2023 Q2 Coleford Quarterly Commentary

North America’s economy trended largely as expected in the second quarter, picking up from where it ended on March 31^st. Inflation moderated in the face of higher interest rates, and the world’s biggest companies continued to become significantly larger.

Taking each trend in turn, we note a gradual month-on-month decline in the rate of inflation in both Canada and the United States. At home, the month of May reading showed annual inflation slowed to 3.4% from its peak of 8.1% in July 2022. For the same month, the Consumer Price Index in the U.S. was 4.0%, down from  9.1% in June 2022.

Consumer Price Indices from January 2020

This trend influenced the decision of the U.S. Federal Reserve to maintain its target interest rate on June 14th, following 10 consecutive rate increases. In March and April, the Bank of Canada also maintained its overnight policy rate at 4.50% after eight consecutive increases that started in March 2022.

Policy pauses in Canada, however, were short lived as the Bank of Canada raised its overnight rate in June by 0.25% reflecting its view that “monetary policy was not sufficiently restrictive to bring supply and demand back into balance and return inflation sustainably to the 2% target.” The Federal Reserve also indicated that it believes more rate increases are appropriate.  That said, inflation moderation is undoubtably good news as it demonstrates to central bankers that their policies are beginning to bite. The question now is what impact tighter credit markets will have on growth in the economy. Clearly, there will be an impact.

A major difference between the year’s first two quarters was the absence in Q2 of bank failures as solutions provided by the U.S. government appear to have contained the fallout from the demise of Silicon Valley Bank and First Republic Bank. This too is good news.

Mega-cap stocks drive index performance

One prominent aspect of equity market returns in North America has been the performance of mega-cap stocks which are driving a disproportionate share of gains. For purposes of discussion, mega-capitalization stocks – those with market values measured in some cases in trillions of dollars – include Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, Tesla and Netflix. While the S&P 500, a broad measure of the US stock market, recorded year-to-date (YTD) growth of 16% (red line below), the index of these eight mega-cap companies alone returned almost 60% YTD (Pink line below).

S&P 500 Indices YTD

At quarter end, these eight companies accounted for almost 30% of the total value of the S&P500 Index.  Minus the contributions of America’s mega-cap companies, the S&P500 gained about 4% YTD – a very similar performance to the Canadian S&P/TSX60 – which returned 3.9% YTD.

EQUITIES

From an equity market perspective, the sheer size of these eight businesses jumps off the page.  At quarter end, the market capitalization of Apple, a Coleford Equity Portfolio holding, is greater than $3 trillion. Apple is the first publicly traded company to breach that lofty valuation.  Of note, Apple’s market value is greater than the market capitalization of all the companies listed on the S&P/TSX60 Index.  The next two largest mega cap companies – Microsoft and Alphabet (owner of Google) – are also Coleford Equity Portfolio holdings.  Combined, these three companies have a market capitalization that is 3.7x greater than the entire S&P/TSX60 Index.

Market Capitalization of Mega-Cap Companies

What’s propelling these equity market values? It would appear that investors are smitten with the idea of Artificial Intelligence (AI) and its purported ability to transform the world and reshape economies. To one degree or another, investors are rewarding those companies that are associated with AI.

Artificial Intelligence: A theme to watch

To its supporters, AI is poised to bring automation, efficiency, and advancements to virtually every industry. It is said to have the potential to revolutionize healthcare with accurate diagnoses and personalized treatments, enable autonomous vehicles and more generally, aid the quality and timeliness of decision-making and improve customer experiences with chatbots and virtual assistants. To its detractors, AI is seen as a threat to labour markets that could also lead to social manipulation without strict controls. As investors, we see both sides of the AI coin, but also note that like other transformative advancements of the past (think the dot-com era), AI has become a fixture of discussions in the capital markets. For reference, see the number of times public companies now talk about AI.

Artificial Intelligence mentions in corporate earnings releases and analyst calls

With any “transformative” (and potentially disruptive) technology, it’s impossible to predict the true impact of AI. However, we are likely further down the path of finding out than many people realize.  Microsoft is embedding AI, via their Copilot offerings, in most Microsoft solutions including Windows, Edge browser, Office 365, Dynamics 365, and much more.  It has also built an end-to-end AI development platform to support customers and partners in building AI-enabled solutions.

Simultaneously, Apple’s announcement of Vision Pro – an augmented reality device that seeks to blend digital content with physical space – could potentially create a whole new computing platform.

AI is a theme to watch and a trend for investors to evaluate across all industry holdings.

FIXED INCOME

While the Bank of Canada and the U.S. Federal Reserve have become less aggressive in hiking short-term interest rates, fixed income securities with longer durations provide attractive yields (some of the highest in over a decade).

Canada 10 Year Note Yield

In our Bond Model, we are taking advantage of these higher yields by selling bonds that are scheduled to mature in the next year and purchasing bonds with maturities of 5-plus years. The Bond Model’s laddered structure now has a yield-to-maturity at a level not seen since 2011.

These longer-term bonds offer fixed-income payments over an extended period, providing a steady stream of income which makes them appealing. When interest rates are relatively high, as at present, investing in longer-term bonds allows investors to lock in for an extended period. This reduces the reinvestment risk of shorter-term bonds

CLOSING THOUGHTS

A steadfast focus on investing in structurally advantaged companies – including selected mega-caps like Microsoft, Apple and Alphabet – continues to produce strong results in a rapidly changing investment climate. As noted above, bond markets are also providing a good backstop for capital preservation.

As we look ahead, we are more certain than ever in the value of the three-step approach we define as Goals, Plan, Portfolio. With well-thought-out goals and a realistic plan to meet those goals, we are building portfolios that will stand the test of time.

An investment in knowledge pays the best interest.
-Benjamin Franklin-