Q3 | 23

Global interest rates have sparked widespread discussions, challenging the belief held by a generation of investors that U.S. Treasuries represent a safe-haven asset. We find ourselves over a year into a period marked by significant interest rate hikes orchestrated by central banks, aimed at unwinding the post-Covid spending euphoria. During this time, interest rates have surged, particularly due to the persistent nature of inflation related to services and labour. The U.S. 10-year treasury is heading towards its third consecutive year of losses, potentially marking the longest bear market in fixed income history, should current conditions persist. At LDIC, we’ve managed to mitigate much of this turbulence by maintaining investments in short-duration fixed income assets.

Throughout 2023, the global economy has walked a fine line between persistent (sticky) inflation, requiring further interest rate hikes, and the risk of a recession. So far, the economy has exhibited signs of a soft-landing pattern. Recent data points to robust third-quarter U.S. real gross domestic production (GDP) growth at an annualized rate of 4%, matching the growth in real consumer spending. Consumer spending accounts for more than two-thirds of U.S. GDP. After a strong Q3, the market expects economic growth to recede to a 2% pace in the fourth quarter.

In addition to rising interest rates, another significant theme in the third quarter was the rapid increase in oil prices, surging from U$70 to U$90. These elevated energy prices contributed to the rise in consumer prices (CPI). While energy stocks performed well, they couldn’t keep pace with the rapid ascent of the commodity. Our belief is that high-quality energy producers will reap benefits from sustained higher oil prices over the medium term.

Considering the challenges posed by rising interest rates and escalating oil prices, we had a correction in the third quarter. In local currency, the Canadian stock market was down 2.2% and the S&P 500 fell 3.3%. The Energy sector was the standout performer, rising almost 9% in Canada and being the only sector to achieve double-digit gains in the US, up 11.3%. Lagging were the interest sensitive sectors, including Telecommunications, Real Estate and Utilities in both markets. In Q3, stocks outperformed bonds. Both the Canadian Universe Bond Composite and the U.S. 10-year Treasury Bond experienced negative returns of 3.8% and 4.8% respectively. Meanwhile, the Canadian dollar depreciated by 2.6% against the U.S. dollar.

So far this year, stocks have shown positive returns, while bond prices have faced challenges. In the context of increasing interest rates, the growth-oriented U.S. market has outshone its value-focused Canadian counterpart. In 2023, when measured in Canadian dollars, the S&P 500 has exhibited impressive growth, surging by 13.3%, surpassing the Canadian stock market, which saw a more modest 3.4% increase. Particularly noteworthy is the dominance of growth sectors, with US Communication Services, Technology, and Consumer Discretionary sectors outpacing the performance of Utilities, Real Estate, and Consumer Staples.

The current market focus has shifted to fixed income investments and the movements in yields. There is growing concern that larger government deficits will lead to an extended period of higher interest rates, given the higher supply of bonds. At LDIC, we have managed our bond portfolio, avoiding material losses by focusing on the shorter end of the yield curve. Looking ahead, we believe that, for the first time in a while (considering the era of near 0% interest rates), bond yields are once again becoming an attractive investment. It’s been years since prospective returns on fixed income have been competitive with those of equities.

Historically, stocks have performed at their best when inflation has been on a declining trend, as we’ve seen for much of 2023. If we are entering a phase of more stable inflation, even if at slightly higher levels, the stock market should perform in line with its long-term historical averages. Several positive factors are worth noting. With the recent rise in interest rates, third-quarter earnings expectations have been modest. Investors are holding high levels of cash ready for redeployment. Consumers are employed and are maintaining healthy balance sheets. The economy, while not extraordinary at 2% growth, is stable, and central banks have the flexibility to reduce rates if inflation subsides. We believe the Federal Reserve’s tightening cycle is in the past, and currently, the likelihood of another rate hike in 2023 is less than 20%, with the possibility that it could be the final one. The market is currently anticipating a Federal Reserve rate cut in Q3 of 2024.

The market correction in stock prices during Q3 has helped in tempering excessive optimism. However, there has been a recent and meaningful increase in geopolitical risks that need to be monitored. Concerns about a potential recession persist, and uncertainties related to China are still prevalent. While we have made notable progress in 2023, the path forward remains somewhat unclear. As we previously indicated in Q2, we would adopt a more optimistic stance if we were to see a clearer path toward strong earnings in 2024, and improved market breadth. It’s important to note that one of the underperforming areas since the commencement of the rate hiking cycle is leverage. Stocks with higher leverage have generally displayed weaker performance. Our focus remains on high-quality businesses and strong management teams, but now, more than ever, we are placing an emphasis on avoiding high leverage investments.