“It’s good to learn from your mistakes. It’s better to learn from other people’s mistakes.” – Warren Buffet
Note that the contents of this memo are all my thoughts, and not the views of RBC Dominion Securities. As well, no part of this content was AI-assisted or created.
Friends & Partners,
A lot can happen in a short period, especially when it comes to markets and investing.
The pendulum has swung 180 degrees from imminent recession calls and its related 7 interest rate cuts from the Central Banks to the current "no-landing" scenario (i.e. no recession coming) that has reduced the expected number of cuts to 2 or fewer! As is usually the case in life, the truth is likely somewhere in the middle.
Inflation has remained a bit ‘sticky’, which has many scared that we see some parallels with the 1970’s and 80’s when inflation ran, ebbed, then came screaming back, causing a nightmare for many. Inflation may remain a bit higher than hoped for a while, but I don’t believe we’re in for that scenario this time around.
It also has to be noted that if we are to see persistent inflation, the traditional and very common “60/40” portfolio model (that is 60% stocks and 40% bonds to smooth out the noise) that many employ and has outperformed for the past 40 years will likely underperform as bonds may not preserve purchasing power. I believe that we are already seeing the starts of this trend, so alternatives have to be considered.
However, as we saw in the 1980s, an inflationary bias to the economy incents investors to accept a higher valuation for equities given their inflation pass-through abilities that bonds lack. And, therefore, stock valuations (P/E ratios) may be consistently higher than you think they should be this cycle. There’s some good news and silver lining!
But, I want to identify what I believe is the single most important long-term indicator in the markets right now: the unemployment rate.
The one event we need to be watching for is an economic slowdown – most think a slowdown is not going to happen, let alone a recession. Even though financial conditions and fiscal policy remain supportive for a continued ‘soft landing’, let’s just say that I think it’s certainly possible that we see some sort of a slowdown along the way here.
And, sadly, a slowdown isn’t really priced into markets, so a potential ‘correction’ if markets smell one coming could be significant and real. The market multiple could well go from the current 21x forward earnings to something like 15x-16x. Given 2025 earnings are around $240/share, that means a market decline of 1200-1400 points is not unreasonable in the S&P 500, which would put the S&P 500 under 4,000.
That may seem outlandish given the market’s resilient nature but anyone who was in this business in 2000 or 2007 knows it can happen, and much faster than most think. Bottom line, it’s not likely but it is possible – and risks must be monitored and portfolio positioning needs to be considered.
So, the unemployment rate is one economic indicator that will tell us if the economy is slowing. Put simply, it’s very unlikely that we get an economic slowdown as long as the unemployment rate stays near 4%. Sure, there may be a loss of economic momentum or even a cooling of growth, but unless the unemployment rate rises into the mid-4% towards 5%, then the likelihood of a market-tanking slow-down will remain low.
Bottom line, markets were bound to get more volatile. They had to, as the past five months isn’t typical market behavior and it won’t last forever. But volatility doesn’t mean an end to markets going higher and understanding the difference is very important.
Some Other Things to Highlight
I am honoured to be a featured panelist at AIMA’s upcoming event entitled “State of liquid alts in Canada” on May 14th in Toronto, hosted by BMO Capital Markets. Alternative Investment Management Association (AIMA) is the global representative of the alternative investment industry, with 2,100 corporate members in over 60 countries. AIMA’s fund manager members collectively manage more than US$3 trillion in hedge fund and private credit assets. I am sharing the stage with some esteemed figures in the institutional finance world, and we will be discussing the state of liquid alts in Canada as the asset under management in alternative mutual funds and ETFs surpasses C$25B across over 250 funds in time for the 5-year anniversary of this structure. This event is complimentary to AIMA Members, Institutional Investors, Family Offices and Advisors, and one can register for this event HERE.
On May 23rd, I will be hosting a private social event at Gibson & Company in Collingwood, which should be fun. We will be discussing behavioural finance, “The Foibles of Human Judgment”. There will be complimentary wine tasting & cuisine followed by an entertaining discussion with Noah Solomon, CIO of Outcome Metric Asset Management – will discuss how some AI-based investment processes can even sometimes outperform their human counterparts. Register for this event HERE.
Finally, I was honoured to be able to help support The Hanley Institute in concert with RBCDS with a small gift. The Hanley Institute is an amazing charity that helps support youth empowerment, growth and mental wellbeing in Grey County. Check them out at https://thehanleyinstitute.ca/.
Missing A Friend
Earlier this month, the world tragically lost a great man, and one of my closest long-time friends in Ryan Selwood. Ryan hired me into the business almost 25 years ago, and we have been very close ever since. Ryan was a beloved husband, father, mentor and dear friend. We made many great memories together in his time in Toronto, NYC and London.
The industry and the world lost a juggernaut – Ryan had a distinguished and long career in financial services and made an indelible impact on his colleagues and the organizations he served. After dedicating 15 years to the Canada Pension Plan Investment Board as Head of Direct Private Equity in Toronto and London, Ryan joined The Carlyle Group in New York as Chief Development Officer. In March 2023, he ascended to the role of Chief Investment Officer at Bregal Investments.
Investing Isn’t Supposed To Be Easy*
We live in an era where the do-it-yourself mantra has never been more popular. These days, there is an app or AI bot that can help users with everything, and access to information has never been greater. Unfortunately, access to information and access to expertise are two very different things. You can quickly get overwhelmed with the volume of information and miss the advice from a true expert, if you can find one…
Most do-it-yourself investors lag the markets – by a lot. That’s mostly because our emotions and biases get in the way.
Each year, DALBAR, a financial market research company, releases a quantitative study of investor behaviour. This report measures the effects of decisions made by investors on investment returns. The results often tell a compelling story which highlights the challenges that behavioural bias can create and demonstrates the value of advice over time. The average investor lags markets by ~6% a year on average over time. I know too many stories of self-directed investors who win, but only for a short period pretty much every time.
Data suggests that the average investor struggles to keep pace with markets
Source: “Quantitative Analysis of Investor Behaviour, 2024,” DALBAR, Inc. www.dalbar.com. Returns compounded annually and ignores taxes. Returns are for the period ending December 31, 2023. Average Equity Fund Investor: comprised of a universe of both domestic and world equity mutual funds. It includes growth, sector, alternative strategy, value, blend, emerging markets, global equity, international equity, and regional equity funds. Average equity investor performance results are calculated using data supplied by the Investment Company Institute. Investor returns are represented by the change in total mutual fund assets after excluding sales, redemptions and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. After calculating investor returns in dollar terms, two percentages are calculated for the period examined: Total investor return rate and annualized investor return rate. Total return rate is determined by calculating the investor return dollars as a percentage of the net of the sales, redemptions and exchanges for each period.
Amazon is a 100x bagger since 2006. Forget regular ‘retail’ investors, how many institutional investors have held this since 2006? According to Bloomberg, 0.2%! It’s amazing to see the intrayear drawdowns you’d have to endure – almost no one can take that pain along the way.
A more recent example is Zoom, a Covid darling, down 90% now. Zoom is a good lesson around the importance of discipline around valuation. Zoom has seen revenues increase 10x since 2020, but is trading at the same price! It was 124x sales in Oct/20…
Can You Explain What’s Really Going On With Inflation?*
Inflation has re-accelerated, making some note some parallels with the 1970s (see chart below). Core CPI has essentially been “stuck” just below 4.0% y/y since October and that lack of a continued decline is the main reason markets now just expect two Fed rate cuts in 2024, and why Treasury yields have rallied and stocks have pulled back from recent highs. But understanding why CPI is stuck is important because it can give us color into what’s next for rates and the economy and why likely we’ll see higher-for-longer rates (though unlikely we see rates scream like in the 70’s) and a slowing of economic growth. Bottom line is that the decline in inflation has likely stalled for now, but is has likely not stopped.
Let’s put some context here though. We have to realize that the decline in CPI over the past year two years has been dramatic. At its peak in September 2022, Core CPI rose more than 6.6% y/y. That increase has been cut nearly in half over the past 18 months.
But the reason that decline in Core CPI occurred was mostly due to a decline in goods prices. Inflation statistics such as CPI are loosely divided into two categories: goods and services. Goods are the “stuff” we buy, actual manufactured products and raw materials. Due to several factors (pandemic supply disruptions, forced pandemic savings, stimulus) the price of “stuff” exploded during and shortly following the pandemic. Much of the decline we’ve seen in inflation since September 2022 has been driven by the normalization of the price of “stuff”.
Think about it practically using cars as an example. Because production of cars was so disrupted during and after the pandemic, prices skyrocketed. However, now that production is back to normal, prices are falling and we’re again seeing cars sell below MSRP. Think about that concept across the entire economy and that’s the main reason CPI has fallen so dramatically over the past 18 months.
Now prices for stuff are largely back to normal. And while they’re higher than before the pandemic, they aren’t going sharply higher anymore (again, we’re seeing sales and promotions to move merchandise, just like pre-pandemic). Goods prices are back to normal and leveling off, and as such, they are not driving inflation stats lower any more. That’s why CPI (and to a lesser extent the Core PCE Price Index) have seen their declines stall.
So, what can make inflation keep falling from here? A drop in services prices. That’s the missing piece to a resumption in the decline in inflation stats. But here’s the problem: The way you get service prices down is by lowering demand and the only way to do that is to slow the economy.
In normal times, the only way to bring inflation lower is to slow the economy so demand for goods and services falls as consumers “tighten their belts.” Over the past 18 months, the decline in goods prices has allowed inflation to fall while growth stayed resilient, a concept I noted last month called “Immaculate Disinflation.”
To get prices even lower it’s going to take a reduction in demand for services and that means we’re back to the classic Fed playbook of higher rates to slow growth and that’s why we can expect rates to be higher for longer, because that’s how the Fed can slow the economy and ultimately reduce service demand and finish the job on inflation.
We are unlikely to see 1970’s-style inflation – in the 1970s, the Fed allowed inflationary expectations to run out of control. That’s not the case today. Even though the breakeven rate has edged up a bit, market-based measures of inflationary expectations are well-anchored. Even though levels are slightly above the Fed’s 2% target, the readings don’t show any signs of acceleration at this point.
So, Are Interest Rates Going to Come Down Or What?*
Now, with inflation metrics proving stickier than expected, investors have been stampeding towards the ‘hawkish’ end of the spectrum (higher bond yields, lower stocks), and if we get another hot economic report soon, don’t be shocked if some analysts start to price in zero interest rate cuts for 2024. At least in the US. In Canada, we have been getting some better (i.e. lower) inflation stats, so the Central Bank is getting closer to cutting ‘on schedule’ (i.e. summer time or early fall).
In the US, 7 rate cuts was not the right answer. Zero rate cuts also is likely not the right answer. 1- 2 rate cuts probably is the right answer for several reasons.
First, inflation metrics will continue to slowly decline over time as the statistical reality of lower housing costs moves through the economic data. The decline in inflation has likely stalled, not stopped. That means that ‘real’ interest rates (if we adjust rates for inflation) will continue to move higher as inflation declines, putting incrementally more pressure on the economy. The Fed doesn’t want more pressure on the economy, it wants constant pressure, so even slightly falling inflation and rising real rates will likely result in a cut or two even if growth stays stable.
Second, to drive the next leg lower in broad inflation (beyond housing), the Fed needs to cool demand. There’s growing anecdotal evidence that’s already happening, not so much from broad economic data, but more importantly from corporate commentary. The reality is earnings over the past month or so, especially from retailers, have floated caution signs on the consumer. So if growth slows in the coming months, that will help the Fed to start the cutting cycle (though not aggressively).
Some Fed members have ‘floated’ that interest rate hikes may be required. New York Fed President Williams stated that while rate hikes weren’t his “base case”, the Fed would hike if the economy warranted it. That’s not a controversial statement in reality, but just the mere mention of rate hikes spooks markets and rightly so, as the lion’s share of the Oct.-March rally has been driven by markets assuming rate hikes were over.
The Fed flip-flopping on cuts vs. hikes isn’t unheard of. For those of us familiar with the 1990s, it was a relatively routine occurrence. It’s only been since the early 2000s that the Fed has shift-ed to this longer, drawn out cut/hike cycle. Point being, it’s not impossible the Fed flip-flops of the data warrants it.
Note that this has now been an above average length of a Fed pause. The average Fed pause going back to 1968 has been 8 months. This can be attributed to the size of the deficit the US is running, propping up the economy.
Source: Apollo
Are We Entering A Commodity Supercycle?*
As many of you have likely noticed, gold has been kicking butt recently (finally!). Other commodities are in the same boat. Are we at the end of a recent commodity downtrend?
The catalyst for a new uptrend could be somewhat obvious if we look at the scarcity of capital expenditures in the commodities space while there has been a boom in construction spending in recent years.
Despite the recent upsurge in construction spending, commodity producers have fallen short of matching this trend. Capital expenditure in natural resource industries has remained near historically low levels, especially when adjusted for GDP. So there will obviously be no uptick in supply down the road. The current scarcity of capex among these producers, along with the upsurge in construction expenditure fueling material demand, speaks to the probability of higher commodity prices to balance these markets in the face of these structural supply constraints. Because higher prices will be necessary to incentivize new capex investment, and it takes many years before these new supplies come on stream in a significant enough way to alleviate pricing conditions, now over a decade to bring in real production given increases in red tape, environmental pushback, etc.
When it comes to oil, and other energy commodities, it needs to be put into context. Even if the world’s entire vehicle fleet is converted to EVs, environmentalists often don’t realize many everyday goods are made with oil. And AI requires massive amounts of energy that hasn’t yet been addressed.
