Markets take a breather; portfolio positioned for disruption
A sharp rise in equity market volatility was one of the key developments in the month of September as we headed to the end of the third quarter. At its peak in July, the portfolio was up 22.0% for the year. The S&P 500 was flat for the quarter even though it declined by 3.9% in September and is up 14.8% for the year.
Several positions were eliminated during the quarter. All of them, with the exception of Deutsche Bank, are profitable. We have sold out of our energy holdings completely (ARC Resources, Ovintiv and BP Plc) and slightly increased our position in gold, while selling out of silver completely. We have also started to add floating rate securities, given the likely and eventual rise in long term interest rates.
Our main concern right now is not so much what we are hearing from corporate managements, but what we are not hearing. Most corporates we track, especially in the industrials and materials sector (but increasingly across other sectors), are raising the issue of supply chain bottlenecks and sharply escalating cost of materials. So far, few if any managements are sounding like this could be a persistent problem. The issue we are not hearing about is that we are likely at the beginning of a new capital investment cycle and that companies are in an expansion mode, adding new capacities and even onshoring. Just as we are seeing supply chain disruptions and skyrocketing material prices, we are entering a new investment cycle.
Along with this corporate investment cycle, governments are also beginning to spend on infrastructure. Households have started investing in homes, leading to new record home prices and a sharp increase in housing starts. Canada has been in record territory here for some time, and the US is racing up the same slope. This could have a significant impact on prices, availability of raw materials, and finished products in the quarters ahead. Developments in China are a major cause of these supply chain disruptions and alleged Chinese hoarding of materials is helping drive prices higher. The immediate concern will be the impact on corporate margins and the broader impact on return on capital (more capital at work with lower rates of return), likely beginning in 1Q 2022.
While third quarter ended with market indicators mixed with a bullish bias, there remains the possibility of a sharp and swift correction (10.0% or more). We are more fixated than ever on what we need to do in case of a correction, rather than anticipating further gains in the stock market (though further gains are a possibility under the loose money central banking policy in operation today). We have been taking steps to adjust the portfolio as we head towards a market correction from the end of the first quarter of 2021 onwards. Our key risk mitigation in anticipation of declines has been building cash positions. In our communication to you after the second quarter (April to June) we had pointed out that the risk/reward set up is not favourable for equities as a class and we were not in favour of being overweight equities. To that end, even though we added some names to the portfolio, we took steps to reduce our overall exposure to equities while building exposure to fixed income and alternative assets. That stance has borne out in the third quarter.
The quarterly results from Nike Inc, has dampened enthusiasm for consumer stocks in particular, and the broader market in general. Even with Nike’s diverse supply chain and significant redundancies built in to its operations, their sales took a 5.0% hit due to disruption in global supply chains resulting from Covid-related lockdowns and disruptions in China. These disruptions could be even more widespread and more entrenched than previously anticipated.
The decision to exit energy stems from the regulatory dynamics unfolding in the US and Canada. With over 50.0% of crude demand coming from automobiles. and the transport sector’s push for electrification, we will see a fundamental impact on demand for crude oil sooner rather than later. We expect significant headline-driven volatility in energy prices but it remains a structurally challenged sector going forward, with valuation becoming increasingly tricky.
Tactics and Execution
We are taking a more tactical approach to some parts of the portfolio and are consistently shortening our holding period and expected returns. This strategy has been executed for the last two or three quarters successfully. We expect that to continue into the foreseeable future, or until we see a significant correction in the market in which we can clearly see fresh longer-term investment opportunities.