“While there is a lot to be said for being lucky rather than being smart, I’ve learned that being smart means putting yourself in the path of luck at the right time. Investing and life are a lot like surfing that way: One mostly needs to hang out, be in tune with the environment, paddle gently every once in a while to be in front of the right waves, and conserve energy - until it’s time. The key is to know when to paddle hard to set things in motion.” – Bill Tai
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,
In some respects, it is interesting how much things can change in even a month.
We have seen a choppy month in August, which wasn’t surprising. I noted at the end of July that “sentiment is currently very bullish, which is often a good contraindicator... the last few weeks everyone changed their minds (from risk aversion), overtaken by greed and FOMO in a strong tech market. This may mark the near-term highs I suspect…”
As much as pullbacks like this can be scary for many, nothing truly bad has happened here. What I mean is that the rise in stocks in 2023 has been fueled by better-than-expected economic data (the “no landing/soft landing” recession expectations), a sharp drop in inflation, and the Fed being almost done with rate hikes. Positively, none of that has materially changed. Rather, the market got ahead of itself in expecting more good things to happen near-term, which warranted caution in recent months.
Think of it this way – markets started 2023 down in the dumps with investors and Wall Street expecting an imminent recession and high inflation. But while the economy is slowing, it’s not slowing as quickly as everyone thought it would. Meanwhile, inflation is still high, but it’s dropped more quickly than everyone thought. Both inflation and growth were not as bad as feared, and that data combined with negative expectations to spark a solid rally in stocks. Then, starting around July, investors began to act like a slowing economy wasn’t happening (it is) and inflation was about to crash back to normal (it isn’t). That very optimistic view (essentially that all our troubles were over) sent the markets higher in a hurry.
But just like investors were too negative to start 2023, investors got too positive in July, because actual economic data can’t back up the “our troubles are over” optimistic market. So, economic growth is still resilient, but we must acknowledge that it’s slowing and account for the possibility that it gets worse. Inflation has fallen, but we must account for the fact that it could level off solidly above the Fed’s 2% target. And the Fed is almost done with rate hikes (or already done) but they likely aren’t reducing rates anytime soon.
It takes time for the effects of the rate hikes to work their way through the economy and eventually lead to a recession. Looking back at history, this can last anywhere from 100 to 450 days, averaging 229 days before central banks cut rates when a recession is apparent. The futures market expects the Fed to start cutting rates in mid-2024, consistent with the average length of prior peaks in 1995, 2000, 2006, and 2018.
From all of this, ‘long bond’ yields (10-year duration or longer) have been a problem for stocks – they have been steadily moving higher over the past few months. With U.S. 10yr bond yields back over 4%, expectations of ‘higher for longer’ rates have resurfaced, and this is one of the reasons why stocks wobbled in August. Remember, it was only a few months ago and the market was thinking rates would be heading lower by now! Long bond yields have been rising more than short rates, with 10-year hitting their highest level since 2007. The main reason for this is that recession fears have subsided, inflation is still present, and the economy is doing better than expected. This all seems like good news for now, but this is what’s called a ‘bear steepener’ and this causes confusing signals and are historically not great for the economy, often preceding recessions.
So, will we get a recession or what? That’s still the million-dollar question. The market and most pundits sure don’t think so, and even the Fed’s staff economists have upgraded their forecast from a mild recession in H2 2023 to no recession… But we must remember history. It always looks like it is going to be a “soft landing”, and then bad things sometimes happen…
Even though recessions tend to cause weak equity markets, on average the markets were positive over these periods noted above, with only the 2000 period seeing a decline in the overall market once the Fed stopped hiking.
The outlook is decidedly ‘mixed’ no question – even though the consumer is relatively strong (for now), consensus expects that earnings growth bottomed in Q2, earnings sentiment is strong, and the economic surprise index is at 2.5-year highs. But, remember that the market is forward looking.
Bonds tend to do well in these times, especially given where rates are today – I have pulled a complete ‘180’ on this position from where I stood prior to a year and a half ago when I was very bearish on the outlook for bonds. More detail on that in the section below.
Bottom line is we remain vigilant and defensive, and are seeing some interesting opportunities selectively. Some ‘alternative’ investments are attractive in the current environment, and there are instruments in cash that can potentially yield higher than GICs with arguably less risk (more on that below). This is not the time to set it and forget it, the world is changing quickly.
A Few Other Interesting Things to Highlight + Upcoming Events
In support of Women, Worth & Wellness, we have some great events coming up in the fall. The focus and theme for this fall is MINDSET – a theme we have included in the various events we have curated and are hosting, this fall for Boomer Women and their Daughters and Granddaughters pertaining to their health & wealth; net worth & self-worth; philanthropy & legacy planning.
On the evening of Thursday, Sept 12, in partnership with Hospice Georgian Triangle, we will host an event on Anticipatory Grief at Chartwell Balmoral in Collingwood. Most people think of grief as something that happens after a loved one’s death. But grieving can also occur before death. This experience is known as anticipatory grief because it occurs in anticipation of a death or other type of loss — such as the loss of abilities or independence. Anticipatory grief can be experienced by loved ones, as well as the person who is ill or dying. Learn more about common symptoms, coping mechanisms, and giving purpose to grieving.
We will also be hosting our annual golf classic at Duntroon Highlands in support of Hall Innovation Fund at Collingwood General Marine Hospital Foundation on Sept 14 and it is sold out once again. Sandra Post (8x LPGA winner) & Mary Pat Quilty will be leading a session on mindset in golf before the 9-hole golf tournament. That afternoon we will honour Youth Mental Health in Nature in support of www.jack.org with a nature walk appreciation mindset at Duntroon, led by Annette Sandberg and in support of Hall Innovation Fund for youth mental health from nature.
Finally, I am proud to support and be part of awesome events like Le Diner en Blanc and bring some great people together. A beautiful August evening.
We Have to Talk ‘Recession’ Again – What’s The Deal Here?*
Recession, are you in the rear-view mirror, ahead of us, or are you with us in the room right now...?
With recessionary fears fading, most asset classes have priced out a recession in the near term (see chart below). Moving forward—and expectedly—the outlook for equity markets will depend largely on the how well the economy holds up in an environment of higher rates. Most economic indicators continue to suggest the expansion is likely to stay intact in the near term. Seven out of twelve prior Fed tightening cycles since the 1960s have ended in an economic downturn. On average, the S&P 500 has rallied strongly in the five non-recessionary Fed tightening cycles after peak rates, while coming under pressure with heightened volatility in those that ended in recessions.
Maybe we’ve already seen the recession everyone keeps forecasting? See the red bars below, showing GDP contraction in Q1 and Q2 of 2022. Stock market for sure has its "recession mandatory" 20% drawdown around that time.
Source: Bianco
Or is it as Rosenberg shows, that this time is no different, and it takes on average 22 months after first rate hike to show up?
Source: Rosenberg
As I noted up front, often investors feel most optimistic right before a recession, thinking that ‘it may be different this time’. Case in point: from a transcript of the staff briefing of economic conditions from the FOMC meeting of October 2007, two months before onset of the ugly recession then:
“There can be little denying that, almost across the board, the readings on economic activity have been stronger than our expectations in September… All told, third-quarter growth in consumption looks stronger than we had expected, and spending appears to be headed into the fourth quarter with a bit more momentum.
At present, it is difficult to find evidence in high-frequency indicators that the economy is in the process of turning down.”
The only warning came from the Senior Loan Officers Opinion Survey as an indication of credit conditions. Bank credit is a major driver of the economy, and it’s drying up quickly today. It can also cause ugly credit events. The July 2023 Senior Loan Officers Opinion Survey on Bank Lending Practices from the Federal Reserve revealed “tighter standards and weaker demand for commercial and industrial (C&I) loans to firms of all sizes over the second quarter” as well as loans in other categories. The latest weekly data shows that bank credit is continuing to contract.
On the consumer side, JP Morgan believes US consumers have blown through their cash savings built over Covid. Excess savings for US households when adjusting for inflation are now fully exhausted from a 2021 high of $2.1 trillion. Student loan payments are also restarting in September. In Canada, things are similar.
Overall money supply is worrisome, we’ve seen the 8th consecutive month with a significant year over year decline:
On the brighter side, Company CFOs are more upbeat on the risk of recession, which was evidenced in recent quarterly commentary.
As well, high rates may not be as much of an issue for consumers as some think. 82% of homeowners have a mortgage rate below 5% (in the US) as many locked in. Only 30% of mortgages have reset to higher rates, though by the middle of next year that number will be closer to 60%. Household debt as a % of GDP has declined to 2001 levels, and is half as much as it was in 2008/2009 (meaning consumer balance sheets are much stronger).
Same goes for corporations, as only 6% of S&P500 companies have debt that is floating, and nearly half of their debt is set to mature after 2030 which is good. Even with Fed funds at the highest level it’s been in 20 years, corporate net interest costs are at a 60-year low.
We may be in a similar market to 2015-2016, when the economic outlook was very murky and many were calling for a deep recession. At the time, earnings were expected to take another hit, and many were calling for an even bigger selloff (even after global equities had already tumbled into a bear market), similar to today. But if you look under the hood, we’ve been in an earnings recession for a couple quarters now.
Source: Alpha Feed
Bonds – Why They’re FINALLY Attractive Again*
Yields on the equities and bonds converged for much of the last decade, but the yield advantage on bonds was decisively restored over the last 18-months. The chart below on the left points to a ~400 bps yield advantage on corporate bonds using the US investment grade market versus the S&P 500.
Simply looking at the yield on the equity market – especially the broad market and not a high dividend index – only accounts for a portion of the return for this market. Comparing the earnings yield of stocks to bond yields is a much better proxy given that shareholders have a claim on the entire earnings stream, not just what is paid out in dividends. The earnings yield is calculated by taking the inverse of a price to earnings multiple. The yield on a broad US investment grade bond index is currently 50 bps greater than the S&P 500’s earnings yield. This stands in stark contrast to the recent history of this relationship as the earnings yield of equities exceeded corporate bonds by ~300 bps from 2010-2020, with the spread sitting in excess of 400 bps at times in 2012-13.
We are also entering a favourable part of the cycle for relative fixed income returns.
Historically, the period between the final Fed rate hike and the first rate cut have been strong periods for bonds relative to equities per the charts below. While forecasting future central bank actions is always a difficult and humbling exercise, it is likely that we are near this part of the cycle given the magnitude of rate hikes that have already occurred and a number of leading economic indicators that suggest we are getting later in the cycle.
So, we need to hold a real allocation to various fixed income and credit again. Because looking at the chart below, something likely has to give:
Source: Macrobond
You Shouldn’t Be Holding Cash – Discount Bonds: Better Yield And Safer Than GICs??*
With the relentless increase in interest rates, there are options to garner significant yields from various cash, money market and bond instruments today. There's no reason for one to be sitting in cash earning close to no yield at this point.
1-year GICs pay an average today of about 5.25%, 2 year GICs pay 5.2%, and so on. Even ‘HISA’ (high interest savings accounts) pay upwards of 5%, depending on the account structure.
BUT, this is yield is 100% interest income. Meaning you get taxed at full haul on all of that. So the after-tax yield is essentially half of the post rate.
What if you can purchase a similar type of product, with the same (or arguably even less!) risk than a GIC or HISA, and garner upwards of an 8% taxable equivalent yield?? (Note that a taxable equivalent yield simply means what you'd have to earn in a comparable interest-only instrument like a GIC or high interest cash account).
Given the current environment, you can – it’s called a discount bond.
What is a discount bond?
When the government or a company issues a bond, it’s priced at what is known as par value, usually $100. They pay a coupon on top of that – if it was issued a few years ago when interest rates were low, this yield could have been something like 1.5%. Investors in the bond receive regular interest payments based on the bond’s coupon rate, and the par value is repaid to the investor when the bond matures ($100).
After a bond is issued, similar to a stock, it can be traded. If market interest rates change, the trading price of a bond will change. For example, when interest rates rise, the market
expects higher returns on their bond investments. In our example, if the overnight, or risk-free, rate is now 5%, and the government bond (essentially risk-free) was paying 1.5% at issue, the price of the bond needs to adjust downward so that it yields closer to 5% today than the original 1.5% at issue. Depending on when it’s term is due, it may now be trading at something like $97.50 to garner the 5% yield. So the price of the bond has been pushed down, but that doesn’t mean there’s any risk in you getting your $100 back when its term is up by any means. (This is what happened to bonds last year, they all traded down as rates shot higher.
So, now the bond is trading below its par value, and that is called a discount bond. If you purchase it today, you get the 1.5% coupon as an annual return, plus the $2.50 capital gain when it matures. A large portion of your return (or yield) is taxed as a capital gain, so the effective yield is higher than if it were all interest. That’s what drives the ‘taxable equivalent yield’ to something like 7.5% in this example – to garner the same after-tax yield on an interest-only instrument like a GIC or HISA, you’d have to earn 7.5%. And this is on a AAA-rated Canadian government bond we are using as an example, so has arguably less capital risk than a bank-backed GIC or HISA! And your money isn’t ‘locked in’ like it is with a GIC.
As a side note, it’s important to not confuse discounted bonds (as presented here) with other “discount instruments”, particularly those issued with zero-coupons such as most money market instruments, as those are NOT tax efficient (the pull-to-par is NOT treated as capital gains).
If You Are Philanthropic, There’s A Tax Change On the Horizon You Need To Know About*
I would note something of value that is flying under the radar for many on the tax front in Canada, and has particular and significant implications for the charitable sector in Canada – the proposed changes to the AMT (Alternative Minimum Tax) set to take effect on Jan 1/24. It is likely that less money will reach charities because generous people will no longer enjoy the same tax benefits. Introduced in 1986, the AMT is designed to ensure that taxpayers who may benefit from certain deductions, exemptions and credits pay at least a minimum amount of tax.
Going forward, the proposed changes will particularly impact individuals with large capital gains, or who have significant tax deductions via charitable donations. For example, 30% of capital gains on donations of publicly-traded securities, which under current rules are not subject to any tax, and an increase of the capital gains inclusion rate from 80% to 100% will all be added to AMT calculations. Here are some planning considerations that donors may want to discuss with their professionals to take advantage of the changing situation:
- If you can donate to charity in 2023 and are able to claim the appreciated non-registered public securities gains (eg stock, mutual funds, ETFs), you won't be affected by the proposed changes. But if you carry forward any amount of the donation, you may be subject to the proposed AMT changes in the future.
- If you would like to make a larger than normal donation in 2023 in hopes of avoiding the new AMT rules but are uncertain as to which charity to make your donation to, this is where pre-funding an RBC Charitable Gift Fund makes sense. A donation to this Fund would allow you to receive the tax benefits this year and you can decide later which charities to grant to.
There is some hope that the government may punt this at least a year and complete a ‘consultation' but we haven't heard of anything as of yet. Charities and others need to continue to push back on this front.
There are more strategies to consider, especially if you're planning to donate in 2024 and beyond. We have some short RBC articles that dive deeper into this subject that I am happy to send out for further detail, and happy to discuss, just let me know.