“Our greatest weakness lies in giving up. The most certain way to succeed is always to try just one more time.” - Thomas Edison
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,
It was not a very kind September for markets, with stocks and bonds both down – reminiscent of 2022. With 4 months left in the year, US Treasuries are still red so far this year – Treasuries have never had 3 consecutive years of negative returns since the 1700s. As Franklin D. Roosevelt once said, “a smooth sea never made a skilled sailor.” Last year’s stormy markets made it clear that what might have appeared to be investor skill in the years after the 2008 Financial Crisis was, in many cases, likely just market beta – aka ‘luck’.
The financial media is filled with tales of ‘fat tails’ – things that went exceptionally well or extremely poorly. They are there to capture attention and entertain and pull on those emotional strings to participate or capitulate rather than head down the boring middle as that doesn’t tend to sell. There is often little to gain from watching the talking heads on the financial news channels. As Albert Einstein famously said, “compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.” Bottom line is that steady returns and smaller drawdowns can create significant wealth over time.
Interest rates are the conundrum today, where Canada and U.S. Central Banks both decided to hold rates steady at recent policy meetings, while Europe raised rates yet again. All three emphasized the need to tread carefully as they try to ensure interest rates stay high enough for long enough to stem inflationary pressures.
The Fed’s recent projections suggest rates have neared cruising altitude and remain on a flightpath toward an economic soft landing. However, the flight may not be without a little turbulence… There’s no denying the economic data has remained resilient, and inflation has been generally improving though has turned up a bit again as of late, somewhat due to high oil prices which had been on a downward trajectory for most of the year until recently. Sticky inflation is yet another challenge for central banks, who remain steadfast in their focus on ensuring inflation can move lower and back to their long-term targets.
Conventional wisdom dictates that we would have had a recession by now, but we still have so much money sloshing around from the pandemic stimulus that it hasn’t happened yet. It takes time for interest rate hikes to work their way thru the economy and slow things, and this was buffered by huge savings built up over the pandemic. So, it may be early to see the impact of rate hikes flowing through the real economy as it was one of the most aggressive hiking cycles in history. The economic models are not working today it seems, but the business cycle is alive and well. I assure you that contraction still follows expansion.
For now, central bankers are sticking with their 2% inflation target. But with headwinds of deglobalization (i.e. on-shoring), demographic/labour dynamics, and government spending, this target might not be achievable without pushing the economy into a deep recession. So something has to give.
As readers know, I have been on the same page for over a year now that Central Banks will keep rates higher for much longer than the market was expecting or pricing in – remember, the market was expecting rates to be dropping by now not that long ago! Here is why: if we are in fact going to achieve a ‘soft landing’ and economic growth is going to stay resilient through the start of 2024, then there’s no reason for Central Banks to cut rates and we’re stuck with higher rates for longer. And the “Immaculate Disinflation” argument is that inflation drops back to 2% by next year and that will allow the Fed to cut rates. But I must remind you that stable inflation and solid growth is not a reason for the Fed to cut rates – it’s essentially a reason for the Fed to do nothing!
Conversely, if the market is right and the Fed is going to cut rates in mid-2024, then that must mean that growth is slowing enough that it warrants a cut. Either way, this is a compelling reason to remain somewhat defensive on portfolio construct.
The evidence strongly suggests macro uncertainty is likely to remain elevated for some time. Historically, macro uncertainty tends to be very persistent—on the scale of quarters and years, not weeks and months. So, the bottom line is that we continue to remain vigilant and defensive. Trying to time the market when you need diversification is usually a fool’s errand, and investors that do so typically find themselves the proverbial, “day late, dollar short.” But with macro uncertainty elevated and likely to remain so for some time, it is an opportune moment for investors to take stock and ensure their portfolios are resilient to a wide range of outcomes. There has been a compelling case to take some profits from the more-richly valued equities and diversify into selected credit and alternative investments, which do not face structural overvaluation given their ability to hedge unwanted risks and improve diversification.
A Few Other Interesting Things to Highlight + Upcoming Events
I was honoured to be the presenting sponsor for the Georgian Triangle Humane Society’s Furball Gala, which raised an incredible $155,000 (and counting) for GTHS Programs and Services. Everyone’s generosity will directly impact the lives of pets and their loving owners in South Georgian Bay.
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In support of Women, Worth & Wellness, we hosted two great events in September, with the focus and theme being MINDSET. On the evening of Thursday, Sept 12, in partnership with Hospice Georgian Triangle, we hosted an event on Anticipatory Grief at Chartwell Balmoral in Collingwood.
We also hosted our sold-out annual golf classic at Duntroon Highlands in support of Hall Innovation Fund at Collingwood General Marine Hospital Foundation, Hall Innovation Fund and www.jack.org on Sept 14. Sandra Post (8x LPGA winner) & Mary Pat Quilty led a wonderful session before the golf tournament.
We are hosting our second event in support of Hospice Georgian Triangle on October 30th at 5pm at Chartwell Balmoral, at 8 Harbour Street West, Collingwood entitled “planned gifts & the impact of legacy philanthropy - you don’t know, what you don’t know”. We have a wonderful guest speaker in Brian Hunt whose wife passed away but after experiencing all the heartfelt service that GT Hospice offers, he shares his awareness of programs and services and celebrate the incredible staff and volunteers at Campbell House and in the community. I will discuss philanthropic and giving strategies and aspects of end of life and estate planning considerations that are often overlooked, forgotten, or misunderstood.
Finally, at this time of year, charitable giving is often top of mind. We are hosting an online event on Thurs Oct 5th at 1pm on charitable giving with our specialists on that front. No matter where you are in your charitable giving journey, there are many ways to make a meaningful difference for the causes important to you. Join us in exploring ideas and actions you can incorporate into your charitable activities and planning. Register HERE.
Will We Ever See A ‘Recession’? Or is a Soft Landing a Sure Bet?*
As I noted above, the bottom line on this is that even though the economic models haven’t seemed to work this year, the business cycle is alive and well, and I can assure you that contraction still follows expansion.
The markets have certainly become much more optimistic that we can achieve a ‘soft landing’:
According to Oxford Economics, the maximum impact of the Fed’s tightening will be felt over the next couple of quarters, and they think that we may see a modest recession.
The bad news for equity markets is if we get a recession, we never have seen equity markets bottom before a recession.
The Inflation Conundrum*
The Citi Inflation Surprise Index has been turning up around the world. While one month doesn’t make a trend, ‘sticky’ inflation will be an issue:
One thing stoking inflation that is flying under the radar is the US Administration’s fiscal program – they’re pouring money into the system while the Fed is trying to slow things down via interest rate increases. They will be ahead of 2022 deficit at this pace. Look at some historical deficits vs. today: In 2009, the U.S. deficit to correct for the “Great Recession” totaled -$1.4 trillion for the full year. The 2020 COVID deficit was -$3.1 trillion. As of July 2023, the U.S. federal budget deficit totaled -$1.6 trillion, more than double the -$0.7 trillion deficit seen in 2022 and already above the total 2022 deficit of -$1.4 trillion. This is a great quote:
“If on the one hand, the Fed taketh away and on the other hand President Biden giveth, then effectively it is like running a heater and an air conditioner at the same time.” ~ James Aitken (Capital Allocators Podcast, 2023)
There is a risk that Central Banks will remain more hawkish than the market is expecting and more persistent for longer than we have experienced so far.
Some Further Reason for Caution – Lessons From History, Valuations & Volatility*
Interesting study noting that "in nearly seven decades, there has never been a post-inversion equity market rally that has not been more than fully reversed going into subsequent downturn or bear market…" Premature jubilation in 2023?...The post-inversion equity rally has always reversed going back 70 years.
The Fed is normally reactive to bad news and by the time they cut it is too late. A very different outcome vs the “buy the dip” mentality of today…
The S&P 500 tends to bottom 195 days after the first cut:
Source: Morgan Stanley
Valuations need to be monitored of course, and they arguably aren’t cheap (on the surface), though some markets are getting there (i.e. Canada!). Historically high valuations don’t mean we can’t go higher but should give you some pause:
Source: Goldman Sachs
US equities are currently trading at a historically rich multiple for the current level of interest rates, as illustrated below:
Today, the price-to-earnings ratio (PE Ratio) of global equities sits at about 14.6, which is neither overly cheap nor expensive. However, Europe, Asia, and the TSX are 2-4 points below this average, while the US market is 3 points above average.
Note that valuations in one market are not always comparable to those in another market. Different composition often leads to sustained differences, like more tech or more value in other markets. But even if you look at regional valuations compared to their multi-decade histories, it paints a similar picture. The US S&P 500 is in the 87th percentile valuation over the past twenty years. 100th percentile would be the most expensive during the analysis period. Meanwhile, the TSX at 13x is in the 15thpercentile, Asia at 14.4x is at the 42nd percentile, and Europe at 12.4x is way down in the basement at its 10th percentile.
As I have noted recently, expect markets to remain volatility for some time. AQR (one of the leading quant hedge funds globally and a thought leader) makes a great point about elevated volatility that is likely moving forward:
“Volatility at the front end of the curve is indicative of elevated economic uncertainty. Even more alarming, however, is the degree of disagreement between the market-implied path of the federal funds rate and what FOMC members and economists forecast. While the market believes the tightening cycle is over and rate cuts are imminent, all FOMC members and over 70 percent of economists surveyed by the Financial Times8 forecast zero rate cuts in 2023. The disparity between FOMC projections and futures market pricing is the largest observed since the SEP began in 2012.9 How is this disagreement resolved? Either the FOMC and forecasters are right and interest rate expectations get re-priced, or the futures market is right and Federal Reserve credibility erodes. Either scenario is likely to contribute to financial market volatility and continued elevated macro uncertainty.
We can square this circle. Perhaps interest rate futures and inflation markets are forecasting an imminent and dramatic slowdown in economic activity. This would likely put downward pressure on inflation and could cause the Fed to shift from focusing on inflation to employment. But a deep recession would be very painful for equities, which show no evidence of pricing in a slowdown. Not only is there stark disagreement between market-based and survey expectations, but there is also material disagreement across different asset classes.
To be sure, I am not arguing policymakers and economists have it right and markets wrong, or vice versa. Things still must play out. But the large amount of disagreement indicates that the economy is on a knife’s edge, and dissonant market pricing is a powder keg for higher volatility.
If macro uncertainty remains elevated, financial market volatility is likely to be high as well.”
Some Reasons for Optimism – The Positives*
Are valuations really that high? Goldman would highlight that "the S&P 500 trades at 19X P/E on a next-12-months earnings estimate basis. But if you remove the 7 biggest stocks from the index (the mega-cap Tech FANGMAT complex), the remaining 493 stocks trade at a more reasonable 17X P/E. And the median stock in the index also trades at 17X -- a median stock multiple that we have seen frequently since 1995”.
Source: Goldman Sachs.
Source: Sarna
Canadian equities tend to generate solid performance following the last BoC rate hike. In analyzing the three, six, and twelve month performance of the TSX following the last BoC rate hike of a given cycle, we found that both average and median returns were fairly strong across all three horizons. That being said, the longer the horizon, the wider the range of return outcomes. One notable highlight is that forward returns on a three-month basis were positive all eight times we analyzed.
In the near term, things may go higher. Since 1950, when the S&P 500 is up >10% Jan thru July (similar to this year), but is negative from Jul End Thru Sep 23 (similar to this year) - 4Q performance tends to be strong. - Of the 8 instances, stocks on average finished up 7-8% in 4Q - With a stunning 100% win ratio.
When the Fed makes its last interest rate hike of the cycle, stocks go up (if there is no recession). But as with most studies like this, if there is a recession, then stocks go down. So that’s the million dollar question:
Remember that markets tend to sniff out a recovery well ahead of time. The stock market bottoms before the economy, payrolls, and jobs all turn higher.
There may be some noise around the upcoming US government shutdown, but that shouldn’t affect markets long term. Our strategy team took a close look at the government shutdowns that have lasted 10 days or more since the 1970’s. Equity market declines during the dates the government was actually shut down tended to be rather mild. In one instance (the shutdown that occurred in late 1979) the S&P 500 even continued to climb after the shutdown began. However, when we zoomed out, we found that the equity market usually experienced a decent sized pullback heading into these shutdowns. These were on an average and median basis around 10%. In recent history, the shutdowns have been one of only several factors contributing to equity market turbulence and we think it’s fair to assume the same was probably true in other episodes. Importantly, US equity markets have tended to rebound meaningfully after the pullbacks associated with these extended shutdowns, with gains of ~18% on an average and median basis 12 months later.
