“Investing is not a game where the guy with a 160 IQ beats the guy with a 130 IQ. Rationality and emotional stability is (more) essential.”
-- Warren Buffett
Apologies for being rather tardy in getting this letter out to everyone. Markets started this year on their back foot and have remained rather challenged and volatile ever since. We knew things were going to get harder once money wasn’t free anymore but the timeline on the withdrawal of monetary accommodation was greatly compressed since my last letter in the fall. We went from expecting a gradual 6 month wind down of new bond purchases (Quantitative Easing or QE) to wrapping the program up in a couple of months. And the Quantitative Tightening (QT where the central bank does not replace the purchased bonds as they mature) that was supposed to start later this year was moved up to a May start date with the rate doubling in June. It appears that the Federal Reserve woke up one day in a blind panic with the realization that it had left interest rates too low for too long and suddenly needed to raise interest rates and accelerate the timeline for even tighter monetary policy. The word transitory was summarily retired in the face of 40 year high inflation numbers.
It seems pretty obvious now that the Federal Reserve made a policy error in leaving rates too low for so long, believing inflation was a transitory anomaly. As your friendly inflation hawk for the last decade, I have talked endlessly about how inflation is an objective of the central bank and is targeted to keep the economy moving forward. While 2-3% is the goal, 7-8% is a problem so most central banks will move to fight it the only way they know how to, which is to raise the cost of borrowing. I say most because Japan has decided it wants to maintain low interest rates and keep a low Yen for its exports and Europe has other problems to contend with. Since those 2 currencies are huge trading partners with the US, the US$ is at a 19 year high (on a trade weighted basis). The Loonie has weakened a bit but has been largely holding its own against the stronger US$.
A stronger US$ is actually deflationary and will help the US economy fight inflation as a stronger US$ buys more for less. But it also depresses US corporate earnings because global profits get devalued on the trip home. So lots of moving parts and forces to untangle. But once again, the US is the dog that wags the tail so we have to pay attention to what the US is doing. And at the moment, it seems don’t fight the Fed now means things got a lot harder for all investors.
That said, higher interest rates will curtail demand but does nothing to increase supply. A great deal of the inflation is coming from 3 main areas which are not going to respond to higher interest rates unless we get a material recession. If you have filled up your gas tank lately you appreciate that energy costs are now at an all-time high and higher interest rates will do nothing to fix this. The energy prices we are witnessing today are a result of underinvestment in the energy patch after the oil price collapsed in 2014 from over $100 to under $40. While the energy industry was being vilified and treated like tobacco, trillions of investment dollars were directed towards green energy initiatives. These investments will take many years to yield meaningful fruit, leaving high oil and gas prices for some time to come. The Russian invasion of Ukraine quite literally added fuel to this fire as Russia is responsible for about 12% of the global oil supply and the bulk of the natural gas that Europe depends on. But as I said long before the invasion, we were heading towards $100 oil anyway.
Higher borrowing costs will also not address the high food costs that we are experiencing in large part because Russia and Ukraine together are responsible for over 30% of the global wheat supply. Ukraine is the bread basket of Europe and obviously not the usual amount of spring planting is happening this year. And over 50% of the global fertilizer supply comes from Russia and Belarus and much of this is not moving to market as normal resulting in much higher fertilizer prices which again will feed through to higher input costs to farmers and to food prices.
Lastly, higher interest rates will do nothing to fix the fragile supply chains that remain dysfunctional over 2 years into the pandemic. China contends with rotating Covid19 outbreaks while clinging to their homegrown and less effective vaccines so this will not be fixed anytime soon. So we are still in a situation where a $10 semiconductor could be holding up the delivery of a new vehicle resulting in used car prices remaining stubbornly high. Used car prices have greatly contributed to the robust inflation estimates and raising the cost of money will not solve this except it may drive out the marginal buyer.
Energy, food and supply chains are responsible for a huge percentage of the inflation but it is clear the additional money in circulation is also to blame with about 25% of all of the US$ dollars in existence today being printed after Covid19 arrived on the scene. Raising interest rates and reversing some of the QE activity are really the only blunt tools in the central banker’s toolkit.
While the central banks in the USA and Canada have just recently begun their tightening cycles, it is important to understand that the bond markets have moved aggressively and unrelentingly to price in much of the tightening already. The 10 year US Treasury yield started the year with a yield of about 1.50% to maturity and four months later, it is now yielding 3% which makes this bond bear market one for the ages already. And as bonds yields have climbed, they have dragged mortgage rates higher in their wake. In the US, due to tax-deductibility, most homeowners never pay off their mortgages and have spent the last couple of years refinancing at rates around 3% for 30 years (while pulling out most of their equity at the same time). This has contributed to the estimated $2.5 Trillion in US household liquidity but now that house as an ATM game is largely over with the 30 year rate back up to 5.5%.
Higher interest rates depress all asset prices but the vast majority of the carnage going on so far is in the highly valued growth stocks that have no prospect of earnings and the need for additional capital to keep the lights on. These names have been crushed by 75% or more (HOOD, COIN, BYND, AFRM, RIVN, and SQ to name a few of the many). Shopify, our Canadian grown software company that was the most valuable company in Canada last year is down over 80% since November. It dragged the TSX higher and has been dragging it lower over the last 6 months. We never had exposure to it as it never fit our investment style (GARP or growth at a reasonable price) but it did find its way into many portfolios as managers desperately tried to keep us with the TSX. Many of you have heard me say that markets do not care about valuations on the way up but they sure do matter on the way down!
We are in a deleveraging market which is painful to all investors but sadly, fatal to some. Because we really never know how much leverage has been taken on behind the scenes, we don’t really know where this process stops. There are so many hedge funds and risk parity funds that all employ massive leverage (think 5:1 or more) that are now being forced to liquidate holdings. While we trimmed a bit of our holdings that did better than expected on the way up, we don’t try to time the market as that is very hard to do sequentially more than once! I already see a great deal of value in many names but until we get some clarity on where we are in the deleveraging process, we are remaining pretty defensively positioned. And for those clients who are relying on their portfolios for income, we have planned for that already.
As always, call if you have any questions!