Market Commentary

Redefining Normal

Exiting the pandemic, we all hoped that the world would get back to normal, and in many ways it has.  The investment landscape of the last twenty years has been atypical, however, with very low interest rates and significant monetary interventions.  With central banks reversing course, the market normal that we settle on could be one that we have not seen in a while.

Here are some of the trends we think are redefining what normal looks like for markets in 2023:

• Positive real interest rates:  If we take 10-year U.S. Treasury yields less 10-year inflation expectations, real rates declined from a high of 2.5% in May 2006 to a low of -0.8% during the depths of the pandemic, in August 2020.  The fall in rates pushed down the discount rate and pushed up the valuation of practically every asset class. 2022 showed what happens when the trend reverses.  With the Fed hiking rates and investors betting that the central bank will tame long-run prices, real rates are now back up to 1.5%, with inflation expectations running at roughly 2.5%.  With real rates much healthier, there are more options in fixed income to beat long-run inflation.  This is likely to pose a headwind to equities, particularly for lower growth, lower yielding names.
   
• Inflation and wage pressures:  Average weekly earnings in the U.S. are up 7.7% in nominal terms since October 2019, but with inflation rising, earnings are flat in real terms.  Pre-pandemic, real earnings rose at a CPI-adjusted 0.6% CAGR between October 2006 and October 2019.  For investors a return to normal wage growth poses a Catch-22:  either wages move up to offset inflation, which will pressure corporate profits, or wages erode and consumer spending gets squeezed.  Sectors that require a higher labor component are likely to come under pressure.
   
• Narrowing corporate margins:  Based on S&P Global data, operating margins on the S&P 500 went from 11.1% in 2019 to 13.3% in the economic rebound of 2021, but are on pace to revert to 11.5% in 2022.  In our view, the pent-up demand, which drove corporate margins in 2021 and the early part of 2022, has now all but faded.
  
  Even if margins remain at 2022 levels, consensus S&P500 operating earnings for 2023 require sales growth of more than 13% this year.   If instead, sales grow at 8% with margins reverting to 2019 levels, earnings would miss current consensus by 8%.  For reference, average sales per share growth between 2010 and 2019 was 4.4% CAGR, while average operating margins were 9.8%.  At these levels, earnings would miss consensus by more than 21%. The tech sector could be especially vulnerable because of their historically outsized margins.
   
• Slowing Chinese growth:  Based on World Bank data, China remains the world's second largest economy, making up roughly 18% of global GDP in nominal terms and accounting for 45% of global GDP growth over the decade ended 2021.  China's growth over that period averaged 8.9% CAGR.  In 2022, China is expected to have grown at half that rate, shaving about 80 basis points off the global growth rate last year.  With China the largest buyer of most commodities - by some estimates more than 50% of cement, aluminum, nickel, coal, copper and steel - it is hard to see a bullish case for commodities unless Chinese growth rebounds.  At the same time, if China does return to historical growth rates, commodity pressures could drive another round of inflation.
   
• Loss of tech leadership:  In 2015, ProShares launched an ETF that models the S&P 500 excluding technology stocks (SPXT).  From 2016 to the end of 2021, the ex-technology ETF trailed total returns for the 500 index by roughly 60%.  Since 2021, the bloom has clearly been off technology stocks.  The ex-technology ETF returned -14.2%, outperforming the full S&P 500 by about 3.9 percentage points.
  
  Investors' willingness to pay for technology exposure has also adjusted.  Entering 2021, investors were willing to pay 28.0x forward operating earning for IT stocks, a 6.7x premium over the 21.3x multiple paid for the S&P 500 overall.  Entering 2023, this premium has narrowed to 3.3x, with investors paying 20.3x for IT and 17.0x for the S&P 500 overall. Arguably, the narrowed gap now accounts for differences in long run earnings growth, but in many cases the gap does not reflect the risk of missing earnings estimates if economic conditions worsen in 2023. Stock selection will be key because we expect market's to be extremely unfriendly to companies that miss consensus.
   
• Shifting consumption patterns:  The most direct effects of inflation and rising interest rates are typically a drag on durable goods spending.   In the U.S., we begin to see signs of this drag in Q2 2022 when expenditure growth on durables fell to 3.2% year-over-year, well behind inflation.
  
  Perhaps the most telling example is U.S. light vehicle sales, which are set to come in near 13.5 million units in 2022, down about 20% versus 2019.  We do know that autos have seen some of the worst supply chain difficulties during the recovery and that work-from-home trends have the potential to eat into demand, so the slowdown is perhaps not surprising.  The question is whether sales have bottomed and when they will recover.
  
  The Great Financial Crisis may offer some clues.  U.S. light vehicle sales over the three pandemic affected years 2020 to 2022 are down -16% versus the three years prior (2017 to 2019).  The drop post financial crisis was similar at -24% (2009 to 2011).  The good news is that vehicle sales were able to recover from the 2011 slump, growing at 8% CAGR over 2012 to 2015, plateauing above 17 million units from 2015 to 2018, falling to 16.9 million units in 2019.
  
  The message then is that durables spending can recover, but it remains unclear whether the bottom is in.  The direction of auto sales will be an important indicator and the move in interest rates could play a factor given the importance of financing in vehicle sales.

As a result of these trends, we think the current investment landscape carries an above normal level of risk.  Companies with strong balance sheets, sustained cash flows and capable management teams should still be able to navigate these risks with minimal downside.  To sort out the good from the bad, we continue to benefit from the work of Veritas Investment Research, which remains one of the best research shops on the street.

In 2022, the NASDAQ was down -32.5%, the S&P 500 was down -18.1% and the S&P/TSX was down -5.8%.  Both our funds closed out the year ahead of the three indices, with our Canadian Equity Fund posting a -1.0% return and our Absolute Return Fund returning -5.2%.  (Performance based on F series). 

As always, we remain focused on capital preservation during the current market volatility while seeking out the best opportunities to drive returns.

We thank you for your continued support.

Your fellow investors,

Anthony Scilipoti
Sam LaBell

Veritas Absolute Return Fund February 2023 Performance Sheets
Veritas Canadian Equity Fund February 2023 Performance Sheets

Source: Refinitiv, S&P Global, Veritas Asset Management estimates as at December 31, 2022. Past performance is not indicative of future performance. The S&P/TSX Composite Total Return Index is a Canadian dollar denominated, capitalization-weighted index that includes the largest float-adjusted stocks trading on the Toronto Stock Exchange, subject to inclusion criteria. The index provides the broadest representation of market-weighted returns for large capitalization Canadian-listed stocks, including reinvested dividends, making it an appropriate index for diversified portfolios that invest primarily in Canadian stocks, such as the Veritas Absolute Return Fund and the Veritas Canadian Equity Fund. While our funds are benchmarked against the S&P/TSX Composite, we may reference returns for the S&P 500 and NASDAQ Composite, as well as yields on U.S. ten-year Treasury bonds, which we view as relevant investment benchmarks for investors in North American equities. The S&P 500 represents approximately 80% of the total market capitalization of U.S. stocks and remains the most broad-based indicator of large-cap U.S. equity returns. In contrast, the NASDAQ has a greater proportion of technology and growth stocks, which we view as providing additional insight into investors' risk appetite. Where applicable, the ten-year U.S. Treasury rate is referenced as a measure of the lowest-risk investment alternative to equities (‘the risk-free rate’). Contact Veritas Asset Management Inc. for more information regarding comparative indices. 

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