“There is always something to be worried about. I would be worried if there isn't something to be worried about.” – Legendary Investor Peter Lynch

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,

Are you feeling that FOMO yet? It may not be as strong as the fear that was so gripping in 2022 as stocks and bonds couldn’t seem to find a floor. This is the emotional side of the human condition that grips us, and emotional biases are the #1 reason that investors typically underperform.

The market rally from the lows of the fall of 2022 has gone far enough to turn many skeptics into believers. Stocks have been propelled by diminishing investor concerns regarding inflation and less worry about the sustainability of economic growth. Though much of the strength in stocks is from the ‘magnificent 7’ – big tech companies Apple, Microsoft, Alphabet (Google), Amazon, Tesla, Meta (Facebook), and Nvidia which represent about a third of the S&P 500's market capitalization. To put things in perspective, these 7 companies are larger than the main Canadian and Emerging Markets stock indices combined, while Apple alone is roughly 20% bigger than the entire S&P/TSX Composite!

The chorus of many Wall St and Bay St strategists and economists are now more positive than they were only a few months ago as the economy and stocks have defied the skeptics. However, this is in the face of reliable leading indicators of U.S. recession that continue to worsen, sticky core inflation readings, tightening credit conditions and Central Banks that continue to withdraw stimulus.

According to Bloomberg, since the early 1950s, strong performance in the S&P 500 during the first half of the year has typically served as a solid base for positive returns during the following six months. But this year’s equity rally may confront some challenges. The markets have been coming to terms with the fact that Central Banks may not be lowering rates any time soon – I noted earlier in the year in these Partner Memos that I was skeptical of rates being lowered any time soon, and certainly not in this calendar year. The market is on that page now – most Fed members in the US think at least two more rate hikes will be appropriate this year. The market remains somewhat skeptical as it has for some time (and has been wrong so far), now pricing in just one further 25 bp increase. That’s still a big change from 7 weeks ago:

Either way, the end of central bank rate hikes is coming into view. A significant amount of monetary tightening has already been delivered and policy rates are now restrictive in most developed economies – we are likely approaching the finish line in the current rate-hiking cycle. But, should inflation fail to come down and economies avoid a nasty recession, some further and currently unexpected rate hikes may still be on the horizon. In all likelihood, the pressure to raise rates will continue to diminish and several central banks should be in a position to cut rates as we get into 2024 as economies weaken and inflation falls. Rates certainly won’t go down to the lows that we saw in yester-year. I will make the call that generally high levels of debt, aging populations and structurally slow economic growth moving forward should keep rates fairly rangebound for the medium and longer-term.

The bigger threat to the stock market is now the sustainability of corporate profits which will be vulnerable if the economy falls into recession (which is still the most likely scenario). Earnings growth has currently stalled as rising costs (inflation) weigh on profit margins. I can’t find when a contraction in the economy didn’t force profits at least back to their long-term trend line, and they’re currently sitting above that. In a slowdown scenario, S&P 500 profits could fall as much as 15% from their peak, limiting the upside potential for stocks at best.

My experience through the early 2000’s tech bubble bursting, and 2007/08 financial crisis continues to make me nervous. Investors operate in days, weeks and months. Markets and economies operate in quarters and years. In both ’00 and ’07, warnings of a looming economic slowdown were wrong for over a year, with those risks all but dismissed by the time the slowdowns actually showed up. This sounds familiar… Maybe this time is different after all... I doubt it.

It's not all doom and gloom though. I have been seeing a set up in some fixed income and credit that are some of the most interesting opportunities that I have seen in years. Selected fixed income (i.e. bonds) and credit strategies offer the most attractive risk/return potential currently in my view, especially versus equities. I have been positioning our portfolios to take advantage of this since late 2022, and expand on the dynamics of this in the last section of this month’s Memo.

I am excited for the outlook and opportunities for our clients, some of which we are able to take advantage of currently. I remain cautious, conservative and well-hedged in this environment, minimizing risk exposures while maintaining flexibility to take advantage of opportunities and strategies that present interesting risk-adjusted return profiles.

 

 

A Few Other Interesting Things to Highlight + Upcoming Events

I will be hosting a Private Credit Investing Panel in the coming weeks with a few of North America’s leaders in the strategy, stay tuned for details.

The third annual Women, Worth & Wellness golf event at Duntroon Highlands in Collingwood is back Sept 14th. This half-day event once again starts with a 2-part clinic with 8-time LPGA champion Sandra Post and Mary Pat Quilty, both owners and operators of their own golf schools. This year we are putting a special focus on ‘mindset’ both for golf and life - included in this year’s event are optional activities after the lunch. Help raise funds for the local hospital, enjoy a fun round of golf, a smart breakfast and delicious lunch with an amazing group of women. There are still some spots available but we’re almost full, you can register HERE.

I am proud to support a number of charitable initiatives, one of which is the Georgian Triangle Humane Society. I will again be supporting their marquis event in the fall – the Furball is back! Last year’s Spirit & Sparkle event raised $58,000 through a critical needs auction that was a blast. See the impact report HERE.

 

 

Recession? It’s The Economy, Stupid*

Perhaps that’s an offensive title, though singer John McCutcheon didn’t think so. Maybe he was ahead of his time.

This strong upswing equities has been largely driven by a handful of mega-cap Tech and tech-related stocks and interest for anything remotely related to artificial intelligence. This could be a case of the tail wagging the dog, as it has persuaded many market pundits that the U.S. economy will avoid a deeper downturn. Interestingly, SocGen astutely noted that Economists usually give up forecasting a recession immediately before it occurs, so they’re likely right on cue again today:

Source: SocGen

The economy has been resilient so far this year, but the most aggressive monetary-tightening cycle since the 1970s is starting to have an impact. Most reliable leading indicators of recession have been moving toward even more negative readings unfortunately. It usually takes many months if not a year or more for higher interest rates to feed through the economy and slow things. Higher interest rates have increased the cost of borrowing, diminished risk appetite and emerged as the root cause of banking-sector stress. Moreover, business confidence is waning, global trade is beginning to shrink and consumers are increasingly turning to credit to support their spending. Further inhibiting growth will be the U.S. debt-ceiling resolution, which comes with a commitment for reduced government spending over the next two years. This all spells RECESSION within the next few quarters. Soft or hard landing? I opined on that last month, but a mild recession could bring about some positives as it would help cool inflation, prompt central banks to cut interest rates and set the stage for the next durable economic expansion.

The Fed’s main challenge and goal is to get inflation down to ~2%. Monetary policy is a blunt tool, and it’s virtually certain to induce a recession. Even the Fed themselves are talking about a recession (it is rare that they mention the ‘R’ word directly), and that it will be mild. Their own staff economists are forecasting a recession to begin in Q4 2022. In the history of 13 rate hike cycles since 1955, there have only been 3 ‘soft landings’. This is a perfect predictor so far when you overlay those with leading indicators and yield curve:

Central Banks don’t appear to want to ‘back off’ their attempt to quell inflation too soon. If you have one takeaway on this topic, it is this: The Fed policy mindset is to err on the side of being too tight as policy makers want to avoid the 1970s Arthur Burns blunder of giving up on the inflation fight too early, which would risk inflation spinning out of control if they screw it up.

On this topic, jobless claims are possibly the most important economic indicator going forward because they simply have to move higher if we’re going to see the type of balance in the labor market that would ease Fed inflation concerns. The unemployment rate must go up, and the sooner the better. Sub-4% unemployment is not indicative of a balanced labor market, it’s indicative of a still-tight labor market.

So why is the economy continuing to run hot? Excess savings at the government levels is still elevated and personal excess savings have not yet been fully drawn down.

Even though cash on the sidelines remains mountainous at $5.5 trillion as per FundStrat, J.P. Morgan thinks household excess savings will run dry by the end of the year:

 

 

What’s Really Going On With Inflation?*

For inflation, things are looking up – or down I should say. The four key factors that drove inflation to its highest level in four decades are all turning. Commodity prices are well off their prior peaks, supply-chain problems have mostly abated, monetary policy has become restrictive and fiscal policy is starting to act as a headwind. Other indicators also point to fading inflationary pressures. Chinese producer prices are dropping, companies have reduced plans to raise wages and the share of products subject to rapid price increases has declined.

There is, however, still some distance to go before inflation returns to levels targeted by central banks. RBC economists and others believe that the path to 3% inflation can likely be traversed in the next several months in North America, but achieving the 2% target could take considerably longer. The biggest barrier to continued significant declines in inflation is service-sector inflation, which remains hot due to a strong labour market. A recession would likely be needed to cool price pressures in this sector.

The takeaway from the June central bank decisions and the associated commentary from various policy makers (including Powell in the US) is that in the eyes of global central bankers, inflation is still far too high relative to mandated levels and it is not yet falling fast enough to satisfy policy makers, especially in certain parts of the economy such as the service-sector. As a result, central banks around the globe are taking an increasingly hawkish stance than markets had believed they would as recently as last week, despite policy makers reiterating their case.

The problem with this current consensus view by central banks is that much of the effects of their rate hikes have not yet been felt in the economy (rate hikes take months or quarters to meaningfully impact growth), much less show up in the mostly lagging economic data the same policy makers are focusing on for signs of easing inflation.

According to bond markets, the Fed and other major central banks have been too aggressive for some time and already overtightened policy, clearly indicated by the deeply inverted yield curve that points to an “above neutral” rate (and meaningfully so given the depth of the inversions across the curve!). Put plainly, markets are pricing in a swift drop to below-target inflation within the next 12 months. And that has contributed to investors pushing back on the Fed’s published policy plans to continue hiking rates as markets are pricing in a sharp drop in near-term inflation pressures (fed funds futures were pricing in 2023 rate cuts as recently as a few weeks ago). This dynamic is one of the main reasons why traders have been repeatedly trying to time a “policy pivot,” but so far to no avail.

RBC Capital Markets expects that most major economies will see inflation back toward more normal levels by early 2024, which should keep any potential central bank rate cuts at bay until roughly the same time.

 

 

What’s the Outlook For Stocks Here?*

In short – mixed at best. Equities have shown significant resilience as the major indices rallied (albeit amid thin leadership) in spite of the cautious moves across other asset classes. This is somewhat understandable as stocks often remain buoyant while yield curves are inverted or continue to fall (which has been happening). It is not until the yield curve begins to meaningfully steepen, led by a sharp drop in shorter-term yields in reaction to ugly events in the economy, that stock market volatility begins to rise. The yield curve steepening is usually because of unplanned or emergency rate cuts by central banks in response to an adverse unforeseen event. As long as the yield curve remains inverted near current levels, or even falls further, the prospects for equities to maintain gains or even move higher are pretty good. But volatility is primed to rise in a big way once the curve begins to revert to a normal dynamic, which will happen at some point in the coming months I suspect.

Any way you cut it, stimulus is being removed from the economy and markets, and will be a headwind for equity prices. The economy may not be there to support earnings going higher as well.

I’ve harped on the earnings outlook for months, but if you subscribe to the idea of an upcoming recession, it’s hard not to see downside on that front. Inflation is pressuring margins on top of that:

It’s amazing how quickly investor moods can swing – just a few months ago, everyone thought the world was ending and stocks were going to zero. Goldman’s US Equity Sentiment Indicator is now at its highest level since April 2021, suggesting positioning is now stretched (readings of +1.0 or higher have historically signaled stretched equity positioning). The sentiment indicator tracks investor positioning across the ~80% of the US equity market that is owned by institutional, retail, and foreign investors.

Source: Goldman Sachs

But if we’re close to the last interest rate hikes, stocks generally tend to perform decently following that:

And even though US stocks have performed better than Canada this year so far (largely attributable to the ‘big 7’ tech names), Canada is more attractive on a relative valuation basis:

Finally, it’s worth noting that the equity risk premium is dismal – this is an important indicator for equity levels. Equity risk premium is earnings yield minus short term yields (as a risk-free proxy), which is the inverse of Price/Earnings. This points to there being risk to valuations for equities as this needs to be higher than it is today if we’re entering a slowing economy:

Which leads me to…

 

The Best Trade Going – No, It’s Not Tech Stocks*

This chart speaks for itself, and may make you nervous. The trade-off between T-Bill yields and the S&P 500 earnings yield has not been this skewed since the Tech Bubble, and shows the limited ‘relative value’ in equities at the present time:

But there is selected value in other places. Since the beginning of the recent tightening cycle in early 2022, bond yields and corporate credit spreads have repriced meaningfully to compensate investors for rising risks across the board. As illustrated in the chart below, the yield-to-worst on the Bloomberg aggregate investment grade universe offers a more attractive yield than the dividends earned by the S&P 500 Index and the TSX now. Remember, the is extremely limited probability of default in investment grade Canadian names. These dynamics aren’t the same in the high yield sector however.

Source: RBC Portfolio Advisory Group

Selected investment grade bond yields garner a solid return, and they should also provide solid capital appreciation potential for portfolios should bond prices rally if and when central banks eventually pivot back toward rate cuts as economic growth and inflation eventually cool. When the yield of the Canadian corporate bond index pays more than the earnings yield of the S&P 500, which has only happened once in 20 years, we should pay attention.

Credit spread in this space are also very attractive (i.e. ‘wide’ – investors need to be compensated with more spread or return when they perceive that risks in the market are higher). The blue bars in the chart below show the level of the short-term Canadian credit spread index, which are currently meaningfully wider than the yellow-line long-term average. This is because current spreads have likely built in more pessimism than many other asset classes, reflecting at least a mild recession. Admittedly, spreads have been wider in the past 20 years, but only during the Global Financial Crisis and briefly during Covid, extreme environments that are unlikely in the coming few years even if we see a recession. Note that the current yield generated by this strategy provides a buffer for potential further spread widening, making this an interesting risk-adjusted trade to consider.