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THIS WEEK WITH SADIQ

The ABCs of Alphabet’s Potential Breakup

September 18 to 22, 2023

THIS WEEK WITH SADIQ

The ABCs of Alphabet’s Potential Breakup

September 18 to 22, 2023

Commentary

Market Recap

  • Equity markets gave up solid gains late this week alongside a decent run of economic data, but another move higher in oil prices.
  • The S&P 500 dipped 0.2%, led by banks and utilities, while industrials and technology lagged.
  • The TSX, however, churned out a solid 2.7% gain as materials, banks, industrials and utilities all posted gains above 3%.

Alphabet

Could Alphabet—Google’s parent company—be broken up by regulators? That’s the question that has arisen from the ongoing trial over the Tech giant’s alleged anti-competitive practices. It’s an important situation to watch, because if it were to occur, it could have huge ramifications for Technology and may open the door for other companies to have similar problems. For the most part, investors’ hope is that it doesn’t occur, because the company is likely to be stronger with all of its operations under the same roof. Of course, voluntary breakups do happen on occasion in cases where it would be beneficial for one part of a business to develop its own identity or focus. But that isn’t the case here—this split would be forcible and likely to negatively impact the stock. It’s too early to know which way things will go, but we’ll be monitoring the situation closely.

Bottom Line: For now, our evaluation of Alphabet remains unchanged, but a breakup would likely have a huge negative impact on Tech.

Europe

Last week, the European Central Bank (ECB) raised its key interest rate by 25 basis points as it continues to fight inflation. After the ECB’s tenth straight rate increase, we are seeing enough slowdown in the economy to warrant at least a pause if not a complete stop to raising interest rates. A weaker economy, led by a weaker consumer, should put less pressure on inflation. The reality is that Eurozone inflation remains higher than in the U.S. and Canada, and it is impacting the consumer. We expect the ECB to pause, but still pay attention to the data. Soaring energy prices could also have a detrimental effect; last winter was relatively mild, which meant that demand for energy was lower, but that may not be the case this year. There’s also China’s slow reopening, which has caused a reduction in demand for European industrial goods. Overall, it’s not a pretty picture, and these headwinds are why we’re slightly underweight international markets (EAFE).

Bottom Line: In Europe, economic surprises continue to be negative, and we see no obvious positive catalysts on the horizon.

Bonds

The bond market is tricky—in some respects, it’s even more complicated than equity markets. Recently, we’ve seen yields go up, and there’s a possibility they could rise further. That tells us something about the interest rate outlook: investors believe that we could see more hikes, at least in the United States, and that inflation could remain relatively sticky. At the same time, we are starting to see some cracks in the system emerge—employment numbers are weakening, the number of available jobs is declining, and in Canada, consumers appear to be increasingly worried about their savings. This tells you that the economy is weakening, which would normally mean that interest rates should be holding steady or decreasing. In short, there’s a dissonance between the interest rate outlook and the economic outlook. The success of High Yield bonds this year is tied more to the economy than interest rates, while Investment Grade credit and aggregate bond portfolios have lagged behind the T-bill rate. The order of High Yield’s outperformance makes sense; the magnitude does not. In our view, markets are confused about the pace of change—is the economy weakening quickly or slowly? In a slowly weakening environment, bonds will likely have mixed results (similar to this year). But it could be a different story in a rapidly-weakening economy, where interest rate cuts may move to the forefront and bonds do very well.

Bottom Line: Bond markets remains slightly nervous, indicating that the rate cycle might not be over.

Positioning

We have Energy back in our portfolios (you may recall we had a big win on Energy last year), and after a strong run-up we have sold call options against it to generate additional returns. We implemented this strategy a couple of weeks back when oil prices shot up on news of production cuts by Russia and Saudi Arabia—we believe it represented a good opportunity to sell some upside. In these kinds of situations, markets typically rise before fizzling out somewhat. If we do get a rally that takes us through our break-even point, we’ll have done really well. If not, we’re still prepared to own Energy for a bit longer, and we’ll happily take the premium on top.

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