To my clients:
It was a mixed week for North American stock markets with the Canadian TSX finishing down 0.4%; the U.S. Dow Jones Index up 0.6%; and the U.S. S&P 500 up 0.5%.
Last week I noted that “recession is nowhere in sight”. This week I want to pursue this line of thought and pose the question: what might disrupt this outlook? To my way of thinking, there are three possibilities:
2) The emergence of a vaccine-immune Covid variant
3) An exogenous “black swan” event (might this week’s news about Chinese property developer Evergrande qualify?)
I’ll only look at #’s 1 and 3 in this week’s update. I think I’ve sufficiently covered #2 in prior missives.
Beginning with inflation, it is common knowledge that inflation measures have spiked to multi-year highs on a year-over-year basis. But one must remember that the readings of concern over the past several months are measured against the very weak near-deflationary readings of early and mid-2020 when the world was experiencing the worst of the coronavirus pandemic. As the global population has begun to emerge from various states of lockdown, demand for all manner of goods and services has naturally increased. Add to this the inability of global supply chains to immediately ramp up to match the bounce-back in demand and its hardly surprising that inflation might surge. But, in time it is inevitable that supply chains will catch up to this elevated demand and the concomitant price increases (for example, container shipping costs from Asia have surged several hundred percent so far this year) will recede. It’s for this reason the U.S. Federal Reserve has repeatedly asserted that elevated inflation readings will prove to be “transitory”.
Frankly though, fundamental rationales like those in the previous paragraph aside, there may be an even better way to gauge whether the current inflationary readings will prove problematic for the economic expansion. [Aside: one of my ongoing duties as a Portfolio Manager is to meet with providers of various financial products to assess the merits of their offerings. My favourite such meetings are those which focus more upon service to me and my clientele, and less on product. For me, “good service” primarily consists of the delivery of new or unique perspectives on economic and market data. One provider which consistently delivers exceptional perspective, analysis and opinion (in addition to great results) is Capital Group. No wonder that I use the Capital Group Global Equity Fund for international exposure in client portfolios.] This week I met with my representative from Capital Group and we had an extensive conversation about the economic outlook. As part of this discussion, I was shown a chart on inflation which astounded me in both the power of its message as well as its simplicity. I requested – and received – permission to use this chart in this week’s client update. Here it is:
So what does this chart show? Well, the dark-blue line shows inflation on a year-over-year basis. Looking at the extreme right edge of the chart shows that this dark-blue year-over-year measure has clearly spiked to the multi-year highs I previously mentioned. But interestingly, the light-blue line measures annualized inflation when compared with two years ago. This is important because two years ago obviously brings us back in time to September 2019 and the more normal, pre-pandemic, world we were all enjoying. In other words, the light-blue line averages out both the spike lower in inflation as the pandemic hit, as well as the spike higher as the world began its - albeit shaky – return to “normal”. And if one were to again look at the extreme right edge of the chart, one will note that the light-blue two year average of inflation is actually well within the typical range of the past 20 years. I think this is a powerful touchstone that helps to maintain perspective on the inflation fears that are constantly being cited in the mainstream business media. Now does this chart definitively prove that inflation will normalize from its elevated year-over-year levels? In a word, no. Of course the year-over-year measure could continue to spike and, in due course, elevate the two-year measure as well. I will continue to monitor data to see if this happens. But given that I and RBC agree with the Fed that supply chain issues have led to the current spike higher in year-over-year inflation, this chart helps solidify our favourable outlook for both the economy and markets.
Moving on to item #3, and the threat of an “exogenous, black swan event”, I must preface my comments by noting the obvious: an exogenous, black swan, event is, by broad definition, unpredictable. When the coronavirus changed our world in early 2020, it was the epitome of a black swan event. Black swan events can happen any time and it is fruitless trying to position portfolios in anticipation. However, when the initial event occurs, one must absolutely incorporate its impact into the economic outlook. As such, when the coronavirus proved to be asymptomatically transmissible, I took defensive measures in client portfolios in February 2020 prior to the extreme market sell-off in March. Going back in time to mid-September 2008 (when, not coincidentally, I began to write these weekly updates), and prior to becoming a discretionary Portfolio Manager, I recommended to clients in my capacity as Advisor to take defensive measures after three European banks failed on the same weekend immediately following the Lehman Brothers collapse (and prior to the end-of-September precipitous collapse of markets). To that point, Lehman’s collapse had been characterized as a contained U.S. sub-prime mortgage issue. So how do three seemingly unrelated European banks fail less than a week later? Well, as we all subsequently learned, the bad sub-prime mortgage debt had been re-packaged and “collateralized” and sold throughout the world leading to a cascade of deleterious economic and market effects. The failure of the three European banks was signal enough to me that something was not right with the broadly accepted narrative.
Which brings me to the case of Evergrande. For those unfamiliar (and I wasn’t until Monday of this week), Evergrande is an enormous Chinese property development company which has run into financing difficulties on its over $300 billion in debt (not a typo). Apparently the company borrowed to finance rapid development of a huge number of low-margin developments. As long as demand stayed strong, the company could afford to continue with its low-margin business model. But demand has slowed and many of its contractors (employing over 2 million people) are now not receiving payment. There are obvious echoes of Lehman Brothers here. However, there are purported differences too. Key of these differences is that a) a very low percentage of Evergrande’s debt is (reportedly… keeping in mind that Lehman debt was repackaged and sold globally) held by foreigners; and b) as a command economy, the Chinese government has a lot more control over how any collapse might play out. These differences have led the vast majority of analysts (including those at RBC) to conclude that a Lehman-like contagion is not in the cards even if Evergrande were allowed to fail. At this stage I will defer to those opinions. But I will emphasize that I am watching the situation very closely and would certainly not hesitate to act if legitimate contagion concerns emerge.
Bottom line: the global economy continues to expand; inflation concerns seem overblown; and for now it would be premature to act defensively in the face of the Evergrande, situation. Portfolios remain overweight equities (i.e. stocks).
That’s it for this week. All the best,
Nick Scholte, CIM, FCSI
Vice-President & Portfolio Manager
Scholte Wealth Management
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