Dear Clients,
The investment markets are home to a broad spectrum of perspectives, and part of our role is to parse through this mosaic and develop an interpretational advantage that can then be used in informed decision making. Style differences, contrasting viewpoints, the yin and yang of expansion and contraction all create opportunities to be agile and adaptable; make results-oriented investment decisions; and reflect on their long-term outcomes. Having a constructive, growth-oriented mindset is also important. Longevity, sustainability, and profitability are the main cornerstones of value creation that we seek to identify in all our investment holdings. This is consistent across both periods of growth and capital preservation, including recessions.
On the topic of financial downturns, part of the success of being a seasoned investor is having the wisdom and fortitude to stay fully invested. Recessions are a natural part of the investing landscape, and for investors who have done their financial due diligence, open opportunities to re-position portfolios and capture attractive long-term opportunities. In this sense, volatility should be embraced, not shunned. For example, we will remind clients that during the downturn of 2022, we re-positioned portfolios from small and medium cap companies into secular growers in the semiconductor equipment space and luxury goods. Our past investment journal detailing this can be found here. Furthermore, we would remind clients about timing – by the time a recession is identified, markets – being forward looking – will start to price in the ensuing recovery, which is what we have witnessed in 2023. Being a successful investor requires, sometimes, tuning out the noise and focusing on what really drives ownership decisions – which is the annuity power of an investment – even through a recession.
Investors who have been following the financial press will see that economists and strategists (the “consensus”) who had initially projected a recession in Q1 of this year have continually delayed their forecasts of a growth slowdown, now delaying them well into 2024. We believe that views of an impactful recession are likely to be misguided, given numerous factors – economic, financial, policy and market driven: 1) Economic Buffers: The nuances of this economic cycle, created by dislocations stemming from the pandemic and its aftershocks, have resulted in some aberrant economic behaviours; 2) Policy Lags: Lags once thought to be “long and variable” may instead be impacting the economy in shorter and more predictable ways, a view acknowledged by US Federal Reserve Chair Powell; 3) Financial Impacts: The underestimation of resilient incomes on the economy has been a noteworthy phenomenon this cycle; and 4) Market Factors: A productivity-led recovery on corporate earnings stems from accelerated computing and generative AI, optimizing profit margins and leading to structurally higher earnings power.
The recession has been “pre-announced” in the words of Louis Vuitton’s CFO Jean-Jacques Guiony in the company’s Q3 2022 sales call. According to Mr. Guiony, this is a “puzzling concept” because “in the economy when things are announced in advance, they usually don’t happen because economic agents take measures to avoid them.” This is exactly what has occurred in 2023. Lags in the economy that were once thought to be “long and variable” are instead now shorter and more foreseeable, a viewpoint even acknowledged by Chair Powell himself. At his Jackson Hole Symposium, he stated:
“Now financial conditions react well before the expectation of monetary policy” and the result is that “the effects on the economy are actually faster than they would have been before.” This is exactly what Louis Vuitton’s CFO was alluding to by stating that economic agents would react proactively before policy movements to mitigate undesired financial outcomes. At a broader level, the pandemic resulted in a series of aftershocks that caused disruptions in how a business cycle unfolds. The economic buffers we have witnessed in this cycle, some of which have been underestimated, include: 1) A structurally tight jobs market that is cooling in an orderly manner, resulting in both resilient incomes and the containment of core inflation; 2) Household balance sheets remain strong, aided by excess savings accumulated during the pandemic; 3) Supply-side factors such as onshoring/reshoring of complex manufacturing activities have bolstered non-residential investment; 4) Extending mortgage amortizations are alleviating the upward pressure on interest payments (indeed in Canada, the top 5 banks estimate between 23%-30% of mortgages have amortizations of greater than 30 years as of July 2023); and 5) In Canada, the impact of immigration has contributed to pent-up domestic demand. Given these economic buffers, thoughts of an impending downturn in 2024 are likely over-exaggerated. Indeed, September’s Employment Report indicates that robust job creation can co-exist with cooling inflation, lending further support to the thesis of resilient incomes on the economy. Finally, even if a technical recession is declared by the US National Bureau of Economic Research (NBER), by the time it does so, such an indicator would be lagging, limiting its usefulness.
As mentioned in the last investment journal, we are in a productivity led earnings recovery, resulting in optimized profit structures and elevated earnings power. We witnessed that in Q2 2023’s reporting season, where a previously anticipated earnings recalibration gave way to an earnings recovery. Corroborating our views of a productivity driven recovery, post Q2 earnings, US productivity inflected positively for the first time since Q2 2021, relating directly to large cap margin expansion, and ultimately P/E expansion. Combined with a mix of decelerating core inflation, enhanced productivity, income resiliency, strong household balance sheets, and the economic buffers described above, we expect the next phase of this earnings driven recovery to further dissipate the bear thesis of an impending recession.
Indeed, financial markets are fluid, and often trade on surprises, not “pre-announcements,” requiring agile decision making and data-dependent analysis. This agile decision making applies to times of expansion and contraction, including recessions, which are a natural part of being an investor. We hope clients have enjoyed this installment and are looking forward to autumn’s changing colour of the leaves!
Warmest regards,
Grace Wang, CIM, PFP | Senior Portfolio Manager Samuel Jang, CFA | Investment Associate | samuel.jang@rbc.com Leslie Mah | Associate Advisor | leslie.mah@rbc.com | 604-257-7059 Katherine Jialing Yang | Associate | jialing.yang@rbc.com | 604-718-3035
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