Quarterly Market Commentary

as of June 30, 2023


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 April 3rd , 2022. Market and index returns noted below are based on the price changes for each quoted item for the period ending March 31st, 2022. Market Statistics: Source: https://ycharts.com

2022 has certainly had a very interesting start to the year. The Russian invasion of Ukraine dates back to 2014, when Russia annexed the southern region of Crimea and invaded the eastern regions of Ukraine. The latest war escalation initiated by Russia began on February 24th, 2022, exactly 8 years later, to the day.

Table #1 below shows the performance of the core indexes, the NFC Tactical Asset Allocation Pool (the ‘Pool’), and some sample model portfolios, for the period leading up to the invasion, and the period since the invasion.

Table #1: Pre & Post Russian Invasion of Ukraine: January 1st to February 23rd, 2022; February 24th to March 31st, 2022. Data Source: https://ycharts.com. Data compiled by Nelson Portfolio Management Corp. NFC Tactical Asset Allocation Pool: Croesus software.

• It is interesting to see how the start to the year, from January 1st through to February 23rd, 2022, was quite negative, with the Canadian Broad Bond Index declining by approximately -5.66%, the S&P TSX Composite Index (-2.26%), the New York Stock Exchange Index (-6.67%), the Nasdaq 100 Index (-17.25%), Europe / Asia Index (-5.84%) and the MSCI Global Equities Index (-8.89%). Regardless of the risk profile of your portfolio, the declines were all in the -5.6% range (without factoring in management fees) as we can see from the returns of the Conservative, Balanced and Growth models shown above. Similarly, the Pool saw a decline of -5.65% (with fees included).
• Yet, since the formal start of the invasion, we have seen positive returns in the equity markets except for the emerging markets, which saw a further decline. We also saw a continued decline in the broad Canadian Broad Bond Market Index (XBB).

So, what’s going on here? Why did the equity markets rise when there is increased global turmoil and uncertainty?

• At the beginning of 2022, the primary concern was inflation. Today we continue to see rising housing prices and higher prices at the gas pump and the grocery store. The higher demand for home ownership is related to continued demand yet there is less supply relative to the demand. Higher prices in most everything we consume has mostly everything to do with continued demand for oil related products (rubber, plastic, gasoline, fertilizers) yet there is declining oil production. (When demand remains level and supply declines, the price will go up). It is interesting to see how the Canadian Energy Index (Table #1 above) increased in value by +36.0% over the past 3 months and the Materials Index increased by +20.0%. The rise in the Energy and Materials indexes is being exacerbated by Russia’s war in the Ukraine, since about 10% of the world’s oil comes from Russia and many important metals such as steel, copper, nickel and tungsten (tungsten is used in the manufacture of batteries) Source: https://www.weforum.org/agenda/2022/03/russia-gas-oil-exports-sanctions/#:~:text=Crude%20oil%20is%20Russia’s%20biggest,billion%20of%20its%20export%20revenues.&text=The%20war%20in%20Ukraine%20has,also%20wheat%2C%20metals%20and%20fertilizers
• As a result, unfortunately, we can likely expect that the cost of everything will be higher than normal over the next few years. This means that inflation may also be recorded at consistently higher levels, which then means that interest rates may also likely be at consistently higher levels. The Bank of Canada will likely increase interest rates so as to cool the impact of inflation. This is their mandate, and it is the right thing to do, however, this means that mortgage rates will also increase.
• 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%. 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.
• So, from January 1st, 2022, through to February 23rd, 2022, we can assume that most of the declines that we saw in Bonds (Bond prices go down as interest rates go up – see the Canadian broad bond index (XBB) above in Table #1 at -5.66%) and in the equity markets were due mostly to concerns over rising interest rates and higher inflation. When the cost of everything goes up, corporate profits may go down, which then may move the prices of stocks lower.

But then the narrative changed, when Russia invaded the Ukraine on a much more significant scale than in 2014. In 2014 the president of Ukraine was mostly “pro-Russia”, but in late 2013 and early 2014, when the “pro-Russia Ukraine President” decided not to sign an agreement to align the interests of Ukraine more directly with that of the European Union, public protest erupted. The Ukrainian population wanted to build a society with a consistent application of the rule of law. During this time of upheaval, the Russian government took advantage of the situation and began the annexation of the Crimean Peninsula. Since that time, the pro-Russian forces in Eastern Ukraine have continued to strive to annex more territory. This brings us to today. It is the opinion of many that this is Russia’s next attempt to annex the entire country of Ukraine, in a bid to re-establish the territory of the previous Soviet Union (Source: The Road to Unfreedom, Timothy Snyder, 2019). And so, the narrative has changed.

In my view, we have to ask ourselves, has the previously not trustable Russia now truly gone too far? Does this mean that the Western nations need to realign our trading activities with only those countries who truly subscribe to the same rule of law? If so, then perhaps this means that the world is about to become just that much smaller: goods that were manufactured abroad now need to be manufactured locally.

On the surface, this would seem to be only a good thing. Yet, which of the “Western nations” has the resources to meet the needs of Canadian society? If those solutions aren’t readily available, in the quantity that’s needed, then the price of those items will go up (less supply, higher demand, means the price will go up). If we repatriate the manufacturing of key items, do we actually have the population base to fill all of these new jobs? Perhaps we don’t.

For these reasons, we can see why the initial stock market reaction, over these past six weeks, has been a move higher: higher Energy (XEG: +12.77%), higher Commodities (XMA: +12.45%) and higher Technology (ZQQ: +9.96%). Technology indexes are on the rise in some cases because if there are fewer commodities available to build iPhone or other semi-conductor chips (for use in computers and cars), then as demand remains level yet supply goes down, prices go up. At the same time, software technology will typically help to increase efficiency in a business and thus reduce costs. It is interesting to see how Microsoft, Apple, Amazon, and Google are all up 9.0% to 12.0% since February 23rd, 2022, yet were down -9.0% to -16.0% leading up to that point.

Before we bring these ideas together, let’s take a step back and look at the inflation question for a moment and ask: Why is there higher inflation today? In short, higher inflation today can be attributed to the global pandemic, which has disrupted the consistent manufacturing process and the shipment of goods from one region to another, due to people being unable to work due to illness or due to government shutdowns. While demand for restaurants, vacations and entertainment declined, demand for products increased. The average consumer continued to buy products, sometimes with the government aid provided to them. The amount of “borrowed funds” used to invest in the stock market also jumped significantly during the pandemic. Increased demand, yet with lower supply and longer lead times, resulted in higher costs. While the initial belief was that these increased costs would decline as supply chains went back to normal, this process has taken considerably longer than initially anticipated, or hoped, by the central bankers around the world.

Therefore, with persistently higher costs due to the pandemic, we have seen consistently higher inflation. This has led to the need and demand for higher wages, which also translates into higher costs and inflation. Combining this with now the potential global realignment of trade, due to the Russian war in Ukraine, we can begin to see an environment with consistently higher costs of living and inflation, leads to consistently higher interest rates as mentioned above.

What has happened since our last report? Unfortunately, in my view, a lot. If the issue was just one about supply chains getting back to normal, then we could see that inflation is likely temporary. Yet, with the Russian invasion of Ukraine, and the corresponding response from Western countries and firms to reduce or eliminate business with Russia, which in turn is likely to further impact supply chains, higher levels of interest rates and inflation may be here to stay for a while.

What does this mean for you? Unfortunately, this means higher costs at the grocery store and at the gas pump, and with most other products that you would purchase. This also means higher costs to borrow money and higher mortgage payments.

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?

Looking back to Table #1 we see the following:

• The Canadian broad bond index (XBB) declined by -7.68% over the past three months. As interest rates rise, the price of a bond generally will drop. This will impact short term returns, but if you hold the bond until it matures, then you will end up with the rate of return you expected from the outset. More on this further below.
• The Toronto Stock Exchange (S&P TSX Composite Price Index – XIC) gained in value by +3.14%, primarily due to the large gains realized in both the Energy sector (XEG, 3-month return: +36.48%) and the Materials sector (XMA, 3-month return: +20.24%). These two sectors represent approximately 28% of the TSX index. If we remove these sectors from the index return calculation, the actual return of the TSX Composite Price index is closer to -5% for the quarter.
• By comparison, the broad-based U.S. market (New York Stock Exchange Composite Price Index) declined by -2.87% while Global stocks (XWD) declined by -5.96%.
• In Table #1 we see these three components (XBB, XIC, XWD) combined into Conservative, Balanced and Growth model portfolios, where no additional fees have been subtracted from these returns. From January 1st, 2022, through to February 23rd, 2022, the returns were almost identical, including when compared to the Pool at -5.65% (after fees).
• Then, from February 24th, 2022, through to March 31st, 2022, the NFC Tactical Asset Allocation Pool significantly outperformed these other model portfolios, with a gain of +3.3% vs. +0.08% (Conservative), +1.12% (Balanced) and +2.16% (Growth). The outperformance of the Pool can be linked back to our exposure to Energy, Materials and Technology.
• Thus, for the first three months of the year, the Pool declined by
-2.57% while the Conservative (-5.55%), Balanced (-4.55%) and Growth (-3.54%) models all had greater downside. The performance of the Pool has been good, relative to these comparisons.
• Over the past 12 months, the Pool generated a positive return of +10.54% which is a significantly better return than the Conservative (-0.30%), Balanced (+2.89%) and Growth (+6.08%) models.
• In the past we have talked about striving to capture 70% or more of the upside of the Toronto Stock Exchange index over time. Over the past 12 months, the S&P TSX Composite Price Index was +17.06%. 70% of this amount is +11.92% vs. the Pool return of +10.54%. We were close, but this is also a slight under-performance using this measure. The reason for the under-performance will be similar to the outperformance figures noted previously. While we did have a decent exposure to Energy and Materials, any underweight exposure of these sectors, relative to their weight in the index, will result in an underperformance, such as the figures described above. We see this same outcome whenever there is a large outperformance of the Energy and Materials sectors in Canada.

The current asset mix of the Pool is 42.0% defensive and 58.0% growth. This is a “Balanced – Growth” risk profile. You can see how the Pool is more defensive today than in the recent quarters.

Table #3: Historical Asset Mix of the NFC Tactical Asset Allocation Pool: Source: Croesus

We use the NFC Tactical Asset Allocation 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?

Over the past few months, we have made the following changes to the Pool:

• Adding to Renewable Energy: The stock prices of Renewable Energy companies have been declining over the past 12 to 14 months. As these prices declined, we continued to add to these positions. Since mid-January 2022, the Renewable Energy securities that we own have increased by +17.0% to +32.0%.
• Adding to traditional Energy: We have added to our holdings in some of the broad-based Energy Exchange Traded Funds (ETFs), with an emphasis on natural gas. We sold some Bond ETFs recently (because of expected future declines in these holdings) and added Suncor, as a high quality, dividend paying alternative. It is our view that many of these “major energy companies” will soon begin to purchase other “alternative energy companies”, so we wish to have investments in each area. Exposure to the Materials sector will provide some exposure to the increased demand for batteries.
• Financials: We have maintained our current allocation to the Financial sector. While we expect that bank stocks can do well during a period of rising interest rates, if these rate increases create a recession sooner than later, then we believe the upward trend for the bank stocks may quickly come to an end.
• Technology: We have fine-tuned our exposure to the Technology sector by reducing exposure to the consumer discretionary area of Technology, while maintaining exposure to core infrastructure Technology. It is our view that the “core infrastructure” area of technology will be the main offset to rising inflation in other areas.
• Reduced exposure to the Core 6 ETF’s: Most client portfolios will have exposure to a group of Exchange Traded Funds that we refer to as our Core 6 (Symbols: ZLB, HAZ, HAC, HAL, ZGQ, XMW). The Core 6 was trimmed by 2/3 on February 23rd, 2022, as it became evident that Russia was going to invade Ukraine, which in turn raised a considerable amount of uncertainty. Thus, we felt it was prudent to hold more cash in the client accounts at that time. At the same time, since the beginning of the year, we have seen the prices of many bonds fall by 7.0% to 10.0%. We have been using some of the cash from the sale of the Core 6 ETFs to top up the bond holdings that you have in your account (more on this below) while then recently investing the remaining cash back into the Core 6. As a basket, the Core 6 ETFs have done very well, generating a 12-month gain of +15.47%. This is slightly lower than the 1-year return of the S&P TSX Composite Price Index (Toronto Stock Exchange) of +17.06% but is considerably higher than the 1-year gain on the New York Stock Exchange Composite Index (+6.85%) and the MSCI Global Equity Price Index (XWD, +8.68%). Thus, we continue to have confidence in this blend of investment holdings.
• Topping Up Our Bond Holdings: When interest rates rise, the price of a bond generally falls in value. When a bond is first issued, it is done so at a price of $100. If interest rates increase, then the price of the bond may fall below $100. The amount of the decline is typically related to the period of time before the bond matures known as duration: the longer the period of time before the bond matures, the larger the potential decline. In your portfolio today, and inside the Pool, the market price of many bonds will be below the original issue price of $100. For example, many of our clients will hold a bond issued by a company called Parkland that matures in 2029 (7 years from now). If the original purchase of this bond was made at its issue price ($100), you would receive an annual interest payment of 4.375%. This is the interest rate attached to this bond. However, today we see that this bond has declined in value by 10%, now trading at $90. If we hold this bond until it matures in 2029, the 10% decline will be earned back, because the bond will mature back at the $100 level. This means that you will earn an additional 11% gain ($10 gain / $90 base value = 11.1%) in addition to the annual interest payment. If we averaged out this gain of 11% over the next 7 years, this would be a potential average annual gain of 1.59% per year (11.1% / 7 years = 1.59% per year). When we add this to the interest payment of 4.375%, we now see a total annual return potential of +5.96% per year over the next 7 years (4.375% + 1.59% = 5.96%). Yes, the average annual return on this bond is now almost 6.0% per year!
• The trend of lower bond prices may continue in the coming weeks or year. As it does, we will continue to top up our bond holdings. Today the bonds we hold in the Pool have an average yield to maturity (an average future expected return per year) that is closing in on 6.0%. In other words, over the years to come, the defensive areas of your portfolio and the Pool, could be earning an average of 6.0% per year. This is very significant.
• Now, this is not unlike some of the trades we have made with the individual preferred shares that you may also own in your portfolio. Most recently, in April of 2020, we saw the prices of these types of securities drop in value by 30% to 40%, as the overall stock market declined, and so we bought them. We did the same thing during the “Financial Crisis” back in 2008 – 2009. Those securities, since April 2020, have risen in value by 40% to 60%, and pay an annual dividend of 6.0% to 7.0% per year for as long as we own them, and we have no intention of selling them. This was a great purchase.
• This is also not unlike what we saw back in 1980. At that time significant interest rate increases were made by Central Banks so as to squash perpetually high inflation, much like we are facing today and potentially in the coming years. As interest rates increased, there was an opportunity to invest in long term bonds at higher interest rates, such as the 6.0% annual return example I illustrated above. Over the next 40 years (bringing us to today), interest rates declined. Holding long term bonds during periods of falling interest rates can be extremely profitable. For these reasons, we will continue to add to our bond holdings as interest rates rise, both at your account level and within the Pool. At some point interest rates will stop rising, and the long-term bonds that we have acquired along the way, are likely to provide an excellent long-term return for your portfolio.

To summarize, we have been doing a lot of things because a lot has changed over the past three months. There is a lot more focus on energy independence for Europe and North America, which means that there are significant growth opportunities throughout all areas of the Energy and Materials sectors. The offset to the increasing costs of Energy and Commodities, will be core, infrastructure-based, technology. In the meantime, we are adding to your bond holdings at the current low prices, so as to significantly increase your yield to maturity from this point forward.

Where Do We Go From Here?

In short, we go one step at a time:

• We expect the Bank of Canada and the U.S. Federal Reserve to increase interest rates by 0.5% to 1.0% over the next 4 to 6 months. If so, then bond prices may drop further, and if this happens, we will continue to top up your bond holdings.
• Assuming the Russian war in Ukraine continues for some time, we expect that Russia will become isolated economically, and that European and North American countries will work towards energy independence away from Russia, in all forms of energy.
• As the Canadian government announces additional measures to move toward a “greener” economy, significant pressure will be placed on the current electrical grid. Thus, we expect there to be significant expenditures on renewable energy infrastructure.
• Assuming we continue to see increased inflation and cost pressure on corporate profits, then those companies that have the strongest balance sheet and the least amount of debt, who have dominant positions in their market and who have the ability to pass on price increases to their customers, will likely be the best performers. BCV Asset Management is focused on these same companies, which makes it very helpful in finding these firms as Lynda and I are both on their Investment Committee.

Chart #1 below helps to illustrate where we have come from since January 2020, just as the global pandemic was getting underway. January 2020 below is just over two years ago and is the point just before the large drop. The markets bottomed on March 23rd, 2020, and has since generated a 2-year return of +27.91% per year. This is the lowest point on the chart that we see in early 2020.

Chart #1: S&P TSX Composite Price Index from September 3rd, 2013, to March 31st, 2022. Below we can see the annual returns for the Toronto Stock Exchange, based on where the market was 1, 2, 3, 5 and 7 years ago. Source: https://ycharts.com.

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 three months have been very dynamic and will no doubt continue throughout the year. To be successful in this phase of the market cycle, we need to take advantage of short-term trading opportunities while also adding to positions once they correct. Both of these strategies increase the odds of longer-term success. Thank you, as always, for the continued trust and confidence that you have placed in my team and I.

All the best!



• 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."