Also available in PDF: McMurtry Investment Report Portfolio – July 2022
Investment Commentary July 2022
US Yield Curve
The 10-2-year US Treasury yield curve narrowed sharply from last month’s 0.32% to the current level of 0.06%. This is a material change and does indicate the probability of an upcoming recession is increasing. Ten-year bond yields actually dropped from last month, an interesting development in the midst of Central Bank tightening.
US Corporate Debt Spreads
As of June 30, 2022, Baa rated US corporate bond spreads relative to 10-year US Treasuries were virtually the same as last month at 2.24%, compared to 2.26% last month.
Covid – 19 Health Stats
Covid cases in North America are gradually improving and this is resulting in the removal of most lockdowns. Even in China the situation is improving.
Equity Market Valuations
The forward PE multiple of the S&P 500 has declined sharply from 17.5 times last month to the current 16.1 times.
Central Bank Monetary Policy
The US Federal Reserve remains absolutely vigilant in their quest to lower the rate of inflation. In this end, interest rates are expected to continue rising until the expected rate of inflation begins to ease. As I mentioned in my newsletter, there are some signs of a peaking in inflation, but it is still too early to call at this time.
Asset Mix
Interest rates have risen sufficiently recently and now provide some competition to dividend paying stocks. Over the next few months, it is expected that the rate of inflation will peak based on the less accommodative monetary and fiscal policies. Evidence of this can be seen from the recent peaking in most commodity prices, with the exception of crude oil that is only off marginally from its recent high. Copper prices are off about 25% from their recent highs and this metal is considered a gauge of the strength of the industrial sector of the global economy. In the US the popularity of Biden is being negatively affected by the rapid rise in US domestic inflation. This is another reason why interest rates will continue to rise to give an opportunity for the Democrats to improve their popularity in the polls. A mid term election is happening in the fall of this year and a lot can happen over the next few months.
The probability of a US recession is rising sharply with many economists putting a 50% probability of this happening over the next six months. Earlier in the year most investors were worried about high inflation with no growth or stagflation as it is called. However, the current expectation is for a peaking in inflation over the next several months from the very restrictive monetary policy. The fear now is for another recession within the next six months.
Historically in a period of stagflation, commodity and cyclical stocks tend to outperform the rest of the market. However, in a recession these groups tend to underperform the rest of the market.
Consequently, I am making some changes to both my recommended asset mix and to the individual equity sectors.
In regards to the overall asset mix changes, I am reducing the cash weight by 5% for both portfolios with all the proceeds being directed back into fixed income. I am not making any changes to my equity weight with a possible recession on the immediate horizon. Taking into account the average decline in US equity prices over the last several recessions is about 30%, the recent 21% decline in the S&P 500 index implies that about two thirds of the equity decline is probably behind us.
I am increasing the 1–3-year Canada corporate investment grade bonds with yields now approaching 4%. I am also reducing the preferred weight by 1% with a peaking of interest rates not that far away. As I have highlighted many times in previous emails, you do not want to own preferreds in a period of falling rates. We are getting closer to this occurring, but not quite yet.
I am making a material change to my North American benchmark exposure. Last month I was at 75% Canada and 25% US. I am now changing this percentage to 65% Canada and 35% US with a possible recession looming.
Equity Sector Weights
Based on a looming economic recession I am making quite a few equity sector changes to better protect the portfolio in an economic downturn.
I am reducing the financial weight from overweight to underweight based on what has happened historically to bank stocks in previous recessions.
On this same train of thought, I am reducing the Consumer Discretionary and Reit sectors from overweight to underweight.
I am reducing the Materials weight from overweight to Market Weight. I am not reducing this group to underweight at this time as it comprises both precious metals, base, agricultural and industrial metals. However, I advise maintaining most of the exposure to this equity sector to the gold stocks. Gold and gold shares outperformed the overall US market in the recession of 2008.
I am maintaining my underweight in both Technology and Communications.
In the Industrials sector I am switching from overweight to market weight with this sector very sensitive to economic activity.
Higher interest rates put a lot of pressure on the consumer and this is why I am reducing the Consumer Discretionary weight from overweight to underweight.
I am increasing the Utilities and Consumer Staples sectors from underweight to overweight in the midst of a slowing economy.
I am increasing the Healthcare weight from market weight to overweight with this sector sharply outperforming the overall market in previous recessions.
Lastly, I have decided to maintain my overweight exposure to the Energy sector at this time. Differing quite markedly from the fundamental supply / demand outlook for base and industrial metals, the situation is much more favourable for the Energy stocks. While an end to the Russian / Ukraine war would probably cause crude prices to fall by about 10% from current levels, there is very little supply on the immediate horizon. As long as demand keeps up, crude oil prices will remain elevated. It should also be worth mentioning that a resumption of the Chinese economy will most definitely increase demand for crude oil.
Individual Equity Changes
In a blog dated June 27th, I added the US grocer, Kroger to both portfolios in the Consumer Staples sector. Defensive stocks like this tend to do well in an economic downturn. Kroger has kept a tight lid on their operating costs with its vertically integrated network of dairy farms and its ownership of its transportation fleet. The company has a solid balance sheet and is steadily growing its operating cash flow.
In a recent blog I recommended a switch out of Premium Brands into Jamieson Wellness, in the Consumer Staples sector. The former company has been experiencing operating margin pressure, while this has not been the case for Jamieson. Jamieson has recently made a major US acquisition and this will provide it with a new platform in the US to expand its array of vitamins and natural health products.
In a recent blog, I added Apple to both portfolios in the Technology sector. Higher interest rates have resulted in growth stocks like Apple experiencing sharp share price declines. The company is currently trading at 22 times this year’s EPS, at the lower end of its five- year range. The company has an unusually strong balance sheet. For the last 12 months, Apple has generated free cash flow of $107.79 billion, of which it has used $85.76 billion to buy back its own stocks. The company continues to generate strong services revenue principally from its Apps.
As a result of some significant new issues with Micron’s revenue outlook for both PC’s and iPhones, a potential recession will not be good for the company’s very cyclical earnings and cash flow. Consequently. I am deleting Micron from the Growth portfolio in the Technology sector.
Lastly, I recently added the Canadian oil producer, Enerplus to both portfolios. The company is a large generator of free cash flow and is exhibiting very strong growth in EBITDA in this period of high crude prices. The shares remain cheap on an Enterprise Value to Forward EBITDA basis at 3.45 times. In addition, the company has a strong balance sheet. Over the next few quarters, the company has announced its intention of using 50% of its free cash flow to buy back stock, reduce its debt even further and make additional acquisitions. Assuming crude prices remain at current levels, the company expects to be debt free by the second quarter of next year.
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