What do we like?

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   By Guest Blogger Ryan Lewenza

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In my last blog I provided our macro outlook for the markets and economy for this year. I’m sure readers we’re riveted by this detailed financial analysis so now I’m going to provide the knockout punch by reviewing some key investment themes for 2023.

Let’s start with fixed income, the safer stuff that helps to reduce portfolio volatility and provide steady income. Speaking of income, as a result of the aggressive rate hikes by the Fed and Bank of Canada (BoC) we’re finally seeing some attractive yields from bonds. For years we’ve (savers more so than borrowers) been moaning about the very low yields from investments like GICs and government bonds. But now, with the rate hikes, we’re finally getting good yields from these lower risk investments.

The problem of course is that it required a year of pain, like we saw last year, as central banks hiked rates from effectively zero to now around 4%. Looking at broad or ‘aggregate’ bond indices, US bonds declined roughly 13% last year while Canadian bonds fell 12%, marking one of the worst years on record.

Bond prices more inversely to interest rates, so as central banks jacked rates higher last year this sent bond prices sharply lower. That’s the bad news. The good the news is that we’re finally seeing attractive yields and we could potentially see some capital appreciation from bonds in the coming year.

It’s our view that inflation has peaked, which was reinforced by this week’s US inflation report with inflation declining for a sixth straight month and now at 6.5% yoy (off its peak of 9.1% last June). Given this trend I believe the Fed (and BoC) are close to the end of this tightening cycle with maybe a few more rate hikes to go. If correct, interest rates should peak this year and we could even see long-term interest rates decline. So how do you play this?

Over the last 12-18 months we shifted our portfolio more into short-term bonds, which are less sensitive to rising rates. Now, with rates potentially peaking, we’re shifting the portfolio back into longer term bonds or in bond parlance, we’re adding duration.

Duration measures the price sensitivity of a bond to changes in interest rates. For example, if a bond has a duration of 8 that means that if interest rates drop by 1% we should see the bond price rise by roughly 8%. Last year we focused on short-term or low duration bonds and now we’re starting to tilt the portfolio back to longer term bonds, which we believe could appreciate this year.

Tangentially we recently added US preferred shares to the portfolio. US preferred shares are mainly ‘perpetuals’, meaning they provide a set dividend in perpetuity. These are very sensitive to rising rates and so not surprisingly they got crushed last year, declining roughly 20%.

You can see this relationship in the chart below where I overlay US interest rates with a US preferred share ETF. I believe US prefs are a buy since: 1) they got hit hard last year; 2) we’re getting yields of roughly 5%; and 3) we could see some appreciation if interest rates decline.

Higher Interest rates crushed US Prefs in 2022

Source: Stockcharts.com, Turner Investments

Moving over to equities we like good old Canadian maple stocks, particularly dividend paying equities like banks and pipelines and REITs.

After years of underperformance from Canadian stocks we believe the TSX is set to outperform for the next few years, like it did last year.

First, we’re bullish on commodities. Commodities tend to trade in six year cycles and we believe we may have started a new long-term upcycle. Also they tend to do well when inflation is hot as it is now.

Second, valuations for Canadian stocks are very attractive. Currently, the TSX trades at a price-to-earnings ratio (P/E) of 13x, which is a steep discount to the S&P 500 at 17x. We also like the higher dividends with the TSX yielding 3.1% versus the S&P 500 at 1.2%.

Lastly, the technicals have greatly improved with the TSX breaking out from its long-term relative downtrend versus the S&P 500.

All of these factors led us to upgrade Canada to ‘overweight’ in the portfolio last year.

TSX Trades at a discount to the S&P 500

Source: Bloomberg, Turner Investments

In the US we continue to like value stocks, which outperformed last year, but we’re also quite bullish on US small cap companies. Over the long-run small cap stocks outperform large cap stocks by roughly 2%. However, in recent years they’ve lagged so there could be a nice ‘catch up’ trade. Also small companies generally outperform as the economy rebounds. And lastly they are attractively valued, especially when compared to large caps (S&P 500). Currently, small caps trade at 2x price-to-book (P/B) versus the S&P 500 at 3.8x.

US Small Caps Trade at a big Discount to Large Caps

Source: Bloomberg, Turner Investments

Finally, in the international markets one exciting idea for 2023 is South Korean stocks. Yes you read that correctly. We believe they are primed for a nice turnaround this year. Here’s the thesis:

• First, South Korean equities were down huge in 2022 at -29%. Additionally, the South Korean currency (Won) was also down a lot versus the US dollar last year. So we see the potential for both stock prices and the currency to rebound.
• Second, South Korea is a very cyclical country so with the slowdown globally, South Korea has experienced a bigger hit to their economy. But, when the global economy bottoms, the South Korean economy/stock market could be one of the first to recover.
• With the big price declines, South Korean equities are trading at their lowest P/B ratios in over 20 years at 0.9x. Additionally, it’s the among the cheapest P/B of the top 20 global markets (see chart below).
• The South Korean equity market is also a play on semi-conductors and a chip recovery.
• Finally, Goldman Sachs and Morgan Stanley have it as their top trade or “rebound candidate” for 2023.

So there you have it! Above we highlighted our top themes for 2023, which we’ve been incorporating in our client portfolios. Now if Russia can just pull out of Ukraine, the Fed stop hiking rates, and China start growing again the.0n all should be good this year in the markets.

S. Korean Equities among Cheapest Globally on P/B

Source: Credit Suisse

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.