The year ended with more of a bang than a whimper as U.S. and international public equity markets generally staged a strong rebound in the fourth quarter. Despite a healthy recovery in the fourth quarter, the majority of equities and bonds still ended the year in the red, with bonds suffering one of the worst years on record. Q4 was a nice reprieve from the sell-off experienced in the first three quarters of the year, however, we are far from being out of the woods. We will likely experience a recession in 2023, and key themes which impacted the market in 2022 are likely to carry forward. Inflation remains front and center along with the response of central banks.
This response will dictate the path interest rates will take as markets continue to price in anticipated rate cuts in the second half of 2023, while we believe that there is the likelihood that interest rates remain higher for longer. We will take advantage of a higher interest rate environment with a focus more on fixed income while maintaining diversification with our approach to allocating to equities, fixed income, and real estate. It is key in this environment to remain patient and disciplined in our approach and to look for opportunities that may present themselves in the future.
Below we outline some brief highlights from the past quarter to keep in mind as we move through the first quarter of 2023:
1. Strong rebound in U.S. and International public equities for Q4 2022
Despite giving back some returns in select markets in December, some equity markets had strong returns in the fourth quarter of 2022. The quarter highlighted the continued bifurcation amongst names as the technology-heavy Nasdaq Composite Index returned -0.8% while the S&P 500 Index returned 7.6% in USD terms. The rebound helped to end the year on more of a positive note and recover some of the losses experienced during the first three quarters of the year. The Nicola International Leaders Fund returned 16.1% for the quarter, while the Nicola U.S. Equity Income Fund returned 11.8%.
The Nicola International Leaders Fund benefitted from signs of decelerating inflation and warmer autumn temperatures which helped abate, at least in the short term, some concerns about the European energy crisis. As we are likely headed for an economic recession and earnings recession in 2023, we anticipate enhanced volatility as a result. Large parts of the past decade have been highlighted by lower volatility in risk markets, we believe that this may change in the coming years, and we will likely experience higher levels of volatility (both on the upside and downside) in the future.
2. Real estate returns were stable for 2022
Our real estate funds had stable returns for the quarter with the Nicola U.S. Real Estate Limited Partnership returning 2.8%, the Nicola Canadian Real Estate Limited Partnership returning 1.3%, and the Nicola Value Add Real Estate Limited Partnership returning 2.7%. Our overall positive returns for real estate for 2022 can be attributed to our positioning, namely our reduced exposure to retail and office and focus towards multifamily residential, industrial, and special purpose (mini storage). We have also focused on geographies with favourable demographics and economic growth while pivoting to have more build-to-own opportunities in both Canada and the U.S., which has allowed us to acquire assets at a lower cost than buying new.
3. International currencies staged a comeback
Returns in the fourth quarter of 2022 for international assets were accentuated by depressed international currencies staging a strong comeback. The Euro recovered 7% versus the Canadian dollar, while the Yen and British Pound strengthened 8% and 6%, respectively. The British Pound had been weakening versus the Canadian dollar throughout the year and plummeted at the end of September following then-British Prime Minister Liz Truss’ mini-budget, which contained billions in unfunded tax cuts. The fourth quarter coincided with Rishi Sunak taking over as the next Prime Minister and regaining the market’s confidence with a renewed focus on economic stability.
4. Interest rates are looking to be higher for longer
In Canada, price pressures have increasingly become domestic, shifting concerns away from supply chain disruptions (particularly as China starts to roll back some draconian Covid restrictions) and towards services. In addition, wage growth continues to be strong while more businesses are passing along higher costs to consumers. During the quarter, Bank of Canada Governor, Tiff Macklem highlighted concerns that we may become entrenched in a situation with higher inflation where higher wages reinforce higher inflation in a sequence of reciprocal cause and effect.
These concerns lead us to believe that while we are closer to the end of the hiking cycle in interest rates, we are likely to have higher interest rates for longer. Despite the volatility in interest rates, our fixed income funds have posted positive returns for the quarter, except for the Nicola Preferred Share Fund. We remain focused on positioning in either floating rate or shorter duration fixed income. Despite a challenging fixed income environment in 2022, we have achieved a 1st percentile ranking for our Nicola Bond Fund amongst 276 Canadian bond funds tracked by Morningstar over a 5-year time horizon.
5. Q4 saw enhanced geopolitical risks that will most likely continue
2022 marked a year with significant geopolitical events. The fourth quarter of the year saw this trend continue, and we believe that this situation will likely not abate in 2023. In October, the Biden administration unveiled new restrictions on exports of advanced semiconductor technology to China, continuing to strain relationships. While in December, the EU and UK started an embargo on seaborne imports of crude oil from Russia while G7 countries enacted further sanctions on Russia by creating a price cap of $60 for Russian oil.
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