What has happened so far this year?

Financial markets have continued to experience heightened volatility year-to-date, due to several factors including, but not limited to, the uncertainty of the path of inflation, continued monetary tightening by central banks, fluctuating energy prices and stress in the U.S. and European banking systems. The ongoing banking troubles have fuelled concerns about further credit tightening, which would put additional stress on households and businesses, weighing on economic growth and making a recession more likely.

Chart 1: Inflation in both U.S. and Canada, albeit still at historically high levels, has moderated recently.
CPI: Consumer Price Index. Source: Refinitiv DataStream and Fidelity Investments Canada ULC. As at March 31, 2023.

On the monetary policy front, the U.S. Federal Reserve (the Fed) raised its benchmark rate of interest by 25 basis points, to a range of 5.00%–5.25%, at its May meeting. While inflation has continued to moderate in the U.S., the Fed noted that tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring and inflation. The Fed remains highly attentive to inflation risks.

Chart 2: The pace of policy rate hikes has reduced in 2023.
Source: Federal Open Market Committee (FOMC). As at May 3, 2023.

The following are the views of various Fidelity portfolio managers who have weighed in on what investors could expect in the remainder of 2023.

Chief Investment Officer and Portfolio Manager Andrew Marchese expects that the price movements of risk assets in 2023 will be predominantly governed by corporate profits, unlike in 2022, when macroeconomic factors, such as central bank actions and rising inflation, heavily influenced the investment landscape. Accordingly, investors need to pay attention to key indicators, such as global nominal GDP, global PMIs, housing, wages, employment and credit spreads, and how they might affect companies.

According to Andrew, it is important for investors to focus on market leadership and opportunities, but not “the market” itself. Markets are a forward-looking mechanism; therefore, it is typical for stock prices to move ahead of earnings. Focusing on stock picking and valuations will be paramount, as timing a turn in the market with precision is nearly impossible. The price of individual securities is the best guide, in Andrew’s experience. Instead of focusing on broad market turns, Andrew plans to focus on individual securities that have asymmetrical risk/reward profiles, and where upsides outweigh downsides over a three- to five-year investment horizon. Investors should use PMIs, negative earnings revisions and shifts in global central bank policy as guideposts to selectively add to risk in their portfolios in 2023, in Andrew’s view.

Chart 3: The global business cycle has become less synchronized, with China accelerating amid a post-COVID reopening. The U.S. is in the late-cycle phase, with recession potentially on the horizon.
The diagram above is a hypothetical illustration of the business cycle, the pattern of cyclical fluctuations in an economy over a few years that can influence asset returns over an intermediate-term horizon. There is not always a chronological, linear progression among the phases of the business cycle, and there have been cycles when the economy has skipped a phase or retraced an earlier one. Source: Fidelity Investments (AART), as at March 31, 2023.

The Global Asset Allocation team, David Wolf and David Tulk, note that major central banks have continued along their monetary policy tightening path, pushing the global economy deeper into the late cycle, leading to increased recessionary pressures. In addition, turmoil in the U.S. and European banking sector, combined with fluctuations in investors’ views of inflation and monetary policy, has contributed to volatility. Slower liquidity growth, persistent inflation risk, slowing growth momentum, and monetary policy uncertainty all raise the odds that market volatility will remain elevated throughout 2023. In the managers’ view, market participants are increasingly buying into a narrative of policy rate cuts and a soft landing – a narrative that they consider unlikely. From a bottom-up perspective, they believe that future earnings growth estimates have become too optimistic, although they acknowledge that corporate fundamentals remain resilient.

The managers continue to believe that inflation risk remains a bigger concern than market participants realize. While they expect the moderating trend in headline inflation to continue, core inflation (excluding food and energy) will be harder to control, because tightness in the labour market is keeping services costs elevated. The managers also note that inflation will likely remain above the Fed’s 2% target in the medium term. Even though central banks are aware of the damage aggressive policy actions will have on the economy and the labour market, their priority is to ensure that expectations of future inflation remain anchored, and that price stability is restored. 

Chart 4: Fidelity Global Balanced Portfolio positioning
Source: Fidelity Investments Canada ULC. Fidelity Global Balanced Portfolio’s blended benchmark consists of 21% S&P/TSX Capped Composite Index, 39% MSCI All Country World ex Canada Index, 23% Bloomberg Global Aggregate Bond Index, 12% FTSE Canada Universe Bond Index and 5% FTSE Canada 91-Day T-Bill Index. Positioning is as at the date noted and is subject to change. As at March 31, 2023.

While the asset allocation managers have maintained a moderately defensive positioning in their portfolios, they continue to find opportunities in emerging markets equities, which they believe should offer attractive growth prospects over the medium term, while also providing attractive risk/reward in the short term as China continues to reopen. The managers aim to build portfolios that are resilient in a wide range of outcomes. They believe constructing portfolios that are well diversified across asset classes, styles and regions is the right way to both protect and grow capital over the long run.


Viewpoints from our fixed income managers

Portfolio Managers Jeff Moore and Michael Plage note that bond investors have recently had to deal with multiple cross-currents. In January, the market widely expected a downshift in the pace of tightening, which would presumably have preceded a pause and then future rate cuts. That expectation, coupled with the consensus view that bonds were cheap, drove bond yields lower to start the year. In February, a string of surprises in economic data (reacceleration of inflation, robust strength in the labour market, no sign of weakness in the consumer) and the accompanying Fed mantra “we may have to do more” reversed January’s “everything rally” in stocks and bonds. In March, there was a historic surge in interest rate volatility: multiple bank failures and a global bank run on deposits drove government bond yields, gapping up and down in rate, often on successive days. The managers will be watching for evidence that broader credit conditions have tightened more recently. If so, the Fed may well see that a pause is needed. However, at this stage, the managers note that it is not obvious that credit conditions have tightened broadly and consistently.

Chart 5: The MOVE Index, a measure of volatility in treasury markets, spiked during the first quarter, while the VIX Index, a measure of equity market volatility, remained relatively range-bound.
Source: Refinitiv DataStream and Fidelity Investments Canada ULC. As at April 17, 2023. The MOVE Index is the ICE BofAML U.S. Bond Market Option Volatility Estimate Index, which measures the implied yield volatility of a basket of one-month over-the-counter options for two-year, five-year, ten-year and 30-year treasuries. The VIX Index is the CBOE Volatility Index, a measure of the stock market’s expectation of volatility based on S&P 500 Index options.

In today’s environment, the managers are most enthusiastic about U.S. Treasuries and duration. They note that Treasuries are paying more yield than they have in years, and with the Fed lowering inflation, they believe the backdrop could become more favourable for strong potential returns in the foreseeable future. They also like Treasuries for their historically inverse correlation to the equity market and the insurance they provide against tail risk events.

To fund an increased exposure to U.S. Treasuries and duration, the managers have primarily been reducing their position in leveraged loans. Spreads are fair value for this asset class, given expectations of relatively low default rates, despite increased downgrade risk and more challenging fundamentals due to increased interest expenses for loan-only issuers. The managers are also reducing their international credit exposure, given the correlation of the asset class to European government yields.

Portfolio Manager Adam Kramer, manager of Fidelity Tactical High Income Fund, notes that in 2023, financial markets have encountered multiple cross-currents in the first few months of the year. Investors saw a Fed intent on pulling off a delicate balancing act of containing inflation and cooling economic growth, while still weighing risks to the financial system. Today, Adam believes we are in the late stages of the economic cycle, and sees more opportunity in the credit markets than he does in equities. He is repositioning his portfolio accordingly.

An area of focus more recently is the “busted” convertibles that many tech companies have issued in recent years as a way of raising capital to fund their growth. Technology firms and other fast-growing companies have long issued convertibles to help fund their growth, and Adam has seen opportunities to buy convertible bonds at prices that are significantly less than their face, or “par,” value. Adam notes that many of these busted convertibles are trading at between 60 and 75 cents on the dollar, and they may be less volatile than stocks, which historically have struggled when the economy slows, as it may do in the months ahead.

Investment-grade fixed-to-floating rate preferred stocks issued by big banks are another example of opportunities in unexpected places. Like tech stocks, bank stocks have been in the news recently, but for reasons that give many investors concern. Adam believes, however, that larger banks do not face the same challenges or pose the same risks for investors that smaller ones do, and their investment-grade debt presents a more attractive opportunity than their dividend-paying stocks.

As the economic and interest rate landscape evolves in coming months, companies that mine gold may offer another unexpected income opportunity. Gold has long been popular with investors who are concerned about the power of inflation to reduce the value of cash and other investments; however, owning gold also comes with risks. Gold miners’ earnings have historically grown when demand has risen –as it often has when economic growth has been weak and real yields have declined along with interest rates. Gold miners also typically distribute a significant portion of those earnings to shareholders in the form of dividends.

Chart 6: Trended asset allocation
Source: Fidelity Investments Canada ULC. As at March 31, 2023.

Viewpoints from our equity managers

Canadian equities

In Portfolio Manager Dan Dupont’s view, risk remains elevated in the current market environment, and traditional recessionary signals such as the inverted yield curve continue to signal decreased demand for risk assets. He notes that every recession has been preceded by an inverted yield curve, which tends to highlight a slowdown in the economy through tightening of money availability and liquidity. Dan believes that restrictive monetary policy and the increased potential for a recession could continue to drive volatility and have a negative impact on the broader market.

Chart 7: The ten-year less three-month Treasury yield experienced its greatest inversion since 1981. Historically, an inverted yield curve has been a reliable recession indicator.
Shaded areas denote U.S. recession as defined by the National Bureau of Economic Research. Source: Refinitiv DataStream and Fidelity Investments Canada ULC. As of March 31, 2023.

Against this backdrop, Dan stresses the importance of positioning the portfolio to be prepared for a variety of market outcomes. In doing so, he remains more conservative than usual, and instead of allocating to inopportune risk/reward ideas, he believes it is a prudent time to concentrate on company fundamentals, fully understanding their upside and downside potentials. He will be patient in waiting to capitalize on future opportunities as they present themselves. Much as in 2020, when Dan took advantage of opportunities that were abundant in the oil and banking industries, he maintains a keen focus on searching for ideas that present appealing risk-reward trade-offs, wherever they might be.

Over his career, Dan has stayed disciplined in his investment philosophy of capital preservation. Depending on the market backdrop, this style could be in and out of favour. Over the longer term, however, this investment approach has been beneficial to the portfolios managed by Dan.

Portfolio Manager Don Newman remains cautious on the economic environment, given the effects of monetary tightening and potentially sticky inflation. Although headline inflation has been easing, Don notes it has been a relatively easy downward glidepath, driven mostly by transitory factors. He is focusing on whether inflation can continue to move toward the 2% target or whether it will be stickier and stay higher, around 4% perhaps, for longer. He notes that the labour market has remained strong, which suggests that inflation may indeed be stickier. With core inflation potentially slower to adjust, interest rates may have to stay higher for longer, in contrast to market participants’ expectations of interest rate cuts later this year. Against that backdrop, Don thinks there may be room for valuation multiples to compress moderately, given that valuations have increased since the beginning of the year; he expects limited earnings growth for the broad equity market.

Don has been focusing on three main themes: 1) reasonable price-to-earnings ratios with attractive dividend yields and earnings growth potential; 2) companies with inflation protection characteristics; and 3) opportunistic ideas leveraging the work of Fidelity’s equity research team.

Don believes dividend-paying equities continue to be in favour in this market environment: unlike much of the past decade, or more, inflation remains high, and could stay higher than the central bank target of 2%. If inflation were to stay at around 4%, purchasing power for investors would continue to erode. Investing in quality dividend-paying equities means that dividend yield could perhaps cover inflation, while allowing the potential for growth, and in this way making for less of an uphill battle for potential total returns.

Chart 8: Reinvesting dividends could provide a considerable difference to returns over time thanks to the power of compounding.
Source: Refinitiv DataStream and Fidelity Investments Canada ULC. Cumulative returns are in Canadian dollars and are calculated for the period between April 1993 and April 2023. Past performance is no guarantee of future performance. Annualized performance of S&P/TSX Composite Total Return Index: one year, 2.67%; three years, 15.15%; five years, 9.03%; ten years, 8.40%. Annualized performance of S&P/TSX Composite Price Return Index: one year, -0.60%; three years, 11.77%; five years, 5.74%; ten years, 5.18%.

Portfolio Manager Hugo Lavallée observes that the market backdrop remains fluid and highly uncertain, which highlights the need to remain flexible in managing his portfolios. He notes that some parts of the economy might face additional headwinds as rising interest rates filter through the system. Consequently, investor sentiment has been poor, and share prices have fallen for companies that are highly sensitive to interest rate fluctuations.

Despite the short-term challenges, Hugo believes there are reasons to be more optimistic about these companies that have fallen out of favour, as behavioural changes have started to become apparent across management teams. Certain companies are increasing an emphasis on profitability and earnings, and Hugo believes this could present attractive opportunities.

Hugo thinks that the current market backdrop is supportive of active investing, and he prefers to focus on company fundamentals and valuation, instead of macro trends, when investing. Volatility often provides opportunity, and active managers can engage with companies to assess the situation thoroughly in order to make calculated investment decisions on a risk/reward basis. Hugo notes that there are always contrarian opportunities in the stock market; he has found interesting ideas recently in the communication services and industrials sectors, including certain gaming companies and U.S. railway firms.

U.S. equities

Portfolio Manager Will Danoff notes that the global business cycle is less synchronized and faces multiple crosswinds. The U.S. is in the late-cycle expansion phase, with an increased likelihood that recessionary pressure may persist in 2023. Banking-related stress after the failure of two regional banks elevates the odds of a recession, based on his analysis. The labour force has grown by about two million people since February 2020, and the labour force participation rate has generally recovered to pre-pandemic levels for prime-age workers. Despite rising costs in 2022, companies were generally able to pass along higher prices to grow earnings and maintain high profit margins. However, the earnings outlook deteriorated in the first quarter of 2023, with investors expecting slower sales and earnings growth for calendar-year 2023. The markets still appear overly sanguine about how quickly and painlessly the Fed can pivot to easing monetary policy. Slower liquidity growth, persistent inflation risk, tentative growth momentum and heightened uncertainty related to monetary policy raise the odds that market volatility will remain elevated. 

Chart 9: U.S. earnings growth is expected to slow, coming down after a decade-high spike during the 2021 profit recovery associated with economic reopening.
Source: Fidelity Investments Canada ULC and Refinitiv DataStream. As at March 31, 2023. Returns shown are in U.S. dollars.

Will did not meaningfully change his portfolio over the first quarter of the year. He entered the new year comfortable with and confident in the moves he made during the fourth quarter of 2022 – moves taken largely to position the portfolio appropriately for a higher-interest-rate environment, dampening economic growth and compressed stock valuations. As rates climbed last year, he shifted positions to be more defensive. He sold some expensive and unprofitable holdings, many of which were in the information technology sector, and emphasized economically resilient sectors, such as health care and the military/aerospace category, along with energy exposure, which benefited from the inflationary environment. Against a dynamic backdrop, Will’s focus on fast-growing, “best-of-breed” firms contributed to performance relative to the benchmark over the first quarter. Will’s approach remains consistent: he favours profitable companies with strong balance sheets and free cash-flow generation, a leading and growing market share and an experienced and reputable management team.

Global equities

Portfolio Manager Mark Schmehl believes that the macroeconomic backdrop remains challenging for investors to navigate, due to many underlying cross-currents. In his view, we are likely closer to the end of the interest rate hiking cycle than the beginning. Still, even with the rate hiking cycle perhaps closer to its end, markets may continue to oscillate, keeping volatility elevated. It is important to analyze companies from a long-term perspective, looking beyond 2023, and instead focusing on what earnings could look like in a more normalized environment.

Chart 10: Sector leadership varies year to year.
Sector returns are shown for S&P 500 Index (in U.S. dollars). Source: Refinitiv DataStream and Fidelity Investments Canada ULC. As at December 31, 2022.

Mark aims to position his portfolios to participate in an eventual economic rebound. With this perspective, he is spending more time looking at areas that he believes represent good risk/reward over the long term. Given heightened uncertainty, investors should remain cautious; Mark wants to own high-quality companies with strong balance sheets, which he believes could be better able to withstand potential economic drawdowns. Currently he is exploring opportunities among companies that are going through turnarounds, especially in the information technology and communication services sectors, and he is also paying close attention to fast-growing companies. He also has exposure to stocks that he believes might do well in an easing cycle, in a scenario in which the Fed eases its policy stance. In this way, he believes that the portfolios are well positioned and have exposure to various possible economic scenarios.

Portfolio Managers Joel Tillinghast, Sam Chamovitz, Morgen Peck and Salim Hart acknowledge there are ongoing risks in the macroeconomic environment; however, they continue to manage their portfolios with a focus on value and quality. In a highly volatile environment, to combat inflation, they want to own companies with strong pricing power that can pass on input price increases to customers. They also prefer businesses that can weather higher interest rates and are less vulnerable to an economic downturn.

They acknowledge that the U.S. may go into recession, but given the strength of the labour market, they believe that it will not be as bad as the global financial crisis. They also know, however, that they can't precisely predict the magnitude, duration or timeline of any U.S. recession. Stocks increasingly are trading on macro data points; this is causing more stocks to trade at prices below the managers’ view of their fair value, leading to opportunities. Amid the broad sell-off stemming from the collapse of certain banks in the U.S. and Europe, the managers have found opportunities among select high-quality banks that were trading at cheap valuation multiples and have strong risk management practices in place, as well as diversified deposit bases. The managers continue to search for the stocks that have become the most mispriced but still meet their criteria for quality. 

Chart 11: Invest in global equities to take advantage of a larger investment opportunity set. There is no doubt Canada is home to some great companies, but there are also many great investment opportunities to be found outside of Canada.
Source: Refinitiv DataStream and Fidelity Investments Canada ULC. As at March 31, 2023.

Emerging markets equities

Despite macroeconomic uncertainty, Portfolio Manager Sam Polyak believes emerging market equities may be poised to outperform their developed market counterparts. Along with the diversification benefits emerging markets typically possess, this asset class continues to trade at historically cheap levels, while showing strong corporate earnings growth potential relative to slowing developed equity markets. Developed equity markets like the U.S. have benefited from stronger earnings growth over the past decade, but profits are widely expected to be challenged as the economy slows with increased interest rates.

Chart 12: Emerging market valuations appear more attractive.
DM: Non-U.S. developed markets, EM: emerging markets. Chart includes trailing 12-month P/Es. DM is represented by the MSCI EAFE Index; EM is represented by the MSCI Emerging Markets Index, and the U.S. is represented by the S&P 500 Index. P/E denotes price-to-earnings. Source: Refinitiv DataStream and Fidelity Investments Canada ULC. As at March 31, 2023.

The start of 2023 brought renewed optimism about emerging markets, given the reopening of China's economy after pandemic-related lockdowns. However, it also brought uncertainty: U.S.-China tensions escalated again, and there was a widespread loss of confidence in U.S. regional banks and certain European banks.

Sam remains focused on the potential for a weaker U.S. dollar and the prospects for increased growth in emerging economies, providing potential strong tailwinds for emerging market equities. The investment landscape continues to be uncertain, with tighter global monetary policies and growing fears that it will take a recession to subdue inflation. However, Sam avoids trying to predict these uncertain macro factors, and focuses instead on owning the best companies at attractive prices. He believes the current short-term uncertainty may lead to security mispricing that can allow emerging market equities to outperform over the long term.

To close

Although the market backdrop remains challenging, with ongoing recessionary pressures, patience and rigour in a disciplined investment approach are still likely to yield fruitful results over the longer term. Investors should ensure that their portfolios are sufficiently diversified across asset classes to help navigate a wide range of outcomes.

Despite market volatility, which is a normal part of investing, investors should not lose sight of their long-term investment goals. Diversification and working with a financial advisor can help manage short-term risks while pursuing one’s long-term investment goals.