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rebalance summary

Q3 2022

Without a doubt, inflation trends are facing much scrutiny and trepidation of late. As most central banks worldwide scramble to hike interest rates and re-anchor inflation expectations, financial markets have exhibited a panicky response. This is unsurprising, as investors had become accustomed to a deflationary environment over the past decade in which central banks took an active role in supporting the economy and asset prices. Furthermore, interest rate hiking cycles frequently tilt economies into recession.  

Having a well-informed view of the underlying inflationary pressures and their respective trajectories is thus imperative, as it will dictate the extent of the monetary tightening measures required and the corresponding economic deceleration. Energy cost increases have been playing a catalyzing role. As such, it implores that we briefly review the current world state of hydrocarbons.

First, of course, it must be acknowledged that recent oil price trends are almost solely driven by the Ukraine/Russia war — as well as geopolitical posturing of non-aligned nations. We do not see an overheating economy driving up oil prices, nor for that matter general commodity prices. If anything, resource nationalism and hoarding have been the greater causes of rising prices.

However, when it comes to commodities, the following must also be acknowledged: 1. That the cure for high prices is high prices. 2. That there is no shortage of energy (and many other commodities) viewed globally. And, finally, 3: That supply/demand conditions can change drastically and quickly. For example, consider that just less than two years ago, crude oil was briefly selling at a negative value.

What will the world look like another two years into the future? We can be sure of at least one perspective: conditions will be drastically different than what we see playing out now. But beware. While many analysts and investors may be jubilant about rising and record-high energy prices, a tsunami of “hurt” will likely beckon. We will explain.

In recent years, much human action affecting financial markets has been driven in defiance of free market economics. Historically, economies (and wealth) have been driven by rising productivity and the demand/supply curve squeezing prices … not causing higher costs. 

To the contrary, what we see today is that human choices and actions have been based on value changes and preference, not economic efficiency. Global demographic trends and carbon neutrality may indeed be the preferred actions for humans, but they come with a price. Kilojoules will become more expensive. Natural market forces play only a small role here. And partly because of that, we are witnessing severe financial market adjustments today.

Oil and gasoline prices may be soaring at this time, but it will not be all roses for energy producers, as alluded to earlier. High hydrocarbon prices provide a competitive boost for renewables supply, which simultaneously benefit from relatively price inelastic government-sponsored funding. ESG trends and advocates of countering global warming are and will be as dedicated to their causes as before; emboldened by the support of governments, the UN and popular consensus on their side. After all, carbon dioxide levels in the atmosphere are still rising (according to recent statistics from the UN). As such, we are of the view that there will be some populist retribution coming in the direction of Big Oil with or without a war in the Ukraine. 

All the foregoing considered, will eventually lead to lower hydrocarbon prices. With no world shortage of oil and other hydrocarbons, a slowdown in global economic growth will further cool energy demand. Concomitantly, inflation fires will be doused, as well. A technical recession (defined as at least 2 quarters of contracting GDP growth) may ensue as financial conditions continue to tighten in the near-term. But the likelihood of a prolonged, severe recession and grinding bear market for risk assets has been grossly overestimated by investors and the financial news media. Assets dependent on low interest rates remain vulnerable. But several asset classes now offer starting valuations and yields that should lead to attractive longer-term returns.


Cash levels unchanged

  • Cash and equivalents’ continue to offer a trade-off between acting as a buffer against volatility while simultaneously reducing purchasing power as inflation remains elevated. 
  • We have elected to maintain cash near neutral levels this quarter.

Currency risk management in focus

  • Foreign currency volatility has been elevated this year, with widening interest rate differentials at the root of swings in major pairs.  
  • From a risk management perspective, it is prudent to cling close to shore during such periods, especially as the loonie has tailwinds from a relatively hawkish Bank of Canada and high energy prices.
  • We have maintained partial hedges on US and European currency exposures in client portfolios this quarter.


    Decreasing equity overweight

    • We remain constructive on global equities which offer a decent inflation hedge and have had much of the froth drained out of their valuations amidst the challenging environment year-to-date.

    • Conversely, we see risk emanating from tightening liquidity conditions and forward earnings expectations which have not fully adjusted to the shifting economic circumstances.

    • Equity positioning remains overweight, but we have modestly decreased exposure this quarter.

    Overweight Chinese A shares

    • China’s punitive COVID lockdowns have caused a severe economic disruption. While the timing of a full re-opening is difficult to forecast with any precision, restrictions have begun to gradually ease.

    • Policy-sensitive onshore stocks should benefit from increasingly accommodative monetary and fiscal conditions, as policymakers attempt to repair the damage.

    • Overweight exposure to onshore Chinese (A share) equities has been maintained this quarter.


    Increasing fixed income exposure

    • The surge in nominal bond yields in response to inflationary pressure and central bank rate hikes has sharply improved the long-term expected return outlook for the asset class.

    • However, stubbornly sticky inflationary pressure is keeping real rates deeply negative, which has done little to reverse investors’ near-record aversion to bonds.

    • Fixed income exposure has been increased but remains modestly below neutral levels in client portfolios.

    Staying short duration…for now

    • As major global central banks begin or continue to tighten policy, bond market focus should pivot from inflation to growth; benefitting the long end of the curve. 

    • We believe it is too early to lengthen duration just yet, as inflation continues to be the dominant focal point for the time being and the US Federal Reserve begins shrinking its balance sheet. 

    • Short duration (overweight floating rate debt in particular) positioning has been maintained this quarter.


    Pivoting Chinese asset class exposures

    • China’s increasingly accommodative policy stance and dampening enthusiasm for aggressive internet regulation should provide a tailwind for offshore stocks. 

    • However, the stark difference in monetary policy versus the developed world has significantly eroded the yield advantage historically enjoyed by Chinese bonds. 

    • A position in Chinese aggregate bonds has been liquidated in income-oriented strategies, while offshore Chinese (H share) equity exposure has been increased in balanced and growth-oriented strategies.

      Adding to mortgage REITs position

      • Mortgage REITs (mREITs) have had a challenging year, as mortgage-backed security (MBS) spreads widened on US recession concerns. 
      • With US consumers still in good financial health despite slowing economic activity, MBS spreads should stabilize and delinquency rates should remain muted; allowing mREITs to produce an attractive yield without further book value impairment.
      • mREIT exposure has been increased in income-oriented strategies this quarter.
      Portrait of David Kletz, VP & Portfolio Manager of Forstrong Global.

      David Kletz

      Vice President, Portfolio Manager

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