The Road to Recession – Fears of a Downturn Dominate

Recession warnings are a dime a dozen, but experts are painting a particularly downcast outlook for 2023. Head of the International Monetary Fund Kristalina Georgieva, for example, believes a third of the world economy will fall into a recession over the next 12 months, while a Natixis survey found that in all regions except Asia, at least 80 per cent of institutional investors believe their economies will see a 2023 decline.

The concerns are not without merit. Inflation, for one, remains well-above central bank target rates around the world. Europe in particular is still grappling with rates above 9 per cent thanks in part to the long-lasting war in Ukraine, a key contributor to high energy prices and a cost-of-living crisis in countries like the United Kingdom. As a frequent precursor to recessions, high energy prices alone have some investors spooked.

Interest rates are also much higher going into 2023, thanks to aggressive rate hikes from central banks. While the 425-basis point move has helped bring inflation down from its June-peak here in North America, it has likewise been a drag on stock performance and has caused mortgage rates to more than double. With the average Canadian household having $1.83 of credit market debt per dollar of disposable income, the rising cost of debt will eventually force some consumers to shed the cheap debt they have accumulated over the past decade.

Finally, there is the fear of a slowdown in China. Throughout 2022, the country has been grappling with a declining real estate sector and restrained manufacturing thanks to its strict zero COVID policy. While a rollback of the lockdown measures was announced in December, the country is now dealing with a fresh wave of COVID-19 reminiscent of the Omicron/Delta waves experienced by other countries in early 2022. With China making up a quarter of the world’s manufacturing capacity, any further shutdowns as a result of the virus could meaningfully hamper trade in 2023.

A recession seems likely, and indeed the days of easy capital for cryptocurrencies and unprofitable ventures seem far behind us. Still, many of the risks we hear about in headlines have already been reflected in stock prices; trading off that same information is self-defeating. Rather than try and time the decline, it is much more prudent to focus on buying quality businesses for the long-run when prices offer the opportunity. These positions may continue to fluctuate in price, but over time will recover and thrive. Afterall, this isn’t our first rodeo, and for many quality companies with low leverage and positive cash flows, it certainly won’t be their last.

As always, we thank you for your support and continued confidence in WDS.

Equities

After two years of stellar performance, 2022 was a year of reckoning for stocks. The decline began right out the gate with the invasion of Ukraine, and continued as central banks began their aggressive contractionary policies to fight rising prices. Canada would be one of the lucky ones, seeing its TSX Composite Index ($TSX) fall just 8.7 per cent for the year, lessened to -5.8 per cent after dividends. The muted decline is largely thanks to our Energy sector, the Index’s largest weighting, which saw a price return of 24.4 per cent for the year. Meanwhile, Health Care and Information Technology, Canada’s worst performing sectors at -62.2 per cent and -52.2 per cent respectively, are small constituents of the index.

The United States, meanwhile, is heavily-exposed to the high-valuation positions that took a beating this year. For 2022, the S&P 500 Index ($SPX) ended the year down 18.1 per cent on a total return basis. In Canadian dollar terms the decline was more moderate at -12.2 per cent thanks to the greenback’s appreciation. Communication services, which includes companies like Meta and Google, was the worst performing sector, down 40.4 per cent for the year.

Stocks did not have a much better time outside North America either - the MSCI EAFE Index ($MSEAFE) ended the year with a total return of -14.5 per cent. The invasion of Ukraine continues to have an acute impact on European countries, who are struggling to cope with the resultant surge in commodity prices.

Fixed Income and Interest Rates

2022 was also a year of aggressive central bank rate hikes, with countries determined to fight off sweltering inflation figures. The Bank of Canada itself followed the US and hiked its policy rate seven times, starting the year at a target overnight rate of 0.25 per cent and ending at 4.25 per cent. The 10-year yield on government bonds rose 186bps as a result to 3.29 per cent, its highest level since 2011. The hikes have helped to cool prices, with November’s inflation rate of 6.8 per cent down from the 8.1 per cent peak seen in June, but a higher cost of debt has yet to satiate demand for credit - consumer debt reached a total of $2.36 trillion in the third quarter, up 7.3 per cent year over year. The rates hikes have further contributed to an inverted yield curve (see top right graph), whereby short-term bonds offer higher yields than longer-term instruments, a phenomenon viewed by many as a signal of an impending recession.

Bonds as a whole underperformed in 2022, with the FTSE TMX Canada Universe Bond Composite Index ending the year down 12.2 per cent. Despite being seen as a safer asset class in comparison to stocks, rate hikes have a direct negative impact on bond prices, and the aggressive movement of central bank rates in 2022 has taken its toll on fixed income instruments.

The story is much the same in the US, where the lower bound of the Federal Funds target rate range was hiked seven times to 4.25 per cent. The central bank also began its passive quantitative tightening, allowing its ~$9 trillion bond portfolio to mature without replacement, something that should slowly push up longer-term rates (10-year government bond yields currently sit at 3.88 per cent, up 236bps). Even still, the Federal Reserve has signaled its intent to continue with aggressive contractionary policies, much to the dismay of investors.

Currencies

Canada’s economy held up much better than many of its peers in 2022. Thanks to high oil prices, the country’s trade surplus rose to levels not seen since before the financial crisis. Inflation figures have also come in lower than most other G7 nations, including the United States. Nonetheless, the Canadian dollar ($CDW) dropped in 2022, starting the year at $0.79 USD and closing out December at $0.74, a 6.3 per cent drop. Some may attribute the fall to declining consumer confidence, which plummeted in November to 46.62 and remains below 50 (a negative indicator) as of year-end.

Another contributing factor was the strengthening US dollar – against a basket of currencies, the Greenback saw its biggest annual jump in seven years. This seems largely thanks to both the Federal Reserve’s aggressive moves to temper inflation, and the US dollar’s popularity as a safe haven for international investors (and domestic ones, for that matter) during times of market uncertainty. Still, with US unemployment at a rock-bottom 3.5 per cent (compared to Canada at 5.0 per cent), the labour market remains red-hot, something that may hamper efforts to control inflation should we see wage hikes.

Commodities

While the invasion of Ukraine (and resulting sanctions on Russian oil) initially caused prices of crude to surge above $120 USD a barrel, the West Texas Intermediate ($WTI) ended 2022 at just $80.26, up 6.7 per cent for the year. The tempered price is thanks to fears of a global recession, with markets particularly concerned about China. As the world’s second-largest consumer of the stuff, the country’s fresh wave of COVID-19 cases threatens to hamper demand for crude.

Gold ($GOLD) likewise saw a surge in March as Russia's invasion unfolded, topping out at around $2,050 an ounce. Nonetheless, the commodity ended the year at just $1,815.64, actually down 0.4 per cent from 2021. While some would expect strong returns for safe havens in 2022, rate hikes tend to decrease the luster (no pun intended) of such non-producing assets. With 10-year treasury yields at their highest levels since the 2008 financial crisis, the opportunity cost of holding gold has risen sharply in 2022.

This report is provided for your information. Conclusions and opinions given do not guarantee future events or performance. Facts and data provided are from sources we believe to be reliable, but we cannot guarantee they are complete or accurate. This report is not to be construed as an offer to sell or a solicitation of an offer to buy any securities. Before making an investment or adopting an investment strategy, each investor should review his investment objectives with their investment advisor. Watson Di Primio Steel (WDS) Investment Management Ltd. and individuals and companies who are related may, at any time, buy or sell securities that are hereby described in this report.