“When having dinner with lions, make sure you are at the table, not on the menu.” – John Cochrane (Economist)
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,
This month’s quote seems prescient given all of the noise out there, largely emanating from south of the border. Perhaps the best quote of the month was from the head coach of the Canadian Four Nations hockey team Jon Cooper stating following the game that simply “Canada needed a win.” That encapsulates what many of us have been feeling of late.
This month, I want to start by taking a step back first and looking at things higher level. It’s easy to get caught in the day to day or week to week market minutiae, but we need to assess the bigger picture – after all, we are investing our client’s capital for the long term, so we aren’t making short term ‘market calls’.
On that note, it’s worth highlighting that most assets out there are not cheap by any means, but there are selected opportunities under the hood even given this picture:
The wrong exposures can portend to weak returns or sudden losses if you’re not prepared. It is painful, all-consuming, and difficult to make money back if you take a serious capital hit. This highlights the importance of approaching investments with caution and risk awareness given the volatile backdrop. One Canadian hedge fund CEO rightfully points out that “beta has been great for investors. However, it would be prudent to be mindful of risk given the current environment.” What he means by ‘beta’ is that any exposure over the last 10-15 years just worked out. But, as I have contended for some time now, the future looks different from here. Even the most iconic firm founded on the premise that passive investing is best admits that price-insensitivity today could be especially costly. "Vanguard's model implies absolute catastrophe for those who invest in large U.S. growth stocks – the kind currently dominating the market. The firm sees them losing somewhere between 20% and 40% of their value in real or constant dollars over the next 10 years.” Ouch.
I don’t like drawdowns, and neither do you. They mess with your head – when you are in a drawdown, it is difficult to focus on anything else. It commands all your attention. When we invest, we invest actual capital, but we also invest emotional capital. If you sustain a major drawdown, you’ve often lost a lot of your emotional capital, and you do irrational things – like sell out everything at the bottom. This is why it’s all about risk versus returns, not just returns. You want to be dealing from a position of strength, rather than a position of weakness, at all times.
The charts below compare two scenarios: the graph on the left shows an investment compounding at 8% annually, while the graph on the right represents one compounding at 10% but experiencing a 30% drawdown in year 5. By year 10, the investment with the lower but steady return outperformed the one with the higher return that suffered a major decline. This highlights the importance of avoiding significant drawdowns, and is our core focus and expertise:
Source: Waratah
And at best, without the right exposures, returns moving forward are likely not going to be nearly what they have been considering our starting point. In fact, Oaktree (one of the smartest institutions in institutional finance) notes that when considering the outlook on equities, historical data indicates the return over the next 10 years may be muted. The following graph shows the forward Price/Earnings ratio on the S&P 500 for each month from 1988-2014. Higher starting valuations consistently lead to lower returns, and vice versa. Since 1988, when people bought the S&P at P/E ratios in line with today’s multiple of ~22x, they always earned 10-year returns between +2% and -2% in stocks.
Source: Oaktree
This is all relevant now because of where things stand – in markets today, there remains a lot of noise out there. Trump noise from all sides, tariffs, the economy, inflation and uncertainty around interest rates. And we’ve seen it in recent markets – for the first time in six months, economic growth concerns weighed on markets recently, along with ‘hot’ inflation data and some underwhelming earnings reports from big and important companies.
Put plainly, over the past few weeks, investors have been confronted with some surprisingly soft economic data and anecdotally negative commentary on the consumer, and those disappointing reports are raising fears that all the policy-related uncertainty emanating from Washington (tariffs and other chaotic headlines) is starting to cause a loss of momentum and may be starting to weigh on consumer behaviour.
Given where markets are trading (see first pic above!), that leaves little ‘room for error’ I’m afraid. This matters because solid economic growth remains the foundation upon which this rally has been built. And if that foundation comes under attack, then it throws this into question.
Tariffs remain a serious near-term overhang, so volatility likely won’t subside anytime soon. A sustained North American trade war would be stagflationary, sinking both growth and profits, raising the risk of higher inflation, and pushing the Canadian economy into a recession. Tariffs are taxes, and when you tax something you get less of it. But, I am ultimately of the view that Trump is a negotiator, and that his ultimate scorecard is the stock market. Therefore, while tariffs are likely to be a negotiating tool, and some form will be put in place to cover lost revenue from tax cuts, there are likely to be concessions on both sides, particularly when it causes disruption for the stock market. As well, the financial professionals in Trump’s cabinet, such as Treasury Secretary Bessent, will likely limit the scale and severity of long-term trade implications. The first week of April is shaping up to be important because that’s when many of the ongoing trade reviews will be published and tariff recommendations made, so expect lots of noise in March heading into that. And this also creates opportunities.
The bottom line here is this is a bit of a crazy and volatile environment, but the underlying fundamentals of the rally (solid growth, Fed still cutting, inflation declining) are still in place. That means the benefit of the doubt remains with the bulls for now looking forward. But, given this uncertainty, I continue to think that balanced exposure across sectors, strategies and factors remains the best approach, and we have the tool box and access to managers and strategies that can deliver this.
Other Interesting Things To Highlight
Our inaugural podcast was recorded recently, and is something I think you’ll find interesting. I plan to keep these brief and succinct and on a fairly steady cadence, and I may also start recording a short version of my Monthly Partner Memo as well, by popular demand! I hope to add some value, keep things brutally honest, and hopefully add some insight. The first episode is focusing on what makes a good investor, and Investment Advisor? The two aren’t always the same. It has something to do with having the right balance between confidence and humility. There is a confidence level required to say, "the market is wrong" (because the market is usually right), but it also requires the humility of saying "sometimes, I'm wrong." We are all always learning. Find that episode on our main website page HERE.
I am proud of my team and am lucky to have found them – I am certain that I have the best team in the business. And we continue to grow quickly, and aim to maintain best in class client coverage and service. We have added another amazing team member in Desiree Thurman who recently started with us. Desiree earned her Bachelor of Commerce in Information Technology Management from the Ted Rogers School of Management. She previously worked as a consultant, implementing and configuring systems to streamline operations and enhance efficiency for startups. Originally from the Collingwood area, Desiree spent time living in Sydney, Australia, and Montreal growing up. Outside of work, she enjoys exploring the outdoors, skiing, traveling, and spending time with friends and family.
Finally, I am writing this month’s Partner Memo from sunny San Diego, where I am attending a wonderful RBCDS trip reserved for the firm’s top performers, and I am honoured and humbled to be included in this esteemed group. However, this is simply a result of applying myself, caring for and doing the right thing for our clients, supported by a team that is second to none.
Expensive Markets, And Further Data Points of Caution*
Though the markets tend to ‘climb a wall of worry’, we are trying to position for stability and small consistent wins along the way, and to avoid the massive equity drawdowns which are a certainty over time. Current investor behaviour remains scary too – as Ruchir Sharma explains in this FT article, "the longer the bull run lasts, the more investors feel emboldened to buy any dip... The bailout culture dates to the first rescue of a major US bank in 1984, and the first explicit Fed vow to prop up the stock market in 1987. Since then, rescues have grown more generous and automatic, encouraging greater speculative frenzies and steadily rising market valuations. Investors have come to see risks as asymmetric, with a state cap on losses and no limit on gains."
Everyone and their brother thinks stocks are going to continue to go straight up this year:
And there isn't much cash sitting on the books at institutions – everyone bullish it seems (though that has shifted a bit in the past week):
And animal spirits are still dominating, as the appetite for leverage in the stock market currently appears insatiable. "Retail daredevils — undeterred by recent Wall Street jitters over AI and crypto — are going long, pumping up leveraged funds to nearly $100 billion, while pessimistic market wagers languish," reports Bloomberg:
At the same time, uncertainty abounds given all the noise out there:
I noted up front about the current situation of ‘everything is expensive’, and that goes for many asset classes.
Bridgewater is a large US hedge fund and thought leader on many things finance. And they’re concerned about concentration and subsequent future returns as well. "Periods of peak concentration have typically preceded periods of weak long-term subsequent returns. Today's concentration is the highest in 125 years."
Market is still very expensive and vulnerable to negative news. US stocks ain’t cheap as we well know. And S&P 500 free cash flow yield is at its lowest level over the past 20 years:
And stocks have lost their valuation edge to bonds even:
Another interesting data point on one market risk is from Jim Paulsen, noting that "the U.S. dollar receives far less attention from equity investors than do other economic policies. But during each of the previous seven times when the US dollar rose meaningfully, the stock market suffered significant declines."
Source: GS
Are Bonds Expensive Too? (An Alternative Explanation Of Why They Appear Expensive)*
Corporate bonds are trading at their tightest spreads (meaning, most expensive valuations) since 1998. No sign of fear. Partially a function of too much money out there, and maybe something else:
The majority of global fixed income markets are trading in the top decile of historical valuations. It is only European leveraged loans and European investment grade stuff trading near anywhere near historic average valuations.
But it’s interesting to note that something else could be driving this – maybe the ‘risk free’ government bond yield isn’t so risk free anymore?!
I have written extensively over the past year about how the US government debt could be a BIG problem. This is now headline news.
The recent rise in yields can be explained by rising ‘term premia’, meaning the market is concerned about the US’ fiscal situation.
So, maybe you’re rather own a good company’s debt instead of the US government’s?? A recent DoubleLine report explored the theme using Microsoft as a case study: Would you rather lend to the U.S. government or Microsoft?
Microsoft is expected to generate ~$48 billion in FCF in 2025 (earning more than it spends). As of December 2024, Microsoft had $9 billion worth of excess cash over debts outstanding, with an interest coverage ratio of 53.5x (earnings were 53.5x greater than interest expenses). The federal government, on the other hand, has negative cashflows, running a budget deficit since 2002 (spends more than it earns), with receipts-to-interest expenses of 5.2x (earnings were only 5.2x greater than interest expenses).
Spreads being unusually tight (or negative) to U.S. Treasuries is not totally unprecedented. During Ronald Reagan’s campaign in the early 80s, chatter of rising deficits and bloated U.S. balance sheets were as prevalent as they are today. As a % of GDP, the early 80s saw deficits at similar levels. In fact, in 1979, IBM issued a 25-year bond carrying a coupon of 9.375%...a meager 5 bps spread over the yield on a 30-year U.S. Treasury. IBM bonds traded right through treasuries at times. In other words, investors felt more comfortable with IBM’s balance sheet than they did with the federal Government’s.
Before you begin to wonder “Are my U.S. Treasuries safe?!” Perhaps none of this really matters. After all, the government’s wallet works different than ours – theirs comes with a built-in printer. The U.S. controls its own currency, which means that defaults and missed interest payments could be avoided by simply printing money. That being said, poor federal balance sheet management does present an interesting thought exercise and yet another possible explanation to the ultra-tight credit spreads that investors are willing to stomach.
The Inflation Outlook & Risks To The Economy*
Economic data has remained relatively strong, with a few weaker data points of late. This still remains a major question, especially around economic growth.
Inflation has remained stickier than most would like to see. We don’t want to see a repeat of the 70’s today, and if tariffs stick that won’t help here:
Source: Apollo
Where are we in the business cycle? It’s actually hard to say with precision, but more likely later than earlier:
Housing is also a factor. Why does the housing market matter? Housing Starts since 1970 indicate that a decline often reliably predicts a recession:
Source: JP Morgan
There Are Always Reasons To Remain Optimistic*
There are always lots of reasons to remain balanced, and optimistic – markets go up over the long term with a perfect record. We need to remain focused on all of the data points longer term, and there are always positive points and green shoots.
US small business optimism has surged post-election, and given that it’s a massive portion of the economy, this is great news:
The private sector is experiencing an economic lollapolooza, and small business capital spending plans have skyrocketed to boot:
There is still a ton of cash out there to buy stuff:
Source: KKR
And there has been no bankruptcy cycle yet:
The consumer overall remains strong (in the US that is, in Canada the consumer is quite indebted). The interest rate hiking cycle hasn’t slowed the consumer as the Fed might have hoped due to the strength of high end consumers.
Finally, this is non-consensus – Trump wants a weak USD in time (though he’s driving it higher near term). You can find signs of this in Scott Bessent’s last hedge fund letter HERE. This is noted in the letter snippet below:
