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Commentary

Our thoughts for 2023

December 8, 2022

U.S. flag and Wall street sign in Manhattan's financial district.

As we write this commentary, stock markets around the world have been staging a spectacular rebound over the last few weeks. Many are now in a bull market, meaning they are up more than 20% since the last bottom.

How to explain such optimism when inflation remains stubbornly high, central bank rates are still rising, the war in Ukraine rages on, and China is still committed to a COVID-zero policy?

In the last few weeks, we attended numerous small cap conferences in the U.S., Japan, the UK, Norway, France, Taiwan and Vietnam to further research that optimism. In all, we met over 100 companies and attended various industry and thematic panels.

There were a lot of takeaways from these meetings, and in this week’s commentary we will focus on the U.S.

  • A majority of companies indicated they will continue to raise prices in 2023 to offset continued inflationary pressures. For example, cement companies expect cement prices to go up 12% in 2023. Residential housing may be down, but infrastructure spending – turbocharged by the Inflation Reduction Act – will more than offset this decline. John Deere just announced equipment prices will go up 11% in 2023. Meanwhile, agricultural prices remain high and farm income is near a record, boosting demand. New car prices will go up double digits.
  • Companies expect to increase salaries in 2023 by more than they did in 2022, with the general expectation that wage inflation will be between 5-10%. As a possible indication of things to come, four freight rail unions – with a combined membership of close to 60,000 rail workers – recently voted down the five-year contract agreement brokered by the Biden administration back in September. The rejected deal would have given workers a 24% raise over five years and an average immediate payout of $16,000 in back raises and bonuses. As we write this comment, Amazon workers in more than 40 countries are staging walk-off protests with the slogan “Make Amazon Pay.”
  • Demand remains strong. Although some weakening has been felt since the latter part of November, the latest economic indicators seem to reflect a resilient economy that is still growing. For example, the Empire Manufacturing Survey came in at 4.5 compared to expectations of -5.0, indicating positive expansion. This follows -9.1 in October. Durable goods orders were very strong. Of note, retail sales were solidly positive – accelerating from the prior month – and new home sales were stronger than expected. As well, jobless claims remain below the pre-pandemic levels. In the hotel sector alone, more than 200,000 positions remain vacant.

Does the stock market believe in a soft-landing scenario? Maybe. But it is now convinced that the Fed will pause its interest rate hiking cycle and may even lower rates in 2023! The consensus right now is that inflation will continue to go down and should end next year at around 3.5%. Interest rates will continue going up but should peak around 4.5 to 5% by mid-2023, and may start coming down by the end of 2023.

Our scenario is very different.

We believe inflation at the end of 2023 will still be at 5% or above. Why?

As indicated above, wages will rise more than 5% and rent increases will continue to exceed 5%. Meanwhile, commodities – after relatively easy year-over-year comparisons in the early part of 2023 – will start going up again towards mid-2023. Metal prices are already going up, as are natural gas prices. Food prices will continue going up, and insurance prices are poised to explode in 2023. 

Facing such inflation, and at the risk of losing its already low credibility, the Fed will continue raising rates. How high? We believe the only way to break the inflation expectation, which is what the Fed is focused on, is to see slack in the labour market. That probably means an unemployment rate above 6%. We are far from that level.

The Fed also needs to see home prices decline 20% or more. Yet despite price declines in the last few months, home prices were still up year over year at the end of October.

In other words, the market is too optimistic.

The rally is also explained by seasonal effect and oversold conditions. This rally, however, has been of poor quality, similar to what we saw in the summer of 2020. Unprofitable companies with weak balance sheets have been the best performers.

We knew that we might trail the market performance this fall and maybe even into early 2023. However, our portfolio is well-positioned for a more difficult environment in 2023, in which we will see much lower economic activity and possibly even a recession combined with higher interest rates.

Towards the end of the first quarter of 2023, we expect to see a rotation to higher-quality companies with little to no debt and the ability to gain market share.