2021 Q3 Newsletter
Welcome
We welcome you to our inaugural quarterly newsletter. Its purpose is to provide us the opportunity to reflect upon both what has transpired in the past quarter (and/or year to date) and discuss our view as we go forward. While the newsletter is a work in progress and may later undergo changes in structure, content, etc., we hope it helps you understand our perspective, in brief. Thank you for taking the time, and we hope you regularly enjoy the read.
The Rear View and the Front View
We just ended a third quarter that was essentially flat as far as the major North American equity indices go (S&P/TSX Composite down 0.5% in Q3 and S&P 500 up 0.2%). Bond indices were similarly flattish, with price returns of -1.2% on the Canadian bond market1 and -0.4% on the U.S. bond market2.
Though the equity indices were little changed, there was much movement underneath the surface. Growth equities outperformed value equities on the quarter, as the path of the delta variant quelled enthusiasm for so-called “re-opening” investments. However, Q3 ended with overall sentiment weakening, as a rapid rise in bond yields over last couple weeks precipitated a sell-off in high-multiple growth stocks, including U.S. mega- cap stalwarts like Apple, Microsoft, and Google. U.S. 10-year treasury yields finished the quarter at 1.49%, still low in absolute terms but notable given they rose very quickly toward quarter-end.
The U.S. Federal Reserve finds itself in a rather uncomfortable place today. Back in August at their Jackson Hole meeting, we were quite taken back as we watched Federal Reserve speakers, one after another, tell us they still believe inflation is transitory and describe a systematic, orderly unwind of their QE program between now and the middle of next year. In our view, that plan was unrealistic, given our understanding of what is causing inflation today. We suspected bond markets would move ahead of the Fed in pricing in such inflation.
We do note that their tune has changed somewhat since then, as many Fed appearances in the past few weeks have acknowledged that inflation is proving far higher and stickier than anticipated, in fact worsening in some cases. Economic demand remains strong but supply shortages, including labour and critical finished goods like semiconductors, are persisting, and it looks like these supply shortages will constrain growth and fan inflation well into next year.
It is our view that the recent move in bond yields occurred because market participants are incorporating higher inflation premia, not higher real rates, into bond prices. They may also be pricing in earlier interest rate hikes than the Fed is forecasting via their dot plot disclosures. We think yields will continue their ascent in Q4, in fact it would not surprise us if the 10-year Treasury approaches 2.0% by calendar year-end. Such a move would continue to pressure high-multiple growth equities, in our opinion.
The Fed has a dual mandate to set policy for maximum employment with stable prices, yet for now, they seem more concerned about employment than prices. That said, the data suggests there are lots of job openings that are not being filled, for various reasons. We believe there are some important yet unquantified structural frictions to hiring that are underappreciated by the Fed. For but one example, the employment skills mismatch (candidate skills vs. job requirements) was already a big problem before COVID-19, and has only grown larger over the last 18 months. as the digitization of the economy accelerated without a taking a proportional number of workers with it. Such factors don’t seem prominent in the Fed’s thinking, and the risk is they wait too long for employment that just isn’t coming, while inflation endures for an extended period of time (albeit abating somewhat from current levels).
In short, we believe the Fed is behind the curve, and if it continues to remain steadfast that inflation is transitory, and that employment is the more important policy goal vis a vis inflation, we believe the Fed risks exacerbating this policy error. If we’re correct, both bond and equity markets could ultimately be challenged over the next twelve months.
Our Model Portfolios
For those who aren’t aware, ATH manages multiple model portfolios for clients of all size. Our models include capital growth portfolios, income portfolios, and specialty equity portfolios. We began Q3 with fairly defensive positioning across all our portfolios, which we generally maintained as the quarter progressed.
Capital growth
We limited our fixed income allocations to short-duration, investment-grade bonds and real-return (inflation-protected) bonds, given our forecast for rising rates. As the quarter unfolded, we added some gold exposure, which has most recently been pressured by U.S. dollar strength, though we continue to believe a modest allocation to gold is appropriate in the current context. We reduced exposure to more interest-sensitive equities, though we continue to hold select publicly-traded real estate and infrastructure – hard assets with secular growth drivers which we believe can do well in an inflationary environment. Finally, we maintain significant exposure to both North American and global equity markets, though we closed the quarter holding a higher-than-normal level of cash, providing us optionality to re-allocate and/or re-enter positions at better valuations in Q4.
Income
With interest rates still low in absolute terms and credit spreads tight, our income portfolios maintain significant emphasis on dividend-paying stocks, and specifically steady dividend-growers. We also hold some REITs and infrastructure equities, despite their potential interest rate sensitivity, given the inflation protection provided by the hard assets underlying those securities. Finally, we have a small allocation to inflation-protected bonds.
Specialty equity
Our specialty equity portfolios serve to generate alpha over the long term. We note these portfolios hold concentrated positions in a number of opportunistic/special situations with varied catalysts. As such, their performance will deviate in the short-term from diversified market indices, with the goal of long-term outperformance vs. the market. The portfolios currently reflect a bias toward companies with strong pro-forma free cash flow profiles that would typically be characterized as value/cyclical. We also hold significant cash in these alpha-focused portfolios at this time, enabling tactical execution as conditions evolve.
1 As measured by the Bloomberg Global Aggregate Canadian Float Adjusted Bond Index.
2 As measured by the Bloomberg U.S. Aggregate Bond Index.