Tracking the Tides
After outperforming markets in 2022, our three funds underperformed the S&P/TSX in the first half of 2023, as we remained defensive during a period of rebounding valuations and economic strength.
Looking ahead, labour markets remain tight, consumer spending is healthy and inflation is decelerating. As encouraging as the economic data may be, we see signs that the global economy is struggling to adjust to cost pressures and higher interest rates. Earnings estimates have not moved even as many companies are lowering their guidance for the second half.
If a deeper economic slowdown is avoided, the reward is likely to be rising earnings and share prices, but in the meantime a degree of caution is warranted as the global economy transitions to higher rates.
This quarter we take a closer look at the current economic backdrop and our expectations for the second half.
No forward motion on earnings
At present, next-twelve-month earnings for the S&P 500 are roughly the same as where they were entering 2023, even after rolling the estimates forward two quarters to Q2 2024. With the S&P up on the year, investors are now paying about 17% more for the same level of forward earnings. Given flat estimates, the year-to-date rise is entirely due to multiple expansion and expectations beyond the next twelve months.
Of course, buying into the higher valuation necessarily requires greater optimism about what lies ahead, including believing that the global economy will avoid a further slowdown; inflation will retreat; and central banks will find room to pause or even cut rates.
Low savings rates driving consumer spending
U.S. personal consumption expenditures (PCE) have been positive for every month since January 2021 and have been growing in real terms at 2% to 3% for each of the first five months of 2023. It's worth considering, however, how much of that growth is catch-up from pandemic spending.
Saving less, spending more: Since the end of 2021, the U.S. savings rate out of disposable income has averaged less than half of what it averaged in the five years prior to the pandemic (last 17 months: 3.8% versus 2015-2019: 7.7%). This is largely explained by a build up of excess savings during the pandemic and pent-up demand.
Defining excess savings: From March 2020 to August 2021, the average savings rate out of U.S. personal disposable income more than doubled to 16.6%. If we define 'excess savings' as the percentage by which pandemic savings exceeded the pre-pandemic average rate of 7.7%, then we calculate that U.S. households accumulated roughly US$2.4 trillion in excess savings during the pandemic period from March 2020 to August 2021.
'Under saving' has been a tailwind since August 2021: If we consider 'under saving' to be the amount by which savings fell short of a 7.7% rate since August 2021, then through May 2023 we calculate that U.S. households had 'undersaved' by about US$1.1 trillion of the US$2.4 trillion in excess savings we calculated for the pandemic period.
Evidence of the remaining US$1.3T of excess savings can be seen in a buildup of significant deposits in the U.S. banking system, well above 2019 levels. Depending on consumers' outlook, they may continue to draw down these balances, generating a lower savings rate and a longer period of excess spending.
Any rise in the savings rate creates a headwind for GDP: The U.S. savings rate has been creeping up over the last year, reaching 4.6% of disposable income in May 2023, up 120 basis points year-over-year. All else equal, we estimate a 360 bps jump in the savings rate back to historical levels would reduce U.S. GDP by ~$715 billion or ~2.8% at 2022 levels.
Meanwhile, the Canadian savings rate dropped to 1.0% in 2023 Q1, down from 6.0% in 2022 Q4 and 7.0% in 2022 Q1. In Canada, we are watching spending and debt service ratios closely. Households are being squeezed by rising rents and interest rates, which may lead to a higher savings rate and more income directed towards debt reduction.
Many are taking comfort from the surprise 3.0% U.S. CPI figure for June, which was followed by a 2.8% CPI reading for Canada. These readings provide some evidence that higher interest rates are working to bring down long-term inflation.
We think that it may still be too soon to declare victory, however, as much of the drop in the inflation rate is due to a normalization of energy prices following a period of high prices during the early stages of the Russia-Ukraine conflict. Core inflation, which excludes Energy and Food, still ran at U.S. 4.8% in the U.S., and 3.5% in Canada for June. Prices are no longer all moving in the same direction.
The good news on inflation is: commodity prices have moderated; spending on big ticket items (homes, autos) remains near cyclical lows; and supply chain pressures are easing. As a result, a lot of the cost push inflation we have experienced since 2021 appears to be easing.
The bad news is that wage growth and strong consumer spending continue to pressure prices. In May, U.S. PCE grew by 6.0% year-on-year. The employee compensation component of U.S. personal income grew by 5.7% year-over-year. High growth rates for consumption and wages suggest that spending power is still ramping up into an economy that is expanding more slowly, which could keep inflation on the boil and force central bankers to consider further rate hikes.
Labour markets remain tight
Tight labour markets continue to see labour supply challenges. More people are staying out of the labour force, while those who remain are working fewer hours than prior to the pandemic, and many are pushing for higher wages.
Relative to 2019, post-pandemic labour demand has been growing steadily, but slowly. Total non-farm payrolls in the U.S. were up 3.6% in June over their level in June 2019, four years prior, resulting in 0.9% annualized growth over four years. Businesses would be hiring faster, but positions are filling more slowly. Job openings represented about 6.3% of payroll employment in May 2023, up from 4.9% in May 2019.
As tight as conditions are, we note that slack can develop quickly. During the Great Financial Crisis, the job opening percentage fell from 3.3% of the payroll count in December 2007 to a low of 1.7% in April 2009. Even a normalization to 5% job openings represents more than 2 million fewer jobs to be filled, which could change the current labour dynamic quickly, especially if corporate margins remain under pressure.
Climbing the Wall
The data we've outlined on inflation, consumer savings and employment suggest a global economy regaining strength despite higher rates, but one faced with an unusual set of tailwinds that may be fading. Concerns over sustained inflation and further rate hikes have softened, however, allowing markets to climb their previous wall of worry.
Even so, there is no shortage of bricks in the wall. Major economic blocs are struggling, most notably Europe, faced with higher energy costs, and China, faced with the after-effects of a property bubble. The yield curve remains deeply inverted. Deposit flight remains a risk for U.S. regional banks as depositors seek higher yields. With higher funding costs, U.S. loan officers are signalling a pullback in credit.
How we are positioned: Under the circumstances, we think a degree of caution is warranted in the second half of 2023. We expect domestic credit conditions to weaken as Canadians face a wave of mortgage rollovers at higher rates. As a result, we have reallocated our portfolio holdings away from Financials to opportunities in Staples, REITs and Utilities. Though defensive in nature, these sectors remain attractively priced and should benefit from stabilizing interest rates.
As always, we favour high quality companies with strong free cash flows, clean balance sheets and capable management teams. Our affiliate, Veritas Investment Research, continues to provide us with compelling investment ideas and remains one of the best research shops on the street.
We are also proud to announce the first anniversary of the Veritas Next Edge Premium Yield Fund. For the year ended June 30, 2023 the fund returned 11.8%, including 4.9% for the year from monthly distributions, outperforming the S&P/TSX by 1.4%.
Year-to-date through June 30, 2023, the S&P/TSX was up 5.7%. Over the first half, our Canadian Equity Fund rose 2.0%, our Premium Yield Fund rose 3.7% and our Absolute Return Fund was 3.9% lower. (Performance based on F series).
We remain focused on long-term capital preservation while pursuing opportunistic investments to drive returns.
We thank you for your continued support.
Your fellow investors,
Source: Refinitiv, Veritas Asset Management estimates as at July 21, 2023. U.S. earnings data drawn from S&P Global. U.S. economic data sourced from the St. Louis Federal Reserve FRED database. Canadian economic data retrieved from Statistics Canada. Bloomberg,Next Edge Capital Corp. estimates. Veritas Next Edge Premium Yield Fund inception date June 28, 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. 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.
The information contained herein is for general information purposes and does not constitute a solicitation for the purchase or sale of securities. The full details of the Fund, its investment strategies and the risks are detailed in the Fund’s current simplified prospectus, annual information form, and fund facts document, copies of which may be obtained from Sedar, your dealer, Veritas Asset Management Inc. (“VAM”) or at Veritasfunds.com. Please read the prospectus before investing. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. All performance data assume reinvestment of all distributions or dividends and do not take into account other charges or income taxes payable by any unitholder that would have reduced returns. The performance of the Fund is not guaranteed, unit values change frequently and past performance may not be repeated. Performance is presented in Canadian dollars, unless otherwise stated, and is net of fees of Series F units of the Fund. VAM is an affiliate of Veritas Investment Research Corporation (“VIR”), which produces and issues independent equity research regarding public issuers to investors and other capital markets participants. VAM is a client of VIR and receives research reports from VIR at the same time as VIR’s other clients. VIR and VAM have implemented policies and procedures to minimize the potential for and to address conflicts of interest, which are available upon request.
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