“Democracy is two wolves and a lamb voting on what to have for lunch!”
Ben Franklin
The second quarter witnessed another uptick in volatility. US markets had a healthy pullback of almost 7% in May which was entirely gained back in June. In fact, June was the best June for the US stock markets in over 50 years and the first six months of 2019 was the best first half for US markets in 20 years! That is not that surprising after the debacle that we endured during the last quarter of 2018. Meanwhile, the Canadian market cannot seem to reach escape velocity as it keeps bouncing within a narrow range that is not that far above where it peaked out in 2008. Until the Canadian resource sectors find another gear, we continue to invest within our borders for the dividend income and in the USA for growth potential.
Any market observer that proclaims that markets have come “too far, too fast” this year doesn’t have a very long memory and has no perspective on the last 18 months which have largely been one giant period of consolidation. Sideway markets are not unusual in long-term (secular) bull markets. For example, from the spring of 2015 until the spring of 2016, markets treaded water (moved sideways) and then continued their upward trajectory to new highs. After a period of consolidation, markets either break higher or lower into a new trend and for several reasons, it feels to me like the US markets want to break higher again this time. At some point, hopefully soon, the Canadian market should break out of its very long consolidation period and I think it will be to the upside also.
As I have expressed on several occasions, there continues to be widespread market skepticism. The China trade war rhetoric, the attack on big tech from Europe (and now even Washington) and ongoing Brexit risks weigh on market sentiment resulting in money managers holding more cash than usual. The 10 year average cash allocation in professionally managed US portfolios is 4.6% but cash levels jumped to 5.6% in June which is actually the highest level since August of 2011. While larger cash balances can be perceived as a negative signal, we are mindful that they also provide the energy needed for higher price levels in the future as money gets redeployed back into the markets. Always remember that markets like to humble the largest number of participants as often as possible and that is one reason I am contrarian by nature (i.e. I am very uncomfortable simply following the crowds)!
Global central banks are stepping on the gas once again with the US Federal Reserve (the Fed) signaling 1 or 2 interest rate cuts starting as early as this month. The Fed has also signaled an acceptance for higher inflation rates in the short term, which is logical as you can’t be willing to cut interest rates without the potential of it causing higher inflation. The long held 2% inflation target is now more of an average rather than an absolute goal. This really begs the question of how much the Fed will allow inflation to run if they do follow through with rate cuts. From an investment perspective, in environments where we expect lower interest rates but higher inflation, money tends to be driven into assets that can return more in real terms (after inflation). It is this need for higher real returns that causes the so called “stretch for yield” as higher paying dividend stocks are favored over lower interest bearing bonds. This inevitably leads to a crowding effect in dividend stocks as investors flock to better yielding pastures. As a result, stock selection becomes more important leading us to believe that mature businesses with a clear competitive advantage that reward investors with growing dividends are best positioned within this type of market environment.
All that said, I am troubled by a couple of developments that are gaining momentum. Firstly, it looks like the Fed is laying the groundwork to characterize Quantitative Easing (QE) as just another monetary tool in their toolkit and not one to be kept in reserve for extraordinary times (like the 2008 Financial Crisis). Remember QE is essentially money creation that injects liquidity into the economy so this would open the door for more monetary expansion (in addition to lower interest rates). After all, so far, there has seemingly been no consequence to the $4.5 Trillion in Quantitative Easing efforts that the US undertook in the years following the financial crisis so why not use it whenever the need arises? Makes me wonder what will be left in the arsenal to combat a recession when we do finally get one. Maybe negative interest rates will eventually wash up on the shores of North America like they have become the norm around the world. At the moment, almost 1/3 of global government bonds (about $13 Trillion) are sporting negative yields to maturity. Lend your money to a government and accept a negative return!
My next concern (or observation) is that there are no fiscally responsible politicians anywhere any longer. In the USA, until recently, Republicans held the line on debt levels but not so any longer. Thanks to the Trump tax cuts, the US deficit is going back above $1 Trillion this year and the US debt-to-GDP ratio is now over 100%. While most of the Democratic presidential candidates are rushing to the far left in an attempt to out-do each other with giveaways. They are floating some ambitious spending ideas like Medicare for all and student loan forgiveness and there is even growing talk of guaranteed minimum incomes. I am not saying that any of these are bad ideas (although I could seriously debate the merits of paying off a Harvard law student’s loan!) but the discussion should also include funding solutions.
Essentially they endorse one of two funding programs. The first is rather traditional which is to make the wealthy pay more and narrow the wealth gap (which has greatly widened this last decade). That is classic liberal thinking and is exactly how Ontario now sports a top marginal tax rate of almost 54%! The more troubling funding path however is predicated on a very radical doctrine called Modern Monetary Theory (MMT for short). Basically this holds that governments can accumulate as much debt as they want and can simply print more money to pay the interest. The only constraint on spending is inflation which can only break out if governments and the private sector spend too much at the same time. Well since there apparently is no risk of inflation these days, there is nothing to worry about. The discussion about whether budget deficits really even matter is being hotly debated. Of course they don’t matter as long as interest rates and reported inflation remains subdued.
Hopefully my sarcasm is rather obvious! As everyone knows, I believe the real rate of inflation is much higher than the reported number but have stated in prior letters that we may never see an inflation print higher than 3% ever again because the cost of servicing these massive government debts with higher interest rates is mathematically problematic. But as most shoppers appreciate, price inflation on every day purchases is not at the 1.5-2% quoted level. Let’s look at gasoline as an example of a daily expenditure. Remember when oil went above $125/barrel back before the financial crisis and that forced all of the gas stations to change their signs over to accommodate a dollar plus price? And when oil crashed down under $30, gasoline stayed under $1 for a very short time and now with oil around $55, regular gasoline is still above $1.20/litre? But thank goodness we measure headline inflation “excluding food and energy”!
As always, feel free to call at any time!
Derrick