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Outgoing tide

Quarterly review

Richard Morin

Update :
Update :
April 17, 2023

"It's only when the tide goes out that you find out who was swimming naked. -Warren Buffett

We have just experienced one of the greatest tides in the modern history of financial markets. Interest rates close to 0% and liquidity injections into the market by central banks (Quantitative Easing) until the beginning of 2022 had pushed all asset classes to record levels - stocks, bonds and real estate.

The return of the low tide was brutal: starting in May 2022, central banks orchestrated the largest and fastest interest rate hike since the late 1970s, early 1980s1. The first victims of this rate hike were bonds, down 12% in 2022, and technology/NASDAQ stocks, down 33%.

Then it was real estate that took the hit. As is usually the case, it is first the volume of home sales that has fallen drastically - with buyers sitting on the sidelines - before home values begin to decline. In Canada, the average selling price has fallen by 19% over the past year.

US regional banks

There is now a third type of victim of rising interest rates: banks with weak balance sheets or whose businesses or portfolios lack diversification, particularly U.S. regional banks. Three of them have recently closed or had to be bought out by another bank. The rise in rates affects these banks in two ways. On the one hand, they are losing deposits as savers move to investment certificates and money market funds that offer higher rates, or to safer banks. On the other hand, these banks had invested a significant portion of their deposits in u.s. treasury bonds, the value of which fell significantly in 2022, forcing them to take losses, which weakened their balance sheets and undermined depositor confidence. And, as we have seen, the life expectancy of a bank that loses the confidence of its depositors is measured in hours.

Note that the closure or merger of three U.S. regional banks is not a disaster. When the U.S. central bank raised its key interest rate to more than 20% (!) in 1981, more than 1,000 depository institutions (Savings and Loans Associations) had to close or be reorganized.

But rest assured, nothing like that will happen in Canada. As much as we like to criticize the Canadian banking oligopoly, our banks are among the best capitalized, diversified and regulated in the world.

We are not out of the woods yet. History tells us that the full impact of an interest rate hike such as the one that began last year is often two years lag. Many economists are predicting a recession later in 2023 or 2024. One economist is predicting nothing less than an apocalypse2. Should we listen to them?

Your portfolio is not a hedge fund

With all due respect to economists, if they could systematically predict the future, we would know. But it is not for nothing that economics is known as the dismal science: it is the most inaccurate of all sciences. It is not that economists are incompetent, but rather that the task is impossible. The global economy is an infinitely complex system and the movements of financial markets often defy logic. When economists predict a recession, a bear market or other events, we must therefore consider that these are "probable" scenarios, but far from certain.

So will there be a global recession in 2023? Perhaps. Will it be accompanied by a bear market? Perhaps. Should you liquidate a portion of your stock portfolio today in anticipation of a bear market?

It depends.

If you're a hedge fund manager and your (very generous) compensation is tied to your ability to generate returns even when the markets go down, you could sell stocks to protect yourself from the potential downturn - and even sell short if you're really convinced - to profit from it. If you win your bet, you'll receive millions (even tens or hundreds of millions!) in performance bonuses. If you lose your can always start over somewhere else!

But here's the thing: you're not managing a hedge fund3, but rather your own retirement fund. You can't afford to "bet" on any market scenario - no matter how likely it may seem to you - because if you're wrong, you can't "start again".

That's why - as pension funds do - you must follow 3 important rules in managing your portfolio:

-Diversification. Avoid concentrating your portfolio in one sector. Index ETFs are an excellent diversification tool because they invest across sectors;

-Balance. Maintain a balance of stocks and bonds in your portfolio;

-Stay the course on your target allocation. You've determined your target percentage of stocks and bonds in your portfolio based on your investor profile and time horizon. Stick with it, no matter what the economists predict or what the market conditions are.

Everything comes to those who wait

In fact, those who had the discipline to do nothing have been rewarded, as the balanced portfolio (60% stocks and 40% bonds) has already recovered half of the 2022 decline, with an increase of nearly 5% in the first quarter. Ironically, it is because the markets are anticipating an economic slowdown - and thus lower interest rates - that technology stocks/NASDAQ and bonds are up. No one predicted this scenario.

Market Review

Asset classesReturns in C$
1st quarterYTD
Canadian Bonds3.2%3.2%
- Canadian4.6%4.6%
- U.S.7.2%7.2%
- International (EAFE)7.8%7.8%
- Emerging markets3.8%3.8%

Canadian equities: we love our banks

Canadian stocks closed the first quarter up 4.6%. As with most major stock markets, the technology sector led the way, accounting for nearly 40% of the Canadian stock market's performance.

Unlike other markets, however, the Canadian banking sector has not been overly impacted by the crisis that led to the closure of three U.S. banks and the forced marriage of Credit Suisse with UBS. This is to be expected since our banks are much stronger - and generally better managed - than most foreign banks. Take the smallest of Canada's big banks, National Bank, as an example. If it were to suddenly realize all of the unrealized losses on its bond portfolio - which is essentially what led to the closure of Silicon Valley Bank - the impact would be equivalent to less than 2 quarters of profits and it would still be well in excess of the capital requirements imposed on it by regulators.

In fact, the "banking crisis" has indirectly benefited the Canadian stock market, as many investors have taken refuge in gold, of which Canada is rich in. Since the announcement of the closure of the SVB, its price is up by more than 9%, contributing to the good quarter of the commodities sector (+7.5%).

After allowing the Canadian stock market to rise to near the top of the developed world last year, energy was the only sector to finish in the red during the quarter (-3.6%). The price of a barrel of oil continued the decline that began last summer. It is now down 37% from its peak in 2022.

S&P 500
(in USD)
Consumer Discretionary4.0%15.8%
Consumer Staples7.5%-0.2%
Healthcare (including cannabis)0.4%-4.7%
Information Technology26.5%21.5%

U.S. stocks: techs rebound

Signs of slowing inflation have raised optimism among U.S. investors, despite the turmoil in the financial sector. Technology and growth stocks accounted for much of the 7.2% performance of the S&P 500 Index.

After being battered last year, technology and growth stocks - which are highly sensitive to interest rates - benefited greatly from the decline in 10-year bond yields during the quarter. The three best performing companies during the quarter were in the technology sector: NVIDIA (+87%), Meta (+73%) and Tesla (+59%).

The drop in bond yields was too little, too late for Silicon Valley Bank and the two other US regional banks that succumbed during the quarter. Other financial stocks also suffered, such as First Republic Bank (-89%) and Charles Schwab (-37%). The financial sector as a whole is therefore down 6.1%.

International equities: Europe up sharply

The MSCI EAFE Index of international stock markets was up 7.8% (in CAD) for the quarter.

Neither the tribulations of Credit Suisse and its forced marriage to UBS, nor the rapid rate hikes by the European Central Bank have dented the optimism of European investors. The STOXX 600 European equity index was up 8.4% for the quarter.

French stocks, up 12.3%, were the biggest contributors to international equity performance during the quarter. The reopening of China is expected to increase demand for luxury goods such as those offered by Louis Vuitton and Yves St-Laurent.

For the same reasons, German stocks - driven by the performance of its carmakers - closed the quarter up 12.5%.

Emerging markets: Chinese equities off to a false start

The MSCI Emerging Markets Index returned 3.8% in CAD terms for the first quarter of 2023.

In response to its reopening to the outside world, the year began with a bang for China, up 17% in January. Unfortunately, rising geopolitical tensions with the United States have since put a damper on the bullish momentum. Chinese stocks ended the quarter up 4.7%.

The rally in technology stocks was not limited to the developed markets, benefiting the stock markets of Taiwan and South Korea by 13.8% and 13.6% respectively.

It was a more difficult quarter for the Indian market, down 6.6%. Allegations of fraud and price manipulation in recent months are a reminder that India still has a lot of work to do before it can be considered a developed market.

Bonds: Will there be a recession (bis)?

The bond portfolio generated a return of 3.2% in the first quarter. In addition to the current interest paid during the quarter, the price of bonds actually rose as a result of significant net purchases by investors.

Source: National Bank of Canada, Bloomberg

Investors clearly regained their appetite for bonds, as they purchased more bond ETFs ($5.4 billion) than equity ETFs during the quarter. Bonds are attractive not only because they provide higher interest payments, but also because they offer a degree of protection in the event of a recession. The recent drop in the yield to maturity on 10-year U.S. bonds from 4.2% to 3.5% (and the corresponding increase in value) provides a taste of the protection bonds will offer in a recession.

If you don't listen too much to the doomsayers, you still protect your portfolio with a good dose of bonds.


[1] At the beginning of 1977, the Federal Reserve began a cycle of increases in its key rate in order to curb the inflation caused by the oil crisis. This rate peaked at 20.61% in 1981.

[2] Radio-Canada, Les faits d'abord

[3] Take comfort in the fact that the average hedge fund generated an annual return of 5.0% from 2011 to 2020, almost three times less than the 14.4% of the S&P500