Quarterly Markets Update: Q3 2023
October 24, 2023
October 24, 2023
Welcome back for another quarterly investment update from your team here at Matco. Investment markets were kind to investors in the first half of 2023.
Despite North American corporate profits shrinking in the first two quarters of the year, investor optimism held strong. Inflation continued its downward trend, central banks nearing the end of their interest rate cycles, and the labour market remaining resilient were all reasons enough for investors to push stock prices higher.
As you might recall from our mid-year market update, our view was that the branch budding fruit for investors lacked a little bit of the sturdiness of growing corporate profits. As asset managers, we’re far more comfortable with a market rally when corporate profits are growing, not shrinking.
Our skepticism seems to have been warranted.
Although pumpkin spice latte season is upon us, some of the froth in stock markets began to fade throughout the third quarter. The Canadian and U.S. stock markets both traded lower by 3% and 3.6%, respectively, over the last three months. This leaves the Canadian market up 0.8% and the US market up 11.7% year to date. We do take some comfort in the fact that profit or earnings expectations for the second half of this year are more positive than the first half.
Although this may provide some buoyancy for stock markets as we progress through the remainder of 2023. We do remain cautious, focusing on companies with quality balance sheets and stable earnings profiles. Now, a few notable highlights from the third quarter are worth mentioning.
First, the US Government’s credit rating was downgraded by the Fitch rating agency at the beginning of August from a rating of AAA to AA+. They cited unsustainable debt and deficit trajectories. Although the initial interest rate reaction was muted, both Canadian and U.S. interest rates trended higher through the third quarter. The Canadian ten-year rate and the US ten-year rate both reached 4% and 4.5%, respectively, for the first time since 2007.
Second, a silver lining in the Canadian economy was the positive trend for oil prices in the third quarter. OPEC+ agreed to extend their oil production cuts in June and again in early August. As a result, oil prices began the quarter at US $68 a barrel and moved swiftly higher to US $94 a barrel by the end of September. Although this is a positive for North American energy producers, it may be a double-edged sword for consumers and inflation going forward.
Third, the Bank of Canada and the US Federal Reserve stepped to the sidelines in the month of September, leaving their overnight interest rates unchanged at 5% and 5.5%. After each announcement, both central banks left the door open for further rate increases if inflation does persist. Whether further rate increases are on the horizon, our view is that most of the interest rate punches have been thrown.
Important to note. Just like taking a real punch, the economic headache from higher interest rates tends to occur well after the fact. This is referred to as the lagged and variable effect, as famously worded by American economist Milton Friedman. It simply means that the pain from higher interest rates and borrowing costs takes some time to filter its way into the real economy. Likely a significant story for next year in 2024.
This segues us nicely into our outlook over the next 6 to 12 months. The economy remains in healthy shape. The labour market has proven resilient, with unemployment rates at historically low levels. This has allowed the North American consumer to keep the economic engine running strong. However, the market is much like hockey, and that, as Mr. Gretzky used to say, it’s about where the puck’s going, not where it is right now.
From that perspective, we can’t help but be cautious and have a little bit of a cautious outlook. Our thesis hinges on three primary risks.
Risk number one: Higher borrowing costs, as mentioned, take time to filter their way into the economy. These lagged effects are likely to be felt by consumers and corporations in 2024.
Risk number two: The excess household savings that were created because of the COVID-19 pandemic have been dwindling. Households will rely more on their income to propel their spending going forward without a material savings buffer to bridge those gaps.
Risk number three: Corporate profitability in North America, although positive in select pockets of the economy, continues to face challenges, broadly speaking. Higher input costs, employee wage pressures and higher debt may limit the growth of profits going forward.
Now, as we progress through the remainder of 2023, it’s important for investors to remain focused on their long-term investment objectives. Although we continue to prioritize the protection of capital over growth, the markets and economy are dynamic and ever-changing. Matco’s disciplined investment process allows us to manage assets through all market cycles. Whether the economy is expanding, shrinking or trending sideways, we focus on consistent execution.
Matco’s Balanced Fund is a multi-asset class portfolio with exposure to fixed-income, Canadian and global equities. The oversight of the Fund’s investment mix is actively managed by Matco’s Asset Mix Committee.
Our primary risk tool, the Investment Horizon indicator, increased from the neutral zone and moved closer to the protect zone earlier this year. Approaching the protect zone indicates, from a risk management perspective, the fund’s mix should prioritize the protection of capital. As a result, the committee made an active adjustment in the first quarter by decreasing the fund’s global equity exposure by 5% while increasing its fixed income exposure by 5%.
Since the first quarter, the committee has held steady with our investment mix as the equity risk premium continues to drift lower. We will continue to assess the outlook and determine if further de-risking is appropriate heading into 2024. The fund is up 0.7% year to date.
The Canadian stock market started this year strong and was leading job markets in the first two months of the year with a gain of 7%. However, since then, the Canadian market has significantly lagged other markets. There are three main reasons for this underperformance so far.
First, in 2022, the Canadian market was down only 6.5%, while other developed markets were down double digits. As a result, markets were down. More like the US and Europe have had a stronger rebound this year than the Canadian market.
Second, the Canadian stock market has a small weight in the technology sector relative to other markets. The technology sector has led the rally this year, up 30 to 40%. Keep in mind this sector was down 50 to 70% last year.
Third, our stock market has a larger exposure to the financial sector, which is interest rate sensitive in the energy sector, which for most of this year faced falling oil prices and natural gas prices as recession headlines loomed.
The Matco Canadian Equity Income Fund primarily invests a mid to large cap dividend paying companies and is diversified across various sectors. Year to date, the fund is up 1% but has an annualized return of 8% over the last three years. The fund continues to have a bias towards income-focused sectors, resulting in a dividend yield of 3.9%, which is higher than the TSX index at 3.5%. During the quarter, the fund trimmed its position in BRP Inc., Canadian Western Bank, CI Financial, Loblaws, and Nutrien.
The fund increased its position in natural gas producer Tourmaline oil. The fund remains well-diversified across sectors but is underweight energy and material companies relative to its benchmark at the end of September. The largest sector weights are financials at 29%, industrials at 22 and energy at 17%.
In the third quarter of 2023. Global equity markets were mixed. The momentum from June carried into July. However, elevated valuations in the US large capitalization stocks, weaker European economic data and a challenging Chinese property market weighed on returns in August and September.
The Matco Global Equity Fund follows a growth at a reasonable price-investment strategy, where we uncover securities with growth potential at fair valuations. In down markets, this strategy allows us to stand out from our peers. The main contributor to the performance for the fund in the third quarter was our large-capitalization U.S. equity strategy. While the main detractor to the fund’s performance was the exposure to mid and small-capitalization US stocks.
Activity in the fund was modest in the third quarter, where we primarily trimmed our U.S. equity positions after seeing positive performance in June and July. Year to date, the fund has returned 7.5%. Over the last year, the fund’s return was 17%. And our three-year annualized rate of return is 8.8%.
Small-cap stocks globally have lagged their large-cap peers for the last three years. Concerns about a global recession have driven valuations on small-cap stocks into deep value territory. In fact, today, small-cap stocks are at the lowest valuation in 20 years relative to large-cap companies. Globally, the two segments of the market that appear to be most undervalued are small-cap companies and energy companies.
The Matco Small Cap fund invests in smaller dividend-paying companies that are typically growing faster than the overall economy. Year to date, the fund is down 2.1% but has an annualized return of 5.8% over the last three years. The fund has a high dividend yield of 5.9% as of the end of September. During the quarter, the fund sold its position in the Calian Group, Gear Energy, Cardinal Energy, and Surge Energy.
The fund purchased new positions in Alvopetro Energy, AG Growth International, Bridgemarq, Chemtrade, Extendicare, Atrium Mortgage, American Hotel Real Estate, and Lassonde Industries. The fund is well diversified but has a bias towards global growth, with the three largest sector weights being financials at 19%, energy at 16%, and materials at 15%.
Matco’s Fixed Income Fund is a portfolio constructed of Canadian investment-grade bonds with the sole focus of preserving capital while generating a healthy income. The fund employs a multi-strategy approach, optimizing its interest rate, credit and yield curve exposures. Given the more attractive yields offered in the marketplace, coupled with the prospect of central banks nearing the end of their interest rate increase cycles, the fund has extended its duration by 1.6 years in the last nine months.
Since the beginning of 2023, the fund has also reduced its corporate and preferred share exposure by 7.7% combined. The recent duration extensions and the reduction of corporate bonds are both proactive approaches to take advantage of higher interest rates while protecting the fund from deteriorating credit conditions. The fund’s current duration is 7.4 years, with the current yield of 3.4% and the yield to maturity of 4.8%.
Overall, the fund is well-positioned to generate healthy income while also reaping the benefits of capital appreciation if interest rates do decrease in 2024, as we anticipate they will.
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