“Great minds discuss ideas; average minds discuss events; small minds discuss people.” – Eleanor Roosevelt
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,
Set-it-and-forget-it used to work for investing, but now it’s just for indoor grilling.
Markets have embraced the idea there will be no economic slowdown just as aggressively as they believed, at the start of the year, there would be an inevitable slowdown. Put in market terms, stocks have rallied aggressively on the idea that there will not be an economic ‘hard landing’ and ‘immaculate disinflation’, as the economy has remained resilient, labour markets remain strong, and inflation subsides. But what if the optimism is a touch premature, and the ‘hard landing’ risk is still very real over the coming quarters? FOMO (fear of missing out) is back, or is it now FOMU (fear of materially underperforming)?
Lessons from the past would tell us to pay some heed – a recession often begins as a benign slowdown before developing into something a deeper one. As well, it is normal to have investors and economists the risk of a recession when it's so long in coming, despite central banks hiking interest rates – especially when new technologies evolve that promise to change the world. This is precisely what happened in the tech boom – look no further than this Wall Street Journal report from the fall of 2000, this sounds alarmingly familiar…
In an era of unprecedented, technology-fueled growth, a soft landing of the economy has emerged as the Holy Grail of U.S. policy makers. But the continued strength of the economy is feeding a running debate among economists about whether the economy needs to be landed at all. – Wall Street Journal, August 11, 20003
Some sentiment indicators are showing the most optimism in a few years, and "recession fatigue" is at peak frenzy. Even though many are getting impatient with any level of caution, are getting impatient, the fact is the yield curve signal – an early indicator of recession that has NEVER been mistaken in over 50 years – has just entered the window of higher risk, with the lag between a broad-based inversion (which occurred in November 2022) and the start of a recession historically ranging from 7 months (which takes us to June 2023) to 18 months (which would take us to May 2024). As well, academics (including the Fed itself) agree that it takes 12 to 18 months before monetary policy impacts the economy. So, even if inflation declines to 2%, we would still have 12 to 18 months of slowing growth ahead of us. To top it off, even though 2023 is shaping up to be stronger than most predicted 6 months ago, forecasts for 2024 have continued to be revised lower for both developed and emerging (developing) economies. Global economic growth appears set to slow to near stall speed – just later than many had previously expected.
This is all to say that some caution is still warranted, so we should position accordingly.
It is entirely possible that “hard landing” risks have been delayed, but they certainly have not been eliminated. Central Banks have dramatically hiked rates and that’s impacted certain sectors of the economy such as housing and manufacturing, as they are very sensitive to the cost of capital. But it hasn’t hit the consumer yet, in part due to the massive increase in savings following the pandemic and as many consumers took advantage of low long-term rates over the past several years. Yes, rates are high, but consumers have a large-cash and low-interest buffer that is, for now, diminishing the impact of the quick increase in rates.
While the environment has been and remains generally positive near term for stocks and bonds, and interest rate hikes from Central Banks are generally finished, don’t confuse the good data with this being a riskless market. Disinflation is a positive now, but it could negatively impact earnings in the second half of 2023 forward, so it’s entirely possible that inflation is falling because growth is cooling (which in the end wouldn’t be good for stocks). Falling inflation is a good thing because it means the Fed won’t have to hike rates materially higher than expected. But it remains unclear if falling inflation will bring with it slowing growth and declining margins, as it usually does.
Economic data remains resilient for now, but the longer the Fed keeps rates high the greater the chances of an economic slowdown.
Making predictions about asset prices is fraught with danger. Most people look at things linearly, and don’t consider the second-order effects. The market humbles even the very best investors at some point. Years in the markets teach you that that when you are looking at things linearly, you are probably going to get in trouble. Investing is hard, and economics is full of surprises. Going all-in or 100% to cash is rarely a smart strategy, but rather building a defensive risk-adjusted portfolio is the goal – some may call it a barbell strategy. TARA (There Are Real Alternatives) is another acronym going around, which speaks to holding a healthy cash position – in the current environment, we can earn a tax-equivalent yield of well over 7% on cash instruments – this is something to discuss if you are curious.
A Few Other Interesting Things to Highlight + Upcoming Events
I hosted a Private Credit Investing Panel on July 27th with Oaktree and PIMCO, the two heavyweights in the space globally. Private credit is potentially offering some interesting opportunities – we may be in the ‘golden age’ for private credit today resulting from the twin challenges of asset values that are under pressure and dwindling availability of capital as large lenders and equity providers are facing pressure and have pulled back. If you want more colour here, let me know.
Diner en Blanc is coming back to Collingwood on Saturday Aug 19th, and I am proud to be a presenting sponsor. This should be a blast. You can find details for this event HERE.
Finally, if you’re in the Collingwood area, save the dates of Sept 12, 5-7 pm and Oct 17, 5-7 pm. Along with Women, Worth & Wellness, we are excited to promote 2 wonderful events, brought to you by Hospice Georgian Triangle. More details coming on those events, stay tuned.
Is A Recession Coming or Not? And What Is ‘Immaculate Disinflation’…*
The average lag between start of hikes and start of recession is 19 months over 13 cycles. We are in month 16. 1980 took 11 months and was only cycle where hikes were more aggressive than now. You’d expect it took take longer for the economy to slow if you subscribe to the government deficit or excess savings are leading to a more resilient economy narrative.
If we look at economic forecasts for global growth, 2023 is shaping up better than the collective wisdom predicted 6 months ago, and even though it will be a deceleration from 2022, it isn't negative.
But forecasts for 2024 have continued to be revised lower for both developed and emerging (developing) economies. Global economic growth appears set to slow to near stall speed…. just later than many had previously expected. The U.S. economy has historically been unable to avert a recession when unemployment has reached today’s very low levels.
Despite the recent positive economic data, it is easy to remain skeptical that a soft landing can be achieved while getting inflation all the way back to 2%. When the Bank for International Settlements took a look back at hard vs. soft landings (HERE), it found “soft landings involve smaller, shorter, and more front-loaded rate hikes.” With that said, given the scale of rate hikes of today’s tightening cycle, that would put us in hard landing territory.
The Fed’s mid-90s tightening cycle stands out as the prototypical soft landing, with inflation coming down, unemployment stabilizing and the Fed cutting rates modestly to keep the expansion going into the 2000s. But inflation wasn’t nearly as high back then nor was the economy running as hot – unemployment was still above sustainable levels, rather than below as it is now. Inflation has slowed to around 3% but the hard yards are still to come, as are the lagged effects of tighter monetary policy.
We know that the yield curve is almost never wrong, while many are saying today “it’s different this time”. Now leading indicators point to a coming recession as well. This is a measure from the Conference Board, which combines various leading indicators into a single measure. This also has a flawless track record in 50+ years.
Finally, this is an interesting concept and chart. Normally in a tightening cycle, corporates suffer from a big rise in net interest payments. But this time debt was ‘termed out’ (i.e. extended) during the pandemic immunizing the impact of rate hikes which has boosted profits and also helps explain the delayed recession:
So, can ‘immaculate disinflation’ continue? That is, inflation subsiding causing a soft economic landing while the jobs market remains robust. We are going to learn whether this is a repeat of the 1970s. In the 1970s there were multiple waves of inflation.
Disinflation makes higher interest rates more of a headwind on the economy. As inflation falls (and wage growth stalls) real rates become more positive, so disinflation will exacerbate the impact of higher rates over the coming months and quarters, increasing the chances of an economic slowdown. If disinflation compresses margins for companies, and if that combines with a general slowing in consumer spending (as high interest rates bite more), then that’s a recipe for a decline in earnings that will increase the unemployment rate.
Source: SocGen
Of course, the ultimate risk is that markets sniff out an eventual recession, which typically causes an equity market swoon as investors panic to figure out how bad it is going to be.
Source: Deutsche
Reasons To Play Some Defense*
There are always reasons for caution, and a wall of worry for markets to climb. Today there are some things that are worth heeding.
Cash is a real alternative currently. As I noted above, one can garner 7-8% tax equivalent yields on cash without taking on much risk.
Source: MacroDaily
Sentiment is currently very bullish, which is often a good contraindicator. And nothing better to highlight sentiment than this chart below, showing flows into or out of T-bills by Bank of America private clients. You can see that the last year was nothing but risk aversion, with people piling into T-bills, and the last few weeks everyone changed their minds, overtaken by greed and FOMO in a strong tech market. This may mark the near-term highs I suspect…
On the sentiment front, there is a significant dichotomy between individual (i.e. retail) investors and professional (i.e. institutional) investors. Individual investors are the most bullish since late 2021, not so much for the institutional side. Which side do you agree with here?
Stock valuations are stretched on some measures. S&P 500 forward P/E multiples closely track the real 10-Year US Treasury yield – this year they have decoupled, and bonds are at the cheapest relative value to stocks in the last 7 years. Bonds have only traded cheaper vs stocks 2% of the time over the last 20 years.
One narrative about why the economy has held up is excess savings built up over the pandemic. Not sure how long that’s going to last. However, it is worth noting that excess savings are a tiny share of overall wealth.
And Some Reasons For Optimism*
There are always reasons for optimism – the market is often climbing a wall of worry. The bearish narrative often sounds ‘smarter’, especially when sentiment is dire. But that’s not the case today – we have generally positive economic news, inflation is coming down, and many stocks are doing well.
Looking at the percentage of S&P500 members that are trading over their respective 50 day moving averages, almost 90% are. That has typically coincided with positive performance going forward, with the S&P500 averaging 15% 12-month performance and positive returns after nearly all occurrences when this figure breaks 85%. That being said, there are reasons to be cautious here – nearly every historical occurrence came after a recession or fiscal / monetary / debt / trading crisis – arguably we haven’t gotten ours yet.
Over the past 40 years in which the S&P 500 index has seen returns above 10% in the first half of the year, subsequent annual returns that follow are generally strong:
Source: RBC GAM
There's no denying that a 20% rise from a recent low sends a powerful signal. Of the 12 times this has happened since 1960, only three instances (2001, 2002, and 2008) have seen the Index relapse to a new low, with the rally continuing on the other nine occasions (i.e., 75% of occurrences):
If research analysts are right, we should see solid corporate earnings moving forward. Too optimistic?
