Monthly Partner Memo – August 2022

July 27, 2022 | Paul Chapman


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

“Patience is not simply the ability to wait – it’s how we behave while we’re waiting.” – Joyce Meyer

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

Friends & Partners,

As we enter the doldrums of August, this summer feels a bit different – many of us have been exhausted by markets, geopolitical events and rising prices. Everyone is feeling it, and that sentiment is everywhere. But that may also prove to be the opportunity.

Markets are dominated by narratives. And I’m seeing this now more than ever during my career. Investors often become hostage to a dominant narrative, which often turns out to be misleading. Our connectivity is higher than ever, and social media platforms have a way winnowing down the breadth of news you’re seeing and reinforcing your own views. Online platforms often serve as echo chambers for already held beliefs, surrounding us with like-minded views. I have never seen the overall narrative so “consensus”.

So, what is the dominant narrative today? It is the notion that the global economy is on the edge of a precipice and about to face a deep and imminent recession. The University of Michigan’s consumer sentiment survey is at a 50-year low! And fund managers are certainly cautious:

To be sure, there is no shortage of risks to consider: supply chains remain tangled by Covid variants and war. Soaring energy prices are driving inflation and crimping economies. China remains in rolling lockdowns and is back pumping money into their system via public infrastructure projects. Markets are all getting walloped this year across equities and fixed income, and many investors succumbed to ‘recency bias’ and greed over the past few years and owned way too much speculative growth stock exposure and crypto.

All of this has forged an easy narrative and following for those predicting macro doom. Understandably, the pull of this narrative is powerful.

In my role, I see a lot of people’s inherent biases. There are many, and one of which is that one’s perceptions of the past shape their view of the future. We live in the past, and project that to the future. For years after 2008’s big downturn, most expected a global financial crisis to strike again. It didn’t. We also saw this in 2020 following the market’s bottom in March, which kept going higher in the months following – most investors and pundits didn’t believe that the market could continue to rally most of the way along.

This is because the market is a “discounting mechanism” – that is, it looks well ahead. Markets move based on expectations and what is already priced in. For example, the worst of the economic data during the financial crisis occurred after stocks had already bottomed, and stocks rose significantly before the labor and housing markets fully recovered. Will the market soon be seeing through the inevitable recession coming down the pipe to brighter days ahead?

Inflation is likely peaking, though energy prices are likely to remain elevated – but the rapid acceleration of inflation is likely behind us now. I would expect North American inflation to subside to ~5-7% and core inflation (excluding food and energy) in the 3-5% range by the end of the year, and should continue to improve through 2023, though we are likely in a higher inflation regime for a couple of years yet. But we need to remember that inflation is a catalyst for more robust overall demand. A higher cost environment encourages government and business to invest in labour and energy-saving technologies, and should kick start a recovery in general capital investment. This should increase capacity and productivity, and along with increasing wages leads to higher nominal growth. Eventually, this will all mean stronger earnings and sustainably higher interest rates.

Bottom line is that inflation will start to subside, central banks will likely cause corporate earnings to slow, but are unlikely to drop off a cliff as many have projected. Interest rates will continue higher near term, but should take a reprieve and even drop somewhat in 2023. The economy likely enters a formal recession (if we aren’t in one now), but should not prove to be deep and drawn out given the labour market we are experiencing. We will experience a slow-growing economy but a healthy one with strong employment demand and strong corporate balance sheets.

I continue to remain cautious near term, and continue to position the portfolios to preserve capital. For this market to move substantially higher and have recent gains underwritten by improving fundamentals, we need to see: 1) peak inflation combined with 2) a solid decline in inflation and 3) a mild moderation of growth, not a material contraction. Markets have recently rallied on the first possibly coming true, but the second and third will be tricky, and at minimum will keep volatility elevated, so we position accordingly.

We could still be 5-10% from a market bottom, potentially occurring in the next few months (barring a significant exogenous event). I am seeing some very interesting opportunities and asset classes that I am starting to take advantage of, and expect to deploy more of our material cash position and slowly add more directional exposures in the coming months. I will continue to avoid ‘fantasy’ growth stocks which will face years of headwinds due to higher funding costs, and will focus on best-in-class active managers and strategies as I have discussed at length – this will be where outperformance will continue to occur. Broad-based index strategies remain vulnerable and are a ticket to underperformance as they are all now heavily concentrated in the winners of the last decade.

Stocks Will Lead The Economy Out of This…*

Equities typically bottom while economy was still getting worse, and start moving higher while the narrative is still negative. JP Morgan Asset Management notes that “in every business cycle downturn, equity markets lead the economy by several months if not longer. In other words, equity markets anticipate the recessions. See the charts below on six major post-war business cycle downturns. In each one, equity markets declined, the economic hurricane worsened a few months later and equity markets bottomed while the economy was still getting worse. That’s what appears to be happening this time as well, at least so far.”

How Much Longer Before The Market Bottoms, And How Deep Will It Go?*

There is significant variance in how long bear markets last, and how deep they go. It’s both art and science to try to remotely predict this.

Here is a good chart showing where we are compared to other historical bear markets:

Source: Goldman Sachs

Looking at it another way, here is the duration of various bear markets, which has a median of 1 year:

Source: Goldman Sachs

And finally, we are seeing some more sell-side Analysts starting to capitulate. We likely need to see more consensus on this end before we have flushed out the optimism required to mark a long-term bottom:

  • Bank of America: “we could see ~3,000-3200 before year end.”
  • Goldman: "in a recessionary scenario, we expect the S&P 500 index level would fall by 17% to 3150 at year-end 2022, including a P/E multiple contraction to 14x."

Have We Seen Peak Inflation? That’s The Million Dollar Question*

As supply chain pressures continue to ease, commodity prices subside, US Dollar strengthens, wages ease and Covid to continue to wane, inflation growth should start to abate. The average of the ISM composite indices (good measures on the overall economic activity) leads inflation by approximately six months. The chart below shows that inflation likely peaked in June:

Source: RBC Research

The good news is that commodity prices adjusting lower is a necessary condition to take some of the sting out of inflation. Ultimately, this should allow central banks to be less hawkish, which could soften the eventual economic slowdown/recession. The bad news is that commodities are typically the last shoe to drop when the economy enters recession. So lower commodity prices may be a blessing down the road, but weaker growth is the price to pay to get there first.

Finally, I would note that the cost of shipping goods has dropped significantly recently, which is a big driver of inflation. According to Bloomberg, transpacific spot rates have been easing over the last few months and are expected to ease further. “The Drewry Hong Kong-Los Angeles benchmark for 40-foot container rates dropped 5.7% in the week ended July 20 and was down 21% from the same period last year. Port congestion in Southern California lessened, with the backup declining to 24 ships from January’s peak of 109, and rates should continue to moderate as supply-chain constraints ease and global demand weakens.

So Where Are The Investment Opportunities?*

A few sectors, asset classes and geographies are showing some promise and opportunity. From a technical perspective, the bull case for equities is institutions and hedge funds have largely sold and the only sellers left are retail investors. Corporate insiders have bought all of the dips recently which is interesting:

Canada is getting downright cheap, for the first time in a while. This is good because many Canadians are overweight Canada, and Canada has underperformed for years until 2022. The TSX forward P/E has tumbled to 11x, roughly 25% below the long-term average and trading well more than one standard deviation cheap vs. history. For the S&P 500, forward P/E has de-rated to the long-term average of 16.2x.

Small caps are also starting to look interesting over the long term at current valuations:

Finally, I would note that selected fixed income is getting quite compelling here – I have been outright bearish fixed income and the 60/40 portfolio strategy for some time as you all well know, but some fixed income is finally presenting a very interesting opportunity. But you have to know where to look and who the best managers are to capitalize on opportunities in this strategy. There are currently opportunities to achieve close to 10% yields in quality credit assets for example. When spreads look like the chart below, you should think about capitalizing on that: