The very strange ‘Year That Was’

Thoughts on inflation, stocks, bonds, and landings hard and soft

In this month’s column I look at the “Year That Was,” and what I learned during one of the most tumultuous investing years in recent history.

Inflation: Up, up and away?

In 2022, after nearly four decades of low interest rates, the developed world started to come down off the sugar high of cheap money. And it wasn’t pretty. For so long, dovish central banks, along with structural trends such as globalization and changing demographics in the rich world, provided the tailwinds for keeping inflation benign – at least on the surface. (Asset bubbles were building elsewhere.) Offshoring manufacturing and service jobs meant lower costs for businesses and weakening bargaining power for workers, which kept wage growth in check, thus reducing cost-push inflation. As populations in the rich world aged, they saved more and spent less, which tamped cost-pull inflation.

With the onset of the global pandemic two years ago, central banks ploughed money into the economy and directly into our pockets, but bottlenecks in global supply chains, a war in Europe, along with weak harvests of essential crops shot up the prices of just about everything. Not surprisingly, rising interest rates have had a deleterious effect on asset prices such as real estate, equities and – wait for it – bonds, too. While few would have exactly predicted the events of the past year, history informs us not to be too surprised.

On a macro level, it is virtually guaranteed that at some point we’ll experience: 1) war and political dissent; 2) natural disasters; 3) economic fluctuations of both collapse and growth, and; 4) technological advances and resistance to them. Accepting there will be downs in life, as well as ups, helps increase the possibility of good outcomes in our decisions.

Soft landing or stinging smackdown?

“The Year That Was” also offered a great reminder to read beyond the headlines or, as Howard Marks puts it, practice “second-level thinking.. Will the assertive ministrations of central banks knock inflation down a peg or two in 2023? Perhaps, but don’t count your chickens. Whether we experience a soft landing or a stinging smackdown is up for debate.

Commodity prices are dropping, and consumer demand is softening, businesses, including big spenders such as Amazon and Meta, are containing costs and initiating layoffs. The University of Michigan’s Consumer Sentiment Index has remained low by historic standards. Growthier, high-tech stocks were severely punished this year for missing forecasts. Those companies whose share prices took it on the chin in 2022 may enjoy a reprieve next year. When nobody is expecting good news and most of the bad news is baked in, it’s not that hard to surprise on the upside where a little good news can go a long way. Indeed, subsequent returns in the year ahead when consumer sentiment is pessimistic tend to be much higher than when everyone is feeling jubilant. Investors will likely enjoy better future returns coming off a lower base.

While it may be too early to jump back into the water, in my opinion, it is certainly a reasonable time to put some investment dollars to work in overly punished sectors with strong secular trends that are now priced at attractive valuations.

Of human bondage: what happened to bonds in 2022?

Bonds of all flavours – government, corporate, emerging markets – took a bruising this year. Normally, an allocation to bonds is meant to provide ballast to a portfolio by smoothing out the volatility from equities while providing a cushion of income. This year, bonds flipped the script as 2022 saw the worst bond market drawdown in decades. Investors sold their bond holdings due to central banks’ aggressive rate hikes and the spectre of slowing economic growth. (Higher interest rates make the yield on current bonds less attractive to investors.) Long-dated bonds, which are more sensitive to changes in interest rates, shook the market the most. The authors of the blog “Bond Vigilantes” compare long-duration bonds to a giant anaconda, drawing little attention during periods of slumber but rattling markets once it is awakened. On a more positive note, investors are finally getting a decent yield and some investors are wading back into the higher-yield market.

“The Year That Was” offered a master class in never being too complacent because anything can happen – and it usually does. Investors who embraced the FAANGs too enthusiastically, for example, had a hard go of it in 2022. On the other hand, those who had built diversified portfolios that included an allocation to non-correlated assets (and, no, I don’t mean crypto tokens), likely benefited from a smoother ride and better overall returns. Whether presciently or not, Pender launched our liquid alternative strategies more than a year ago, and I’m happy to report they have performed as advertised, providing market neutral returns to our investors.

What else I learned in the “Year That Was”

The uncertainty principle: I don’t know about you, but my crystal ball broke a long time ago. Instead of imagining what might happen next, I continue to lean into Pender’s investment process: pursuing a deep understanding of fundamentals to discover quality businesses at reasonable prices and other securities that are mispriced.

Conscious decoupling: The bond route was an excellent reminder to never assume anything when it comes to investing. Asset correlations can hold for a long time – until they don’t. If you are planning for a future that depends on things being the same as they are today, you’re going to be sideswiped when things change. As investors, it is vital to always have multiple tools in the kit. Here at Pender, we leverage our strengths in mandates that we believe operate in less efficient parts of the market and our flexibility to adapt to drive long-term investment performance. For investors who prefer fewer ups and downs, we have mandates with low correlation to the markets, and, also mandates that provide meaningful diversification throughout the economic cycle.

Finally, gratitude. A heartfelt thank you to our many supportive clients and to the Pender Team whose underpinning has been both the ballast and the wind in our sails during the “Year That Was.”

Felix Narhi, CFA, is Chief Investment Officer and Portfolio Manager at PenderFund Capital Management and Portfolio Manager of the Pender Global Focused Fund and the Pender Strategic Growth and Income Fund. This article first appeared in the Pender blog. Used with permission.

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