it had a quite concentrated customer base.
Now, the cause of this failure was the mismanagement of interest rates and that is fundamentally different from what we saw back in 2008 with the Global Financial Crisis and the banking sector was highly levered and there was a pervasive use of off-balance sheet derivatives.
You fast forward to today, the Fed, the US Treasury have lots of tools to ensure the stability of the financial system. We saw those in action after the failure of Silicon Valley Bank and Signature Bank. However, these recent bank failures did show the unintended consequences of aggressive central bank tightening, that immediate market impact, right.
Number one, we saw short-term market volatility and uncertainty. That flared up in March, for sure. We also saw a migration of deposits from regional banks over to bigger banks as people were concerned. We saw the sell-off I just mentioned in the financial sector and, of course, as Wes mentioned, we saw the contagion impact spill over to things like Europe or Credit Suisse, which has had some difficulties of late anyway and this created a catalyst for them to also fail, requiring them to be taken over by UBS.
On top of that there's the impact, as Wes said, to the economy and the central banks' policies. The banking crisis really sparked this shift in market expectations around will the Fed hike, will they not hike? And it pushed up, if you will, the expectations around when this Fed hiking cycle will end because, to be fair, with banks in play right now, if there are some issues around that it could in fact tighten the system all on its own.
So, now the Fed has to balance off do you support the banking system with liquidity or do you fight inflation with interest rate increases, given that inflation is still with us. This recent banking crisis or stress, if you will, is likely going to result in higher funding costs, tighter credit conditions for households and businesses, which is ultimately going to slow down economic activity. It will slow down hiring and ultimately help to tame inflation a little bit.
GS In your opinion, do you think things have settled down?
CM I think the scariest scenarios have definitely been avoided. I think it's important to note, though, for Canadians that things are generally fine for Canadian banks and the Canadian economy, which are in a much different position than our global counterparts. So, will global banks tighten up lending, slowing down the economy? Probably. Will the financial system collapse as it did in 2008-2009? Probably not.
GS So, obviously, some big questions that remain for investors when it comes to how things will play out throughout the year. Is that fair to say, Wes?
WB It sure is. I think the biggest ones in our mind revolve around inflation still being elevated. That's led to an inverted bond yield curve which typically leads to recessions. Then, the last question is around when will central banks stop raising rates and when are they going pivot back into cuts?
Starting with inflation, inflation is still really high. There are continued signs of it slowing down and that we've seen headline inflation come down with energy falling materially, food prices still high but they've come down a little bit as well. Then, even core inflation is falling from its September peak. Goods are the main factor that are causing that disinflationary pressure but services, so thinking of shelter and transportation, those are still really high.
We do think that, particularly in the US and in Canada as well, that household metrics are going to start to slow down as the consumers' ability to continue to spend as much as they have been spending will gradually slow down. That said, we don't have a lot of confidence that it is going to slow down as quickly as is being predicted by the market.
Part of the reason for that is that personal savings are still pretty elevated. There was a good opportunity for personal savings to be ratcheted materially higher from March 2020 through until August 2021. The consumers have been spending that down but they still have enough cash to be able to go out and do things they were not able to do during the pandemic.
Now, part of the reason why we've got an inverted curve is that inflationary pressure and that central banks have been predicted to act very strongly, swiftly and take in measures to combat that inflationary pressure. They've done that in a material way such that the bond yield curve, this is talking about US ten-year bonds, relative to US ten-year bonds. That curve is not normal and the two-year yield is higher than the ten-year. That's not something you would normally assume to happen.
If you go back to the early 2000s, right before the Global Financial Crisis, the late 1980s, those were all predictors of negative events from an economic perspective, negative events from an equity perspective. We are now at a greater inversion of the bond yield curve than where we were at any of those three events. You have to go all the way back to the early 1980s for an equivalent inverted curve.
Now, I mention that that's usually a predictor of an upcoming recession. We do think that there is going to be an economic slowdown, there may even be a recession, but we don't think that that's going to be a deep and long-lasting recession. It is also the best telegraphed recession in my career. Economic data clearly slowing but we've had companies, investors, they've been provided with ample time to think through how they will be able to manage that economic slowdown, but it hasn't happened yet.
Now, PMIs are declining in Europe. We are moving away from our own economic recovery models and we're moving back into contraction. The reopening of China and the positive boom that we were expecting from China reopening, that has passed us now and we're starting to see a corresponding easing of financial conditions, which is what we talked about earlier around the change in interest rates.
So, will central banks pivot? That's kind of where we're all leading these questions towards. Investors clearly think that there will be cuts in 2023. Central banks, themselves, are not suggesting that there are going to be cuts in 2023. Their guidance suggests that those cuts will happen later into 2024.
Bank of Canada is not raising rates anymore. They're obviously subject to incoming economic data which may lead to a different decision down the road, whereas the Federal Bank in the US is still guiding towards higher rates than where we are right now. From our perspective, we think that there is the ability for central banks in North America to pause but we don’t really think that there is going to be material cuts taking place this year.
GS How do the events from the first quarter inform your views for investing throughout 2023? Has anything changed?
CM Greg, I often talk about how investors naturally think in terms of quarters or even calendar years but really what's important is how you perform over a lifetime of investing. It can be pretty uncomfortable when things move the wrong way and, of course, it gets pretty exciting when markets rally but, for me, it's really always the long-term that matters.
Now, we know that both stocks and bonds will fluctuate in value but we also know that they generally go up over time. Certainly, after a very tough 2022, Q1 of 2023 looked really good for a lot of reasons, but that doesn't really change too much for the long-term. We still think there are good investment opportunities available and we believe that volatility will continue. That means there are going to be some economic ups and downs and, of course, we plan for that into our portfolios and build them accordingly.
For example, we updated our long-term capital market assumptions and we do this every year, and we use those to position our portfolios for the future. So, thinking ahead, how do we think different asset classes will work? And then how do you put those together in the most compelling way for a portfolio?
Last year, we had a decline of both stocks and bonds and therefore forward-looking assumptions are meaningfully higher and that bodes really well for long-term investors. In addition, we use these expectations to adjust portfolios between things like stocks and bonds or style of investments and how we expect each strategy to perform. So, with these higher interest rates, the possibility of them being higher for a while, strategies like value investing start to look more attractive and perhaps can help improve a portfolio.
So, for me, in that regard, it's more of an evolution than just how the quarter showed up. The team is constantly reviewing our portfolios, always trying to find ways to add extra return or reduce risk or do both if we can. And I'm constantly challenging the team to consider what adjustments could we make to the market based on these investment opportunities.
Can we do things like regional allocations, how we allocate between US, international, emerging markets, other things? And within our bond mandates, can we adjust for the fact that interest rates are higher and what do we do with our duration exposure? Or how do we use credit? How might we use things like alternative investments in portfolios to enhance return or manage risk?
Then, finally, which manager or strategy is likely to do the best going forward and how do we factor that into our portfolio. So, with all that background, we're constantly making shifts, ways to improve portfolios and I wouldn't suggest that just because something incredible happened in the quarter, we're going to make any radical shifts to portfolios.
GS Wes, it would only be fair to ask you the same question. Anything change your views on markets?
WB Long-term capital market assumptions. That is an exercise that we do every year. As we talked about a few months ago, we're now expecting higher returns in the coming years, that's expressly over the next ten years, than what we were expecting a year prior. This is mostly coming from an increase in our return assumptions around bonds, mostly because of bond yields.
The vast majority of forward-looking return through time for bonds comes from the starting yield but it's also true for equities in that, as last year's poor performance has worked its way through, it has led to some more attractive valuations in terms of how return is going to be derived for equities going forward.
That is giving us a little bit more wiggle room in the more near-term because a lot of the negativity around capital markets, particularly in bonds, was already priced into in the market. So, we may get a little bit more of a tailwind in the short-term but our view here is really around the long-term and building that long-term strategic allocation based on dramatically improved long-term capital market assumptions.
We're currently positioned defensively. We are more focused on preservation of capital and as we get signs, we’ll start to increase the equity allocation in select portfolios and what we’re looking for specifically would be kind of what I was talking about earlier, in that as we start to get signs for inflation being more clearly and convincingly slowing, that may help us to move towards a higher equity allocation.
We also recognise that there is a lot of negativity around equity performance right now and that bears are outweighing bulls in terms of investor sentiment. And as that dynamic starts to shift, that would be another sign that we would start to look to increase our equity allocation in some portfolios.
In the meantime, I think the way that we're positioned from a fixed income perspective and that laser focus on capital preservation has us really well positioned to add value. We talked a couple of months ago about adding a lot of value in 2022. I talked earlier about the absolute return from fixed income being so strong year-to-date. And what I'm really happy and proud to say is that we've also added excess return from our fixed income investing as well.
GS It sounds like a lot of your team's views on the state of the market continue to align with what our advisors have been telling our customers. We've been telling them to stay invested, think long-term. We really want them to focus on their investment plans and to talk to their advisor about making sure that their plans are optimized to meet their investment needs.
I'd like to thank you both from me but also from our customers that learned a great from our conversation today. This kind of conversation can help provide our customers with the knowledge and the confidence to tackle these issues, leading them to make smart decisions with their long-term investments and ultimately helping them maintain the health of their long-term financial plans.
And to all the listeners of this podcast, I want to thank you for investing your time in this discussion today. Our goal is to lead with advice and help our customers for every future. Thanks so much for spending your time with us today.
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