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Quarterly Update | Q1 2022 | EP106

April 20, 2022 Print

CIO Paul Moroz shares his take on what’s happening in the markets, some of the underlying factors behind recent performance, and a reminder that the wheels of capitalism will continue to turn.


  • The current market themes: war, wartime economy, inflation, central banks raising rates, and rising bond yields
  • Findings from our attribution analysis
  • The tug-of-war between valuations and interest rate sensitivity
  • Looking ahead: The scenarios that Paul is thinking about


A transcript of this episode is available below, modified for a more enjoyable reading experience. For more posts exploring the ideas we talk about in the episode, check out our Related Reads links.

Your Host
Rob Campbell 113 Web 2022

Rob CampbellCFA

Institutional Portfolio Manager

Rob Campbell is an institutional portfolio manager at Mawer Investment Management Ltd., which he joined in 2016. He is responsible for the management and servicing of institutional clients and their portfolios.

Prior to joining Mawer, Mr. Campbell was an investment product specialist with MFS Investment Management, where he communicated investment policy, strategy and positioning; performed portfolio analysis; and led product development.

Mr. Campbell received a Bachelor of Arts in economics from Harvard University. He is a Chartered Financial Analyst (CFA) charterholder with investment experience since 2009.

He is a member of the CFA Institute and CFA Society Toronto. He is also a Canadian Ski Instructor’s’ Alliance (CSIA) Level 4 instructor.


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This podcast is for informational purposes only. Information relating to investment approaches or individual investments should not be construed as advice or endorsement. Any views expressed in this podcast are based upon the information available at the time, and are subject to change.

Rob Campbell:


Our CIO, Paul Moroz, is back on the podcast this week. Paul, welcome.

Paul Moroz:


Hi Rob, thanks for having me.

Rob Campbell:


Paul, there's a lot happening in the world, obviously, and we'd love to get your take on what you see happening out there. Can you, just to start, paint us a broader picture of what you see that's been notable?

Paul Moroz:


It's been a rough ride if you haven't been paying attention. Let's start with we all of a sudden have a little bit of a wartime economy. We're in war mode. We had the Russian invasion of Ukraine. It's something we haven't seen for a while in terms of pitting one superpower, so to speak, against another. I mean there's over four million (it's estimated) refugees that have fled Ukraine. Poland's picked up a lot of that. It's something like the largest human migration since World War II. That's also resulted in a lot of pressure on energy prices as you can imagine. Europe gets over 40% of their natural gas from Russia, so that's created a lot of challenges.



You've had things that have come out of this in terms of boycotting. There's been all of a sudden logistical problems if you're trying to get oil out of Russia, even if you are buying it. And you got to think longer term, that as the West has pulled their resources out of Russia, you end up having some technical maintenance issues in their reserve production, [making it] more difficult to be sustained even if someone is a buyer of Russian oil. Here's another problem with that—as Ukraine is the breadbasket of Europe, this is something that I still think that we will see ripple across the globe in terms of food security. Ukraine… it's either the fifth or the sixth largest exporter of wheat. I've seen stats that suggest that they have about 10% of market share, so that's significant. And stay tuned on that because often when you can't feed your populations, a) it's a humanitarian crisis, but it can lead a lot more political strife.




Paul Moroz:


Then finally, it's created more pressure on supply chains. So, simple examples of car companies in Europe that might have been importing like a wire harness or something, maybe have to shut down their factories for a bit. Any time you have this deglobalization, it creates supply chain pressures. It is effectively inflationary. So there's a lot of pieces going on there. That's the first one: wartime economy.



Second one, just picking up on this inflation theme. Stuff costs more. Just to give you some stats—in the United States, CPI, or the Consumer Price Index, for the last 12 months [ending in] March, that was up 6.5% if you exclude food and energy. If you include food and energy, which are often more volatile—sometimes that's why it's excluded—that number's at 8.5%. Rob, that's the highest inflation in 40 years. In Canada, honestly it's not that better. I mean, we're going to have a new number that comes out soon. To February, we're close to 6%, and I suspect that the reading will be over 6% when March comes out.

Rob Campbell:


To your point earlier, it may still be early yet. In other words, the impact on the inflationary picture may yet take some time to play out.

Paul Moroz:


So, the third piece to that, of what's going on is, central banks are starting to hike in the West more aggressively. The Bank of Canada just hiked rates 50 basis points. As a result of that, as a result of inflation, bond yields are rising. Just for context, the Canada 10-year bond yield got down to about a half a percentage point during… call it “the depths of despair” of COVID. That yield now sits at just shy of 2.8%. That's a pretty rapid move. This is the highest yield in Canada (10-year yield). You have to go back to about 2013 before you've seen this before. So, that is the backdrop: wartime economy, stuff costs more, and central banks are hiking, bond yields are rising because of inflationary concerns.

Rob Campbell:


Just to go a little bit deeper on the move in bond markets. I mean, it does seem quite remarkable across the curve. I know you mentioned rates in the 10-year [are] quite volatile. I think it's long been perhaps expected, or market participants have long sort of figured that rates and yields may go up. But are you surprised by just the speed at which that rise accelerated and has accelerated so far this year?




Paul Moroz:


Well, you had a few things come together. I don't think anyone was surprised that rates would somehow normalize a little bit more. We certainly, central banks, governments, we had easy monetary policy during COVID. We spent lots of money. The printing press was running. And so, we figured that creates some inflation. But I think it's some of these added things that have piled on, so, under-investments in commodities, the resulting pain points in supply chains that have been inflationary. The challenges, Russia and Ukraine, that's just one more to add to the mix.



All that has sort of accelerated the concern about normalizing monetary policy and the bond markets reacted. So, the short story with the quarter is we've seen rates rise enough, we've seen bond yields rise enough. When they're moving this fast, all assets are worth less. That's just the math of it. So, if you're listening and thinking, "Why were balanced funds down?" Both equities and bonds lost in the quarter, and that's why. Everything was backing up at a fast enough pace that the assets are worth less.

Rob Campbell:


With very few places to hide. I mean, if you're a fixed-income investor… really nowhere to hide across that curve, I guess.

Paul Moroz:


The scenario that played out wasn't a great scenario. I mean, in our balanced funds we've been underweight bonds, certainly, high on cash, and not enough.

Rob Campbell:


Fair enough. Talking about some of those other asset classes for which rates sort of underpinned valuations. I mean the other half, or more than half, are our balanced funds, is the equity side which saw quite a bit of volatility exacerbated by war. But I think that volatility started late last year, just with the anticipation of rate hikes. Can you speak a little bit there in terms of what's not a homogeneous asset class? What are some of the areas of the equity market that have been most vulnerable in the last little while for any of the sort of three themes you outlined earlier about just what's happening so far, big picture, this year?

Paul Moroz:


There is, I think, a few things going on. And let's say for a lot of the asset classes on the equity side, the performance wasn't great. It was bad on an absolute basis and in some cases, it was bad on a relative basis. I think that surprises—and it could surprise some people—because historically the way that we manage money and the outcome of our investment process is that we tend to do better as things don't go as well out there in the world. And I think that's because of the quality of the businesses that we invest in. They sort of stand the test of time. This was an interesting period because there's a lot of other factors and it wasn't simply about the earnings quality of the businesses that would play out during a recession. There's a bunch of other things going on.

Paul Moroz:


So when we look at the attribution analysis, there's…I think I'll call it three pieces to this story. One, in our Emerging Markets [Equity] Fund and a little bit in our international mandates, we had some Russian exposure. So as the war was gathering, we were trimming securities to manage risk. I don't think a lot of people expected this full-blown scenario, including the cancelling of Russia, so to speak. We've since sold all those securities, and when we look back, that was a drag on performance both absolute and relative. So a bit there. Another one was—as listeners are aware of our investment philosophy, we are long-term investors, we focus on industries, structures, economic situations, that create wealth.



And over the long term, the wealth created in the stock market is tied highly to the wealth that's created at the company level. How capital allocation is being managed and the excess returns that a business can generate. That means that we actively, consciously, choose some industry structures over the other. So, one of the things that we have always had less exposure over time is commodity-like industries. The reason for that, despite the cycles, whether it be up or down, over a long period of time, the excess returns that that industry can create because of its structure is less than other industries that have characteristics that lead to greater wealth creation. That story's been pretty consistent for a long period of time.



Here's what happened in the last quarter and kind of coming out of COVID is, you've had a really significant boom in energy, in other commodities-based metals, and those were a couple sectors where we didn't have as much exposure. The Russian prices only exacerbated that situation. And so when we go look at the attribution analysis, that shows up. That's small because it's a small part of a lot of the benchmarks, Rob, and that either shows up in allocation—there might be a two or three percentage point weight, say, in the United States to energy where we weren't really there. Or it could be in security selection where it shows up in the type of materials companies that we own, where we've tended to own less cyclical stuff—maybe special chemical companies as opposed to something that is a base metal company.

Rob Campbell:


Got it. It's stronger in Canada as well, just within our domestic strategies as opposed to the international or U.S. ones.

Paul Moroz:


Absolutely. Now the third one, and this is probably the biggest detractor when we go through our attribution analysis, is that a lot of the securities that performed poorly… their business models are intact. Their earnings are intact. It's not so much about cost pressures or something like that. But it seems to be a correlation with higher duration or higher interest rate sensitivity. And some companies… it's a good company, but maybe a little bit more expensive. So in my mind that would be the adjustment. Each of the portfolios had more or less of these companies.



I think I want to pause on this note because over time it's really important to balance out the ability of a company to create wealth—and it might be priced a little bit more because you know it's going to create wealth—versus companies that may appear to have better valuations, and it might be more mature, there might be other problems with it. And that is a balance that [is] not going away. I've characterized it as a tug-of-war—that balance between not so much growth and value, but securities that are just going to have more interest rate sensitivity. This quarter, there was an adjustment. And some of the mandates were certainly on the wrong side of that.

Rob Campbell:


You mentioned the tug-of-war… I suppose it's always been a tug-of-war, just one side has won for the better part of the last, call it 10 or 15 years. Is something different now or is this just a period of sharp adjustment given what we talked about earlier about a lot of things happening out there all at once?

Paul Moroz:


There's a couple things. It's tough to know because you don't know how far this will go. Are bond yields going to go to five percentage points? Are 10-year treasuries going to go to five percentage points? That would result in something very different than if they were to stay low. I would guess that the economy is going to continue to move forward, continue to develop more things in the future that look different than what we have now and not go backwards. So, oil and gas as an example, is you still have a lot of ESG pressures, you have a lot of pressure to transition to greener technologies…

Paul Moroz:


It's still probably going to move forward. Same thing with technology companies. We'll go through cycles, and I think there's going to be a lot of different technology companies that aren't going to make it. We've seen this in the tech boom and bust before. But there's also a lot of wealth that will be created because the businesses are scalable and can create competitive advantages with switching costs. I think it's really important to keep balanced, and for us and the message to our team is, just run process. You are going to get some variation from time to time.



I think that the math of this quarter created sharper variation than we were expecting and that we're used to. Am I worried about the companies that we own and the portfolios if there's a recession in the future? No. We have a number of high-quality businesses. Does it give everyone on the team a huge dose of humility to double check that balance? Absolutely. So, certainly that's been something that everyone on our Research team is looking at and double checking: do we have that balance right?

Rob Campbell:


I appreciate the comment on process—[it] does seem like something important given how quickly the world is moving. Can you speak a little bit about where that process has led us? Where have we either at an individual portfolio level, or I know you've got into the asset mix process for our Balanced clients—where has that process sort of led us? Where have we seen changes within portfolios in the last little while?

Paul Moroz:


Well, on a first-principles basis we've been very concerned about how inflation trickles through the companies, and valuation or duration, which is a fancy word for earning sensitivity, is one thing. But there's also an element of how a business can pass prices through, what that does to their inventory depending on accounting, what that does for their margins over time. And there's business models that sometimes are a little bit better or a little bit worse, and that is something that we have been looking at and adjusting at the margin, tweaking that.



We've also been very concerned, given the amount of inflation, with companies that have business models that are more discretionary in nature. Back to the recession resiliency—I mean this would be a characteristic of the companies that we have in the portfolios where they tend to be more industrial in nature and more resembling infrastructure versus just businesses that rely more on discretionary spending. That's the direction it's gone with process.




Paul Moroz:


My friend, Matthew Andrade, he has a great slogan, and this comes back to maybe the way the world is moving, but it impacts the companies. He says, "The world seems to be going from just-in-time to just-in-case inventory." That statement I think has profound implications. It describes deglobalization, it describes how business models are starting to change and evolve a little bit. And the math ends up adjusting in terms of how much money these companies can make as the world moves in that direction.

Rob Campbell:


So from an asset mix perspective, is that theme of the potential for increased deglobalization, has that shifted anything from an asset mix perspective?

Paul Moroz:


Well, from an asset mix perspective, I think a lot of the adjustments are actually going to be done at the security level. I think that the conversations we’re starting to have—because we've had a pretty vicious move in bonds—and the question for many investors is, "Well, at what point is a lot of that risk taken off the table?" So yes, inflation is higher; you might have a little bit more weakness in bonds. But at some point, you may want to start to neutralize that exposure.



And you’ll see that. If we have rates rise significantly enough, at some point it's really your riskier assets that are going to get hurt more, and you're going to start to see flows into bonds because that's going to attract dollars. And then imagine rebalancing at large pension plans as firms look at their liabilities and try to immunize it. Now, if inflation is persistently high, if we're running at 6.5% or 8.5% percent for a long period of time, well then we have a problem. If that gets under control, then maybe this starts to look a little bit better. So Rob, those are the conversations that we're having at the asset mix level.

Rob Campbell:


Maybe just to push on that a little bit further, because you've talked I think already about a few of these—deglobalization… what if inflation stayed high and uncontrollably so? We talk a lot about preparing as opposed to predicting, which I take to mean, don't take a bet on one particular outcome, stay balanced, but be aware of what different scenarios could evolve. Can you speak to just a couple of those scenarios that you think are really important for either us as investors or for our clients thinking about their portfolios to be prepared for, just given the way that you see how the world may evolve?




Paul Moroz:


These are such difficult questions, and the stock market, the economy, is a complex adaptive system. And that means something moves a little bit to the left and you get a response that you didn't appreciate would happen and it changes the ball game. Even you start to read about things like people coming back into the workforce that have retired, and this inflationary effect is actually increasing your supply of labour at the margin. That's something that maybe you didn't think would be a balancing factor in this. Or simply not spending that much money. I was reading about streaming services, how in the UK there's been a significant amount of cancellations because of the discretionary nature of that.



COVID boom is coming off. It's something if you need to spend more on petrol, you cut your streaming service. My point is here, before we think about scenarios is, this stuff is so complex. But I do believe we have to consider a scenario where actually, energy prices are a significant tax on the economy. They're very high. We have supply chain disruptions. We have rates that are rising. And very soon it actually tips a whole economy into a recession. I think economists are already starting to raise the probability of that happening as early as next year. Now, does that actually happen? I don't know. But all of a sudden if you're back into recession mode, recessions are typically deflationary by nature, all of a sudden you have falling inflation and maybe rates are coming down again [laughs] and what's a great performing asset class?



Maybe it's bonds. Maybe they're back in favour. That would be different than a scenario where let's say rates have to keep on moving higher because inflation is running higher and the Fed and other central banks want to put a stop to that. Honestly, that's one of the reasons why we're running higher cash balances [is] for that optionality. What's the probability of that? Is that a for sure thing? Absolutely not. But is there some probability? For sure. Same thing with the concept that the world is never as sour or as rosy as one might think it is, and there are going to be businesses that create wealth.



So, back to the blow-off with technology companies. A lot of wealth will still be created in these businesses and there will be ones that not only survive, but absolutely thrive. So, we're trying to prepare for these types of scenarios by building diversified portfolios, by staying balanced in our thinking, and just keeping on process. I think that's the message that I want to leave people with. Investing isn't easy because there's always a reason to think that the world is going to end.

Paul Moroz:


The world hasn't ended yet [laughs]. The wheels of capitalism keep on turning, and that's what I tell people. Over long periods of time, you gain a lot more perspective. It is a different period of time; there's a lot of risks out there. It might be a tougher period of time. But capitalism doesn't stop.

Rob Campbell:


Great. Well, Paul, thanks for summarizing that for us and for walking us through how you're thinking about it, and the team. As always, appreciate having you on the podcast.

Paul Moroz:



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This blog and its contents are for informational purposes only. Information relating to investment approaches or individual investments should not be construed as advice or endorsement. Any views expressed in this blog were prepared based upon the information available at the time and are subject to change. All information is subject to possible correction. In no event shall Mawer Investment Management Ltd. be liable for any damages arising out of, or in any way connected with, the use or inability to use this blog appropriately.