Foresight - Winter 2020

At the time of writing, global stock markets are rallying, up 8-10% since the U.S. election night. The markets seem to be discounting the  post-U.S. election night theatrics in anticipation of the Electoral College confirming the President-Elect on December 14^th and welcoming the potential roll outs of Covid-19 vaccines at Pfizer and Moderna. Calendar year 2020 has been a rollercoaster year for global stock markets. After hitting all time highs in the first six weeks of the year, the near 11-year-old Bull Market came to a decisive end in mid-February, falling close to 35%, as the global economy ground to a near halt due to the Covid-19 pandemic. More surprising than the Bull Market ending was how quickly global stock markets rebounded! The U.S. S&P 500 is currently up 65% from mid-March lows and 12% above year end 2019. The Toronto Composite Index is up 50% from its mid-March low; however it is 1.5% below year end 2019. The technology, communication services and healthcare sectors have been leaders in the revived Bull Market. The iShares Global Technology ETF (Apple, Microsoft, Visa, Nvidia, Mastercard, Taiwan Semiconductor, Samsung Electronics) is up 31% from year end 2019 levels and up 78% from mid-March lows. The iShares Global Communication Services ETF (Facebook, Alphabet (Google), Tecent Holdings, Netflix, AT&T, Walt Disney) is up 18% from year end 2019 and up 58% from mid-March lows. The iShares Global Healthcare ETF (Johnson & Johnson, United Healthcare, Roche Holdings, Novartis, Merck, Pfizer, Abbott Laboratories, Amgen, Abbvie) is up 10% from year end 2019 and 47% from mid-March lows. 

Interestingly, inflation-hedged bonds have done well this year. The iShares Government of Canada Real Rate of Return Bond ETF is up 10% and the iShares TIPS Bond ETF is up 7.5% thus far in calendar 2020. Given that the Canadian and U.S. economies struggle with unemployment, negative GDP growth on a year-over-year basis and wide-scale threats of business closures, it is somewhat surprising to see inflation-hedged bonds rising.

Whether the final weeks of 2020 see the current rally in global equities continue or see markets revert to a worry driven correction, it is relatively inconsequential to the long-term management of your portfolio and execution of your asset allocation plan. In mid-March, when asset allocation plans responded to the call for the sale of fixed income (bonds) and purchase of equities (stocks), we were confident that we would be very happy in two to three years to be buyers. As it has turned out within the ensuing six months, we already have been happy that we were buyers of stocks last Spring. If stocks continue to rally, we will switch to taking profits and selling stocks selectively and buying bonds as asset allocation plan calls dictate. Or, if we see another major correction in stocks, we will be very happy to buy stocks “on sale” from those investors who choose to focus on the short term worry of the day. 

IN F   L    A    T    I    O    N

In the adult lifetimes of many people living today, the ‘70s and ‘80s were back-to-back decades of  high inflation. In 1991, the Canadian government and the Bank of Canada agreed on targets for inflation reduction with the aim of keeping inflation at 2%, which still remains the target today. So, we have had thirty years of managed low inflation, which doesn’t cross our radar screen very much.

But with the global economic impact of Covid-19, and Central Banks pumping up the money supply in response, inflation is now on the radar screen. In August 2020, the U.S. Federal Reserve (the Fed) announced a new inflation policy called Average Inflation Targeting (“AIT”). In the future, following periods when inflation has been running persistently below 2%, monetary policy likely will aim to allow inflation moderately above 2% for some period of time, such that the average 2% target is attained over an averaging period. So, the U.S. Central Bank is giving itself permission to support interim periods of higher inflation. The Canadian central Bank of Canada is scheduled to review its monetary policy framework in 2021; however it is unknown whether it will follow the Fed’s new inflation policy.

The impact of a country’s inflation management has many vectors. Investors anticipating higher inflation seek higher interest rates to compensate. Higher domestic rates attract incoming investment funds from abroad. Those incoming funds raise that country’s foreign exchange rate. The strengthened domestic currency encourages imports and discourages exports, the latter of which would be bad for the domestic productive economy….and this all circles back to you….!  

We each experience the impacts of inflation wearing many different hats; as employees, consumers, investors, taxpayers and perhaps as business people. The incidence of inflation, a term in economics, aspires to identify who actually bears the brunt of inflation. When a business experiences inflation in its production inputs, does it merely pass this on to consumers by way of higher prices? Does it share that cost increase by moderating employee wages, or do the business shareholders (investors) bear it? Or is the increase somehow apportioned amongst all of those?

As an investor, inflation acts to reduce the purchasing power of your capital. At approx. 2% per year, this isn’t a lot….a “Death by a thousand cuts”! But, thirty years of 2% inflation since the early Nineties means the purchasing power of your capital today has dropped by almost half!  

An inflation hedge is any strategy that protects against decreased purchasing power due to rising prices. For investors, classic inflation hedges include gold, other commodities, real estate and, arguably, equities in general. Stocks can be considered an inflation hedge because company earnings tend to rise with inflation over time.

At the big picture level, our website shows data on the 100 Year History of Investing in the Canadian stock market, and globally. The first chart below shows the spread between nominal (N) and real (after inflation-R) Canadian stock market returns, by decade. There were three decades of notable disparity, and two of those were twenty years back-to-back 1970-90.

The second chart compares those same Canadian REAL returns to the global scene. The 100 Year average inflation rates in both Canada and the US were approx. 3%.

At the drill-down level, we aspire to manage your inflation risk through various sub-strategies.   First, we hold equity investments in gold, materials, commodities and energy through specifically targeted vehicles (both direct stocks and ETFs), as well as through broader index ETFs which include these sectors. We also buy real estate investment trusts. By purchasing targeted investments, rather than broader indices, we are better able to harvest gains when these sectors enjoy a runup.

Not surprisingly, most commodity prices are significantly higher than their pandemic-driven lows of 2020. Interestingly, and somewhat more surprising, we are seeing commodity prices continue to edge higher and, in many cases, are well above year end 2019 levels: copper +15%, aluminum +10%, zinc + 20% and lumber +50%. Although crude oil prices continue to suffer, down 25% YTD, many forecasts have crude prices rallying significantly in 2021, as the global economy starts to return to more normalized levels. These higher commodity prices will have an impact on prices of goods and general inflation in 2021.

Listed below are some common equity ETF inflation hedges that we invest in:

Canadian Equities:
iShares S&P/TSX Capped Materials Index ETF (XMA)	Targeted exposure to Canadian materials companies, such as Barrick Gold and Franco Nevada.
iShares S&P/TSX Capped Energy Index ETF (XEG)	Targeted exposure to companies in the Canadian energy sector, such as Canadian Natural Resources and Suncor Energy.
iShares S&P/TSX 60 Index ETF (XIU)	Exposure to large, established Canadian companies, with approximately 24.6% exposure to commodities.
Foreign Equities:
iShares S&P/TSX Global Base Metals Index ETF (XBM)	Targeted exposure to global securities of issuers involved in the production or extraction of base metals.
Sprott Physical Gold Trust (PHYS)	Targeted exposure to physical gold bullion.
iShares Global Materials ETF (MXI)	Exposure to global companies involved with the production of raw materials, including metals, chemicals, and forestry products, with approximately 32.7% exposures to commodities.
iShares MSCI Emerging Markets Index ETF (XEM)	Exposure to equities of large and mid-sized companies in emerging markets countries, with approximately 12.1% exposure to commodities.

 The safe “boring” part of your asset allocation portfolio - bonds - struggles with inflation. The part of a bond portfolio that tends to perform the worst during inflationary periods is long duration, low coupon bonds. Short term bonds may not fare well either, due to the combination of taxation of the income earned and the loss of, say, 2-4% purchasing power before you get your money back in, say, 1-2 years.

Thus, our second sub-strategy to protect your portfolio against inflation risk relates to the fixed income component. We maintain a direct bond portfolio of short duration and invest in real return ETF bond funds, and ETF floating rate bond funds. 

Real return bonds provide a consistent and inflation-adjusted income stream and principal repayment upon maturity. The bonds themselves are issued by the Government of Canada with a thirty year maturity. For a brand new issue, a coupon rate (with semi-annual pay) is ascribed, which is commensurate with the current interest rate world. The CPI at issue date is noted. At each interest date, the present CPI is noted vis-à-vis the issue date. The change in CPI adjusts the original principal, and the coupon rate is calculated and paid against this new “notional” principal. Thus, both the principal and the interest pay in constant dollars. And so it continues semi-annually for the life of the bond. At maturity, the principal is repaid in the amount of the final “notional” balance. Thus, the investor’s cash should compensate the purchasing power over those thirty years of inflation. As discussed in the “Bond Talk” section of our website, the year-to-year returns on these long duration bonds can vary significantly.     

In fact, our real return bond strategy is executed through the EFT symbol XRB. The Fund is the buyer and holder of those Government of Canada bonds. For an individual investor, individual bonds do not have much liquidity if you need to cash out early. However, the  Fund has liquidity because it holds many bonds and can execute a staggered maturity ladder to have those 30 year bonds turning over at various points in time.  Approximately 45% of its holdings are greater than 20 years and 10% are less than two years.

There are some tax issues with real return bonds if they are  held in taxable Trading accounts. The inflation-adjusted coupon payment is taxable as interest income as is the annual notional principal adjustments. Note that the latter creates taxation without cash flow. Note also that all of those notional adjustments ought to be tracked as cost base increases from the original purchase price, elsewise the taxpayer will inadvertently pay (capital gains) tax a second time upon maturity.

Welcoming…

We are very excited to announce that Mike George has joined us at AFT Trivest as an Assistant Portfolio Manager. Mike brings seven years of combined public accounting and corporate finance experience. Previously, he was a Vice President with PwC’s Deals Practice, specializing in corporate finance, where he advised mid-market companies in mergers, acquisitions, divestitures and capital raising. Mike started his career in the Assurance practice at PwC, where he led financial statement audits for both public and private companies across a wide range of industry sectors.

Mike is a Chartered Professional Accountant (CPA) and Chartered Investment Manager (CIM). He holds a Diploma in Accounting as well as a Bachelor of Arts in Economics from the University of British Columbia.

Outside of the office, you’ll find Mike and his wife chasing their toddler son around the North Shore.