Second Quarter | 2022

Market overview

Investors have had a punishing year so far in 2022, and in the second quarter there were even fewer places to hide. Many themes from the beginning of the year have persisted, most notably inflation continued to reach multi-decade highs. In the second quarter, the commitment by central banks (such as the U.S. Federal Reserve) to tame inflation and the increased probability of a recession had a profound effect on risk assets, with both bonds and equities once again experiencing significant declines. Commodity-heavy markets such as Canadian equities, that were able to weather the storm in the first quarter, were also unable to escape the fall as metals prices pulled-back from recent highs.

Despite a reversal toward the end of the quarter, bond yields moved higher in most major economies. Credit spreads also widened, and, in a further sign of heightened investor anxiety, both the euro and the Japanese yen slid to multi-decade lows relative to the U.S. dollar.

How did we do?

Performance has been presented for the A-Series Mawer Mutual Funds in Canadian dollars and calculated net of fees for the 3-month period of April 1 – June 30, 2022.

This quarter saw another period of significant declines for equity markets as the combination of higher discount rates and a more muted outlook with respect to companies’ top-line growth and margins have added further fuel to the sell-off.

Many of the same themes that played out in the early part of 2022 continued in the second quarter. Most notably, another move higher for discount rates has continued pressuring stock prices on businesses more sensitive to rising interest rates. Examples of higher growth holdings that had their stock prices pull back in the quarter include Amazon.com, payments processor Adyen, and IT value-added reseller Converge Technology Solutions.

Overall, as the interest rate environment has evolved, we have been lowering our exposure to holdings more sensitive to rising interest rates, which is often also where valuations appear stretched.

More recently, as concerns about the economic outlook have grown, it is no longer just inflationary concerns and discount rate considerations that are impacting stock prices. Given an increasing probability of a recession, stock prices declined for holdings such as Taiwan Semiconductor Manufacturing, a business where end market demand could wane in a recessionary environment, and Ashtead Group, an economically sensitive construction equipment rental company. In both of these cases the pullback is due less from recent results, and more from uncertainty in the economic outlook. More cyclical businesses such as those within metals and mining also experienced sharp declines over the second quarter. Our general underweight exposure to such materials businesses, which we believe are typically less competitively advantaged, had a positive impact on relative performance.

One of the key elements of our investment philosophy is to seek wealth-creating companies that exhibit sustainable competitive advantages. As recession worries grow, boring businesses with more stable and recurring revenues—those with competitive advantages that allow them to exert pricing power in the face of inflationary pressures without impairing demand for their products or compromising their competitive position—may be in a better place to endure. More recent relative performance has reflected this trend, as businesses fitting this category have weathered the storm comparatively better this quarter. Examples of holdings that have managed to outperform include Novo Nordisk, a Danish pharmaceutical company that focuses on treatments for diabetes, Hydro One, a Canadian utility, and Essity, a Swedish hygiene and health company.

Mawer’s balanced funds declined over the second quarter as both bond and equities finished with negative returns. With Canadian bonds’ notable fall in the first half of 2022, their long-term return potential has improved as yields are no longer hovering near historic lows.

From an asset mix perspective, we continued to trim our equity target weight in the quarter, while electing to increase the cash target. Higher cash weights help lower the overall sensitivity to rising rates and give us greater optionality to reinvest moving forward. Overall, we have steadily reduced our equity weight in the last six months.

Looking ahead

While predicting the economy’s future is an exceptionally tough task, as we have mentioned above, the probability of a recession has grown as it appears increasingly difficult to get inflation under control without impairing economic growth. The risk that inflation becomes entrenched could also rise as we see signs of changing inflation expectations with workers demanding higher wages. On top of being impacted by rising interest rates, global growth is also facing headwinds from higher food and energy prices that are eroding consumer purchasing power and the COVID-19 lockdowns in China that are dampening economic activity.

Even though the possibility of a soft landing appears increasingly challenging for central banks to achieve, nothing is a foregone conclusion. And despite the plethora of economic and geopolitical challenges, there is a possibility of positive surprises that the market may have overlooked including the potential for subsiding inflationary pressures, China relaxing its zero COVID-19 policy, and a resolution to the war in Ukraine.

While the risks may appear heavily one-sided, we have been focused on ensuring that our emotions stay balanced. Our philosophy and process orient us toward businesses that are enduring, that have the ability to exercise pricing power through the value propositions they provide to their customers, and that are run by able and honest managers. We have been revisiting our discounted cash flow models to ensure that they reflect the economic scenarios that many of these businesses may face, and we’ve been speaking with management teams to understand how they’re planning to tackle a potentially more challenging environment.

Considering the many risks facing the economy, our own path continues to be playing the plan: focusing on the fundamentals of the businesses we own and adhering to our investment process. We also see market volatility as a potential opportunity to invest in many high-quality businesses that we have previously passed on due to valuation.