Quarterly Market Commentary

as of December 31, 2023

Commentary

What's happened since the last report?


The following commentary represents the opinions and analysis of Doug Nelson, Portfolio Manager and Founder, Nelson Portfolio Management Corp. as of July 3rd, 2022. Market and index returns noted below are based on the price changes for each quoted item for the period ending June 30th, 2022. Market Statistics: Source: https://ycharts.com

“The S&P 500 index in the U.S. (the 500 largest companies in the United States), had its worst first half of the year in more than 50 years with a decline of -19.74%. This last time we saw a start to the year like this was in 1970. The good news, perhaps, is that the 2nd half of 1970 generated a positive return of +26.5%. (Source: www.cnbc.com).”

The first 6 months of 2022 has definitely seen a lot of downside (January 1st, 2022 to June 30, 2022):

• Nasdaq 100 Composite Index: -29.22%.
• The Nasdaq 100 Composite index is where you will find companies like Facebook (now called Meta Platforms; -52% year to date), Apple (-23% year to date), Amazon (-36% year to date), Microsoft (-23% year to date), Alphabet (Google: -25%) and Tesla (-36% year to date).
• Some of the biggest decliners have been Netflix (-71% year to date) and Shopify (-77% year to date).
• Remember Shopify? Shopify is still a great Canadian company, and at one point the largest company in Canada by market capitalization, even larger in value that the Royal Bank, but it too has seen its share price fall considerably. In early 2021, I was writing about Shopify, and its significant gains during Covid in 2020, and how these gains greatly impacted the performance of the Toronto Stock Exchange price index. Since January 1st , 2021, Shopify has declined by -72%.

Here are some questions and answers, to help put today’s environment into perspective:

• What’s been driving these downside moves to the stock market? The short version is: Inflation. The annual inflation rates in both Canada and the United States have been in the 7.0% to 8.0% range, when the target inflation rate is in the 1.0% to 3.0% range.
• What’s been driving inflation? What has been pushing the costs of everything that much higher? The short version: i) disrupted supply chains (more demand than available supply will push the price of things higher), ii) the War in Ukraine (which has created disrupted supply of oil, gas, materials, and grains) and iii) the Covid shutdowns in China (which has created disrupted supply of a very wide range of manufactured items). I wrote at length about this in the March 2022 Commentary.
• What does the Bank of Canada do (and other central banks around the world) to help control inflation? The short version: they increase interest rates. By doing so, this helps to curb the spending of consumers, which in turn slows down the economy and ideally brings inflation back to the target levels. Today we are at the early stages of this cycle.
• How much have interest rates increased so far this year? The Bank of Canada has increased interest rates by 1.25%. In July, this is expected to increase by another 0.75% and in September this may increase again by as much as 0.5%. This means that between January 2022 and September 2022, interest rates in Canada may increase by as much as 2.5%. By the end of 2022, some believe that the total increase could be as much as 3.0%.
• What does the higher interest rate mean to those with mortgages? In the March 2022 commentary, I wrote: “12 months ago, it was possible to obtain a 5-year fixed rate mortgage for under 2.0%. Today a common 5-year fixed mortgage rate is closer to 3.6%.” Today the posted 5-year fixed rate mortgage at the Royal Bank is now 5.34%, an increase of almost 2.0%.
• What is the impact of higher interest rates on monthly mortgage payments? In the March 2022 commentary, I wrote: “Based on a $400,000 mortgage, for every 1.0% increase in interest rates, your monthly mortgage payment could increase by as much as $200. An increase of 1.0% could also add as much as $20,000 in total interest costs over the life of the mortgage. This is significant, but it may be even worse. The expectation is that interest rates are likely to be a full 1% higher 12 months from now. If this takes place, this means that the average 5-year mortgage rate may have increased from 2.6% to 4.6% in just two years. This means that monthly mortgage payments could increase by as much as $433 per month (in total) and total interest costs over the life of the mortgage could be almost $40,000 higher. If this happens, you will need to have a plan to adapt.” As you can see, mortgage rates are actually higher than what I said at that time, which means that the negative impact to those with a mortgage that is coming up for renewal, could be a monthly payment that is $600 to $700 per month higher than previously. This is a very important time to pay down your mortgage before it renews.

With all of these things in mind, let’s now turn our attention back to your portfolio:

• What is the impact on an investment portfolio in this type of environment? When interest rates are increased by the central bank, two things happen: i) the price of bonds will go down (this is typically the defensive component of your portfolio) and ii) the price of stocks can also go down (because companies are expected to be less profitable when their costs are going up, due to inflation).

Table #1 shows the year-to-date figures. Here is the short version:

• Defensive investments: Declined by -13.0% to -17.0% so far this year.
• Growth investments: The Toronto Stock Exchange Composite Price Index: -11.13%, New York Composite Price Index: -14.72%, Europe / Asia: -12.25% and the MSCI Global Stock Index: -18.86%.
• You can see how the defensive holdings have declined almost as much as the growth holdings. This is to be expected in a rising interest rate environment, but it has not been the norm historically, more on this below.
• Sectors: Of note is the sizable increase in the Canadian Energy sector (traditional oil and gas), which has an increase of +40.0% so far this year. By comparison the TSX Renewable Energy and Clean Technology Index is -15.0% year to date.

To put these returns into perspective, let’s look at this from a comparative portfolio perspective:

• Conservative Portfolio: (68% Canadian Bonds, XBB; 16% TSX Composite Index, 16% MSCI Global Equities): -14.07% year to date.
• Balanced Portfolio: (50% Bonds, 25% TSX, 25% MSCI Global): -14.29% year to date.
• Growth Portfolio: (34% Bonds, 33% TSX, 33% MSCI Global): -14.52% year to date.

To put this into further perspective, the last two significant market declines happened in 2000 and again in 2008:

• July 1st, 2007 – March 9th, 2009: The Toronto Stock Exchange Composite index declined by -45.59%, yet the Canadian bond index (XBB) actually increased in value during that time by +3.92% (vs. the -13% decline we see today).
• May 22nd, 2000, through to October 8th, 2002: the Toronto Stock Exchange Composite index declined by -26% while the Nasdaq 100 index declined by -53%. Yet the Canadian bond index (XBB) increased in value by 1.93%.
• During those two market corrections, interest rates were reduced so as to stimulate the economy. Alternatively, today, interest rates are increasing due to significant inflation pressures.
• If interest rates were reduced, as they were in previous market corrections, and as a result the bond index had a small increase in value of 1% for example, a typical balanced portfolio, using today’s decline in equities, would have a portfolio return of -4.0% to -9.0%, so far this year, vs. the -14.0% figures we see above.

Thus, it is important to recognize that a large portion of the declines we see today have been caused by the defensive side of the portfolio, due to increasing interest rates, and falling bond prices.

Table #1: Year to Date Price Returns. Data Source: https://ycharts.com. Data compiled by Nelson Portfolio Management Corp.

You will see above that the Toronto Stock Exchange Composite Index has fallen less than the U.S. indexes, primarily due to the very large increase in the Canadian Energy Sector (XEG). Without this increase, the returns on the Toronto Stock Exchange could have been much lower. However, even with this being said and with this excellent gain in mind, the Energy index (XEG) declined by -15% in the month of June.

Looking back over the past 8.5+ years, to September 2013, the Toronto Stock Exchange Composite Index is as follows.

Chart #1: Historical Returns of the S&P TSX Composite Price Index: September 3, 2013, to June 30th, 2022. Data Source: https://ycharts.com. NFC Tactical Asset Allocation Pool source: Croesus software.

• The Last 12 months: The TSX Composite Price Index: -6.72% vs. the NFC Tactical Asset Allocation Pool: -3.0%.
• The Last 2 years: July 1, 2020, to June 30th, 2022: TSX Composite Price Index: +10.26% per year vs. the NFC Tactical Asset Allocation Pool: +8.94% per year.
• Since the market peak before Covid-19: February 20th, 2020, to June 30th, 2022: TSX Composite Price Index: +2.14% per year vs. the NFC Tactical Asset Allocation Pool: +2.7% per year.
• The Last 3 Years: July 1, 2019, to June 30th, 2022: TSX Composite Price Index: +4.62% per year vs. the NFC Tactical Asset Allocation Pool: +4.87% per year.
• The Last 5 Years: July 1, 2017, to June 30th, 2022: TSX Composite Price Index: +4.43% per year vs. the NFC Tactical Asset Allocation Pool: +4.1% per year.
• The Last 7 Years: July 1, 2015, to June 30th, 2022: TSX Composite Price Index: +3.77% per year vs. the NFC Tactical Asset Allocation Pool: +4.4% per year.
• Since Inception of the NFC Tactical Asset Allocation Pool: September 3, 2013, to June 20th, 2022: TSX Composite Price Index: +4.62% vs. the NFC Tactical Asset Allocation Pool: +5.6% per year.

(Note: NFC Tactical Asset Allocation Pool is also referenced in this document as “the Pool” and “Tactical Pool” throughout the remainder of the commentary.)

Below we see Table #2, which is our usual summary of different asset classes and regions.

Table #2: Asset Class, Region and Sector Returns Over Past 4 Quarters and Last 12 Months.
Data Source: https://ycharts.com. Data compiled by Nelson Portfolio Management Corp.


How Has the NFC Tactical Asset Allocation Pool Performed During This Time?

• Over the past 3 months the NFC Tactical Asset Allocation Pool declined by -7.3%.
• Over the past 6 months the NFC Tactical Asset Allocation Pool declined by -9.66%.
• Over the past 12 months the NFC Tactical Asset Allocation Pool declined by -3.0%.

To put these numbers into perspective, we are going to measure against two comparative balanced portfolios:

• Balanced Income Portfolio (60% Canadian bonds, XBB; 20% TSX Composite Index, 20% MSCI Global Equities Index, XWD).
• Balanced Growth Portfolio (40% Canadian Bonds, XBB; 30% TSX Composite Index, 30% MSCI Global Equities Index, XWD).

In Table #3 we see the comparative returns of the NFC Tactical Asset Allocation Pool vs. these two comparative portfolios:

Table #3: Comparative Performance Over the Past 3, 6 and 12 Months: NFC Tactical Asset Allocation Pool vs. the comparative Balanced Income Portfolio and a comparative Balanced Growth Portfolio. Source: https://ycharts.com. Data compiled by Nelson Portfolio Management Corp. Croesus Software.

• The NFC Tactical Asset Allocation Pool generated a return that was 15% better than the comparative Balanced Income Portfolio over the past 3 months. The comparative difference increases to 69% over the past 12 months (-3.0% for the Tactical Pool vs. -6.68% for the comparative Balanced Income portfolio).
• The NFC Tactical Asset Allocation Pool generated a return that was almost 29% better than the comparative Balanced Growth portfolio, over the past 3 months. Over the past year, the difference increases to 65% (-3.0% for the Tactical Pool vs. -5.75% for the Balanced Growth comparative portfolio.

So, despite the declines of the NFC Tactical Asset Allocation Pool, we see that the Pool did outperform quite significantly relative to some comparative portfolios. Other defensive holdings that we hold in some client accounts include the Horizon’s Conservative Total Return ETF and the iShares Core Moderate Allocation ETF. For the first 6 months of the year, these defensive ETF portfolios declined by -16.07% and -13.77% respectively (vs. the Tactical Pool at -9.66%). Over the past 12 months these two ETFs declined by -12.91% and -12.95% respectively (vs. the Tactical Pool at -3.0%).

Now let’s look at this a little more deeply because there are some key dates below that also put things into an interesting perspective:

• From January 1st, 2022, to February 23rd, 2022:

o In the weeks leading up to the Russian invasion of Ukraine, the NFC Tactical Asset Allocation Pool declined by -5.65%. This means that of the total decline over the past 6 months, more than half of this decline took place by February 23rd, 2022.
o To put this into context, the comparative Balanced Income portfolio declined by -5.31% and the comparative Balanced Growth portfolio declined by -5.34% during this same period of time.
o Outcome: The Tactical Pool had similar performance at the start of the year.

• February 24th to May 31st, 2022:

o Between February 24th, 2022, and May 31st, 2022, the NFC Tactical Asset Allocation Pool declined by only -1.06%.
o In comparison, the comparative Balanced Income portfolio and the comparative Balanced Growth portfolio declined by an additional -3.77% and -2.94% respectively.
o Outcome: Between February 24th, 2022, and May 31st,2022, returns for the Pool were mostly flat, protecting against the -2.0% to -3.0% additional declines seen by the comparative Balanced portfolios.
o The gains seen in late February and early March were offset by the declines seen in April. May was mostly flat in terms of returns.

• June 2022, however, saw additional declines in a number of areas:

o Toronto Stock Exchange composite index: -9.01%.
o Canadian financial services sector index (XFN): -9.08%.
o Canadian energy index (XEG): -15.15%.
o Canadian materials index (XMA): -15.32%.
o New York Stock Exchange composite index: -8.46%.
o Nasdaq 100 index: -9.25%.
o Europe / Asia: -7.92%.

o Comparative Balanced Income portfolio: -4.43%.
o Comparative Balanced Growth portfolio: -5.56%.

o Whereas by comparison: the NFC Tactical Asset Allocation Pool declined by -3.16% in the month of June.
o This means that the Tactical Pool protected against 65% of the downside move in the Toronto Stock Exchange composite index during the month of June (-9.01% for the TSX index vs. -3% for the Tactical Pool). This is good!
o This also means that the Tactical Pool protected against 30% to 50% of additional declines that occurred in the comparative portfolios. This is also really good!
o This means to us that the current asset mix of the Pool is well positioned to help to protect against further downside moves to the market.

• February 24th to June 30th, 2022: Now let’s look at this total time period:

o The NFC Tactical Asset Allocation Pool has declined by -4.21% since February 24th, where the bulk of this (-3.16%) took place just in the last month.
o By comparison, the comparative Balanced Income and Balanced Growth portfolios have declined by -8.0% and -8.34% respectively.
o This means that the NFC Tactical Asset Allocation Pool protected against 50% of the declines seen by the comparative portfolios. This is good!

Table #4: Return Breakdowns: January 1st, 2022, to June 30th, 2022:

Conclusions:

o The NFC Tactical Asset Allocation Pool has outperformed since February 24th, 2022, the day that Russia invaded Ukraine.
o With all of the adjustments we have been making to the Pool these past 5 months, it is really nice to see how well we protected from the downside moves in the market during June.
o The Pool has a very defensive asset mix, which is well prepared for any further downside that we may see this coming summer.

The current asset mix of the Pool is 53.0% defensive and 47.0% growth. This is a “Balanced – Income” risk profile. You can see how the Pool is more defensive today than in the recent quarters. On December 31st, 2021, the cash component was 2.0% whereas today it is 12.9%. On December 31st, 2021, the defensive component was 33.6% vs. 39.8% today. This means that the growth component has declined from being 64.39% on December 31st, 2021, to 47.30% today.

Table #5: Historical Asset Mix of the NFC Tactical Asset Allocation Pool: Source: Croesus

We use the NFC Tactical Asset Allocation Pool returns because this will either represent 100% of your portfolio or 60% of your portfolio and it is a good proxy for your overall portfolio returns depending on your fees and risk profile.

What Have We Been Doing Over the Past Few Months?

As markets, and our individual holdings, fluctuate, we continuously assess the trend. Is the investment trending higher? Is it trending sideways? Is it trending lower? Based on these trends, we will then make a decision as to whether we should add to the position, leave our current allocation as is, trim the position so as to take our profit and set it aside or if we should exit the position in its entirety. Since the last 6 months have been quite volatile, and we have seen a lot of trend changes begin to unfold, we have been very active:

• As markets have declined, you can see in Table #5 that both the cash component and the defensive components have increased in weight, from 33% in June 2021 to 53% today (June 2022).
• What does this mean to you? Throughout this 6-month period we have actively, and methodically, adjusted your portfolio from a growth-oriented stance to one that is defensively balanced. This is a very, very significant shift to defense in a short period of time, the benefits of which can be seen in our June return figures (-3.16% Tactical Pool vs. -9.0% for the TSX, -15.0% for the TSX Energy Index, -8.46% New York Stock Exchange composite index).
• Sells: Over the past three months, in the NFC Tactical Asset Allocation Pool, we executed 27 sell orders, so as to i) take profit on positions that looked like further declines were due to occur in the near future, ii) exited positions where we wanted to realize a capital loss for tax purposes and iii) to reduce our overall exposure to the equity markets.
• Buys: During this time, we also added to other positions that we wish to hold for the long term, but where the price had seen some considerable declines. We executed 43 buy orders, again to take advantage of some of these lower prices. Most of the buy orders were smaller dollar amounts, so as to top up current holdings at lower prices.
• Tax Management: As markets fluctuate, and investments decline in value, losses do occur. The question is: What do you do with those losses? Do you continue to hold the investment as is with the expectation that it will rise in value? Do you sell the investment with the expectation that it may fall further in value, thus protecting against further declines? Or do you purposely sell the position, trigger the capital loss, so that the capital loss can be applied against the capital gain earned from other investments, thus proactively managing the tax picture of the Tactical Pool? In short, you employ all three strategies, while paying close attention to the 2022 realized gains and losses. In 2021, the NFC Tactical Asset Allocation Pool gained in value by close to 18%, creating a lot of realized and unrealized capital gains. In 2022, due to the wide fluctuations in the market, we have also seen some losses. As a result, we have been methodically triggering our capital losses, so as to offset the taxes owing on previously realized capital gains. Several of the securities that we sold from the Pool, and from your account, will likely be repurchased in the coming months.
• Increasing Exposure to the Private Markets: The stock and bond markets are referred to as the public markets. Due to the increasing level of automated trading and leverage in the public markets, the level of volatility in these markets seems to have increased considerably over the past decade. At the same time, the “private markets” are now considered to exceed $18 Trillion in market cap, consisting of exposure to private lending, private real estate, private infrastructure, and private equity. Source: https://caia.org
The Canada Pension Plan is an excellent example of exposure to the private markets. From the March 2022 year-end report, the asset mix of the Canada Pension Plan is as follows:

• 32% exposure to “private equity” vs. a 27% exposure to the public equity markets.
• 7% exposure to traditional bonds.
• 9% exposure to private “infrastructure” and 9% exposure to private “real estate”
• The remaining 16% is allocated to different lending and credit risk management strategies.

We are continuing to follow the same approach with the NFC Tactical Asset Allocation Pool, increasing our exposure to private equity, infrastructure, real estate, and private lending. Over the past 6 months, and in the continuing months, the allocation to these investment areas has grown from 18% (December 2021), to 24% today, to our target of 30% to 35%. The purpose of this exposure is to continue to generate annual target returns in the 6% to 9% range (in these asset classes), but with considerably less volatility than what we see in the public markets. It is important to note that we began to move in this direction almost 6 years ago and, as we have felt confident in what we were investing in, continue to expand our exposure in these very important asset classes.

To summarize, we have been very busy actively managing the portfolio with the goal to protect against further losses (should this market continue to move downward), add to positions at much lower prices (looking forward to generating future profits when markets recover) and add to the diversity (so as to generate a consistent return with less risk).

Where Do We Go from Here?

At this time, there continues to be three main disruptions that are impacting the investment markets:

• Disrupted supply chains and shortages of labor (due mostly to Covid-19),
• War in Europe and the supply of oil, natural gas, materials, and food (due to Putin’s war in Ukraine),
• The resulting impact on inflation, forcing central banks to increase interest rates.

As in all times, these disruptions could either find a solution in a) the short term, b) the medium term or c) the longer term.

If a solution is found in the short term, then we may begin to see stock prices begin to rise again in the coming weeks. If it is determined that these problems are going to be with us a little longer, then we could see another downward move in the equity markets between now and the fall. Finally, if these problems take longer to solve, then my view is that we could see these markets continue to trend lower into the spring of 2023. Some project that markets could move 15% to 20% lower from the current levels. Should this occur, then the correction of 2022 – 2023 will not be unlike the corrections we saw in 2000 (to 2002) and 2007 (to 2009).

With these thoughts in mind, we are choosing to position ourselves for the middle scenario for now. We are going to maintain our defensive stance assuming that markets have a higher likelihood of seeing some further declines this summer. But as these declines occur, we will continue with the same strategies that we have used over the past few months: actively trimming positions to hold on to profits as they occur while actively adding to positions as stock prices move further downward, with a goal to setting us up well for the next market rally.

We do expect to see interest rates continue to climb this year, possibly by another 1.5% to 2.0%, which is very significant.

Predicting the future market direction is always difficult as sentiment changes daily. We will continue to watch the market, and our investment holdings, and act accordingly as the days, weeks and months unfold.
Should you have any questions or concerns about this commentary, our approach, or your specific portfolio, please reach out to Lynda or I. We would love to review your portfolio in detail with you any time you wish.
The first six months have been very dynamic and will no doubt continue throughout the year. Thank you, as always, for the continued trust and confidence that you have placed in our team.

All the best!
Doug

Announcements:

• Book Value vs. Market Value on Your National Bank Independent Network (NBIN) statements: The book value information on your NBIN statement is not your net invested value. Rather, the book value is the total of your invested value minus withdrawals and plus any dividend income received. Thus, part of your investment return over time will show up as part of your book value. Therefore, please do not compare the book value and market value on your NBIN statements and believe that the difference is your investment return.

• Discrepancies between the Nelson portfolio reports and the NBIN monthly statements: We see that in some cases there are some small discrepancies between the total portfolio value seen on the Nelson statements and the NBIN monthly statements. In most situations these discrepancies are caused by the timing of when the NBIN statements are produced and when the data concerning the quarterly distribution for the Pool is provided to NBIN. This is a timing issue and not an error. Should you have any questions or concerns, or if you identify other discrepancies, please let us know immediately.

• Paper vs. Secure E-Mail Link: It is NPMC’s preference to provide to you this quarterly portfolio package by e-mail. However, if you would like to receive this package in paper format, please let us know and we will accommodate your preference accordingly.

"IMPORTANT DISCLOSURES: The comments above are for information purposes only and do not constitute specific financial advice regarding your specific situation. Please consult a professional financial advisor who is familiar with your personal situation before acting on any information presented above. Every effort has been made to ensure this information is presented responsibly and accurately. However, important details may have been missed or these details may have changed since the publication of this note. All facts and opinions noted above must be reviewed to ensure their accuracy is still relevant based on today’s specific situation, whatever that may be. Nelson Financial Planning Corp is not responsible for any action you take regarding this information."