Monthly Partner Memo – October 2021

September 29, 2021 | Paul Chapman


Take comfort in the knowledge that your capital is being managed the way your friends complain they wish their capital was managed.

hand holding compass in page

Friends & Partners,

We were finally reminded over the past few weeks that stocks don’t always just go up. The financial media finally got some semblance of a pullback that all the pundits were expecting for the last 6+ months. Investors panicked briefly last week because so many talking heads were making more noise than ever, and the financial media needs to fill 12 hours/day (most of which will be of the negative variety). Many were quick to label the Evergrande episode in China another "Lehman event", which my colleague Dominick Hardy noted the parallel to “Maslow's Hammer” – if you are not familiar with the "law of the instrument", in short, people who carry hammers look for nails.

The swings are often overdone (for a number of reasons, including the fact that computers and algorithms drive a lot of intraday trading). It’s hard to time the market’s turns, but we can prepare for the inevitable volatility that I expect to continue. Timing is hard. Markets may go down, and there are scenarios where it may go down a lot – and a significant number of investors aren’t positioned for this possibility.

I’ve been consistently alerting you to the reality that the trend in global central banks was towards less accommodation, and that should put upward pressure on interest rates over time, potentially causing increased market volatility. But volatility does not automatically mean a significant correction. For now, the main pillars of the rally remain in place (Fed support, stimulus, vaccine effectiveness, and a solid economic recovery), meaning the outlook for stocks remains generally constructive, but the path is precarious.

On a lighter note, it’s a relief that the world is slowly opening up and we can attend events in person – I’ve had the pleasure of hosting two great events over this past month in partnership with Women, Worth & Wellness. The first was an event at Georgian Hills Vineyards entitled “Paris in Our Own Backyard”, and you can see a short highlights video of that event here. The second event was a morning of golf where we hosted the legendary golf pro Sandra Post to Duntroon Highlands, and you can see a great highlights video of that event here.

Can This Market Resume Its March Upward? Most Definitely*

Here are 10 points to consider that could continue to drive this market higher thru year-end:

  1. The recent slowdown is temporary and primarily driven by the Delta variant. "We see these risks as well-flagged and in some cases overdone" says UBS strategy. And cases appear to be rolling over in many of the worst hit states.
  2. US Household wealth has topped $142 TRILLION, or over 600% of GDP. Remember, total US stock market cap is $46 trillion (Wilshire 5000), so still ~$100 trillion can still be allocated to equities. Millennials are inheriting $76 trillion over next 20 years, and lean towards equities and higher-risk asset classes.
  3. Central bank policies should remain growth-oriented.
  4. China’s slowdown YTD is likely to be countered soon with a policy pivot.
  5. Low probability of significant US corporate tax policy change.
  6. Periods of significant market weakness are likely to get dampened by accelerated buyback programs (current daily buyback run-rate is at ~$3.5 billion and rising) and positive retail flows given “excess” savings.
  7. The inventory (~25 year lows) and capex cycles (post-2008 low), while not tracking their usual cyclical behavior, are still in early innings with ample room to drive growth as per UBS.
  8. The state of the US Consumer is strong. JPM thinks the market underestimates the robustness of consumer balance sheets and more pointedly the savings war chest in place to support future spending. "The cumulative “excess” savings for consumers since onset of Covid (2/2020) is at $2.4T excluding the likely boost from rising asset values".
  9. Cross-border activity has the potential to more meaningfully rebound for the first time since the onset of the pandemic.
  10. Consensus is currently assuming a very conservative earnings compression of -1.3% for 2H21 compared to 1H21 (seasonally demand has been much stronger during 2H compared to 1H in the US). "In our view, the street estimates do not fully account for this seasonality and the cumulative effect of ongoing global re-opening with rising mobility as Covid eases, expanding labor market with wage gains, higher operating margin and falling interest expense, and reduction in share count from buybacks"

It’s difficult for the market to ‘crash’ when bullish sentiment is waning (lowest since last summer):

refinitiv chart in page

Source: Refinitiv

Recently, a number of major investment banks have published warnings for the U.S. stock market. The strategists at BoA, Citigroup, Credit Suisse, Deutsche, Goldman Sachs and Morgan Stanley have issued either bearish or cautionary outlooks.

In these circumstances, we are reminded of Bob Farrell’s Rule 9, “When all the experts and forecasts agree – something else is going to happen.”

A good start to 2021 could mean a strong finish

Sure, the market does keep hitting new highs, but record highs aren't the same as market peaks. The fact that all-time highs are often followed by further gains seems counterintuitive. But UBS notes that since the 1960s, the S&P 500 rose an average of 11.7% in the following 12 months after reaching a fresh high. As for the odds of suffering drawdowns after buying at record highs, based on data since 1945, investors would not have suffered any losses 34% of the time, while in 59% of cases they would have lost no more than 5%. Only in 15% of instances would investors have suffered a “bear market” drawdown of more than 20%.

Markets Can Perform Well Thru Tapering, But Government Debt Remains the Biggest Market Risk*

The US Fed is going to ‘taper’ soon, meaning they start to pull back the punchbowl. But they are walking a tightrope, and may stay behind the curve, meaning that inflation could run a bit hot. My friend Bob Decker sums up the implication of this perfectly: “This socially laudable but economically risky policy shift will ultimately create financial stress cracks in the already over-levered system. But for now, we will benefit from the loose policy of too much money chasing too few investment opportunities that has generated the current asset bubble. Remember, it took years for inflationary expectations to become embedded the last time this policy was tried in the 'Stagflation '70s'. And it took even longer for the Fed to summon the will to do something about it. We will have time to play this trade well into the current decade.”

Markets will continue to be volatile moving forward – governments across the world will carry levels of balance sheet debt that no one thought fathomable just a few years ago. That level of balance sheet debt means the developed world will be lucky to break 1% annual growth a few years out, and interest rates/bond yields will continue to increase (meaning your bonds are going to return close to zero for a long period of time, and may not smooth our your stock volatility):

public debt as a % of GDP in page.

But, equities can continue to move higher as the government removes the punchbowl:

S&P 500 through QE tapering in page

Source: RBC GAM

Stagflation Remains a Risk – A Brief Teach-in on Stagflation and How it Could Hit Stocks*

I’ve been getting a number of questions on this topic, and I was going to write about the risk of stagflation a few months ago, but ran out of room in my monthly notes. Inflation has remained sticky, and we’ll see if it starts to subside soon. If not, we could be into a situation that is dreaded by the market, and things could turn ugly if we encounter a period of ‘stagflation’.

Stagflation may be the worst possible scenario, and this is why:

We know that there’s good growth and there’s high inflation. The key going forward is whether both continue to be elevated (“reflation”) or growth stalls and inflation remains high (“stagflation”). Growth and inflation are intertwined because if inflation is stable high growth falters, that’s a big problem (stagflation). Conversely, if growth stays solid and inflation cools, that’s good for stocks. Finally if both remain high, that’s positive for cyclical stocks and commodities.

Central banks appear committed to reducing stimulus and will likely continue to reduce accommodation even if Delta spikes or the recovery slows in an effort to reduce upward pressure on inflation which has persisted so far. That’s the potentially slowing growth part of “stagflation.”

Higher inflation is already here and hasn’t yet proven to be ‘transitory’ (i.e. short lived). And there is a growing chorus of corporate executives and Fed/Treasury officials that are now warning that elevated inflation will be here through year-end, and while that’s not “long-term,” many of these same officials thought higher inflation would last only for a few months. Point being, inflation appears to be much more sticky than previously anticipated, in part due to ongoing supply chain disruptions (which aren’t ending anytime soon) combined with continued massive Federal spending, quantitative easing and higher savings rates.

We haven’t had inflation in over a decade in this economy, so there’s been zero stagflation risk in recent memory. But that has changed now that inflation is high and seemingly sticky. And, markets haven’t been afraid of economic slowdowns for years because the Fed has always promptly rose to the rescue via rate cuts and/or Quantitative Easing. What’s scary about this potential outcome is that the Fed won’t (or can’t) ride to the rescue for fear of creating more inflation. That’s why stagflation is such a bad environment for virtually all investments.

So, when could this become a problem? Over the next few months, if we see the Delta variant cause a slow-down, and the Fed is reluctant to delay tapering due to inflation, that could easily provide a “stagflation” scare that could absolutely cause a correction in stocks.

This Brings Us Back to Inflation Risk*

We could spend days discussing inflation, and I have in my prior notes, but there are smart people with excellent arguments on both sides of the fence of whether inflation is here to stay or not. The recent rise US yields is bringing this risk to the forefront again. If this thing is transitory, Fed can continue supporting the equity market. What if it isn't transitory? That’s where things could get ugly. Do you feel like prices will subside?...

This chart shows US 10 year real yield breaking up big...

chart in page

Source: Refinitiv

Let Me Say it Again – Your Portfolio Likely Isn’t Positioned Very Well…*

I will put this out there in print – since I’ve been in this role, I’ve seen a good number of people’s portfolios. I can honestly say I have yet to see one that I would deem as well-positioned. Most are far too geographically concentrated (almost always in Canada), and often have poor fixed income vs equity weightings. Almost none have any other asset classes than stocks and bonds (or mutual fund versions of those).

Most portfolios that I see are essentially “passive investment strategies”, meaning they simply mirror broad indices – so why are you paying fees for limited value-add? Passive strategies have started to stumble as of late, and I expect active strategies to continue to outperform for a long time. Dispersions within and across asset classes have widened (meaning that strong portfolio managers can outperform by picking winners and avoiding losers). As well, 'retail' activity has become a massive amount of overall trading volumes, as much as hedge and mutual funds combined. This is likely to continue.

This will all result in continued high volatility and less market efficiency - contributing to a ripe environment for sophisticated active investing. The implications is that traditional investment portfolios, especially passive index funds (which is what most investors are exposed to), are not going to perform anywhere nearly as well as they have in the past.

The “60-40 portfolio” (meaning 60% stocks and 40% bonds) just finished one of its best decades in history, and has done well since ~1980. In hindsight, the fact that bond yields were very high at the beginning of the period and equity valuations were fairly cheap indicated the portfolio was likely to perform relatively well. But if we apply the same logic today that we did in hindsight to 1980, things look brutal. Bond yields are currently very low relative to history and equity valuations are very high. The dual forces that the 60-40 had at its back in 1980 are now both significant headwinds. AQR is a leading US investment fund and thought leader in the institutional finance world, and they estimate that a traditional diversified 60/40 portfolio will return just 2.1% a year after accounting for inflation over the next five to 10 years.

I think that most of us can agree that pension funds and endowments are some of the most sophisticated, low risk and diversified asset allocators around. I’ve shown Canadian pension fund asset breakdowns in the past (the punchline being that almost 40% of their assets are allocated to ‘alternative strategies’ in aggregate), and here is a fresh chart showing US endowment allocations. Does your portfolio have any exposures to anything other than equities and bonds?

Endowment asset split chart in page

Source: RCM Alternatives

You are going to need a completely different approach to investing if you want to see your portfolio grow more than low single digits on average into the future. You are not limited to stocks and bonds either anymore, access to alternatives is becoming democratized and accessible. Partner with an Investment Advisor who has extensive experience in the alternative landscape and can help navigate and simplify them for you – it will matter for your wealth and capital preservation moving forward.

Thanks for reading me and please feel free to forward this and any letter to your friends. An endorsement from a friend is the ultimate compliment.