2023 : How to cope with an economic slowdown

September 14, 2023 | Alain Daaboul


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The first 8 months of the year were very different from the previous 8 of last year. A year ago, investors had a very negative outlook, fearing inflation that was close to 8%, as well as a looming recession.

We disagreed and believed that inflation would slow down sharply, and that a short-term recession would be avoided. After benefiting from high inflation in the first half of 2022, we positioned ourselves towards cyclical stocks. Today, inflation is at 3% and economic data has been strong since, despite the largest interest rate hike in history. This has allowed our investments to grow faster than the rest of the market. Since we performed well in 2021 and 2022, our portfolios have doubled our benchmarks over the past 3 years, while being less volatile.

The surge of the stock market over the past year is not due to profits, as these have hardly increased, but by the expansion of multiples. Investors are now willing to pay 17% more for stocks, which shows that they are more optimistic, and hope that rates will fall again while avoiding a recession.

However, we now believe that there is more uncertainty ahead. Without being negative, we prefer to take a more cautious stance, and protect some of our gains.

We have taken profits in cyclical stocks that have performed very well, and now own more stable and high-quality defensive companies.

Inflation

A year ago, we believed that reaching an inflation rate of 3% would be easy, but not the 2% target. The market estimated a few months ago that central banks would lower their rates several times by the end of the year. Since then, central banks have continued to raise them and there are no rate cuts on the horizon.

We must analyze the main elements of inflation:

Supply chain: In October 2021, 60% of inflation came from this factor, because of the pandemic. Today, it is in a state of deflation, a result of lower demand and production returning to normal levels, which caused a high level of inventory.

Wages: Lately employment has slowed down and vacant positions have decreased, but the unemployment rate in North America is still close to the lowest it has been in the last 50 years. Wage growth is still at 4%, due to the shortage of employees.

Energy and food prices: One of the main reasons for the slowdown in inflation is due to the 40% drop of oil prices between March 2022 and May 2023. Unfortunately, it has rebounded by more than 25% since, due to high demand and lower production. As for food prices, they remain high due to natural disasters and the war in Ukraine.

Real estate: This sector being one of the largest contributors to the Canadian economy, it is important to lower it to control inflation. But a shortage of housing combined with strong immigration makes it difficult. Moreover, rent and financing costs, which are both rising with higher interest rates, contribute to inflation.

Central banks are powerless regarding the shortage of labor and housing, as well as the drop in oil production. They will still do everything they can to achieve their 2% inflation target, a matter of credibility.

Impact on the Economy

Reaching the 2% inflation target will not necessarily mean that rates will go down right away. We believe that we will have to live with higher rates than in the last 15 years.

It takes between 12 and 18 months before rate hikes are felt in the economy. Since the first one came in March 2022, that brings us to today. The real effects will therefore be felt in the upcoming months.

Raising interest rates to lower inflation has triggered job losses in the past. This usually occurs towards the end of the economic cycle. History shows that a 0.3% increase in the unemployment rate has always been accompanied by a recession. In the United States, real estate being less important than in Canada and mortgage terms longer, it will take job losses to slow down inflation.

There are more and more signs that the economy is slowing down. Corporate profits have been falling for 6 quarters in a row due to inflation and high financing costs. For now, companies have accepted lower margins to cope with the labor shortage and inflation. If consumption slows down, job losses will be expected.

In Canada, strong immigration (2.7% of the population in 2022) hides economic weakness. Consumption per Capita has been falling for 2 quarters and is at the same level as 2020. Delays in credit card and auto loan payments have started to increase, as well as personal bankruptcies. Finally, China and Europe are already in an economic slowdown.

Risk in the Banking Sector

Canadian banks greatly outperformed the market between 1982 and 2007 but have underperformed since. We expect this to continue.

First, they face a decrease in bank deposits. An investor can now get close to 5% in money market instruments.

In addition, they want to avoid a real estate crisis at all costs. They are very lenient with variable mortgages, accepting less capital being repaid. But 60% of mortgages will likely be renewed at higher rates in the next 3 years, which were taken when rates were below 2%. The longer the rates will stay at these levels, the more it will hurt. People will do everything they can to keep their homes but will have to reduce their spending elsewhere; and some investors facing negative returns will be forced to sell.

The situation is even more precarious in commercial real estate. In North America, about 15% of commercial buildings are vacant, a record, and this figure is bound to increase. About $1.5 trillion of debt in this sector will mature in the next 3 years, most of which only pay interest, in the meantime. The effect could be devastating if rates don’t fall quickly.

The value of alternative investments (real estate, private equity, infrastructure) is linked to interest rates. The rate hikes caused a price drop of more than 30% in these types of companies on the stock market. But a large part of these investments is held privately, mostly by pension funds. Their repricing, often done by companies hired by the owner, has yet to be done in many cases. This could happen in the coming months, which could cause huge losses and bankruptcies.

All this explains why banks are becoming more restrictive on new loans, which is putting negative pressure on the economy.  

Sectoral Positioning

Sectoral positioning is often more important than stock selection. We are therefore active and do not fear deviating from the index.

Based on our comments, you will not be surprised to learn that the sector where we are most underweight compared to the index is the financial sector. Eleven percent of our stocks are held there compared to 24% for our equity index, including less than 2% in Canadian banks. Bank stocks rebound when credit losses are at their peak, and we haven’t reached that point yet.

The second sector where we are most underweight is technology (12% versus 18%). In early 2022, we were only at 6% and increased it at the end of 2022, which greatly helped, as this sector was the worst one in 2022 and is the best this year. Never has this sector outperformed this much the rest of the stock market since 2000, which ended very badly. Most of the return on the stock market this year was made by stocks connected to artificial intelligence. In the first half of the year, companies had to merely mention this word for their stock price to go up. Even though these firms are at the center of our lives, we prefer to be cautious in the face of excessive valuations, especially in a context of high interest rates.

 

Since we now hold nearly 20% of cash, there are only 3 sectors where we are overweight by more than 1%, consumer staples, health care and energy. The first two should do well even if there is an economic slowdown. The energy sector benefits from favorable winds, their companies generating strong cash flows, and the price of Canadian oil relative to the rest of the world has never been so attractive.

Finally, we now hold less than our benchmark in the industrial, consumer discretionary and materials sectors, 3 sectors where we were very overweight a few months ago. We took profits in retail, materials, automotive and travel.  

Impact of higher long-term interest rates on asset classes.

The rise in interest rates causes big changes in asset classes.

Cash now generates more than 5%, unheard of in 20 years. It is now profitable to be patient and wait for better entry points.

Two years ago, we wrote that fixed income was experiencing one of the biggest bubbles in history, paying 1.5% for a 30-year bond. They are now heading for a third consecutive year of negative returns, a first in over 200 years. The rate of a 10-year bond is at its highest since 2007, but we are still patient in this sector, as the yield curve is inverted. A 1-year bond yields 1.5% more than a 10-year bond. This sector does better than cash when rates stop rising so we are monitoring it. We are starting to see excellent opportunities in discount bonds for taxable accounts.

Finally, if stocks look expensive in the short term, they tend to rebound much earlier than the economy. Moreover, inflation and high interest rates should be good news in the long run, notably for quality stocks with strong competitive advantages and low debt. Stocks perform better than other asset classes in the long. They did very well during the 80s and 90s, when rates were high.

All this will probably help us achieve our long-term financial goals more easily. The rise in rates allows us to get a better return, while taking on less risk.