Monthly Partner Memo – April 2022

March 28, 2022 | Paul Chapman


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

“The big money is not in the buying and selling, but in the waiting.” – Charlie Munger
“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.” – Albert Einstein

Note that the contents of this memo are all my thoughts, and not the views of RBC Dominion Securities.

Friends & Partners,

Equity markets continue to frustrate the naysayers, as it usually does. The wall of worry continues to grow, and markets usually have a way of climbing it though it’s never without its risks and a choppy road. Bonds have done what I’ve expected them to do for some time I’ve written here, which is go down, and they’ve gone down a lot in the last month as markets continue to struggle with the rate of rate increases coming down the pipe. And where does inflation factor into that, and eventually recession? See more on that below.

Time in the market is a far more important strategy than trying to time rotations. Through the first few months of the year, the S&P 500 had its fourth worst start ever, and it’s worth noting that the five other worst starts resulted in strong rallies through year end.

Rates are rising. Markets expect as many as 7-8 hikes this year alone! They will continue to become a stronger and stronger headwind on the economy and the markets, but they aren’t near levels yet that would imply economic growth is stalling. That’s why, despite many risks facing markets, we could still have a year (or more) of expansion left. Equities typically perform well in the twelve months following the commencement of a Federal Reserve monetary tightening cycle. For now at least, the risk of stagflation (meaning high inflation and stagnant economic growth) remains a future problem, not an imminent one.

Many readers hear about an ‘inverting yield curve’, which means that short term interest rates are higher than long term interest rates in bond markets, and this is usually a very good leading indicator of recessions so is watched very closely. This is happening now so the clock could be ticking on a recession... But we aren’t there yet, and it doesn’t necessarily spell disaster for equities. The message from the leading indicators for U.S. recession risk remains benign, with all of them still pointing in a direction consistent with an ongoing economic expansion and few signs of an imminent turn in the business cycle. As well, a slower but still positive pace of economic growth should allow earnings to remain in expansion mode (contrary to what many pundits would have you believe, 2022 bottom-up consensus EPS for S&P 500 companies has actually been increasing year to date).

The people of Ukraine have proven themselves as tougher and more resilient than any other, and the situation remains a tragedy – please help where you can. I noted a number of charities on this front in last month’s memo. Surprisingly to many, the market implications have been relatively subdued outside of commodities. Even though Putin has been threatening nuclear war, few have taken those threats seriously (so far). If that threat became closer to a reality, you can bet that markets would see significant downside (BCA Research sees a 10% chance of a nuclear war). A land war in Europe has implications for trade, commodities, and inflation/interest rates, but the economic consequences have been otherwise limited. Things could get worse, however the markets so far have discounted limited escalation – let’s hope it is right. Nonetheless, hope is not a strategy – preparation and process is.

As with many things nowadays, you’ll always find pundits to reinforce any view (usually bearish views in mainstream financial media). However, one theme should continue to prevail – the current landscape is going to favor stock-pickers, and it will be a market of "great differentiation" as the brilliant economist Mohamed El-Erian recently stated.

Markets may even move upwards over the remainder of the year, to the chagrin of many – that’s what it does best, it frustrates, right as most are expecting it to weaken. Current market sentiment is at levels where in the past have resulted in strong returns for the months ahead. Fundstrat believes that US avoids a recession and clarity will emerge in H2 2022 of a better road ahead, and cash levels are up to similar levels as April 2020 and comparable to other times when the market hit a bottom before rebounding. Maybe we even see investors gain some confidence that the fed is hiking for a 'good' reason after all – that is, the economy and company growth rates are actually looking supportive…

Though negative headlines are a long way from ending, we can remain optimistic that the markets will endure this as they have other seemingly existential threats. So choose your advisor wisely, the road will remain bumpy. Most portfolios are getting crushed on the year, and fixed income is having its worst run in decades. Basically everything in your average 60/40 portfolio has gone down significantly, and will remain challenged (something I’ve been noting for some time). We build portfolios to weather the noise, preserve capital, and build wealth. We build portfolios with institutional experience and positioning. This recent market has battle-tested many portfolios, and with limited exposure to alternative assets, many are failing. And now your Canadian real estate may even finally take a breather… Oxford Economics thinks so.

You can and should be invested for the long-term – you can protect your capital and build capital over time, even thru environments like this. Having cash under the mattress is valuable to a certain point, but not for your nest egg.

How long until inflation cuts money in half chart in page

Source: NBF

The Million Dollar Question – Will We Get A Recession? (And A Quick Lesson on the Yield Curve)*

Will we see a recession? If so, when? Answer: Likely, but maybe not anytime soon.

For this signal, everyone monitors the ‘smart market’, which is the bond market. If the yield curve ‘inverts’ (when long bond rates drop below short bond rates), that’s a fairly reliable sign that a recession is on its way – but it’s not for sure, and timing is always TBD. Most recessions are preceded by an inverted yield curve, however the inversion had to go relatively deep and last for some time to really be reliable as a recession predictor. For this indicator, most watch the 10yr versus 2yr spread, and that recently went negative. Is this an impending signal of doom? And are we looking at the right spread?

Now to be clear, I do not think “it’s different this time” with regard to the recession signals offered by the traditional yield curve spreads such as 10-2. I am in good company with a new practice as a lot of very smart and well-respected investors, economists, and Fed board members are acknowledging that focusing on shorter-duration yield curve spreads should be considered. This is because of some fundamental changes and new market factors that have occurred over the last decade or two. One of the factors is that many analysts believe are artificially depressing the 10-year yield (making it lower than it otherwise should be and possibly artificially compressing the 10’s-2’s spread). The first of those reasons was relative yield as bonds in Europe and other parts of the world have been considerably lower and, in many cases, negative, leading fixed income investors to look to U.S. Treasuries for core bond holdings with durations of 10 years and beyond. Additionally, so far in 2022 the yield on the 10-year note has risen more than 90 basis points, which is beginning to draw the attention of cross-asset portfolio managers, especially those with global reach based in Europe who also are trying to maintain some exposure to safe havens given the lingering geopolitical uncertainty surrounding Ukraine. So, foreign demand for the 10-year Treasury has had an impact on the yield (pushing it down), and absent that foreign demand it does stand to reason that the 10-year yield should be higher.

While the 10yr-2yr yield curve has been under pressure, the 10yr-3month spread is at a much healthier level and actually steepening (i.e. increasing). Same goes for the 2yr-3month as well as the 5yr-3month yield curve spreads. And note that all 3 of these shorter spreads have been very accurate in forecasting recessions dating back decades, and all inverted before the bubble, financial crises, and COVID-19 pandemic. They are also currently less impacted by the global bond market dynamics that could be skewing the 10-year yield. However, it is worth noting that data going back to the 1970s suggests that every time the more widely followed yield curves invert, the 10yr-3month eventually inverts as well, anywhere from a couple of weeks to a year later. But we’re not there yet.

So, a recession could be coming, but how soon? Credit Suisse acknowledged that real GDP forecasts have softened recently, though noted that they remain well above the 20-year average. Meanwhile, ISM (manufacturing) readings are still broadly consistent with solid GDP forecasts, which should help earnings to maintain an upward trend in the quarters ahead. Prospects of Fed monetary tightening at time of growth uncertainty have understandably led to worries of a “policy mistake” (meaning the Feds in the US may ‘screw up’ the rate hike pace), but the Fed’s recession models currently point to limited recessionary risk, and while financial conditions have tightened recently, they remain at fairly supportive levels.

Finally, healthy household wealth can offset weaker real wages and inflation:

Stagflation and a Recession? Or is there Some Hope? *

Recessions are usually deflationary, since unemployed people have little choice but to reduce spending, so most businesses lack the ability to increase prices. Negative growth and rising prices don’t normally occur together. However, a recession can be inflationary when accompanied by a supply shock in essential goods – sound familiar? In this scenario we get falling growth and rising prices together, which is an ugly combo, and this is the recipe for stagflation (recall that I wrote a quick overview on stagflation last year, which you can read here). It last occurred in the 1970s for similar reasons as today – driven by higher energy prices. At that time it was driven by the Arab oil embargo, but today it’s a buyer’s embargo as Western countries halt trade with Russia.

And other supply issues are pushing up other prices too as I’m sure you’re feeling.

Energy spikes preceded almost every recession for the last 80 years. We now have another one, which isn’t a great data point.

But this may not cause a consumer recession by itself, the CIO of KKR notes. The consumer is flush. “Remember that the top 20% of Americans account for around half of all consumer spending, and their net worth is actually at a record high. Moreover, the wealth bracket just below the top 20% now has more cash in their bank accounts than the top 20% did just before the pandemic.”

Source: Pictet Asset Mgmt

How Do Markets Act During Rate Hike Cycles and If We Go Into a Recession? *

Over the course of the last two Fed hiking cycles, equities have typically performed well. The 2004-06 episode was by far one of the most aggressive in recent decades, with the Fed raising interest rates 17 times from 1% to 5.25%, while the S&P 500 index generated about a 12% return in the same period. The storyline is even further reinforced in the 2015-2018 monetary tightening episode where the Fed raised rates 9 times and the S&P 500 index generated around a 21% return during this period (please see below).

On a longer term basis, the story is largely the same. Over the course of eighteen monetary tightening cycles dating back to 1958, the S&P 500 has generated positive forward total returns 72% of the time on a twelve month horizon. The average and median twelve month total returns were 8.4% and 7.0% respectively (please seen table below).

So we know that rates are climbing, and fairly quickly. The pace of hikes appears to matter. Here is a chart showing that though markets don’t always falter during rate-hiking cycles, they do tend to struggle when the pace is brisk (like we may see this year):

Source: Ned Davis Research

If we do eventually get a recession, markets will likely struggle with this, though when that happens is the million dollar question, and we aren’t there yet, and may not be for quite some time:

Source: RBC Strategy

Friend Don’t Let Friends Buy Index Funds – Part 3 *

High growth names have been struggling as lofty expectations wane, and with so much focus and attention put on overall market valuations and earnings growth, many appear to have missed some interesting trends materializing beneath the surface. The dispersion or differentiation of 2023 earnings growth among S&P 500 companies has been sharply rising, recently climbing to its highest level since March 2020. As well, valuation dispersion has exhibited a similar trend and is well above average. This means that companies are operating at considerably different fundamental rates if the analysts are correct. At the same time, stocks are moving together in their price action, so the baby is getting thrown out with the bath water. There are deals to be had… earnings will continue to be the major driver of equity market returns. Individual stock selection should be brought to the forefront, and an active investment approach with the best managers on the planet will be crucial in identifying the best investment opportunities. We will focus on high quality companies with real pricing power and high cash flow conversion, and work with the best managers to find those. It takes an army to do so, and we’re lucky to be blessed with such troops and their leaders.