12 Themes for 2023
1. Attractive Risk Reward in Shorter Dated Investment Grade Fixed Income
The Kipling Strategic Income Fund recently purchased several Investment-grade fixed-income securities with maturities between two and three years. These securities offered yields to maturity between 6.79% and 7.00%, which we believe to be attractive. Investment-grade bonds generally have better liquidity than their high-yield counterparts and typically carry less credit risk than high-yield bonds. This could become particularly important if the economy enters a slowdown/recession. If interest rates decline, these bonds should appreciate in value and there may be the opportunity to sell them at a gain. Alternatively, if interest rates rise, the coupons still seem attractive, and the bonds can be held to their maturity in two to three years.
2. Book a Cruise for fun not as a debt investment
Many cruise lines took on substantial amounts of debt during the pandemic in an effort to remain solvent. Policies invoked by governments and health authorities and lack of demand forced their revenue to decline to near zero and stay there for many months. While revenue has started to recover it is generally still not back to pre-COVID levels. Meanwhile, these companies are dealing with inflation in many of their costs: labour, food, and fuel (although fuel prices have declined more recently). Due to industry overcapacity, cruise lines do not always have the pricing power to pass these higher costs through to customers.
Many cruise lines continue to have somewhat significant capital expenditures for new ships ordered before the pandemic. In many cases, this will add even more capacity to an
already saturated market. If we do go into an economic slowdown, a cruise is arguably one of the most discretionary of all consumer expenditures and could be the first thing a customer cancels if they have a cash flow issue. Finally, while we all hope this does not happen, if there is a COVID variant that mutates to be more serious/deadly, demand could be hampered.
We are not predicting all cruise lines will go bankrupt in 2023. However, with some bonds that mature in 2028 trading at yields below 7.5%, we do not believe investors are being adequately compensated for the risks they are taking.
3. Thematic ETFs make a roaring ‘20s comeback.
Back in 2020, when Jerome Powell had his foot firmly pressed on the money printer, Thematic ETFs became the darling of the ETF industry with their highly concentrated Sustainability, Disruptive Tech, Industrial Revolution, Evolving Consumer, Health Innovation, FinTech and Concept Financing strategies. Thematic ETFs have amassed a great deal of fund creations over the past 3 years with over $81B allocated to these strategies with less than $10B in redemption since they went parabolic. As one could imagine, nearly all Thematic ETFs are down substantially in 2022, ranging between +6.9% (only 3 with positive returns) and -83.4% among the 261 US-listed ETFs. Without cheap financing, many of the companies held in these strategies have had massive selloffs and hence the poor returns YTD. As we press on to 2023, we believe Thematic ETFs will have a comeback year as the Fed becomes more dovish throughout the year. With the potential for a FED pivot and easier financial conditions, it should be positive for Thematic ETFs.
4. Volatility continues in unusual places
While financial media in 2022 has concentrated primarily on the damage seen within the equity markets, the true underlying story has been the volatility felt in traditionally less volatile asset classes such as government bonds and currency markets. In our view, 2023 will see a continuation of the volatility in these asset classes due to external market forces creating a liquidity crunch within those markets. While this doesn’t necessarily mean the price direction seen in 2022, a lack of natural/historic buyers will continue to drive the liquidity picture. Underlying trends such as aging demographics, tightening financial conditions and deglobalization are the main culprits and do not appear to be changing direction.
5. Commodities do not 3-peat
The last 30 years have seen 3-peats reserved solely for the Chicago Bulls of the 1990s and the LA Lakers of the early 2000s. In the previous two years, the best-performing asset class (barring any major change from this writing) has been commodities. There is an old saying that the cure for high prices is high prices. In this vein, we are predicting commodities will not 3-peat as the best-performing asset class for 2023. While a lot easier of a prediction back in June, we view there will be two outcomes for 2023, an avoidance of a recession with prices coming down due to a cooling of demand or a recession which would ultimately lead to demand destruction. Either way, a weaker/tougher environment for commodity pricing should be expected. The caveat, this is not 2014 in our view, energy companies should not go through the same winter that we saw from 2015-2020.
6. Labour markets will remain tight in the short term
The labour market will play a key role in 2023. With rates seemingly cooling off, it will now be up to the consumer and our labour market to compensate for the slower growth predicted in the market. Will we require wage inflation to the same degree we have seen rate hikes? There are several ways to measure the health of the labour market; job growth, unemployment, participation rates and wage inflation. We have seen a decline in the number of people participating in the labour market, perhaps due to not re-entering the market after covid or early retirement.
In conclusion, we will want to see some compensation concerning the rate hikes in wage inflation but would want to see an increase in the unemployment rate to reduce the pace at which rates have been increasing. Economists believe that until we see a 6% or higher unemployment print in Canada, the Bank of Canada will continue to raise rates. At the end of October, Canada’s unemployment rate was 5.2%, whereas, in the US, the rate was 3.7%. Labour markets are still looking strong. Once these rates peak and we see interest rates stabilize, we believe fixed income will continue to look relatively attractive for our balanced portfolios but will remain defensive as the markets absorb a consumer spending shift.
7. Debt servicing to remain at attainable levels, although higher than we have seen in the last couple years
Debt servicing as a percentage of income will help determine where the dollars are being spent and how well the consumer is absorbing the rate hikes. In Canada, between 12-15% of our income is being directed towards debt repayment and is around 10% in the USA. Canadians are more rate-sensitive due to the structure of home ownership and mortgages and therefore it may be a key measure of how well Canadians are absorbing the 2022 rate hikes. The consumer in North America and their health are a large determinant of the GDP number. If our income is directed more towards debt servicing, we could see GDP slow down more than expected. In 2023, expectations in Canada are for the growth rate to be below 2%. Any surprises to this number will direct the market enthusiasm. We are optimistic as we see the speed of rate hikes slowing and the cash savings buildup during covid could provide enough of a cushion to help the consumer absorb and adapt to higher rates in the short term.
8. The Rumors of Software’s Death Has Been Greatly Exaggerated
Prediction – Software will outperform the S&P500
Following last year’s theme of unprofitable technology being a terrible spot of the market to be in. This year, large capitalization software businesses are potentially the most attractive they have been in nearly half a decade. Circa 2021, not a single software business could put a foot wrong. Demand was infinite and the margins did not matter because they were “investments” for the future. Trailing returns for software over the year are now -29.8% versus -14.6% for the S&P500 (as of Dec 7th, 2022). Software is a broad definition, so to highlight specific examples, Adobe and Salesforce are some of the largest software businesses and they are down -49.5%/-50.8% over the trailing year (Dec 7th 2022). Adobe at its peak traded 2.55x the forward P/E multiple of developed markets. Today it stands at 1.25x - the lowest relative valuation since 2012. Many of these businesses are still growing in the teens versus mid-single digit growth of the market in general.
All it took for this opportunity to arise is one of the largest and sharpest increases of interest rates and inflation on record, combined with the weakening of demand from unbelievably high levels. Investors have exited the sector, favoring the cyclical businesses which benefit from rising commodity prices. According to Goldman Sachs, both long only investors and hedge funds have their lowest exposure to Information Technology and Communication Services since 2012.
9. The Economy Is Not the Market - Never Overstay Your Bearish Welcome
Prediction – US markets are strongly up in 2023 >10%
Market cynicism has its greatest appeal at the bottom. Investors look for positive changes, often called “green shoots”, before buying into the market, believing that they indicate we have finally bottomed. Contrary to this belief, stock prices precede positive changes. Historically, the market leads the economic results, leading to an expansion of the valuation multiple out of the bottom before results filter in. There are statistical indicators that point to potential bottoms, leading to potentially stronger than average returns over the subsequent year. Many of these indicators have been materializing recently:
Goldman Sachs tracks its hedge fund client portfolios and has estimated the beta exposure to the Russell 3000 is at the same level as 2008, at 0.1x. The historic peak is 0.6x.
The Commitment of Traders (how long or short asset managers and speculators are in the futures market) is matching the negativity of 2008 and in 2016. This indicates that there is a lot of pent-up potential buying.
There is a plethora of quantitative, price-based indicators - highlighted by institutional research providers, that occur infrequently and only around market bottoms. Below is a handful of these indicators:
S&P500 Upside to Downside Volume >10/1
CBOE Put to Call Ratio >1.2x
NYSE Ratio of Advancing vs Declining volume >10/1
S&P 500 Three Day Price Thrust
Greater than 55% of S&P 500 constituents made a new 20 Day High concurrently
Greater than 61.5% of S&P 500 companies rose above their 10 Day Moving Average concurrently
Check out twitter accounts of @BergMilton and @NDR_Research to view some publicly shared information.
Investors are strongly positioned against the market while new broad-based indications of strength are appearing. If this turns out to be the bottom, we can expect the negative headlines to continue into early 2023, then we may see the “green shoots” people are looking for. At this point, it will require more than a garden variety negative headline to shake any investors that are still holding.
10. Three Mile Island, Chernobyl, Fukushima. Why Nuclear?
These 3 places have come to mean so much more than just push-pin locales on a map. They have become synonyms for “Disaster” and perhaps a fitting reflection on the “Hubris of Man”. Unfortunately, these tragic episodes have left a pervasive and enduring public perception that the nuclear energy industry can never be safe.
Let's look at the facts;
Based on IAEA data, only 33 countries generate nuclear power (72% coming from the US, China, France, Russia and South Korea)
The IEA World Energy Outlook predicts a 52% increase in electricity demand from 2020 to 2040, with a 75% increase predicted from 2020 to 2050
Many industrialized countries around the world are setting 20 and 30-year targets to replace 85% of their current electricity grids with net-zero carbon power
The most common sources of base load (aka reliable) electricity demand in North America comes from; Natural Gas (33%), Oil (28%), Coal (17%), Hydro (12%) and Nuclear (10%)
Nuclear power has been on a steady decline as a share of global gross electricity generation (fallen to 10.1% in 2021 from 17.5% in 1996) and is set to drop to 8.7% by 2029 as more global reactors age and close
According to Bloomberg, to just maintain a 10% nuclear participation rate through 2035 it is estimated that the global energy grid needs an additional one hundred 1-GigaWatt reactors and one hundred and fifty-five 250-MegaWatt Small Modular Reactors (SMRs) worldwide at a price tag of north of $1.4T USD
Nearly 80% of primary production is in the hands of state-owned enterprises while nearly 90% of consumption occurs in countries that essentially have little-to-no primary production domestically
So, basically, what this is saying is that quite frankly it really doesn’t matter what side of the safety debate anybody is on. The facts are, the demand for electricity is rising exponentially, and nuclear energy will have a role to play in global energy base load production. We are in the very early days of this investment theme and the industry is poised to benefit from very clear and simple economic fundamental tailwinds making it a very, very long-term story.
11. This is not your grandfather’s pivot
Remember TED talks? Well, the investing world has been concentrated over the last few years on FED talks. Any time a FED governor got in front of a microphone participants stopped-listened-and tried to decipher any clues on what the next move would be by the central bank. To be blunt, predictions in this space have been poor across the board with a serious underestimation of what this FED was capable of on the rate hike spectrum. In 2022 we saw the FED funds rate move from 0% to 3.75% in the first 11 months of the year. Discussion over the past 3 months has been revolving around “when will the FED pivot?” and when will we start to see rates head the opposite way. Historically speaking, we saw this in 2019.
A “pivot” means that we end our rate hiking cycle and start to see the central bank begin to ease financial conditions through rate cuts. As of right now the bond market is pricing in another 2 hikes in December followed by a moderation of more hikes in the first half of 2023 with futures seeing a probability of 60% that Fed Funds rate will be at least 5.0% by May. The back half of the year is where things get interesting. The bond market is beginning to price in rate CUTs with an 86.7% chance of rates being lower than 5.0% by the end of 2023.
We believe rate hikes will teeter off in 2023, but we do not think there will be any rate cuts during the year. While we still have Jerome Powell at the helm (same as in 2019), the narrative and discussion feels much different this time around then in 2019. Politicians and the public are typically late in realizing what is transpiring and although based off of our research, inflation (at least the rate of change) is coming off and improving, it does take time to change that narrative across the broader public.
Inflation has reduced the consumers’ ability to spend. However, the pandemic led to an increase in consumer savings. There is evidence that the consumer still has roughly $1.5 trillion in accumulated excess savings which should take at minimum another year and a half to wind down to normal levels. Additionally, our view is that this labor market is going to be much more difficult to break than historically speaking. 3 million people exited the labor market over the last few years, which has made labour shortage a structural issue. The last reason we believe there will be no rate cuts this coming year, is Jerome Powell does seem to fancy himself as Paul Volker 2.0. All of these issues combined makes us think that short term rates will remain high throughout 2023 and that a FED pivot is not what it used to be.
12. Coming Home
North American Manufacturing will move from “Just-in-Time” to “Just-in-Case”
When the pandemic hit, it caused a massive wave of instability rippling through the global supply chain system (GSCS) and forced many companies to rethink the value of their global production processes, especially those in industries that rely heavily on offshore manufacturing such as pharmaceuticals and automobiles. Hmm, that’s interesting …. But, so what? Or more appropriately, what exactly is the GSCS? Well, as it is defined by the Business Development Corporation of Canada a global supply chain covers all the steps involved in manufacturing and delivering a product or service when those steps take place in more than one country. For example, if a company sources raw materials in China, manufactures the product in India and sells it to customers in the United States, then its supply chain is global.
The foundation for the globalization of supply chains is based on the idea of comparative advantage. The thought is that aggregate global benefits arise when certain regions/countries create goods and services at a lower opportunity cost (ie. they are more efficient in creation either by way of capital, labour or both) and trade for those goods and services where they don’t have a comparative advantage. Suffice it to say, comparative advantage is a key principle in international trade and forms the basis of why free trade is set out to be beneficial to all participating countries.
Sounds good in theory, but as the Pandemic showed, in the real world the calculus of what many companies perceived to be their own specific “total opportunity cost” was drastically underestimated. In a survey from the Institute for Supply Management (July 2022), 77% of respondents saw extended lead times for Chinese-sourced raw materials or components (inputs) compared to the end of 2019. Chinese source materials were not alone as European and North American inputs were also significantly delayed. In response to these holdups, 20% of the companies surveyed said they were planning or had already started, to re-shore or nearshore some operations. Meanwhile, 64% of manufacturers say they are “likely to bring manufacturing production and sourcing back to North America" according to another survey in May, by product sourcing and supplier network Thomas.
A huge part of the drive to “onshore” is about risk mitigation but many supporters argue that domestic production gives better control of intellectual property rights, boosts product quality, reduces shipping costs/times, increases flexibility, and also has the ancillary benefits of supporting local industries and employment.
In the end, while we believe that there are still economic benefits to globalization, the fact is that there is no correct answer for what optimal balance between domestic/global manufacturing should be as each industry’s end market will dictate that. However, there is a clear trend to “onshore” and it is an investment thesis that should not be ignored by portfolio managers.
13. Bonus! Bitcoin – Still the King of Crypto
Bitcoin (BTC) is going to have its George Costanza via mango moment, “I’m Back! Baby!” BTC and the crypto industry have taken it in the teeth in 2022, and FTX, the now infamous cryptocurrency exchange Ponzi scheme (allegedly), has not helped things. As you recall, the Bahamas-based company is under investigation for using the client’s funds to cover massive trading losses, but I digress, this is about BTC.
Refresher, BTC is a decentralized digital currency that can be transferred on the peer-to-peer bitcoin network. BTC transactions are verified by network nodes through cryptography and recorded in a publicly distributed ledger called a blockchain.
BTC most likely be the survivor of the washout of the crypto industry when all this is said and done as BTC’s network and scale are by far the biggest in the industry while also being the original digital currency. I believe this will work in BTC’s favour as the long-term store of value as “digital gold”. We currently hold a 3% weight in our Innovation strategy.
*Cumberland and Cumberland Private Wealth refer to Cumberland Private Wealth Management Inc. (CPWM) and Cumberland Investment Counsel Inc. (CIC). NCM Asset Management Ltd. (NCM) is the Investment Fund Manager and CIC is the sub-advisor to the Kipling and NCM Funds. CIC is also the sub-advisor to certain CPWM investment mandates. This communication is for informational purposes only and is not intended to provide legal, accounting, tax, investment, financial or other advice and such information should not be relied upon for providing such advice. Any comments, statements or opinions made herein are those of the author and do not necessarily reflect those of Cumberland Private Wealth Management Inc. (Cumberland) and are not endorsed by Cumberland. The communication may contain forward-looking statements which are not guarantees of future performance. Forward-looking statements involve inherent risk and uncertainties, so it is possible that predictions, forecasts, projections and other forward-looking statements will not be achieved. All opinions in forward-looking statements are subject to change without notice. Past performance does not guarantee future results. CPWM and CIC may engage in trading strategies or hold long or short positions in any of the securities discussed in this communication and may alter such trading strategies or unwind such positions at any time without notice or liability. CPWM, CIC and NCM are under the common ownership of Cumberland Partners Ltd. Please contact your Portfolio Manager and refer to the offering documents for additional information.