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Martin Pelletier: Betting one’s portfolio on an outright win over rising prices could be a dangerous proposition
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Those in political power along with equity market participants seem to think the war on inflation has already been won, but perhaps it is too soon to declare victory.
Canada’s Minister of Finance Chrystia Freeland certainly appeared to be declaring mission accomplished a few weeks ago when she described the 2.8 per cent inflation print for June as a “milestone moment.”
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South of the border, July’s 3.2 per cent inflation figure was welcomed with open arms by long-duration equity participants, with the Nasdaq rising on the news. As usual, long-duration bond market investors were having none of it, as 20- and 30-year U.S. treasuries traded slightly down on the day.
Some serious progress has been made on inflation, but this war is far from over, even though the United States government is spending as if it is. The U.S. budget deficit has hit US$1.6 trillion so far this year, more than double what it was a year ago. We worry that as this continues it could undo a large part of the progress accomplished through interest rate hikes by the United States Federal Reserve.
We’re already seeing some signs emerging that inflation is starting to fight back. For example, the U.S. July CPI print marked the first month-over-month increase since June 2022. Though inflation was down year over year, the largest components of the drop were fuel oil, down 26.5 per cent, gasoline, down 19.9 per cent, and gas utilities, down 13.7 per cent. Core inflation for the month still came in at a hot 4.7 per cent.
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Base effects that have been working to reduce inflation could also turn against it. For example, WTI oil prices last July were more than US$100 per barrel, but fell to US$93 in August and then US$84 in September. If oil prices are higher than those levels in the months to come, something that is quite possible, where will the large drops in inflation come from?
You also have the situation where global commodity prices have been rising with wheat, corn, cotton, sugar and cocoa up 2.5 to 5.5 per cent in July. Current prices for these items could continue to rise above last year’s levels as well.
Overall, we believe that should inflation remain persistent, institutional investors will have no choice but to once again rotate out of the high-flying, interest-rate-sensitive segments of the market, such as the Nasdaq and megacap technology companies, and back into energy and commodities.
One way we’re playing this is via Canadian energy companies, which on the whole are trading at 2.5 times cash flow and less than six times earnings. This multiple is quite something considering the megas are trading at 35 times earnings. It doesn’t help that you have trillion-dollar companies such as Nvidia Corp. trading at 220 times earnings, and as if artificial intelligence will displace 50 per cent of U.S. knowledge workers by the end of 2027, according to 3Fourteen Research.
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We like the Capped Energy index because 66 per cent of it is in four excellent companies, Canadian Natural Resources Ltd., Suncor Energy Inc., Cenovus Energy Inc. and Tourmaline Oil Corp. For some higher torque, we also own some mid-cap intermediates such as Tamarack Valley Energy Ltd., MEG Energy Corp., Whitecap Resources Inc. and Crescent Point Energy Corp.
We think the catalyst for these stocks to get a large lift will be oil prices staying at current levels for the next few months.
We also have a good exposure to direct commodities as well via a commodity futures fund, and the Invesco DB Agriculture Fund. Global drought conditions along with disruptions from the ongoing war in Ukraine are starting to wreak havoc on supplies of sugar, rice, wheat, corn and olives.
Finally, we think owning some U.S. dollars is also not a bad idea as a hedge against the weakening Canadian economy, which has much greater sensitivity to interest rates than the U.S.
It will be just a matter of time before interest rates start to really impact Canadian mortgage holders, so there is a greater likelihood for the Bank of Canada to cut rates faster than the Fed. This is because Canadian mortgages have significantly lower terms, at less than five years, than the U.S., with the majority of households having locked in ultra-low rates for 30 years.
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We’re parking a large part of our U.S. cash into the iShares Floating Rate Bond ETF, which has a 6.3 per cent yield to maturity and owns short-term investment grade bonds, with two-thirds invested in bonds with less than two-year terms.
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Battles come and go, but betting one’s portfolio on an outright win over rising prices in the near term could be a dangerous proposition. We prefer to have a bit of insurance in place in the event that the war on inflation drags on longer than many expect. As Louis L’Amour famously said: “Victory is won not in miles, but in inches. Win a little now, hold your ground, and later, win a little more.”
Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc, operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.
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