“When everything seems to be going against you, remember that the airplane takes off against the wind, not with it.” — Henry Ford
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 the spirit of Henry Ford’s quote that I cited above, this month I am going to ‘zoom out’ and discuss the longer-term winds of change that are affecting markets now and will continue to longer-term.
There are two inter-related drivers to touch on – interest rates and debt levels. The market is finally coming to terms with the fact that rates may be higher for longer than they had thought, and that will cause continued volatility. This environment isn’t going back to rock-bottom interest rates any time soon, and that has fundamentally changed the investment landscape I would strongly suggest.
Howard Marks is one of the most respected financial minds on the planet, and his recent memo HERE is arguably his most relevant of them all in my view (you can read it or listen to it, which is only 30 mins long). If you read one thing with respect to finance and markets (other than my Monthly Partner Memo of course!), it is this. In short, he suggests that the single biggest tailwind for all assets (markets, real estate values, etc) has been the low interest rate environment we’ve been experiencing for decades. Central Banks have flooded the system with liquidity and support at the same time. You can attribute the bulk of your investment and real estate gains to this single phenomenon. These are reversing now, and rates have risen significantly. Bonds were borderline poisonous through this recent shift (as many traditional ‘conservative’ investors have felt), but this interest rate shift has now created an opportunity in selected bonds and credit which we haven’t seen in many years. Howard is calling for a colossal tactical shift in portfolios, and this is a theme I have been championing for months (see my early-summer thoughts on this in a section entitled “The Best Trade Going – No, It’s Not Tech Stocks”), and I expect this to remain the case for some time. We are in a new paradigm, equity returns won’t be what they were, and volatility will remain the norm – we certainly aren’t in Kansas anymore, Toto.
On top of interest rate moves higher, debt levels are becoming uncomfortably high, both at the personal level (especially in Canada) and at the government levels (Canada, US, China and beyond).
Debt represents future consumption brought forward in time, so today’s spending is curtailed by monthly mortgage payments for example, or anything funded by debt. Debt isn’t always a bad thing, and can be useful if you can service it and you spend the borrowed money productively – perhaps to grow a business for example.
The US is now at almost $34 trillion of government debt on their way to $60 trillion, and interest costs are beginning to significantly eat into the total revenues. In short, debt is rising because government spends more than it collects in taxes, and this is politically difficult to curtail. The US may see $1 trillion of annual interest expense in the coming years.
Will this cause an implosion? Perhaps. But even if we muddle through, the debt will weigh heavily and be a headwind on GDP growth when the economy will already be struggling with other challenges like demographics. John Mauldin puts it well in noting:
“What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price gains seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite.”
This is another reason we are in a different world than we have been prior to 2022 – interest rates won’t hit the floor again, debt levels continue to balloon, and expected returns in stocks are highly unlikely to be what we have experienced in the prior period. The US government has to issue more and more bonds to fund this – who will buy the $1,784,000,000,000 of newly-issued Treasuries next year (and climbing)? At what interest rate will they demand to be paid to soak that supply up? These are some of the questions the bond markets have struggled with of late.
Solid risk-adjusted returns will be the holy grail, and the traditional approach may not achieve what most investors are looking for. This will be achieved by minimizing losses, not chasing big gains – let me explain with an example:
David VanBenschoten was the head of the General Mills pension fund. In each of his 14 years in this role, the fund’s return had never ranked above the 27th percentile or below the 47th percentile. Using simple math, one might assume that over the entire period the fund would have stood in the 37th percentile, which is the midpoint of its lowest and highest ranks. However, despite never knocking the lights out in any given year, VanBenschoten managed to achieve top tier results over the entire period. By consistently attaining 2nd quartile performance in each and every year, over the 14-year period the fund achieved an enviable 4th percentile ranking.
Most of the managers who were at the top of the pack in some years also had a commensurate tendency to be near the bottom in others, thereby tarnishing their overall rankings over the entire period. In contrast, the General Mills pension fund, by being consistent and minimizing downside, managed to outperform most of its peers. Managers who aim for top decile performance often end up shooting themselves in the foot.
The moral of the story is that when it comes to producing superior results over the long term, protecting capital first and avoiding underperformance tends to be more important than occasionally achieving outperformance. This is what I am obsessively focused on for our clients.
Most of the existing personal finance literature is focused on getting people the most money the easiest and quickest way, and therefore doing things that increase their stress. It causes them to be thinking about money all the time, which is the opposite of what we want to be striving for – leave that stress to me. I will quote Howard Marks once again to summarize this very theme:
“To achieve a superior long-term record, an investor should strive to do a little better than average every year and through discipline to have highly superior relative results in bad times. This approach is more likely to avoid extreme volatility and large losses. The best foundation for above-average, long-term performance is an absence of disasters.”
In terms of a near-term market outlook, clients and readers know that I am obsessively focused on the preservation of capital in this environment, and have remained generally cautious on equities while identifying the more tactical opportunities on the fixed income and credit side. The economic backdrop is confusing and prone to extreme narrative swings (from ‘soft landing’ calls to an upcoming growth scare which may be in the cards). Geopolitics aside, the range of predictions is wide. Preservation of capital remains paramount as always, but requires more than a traditional ‘balanced’ portfolio mix – minimizing risk while growing capital prudently remains my key focus as always.
Some Other Interesting Things to Highlight + Events
On Oct 30, in concert with Hospice Georgian Triangle and Women, Worth & Wellness, we hosted an in-person event focused on Philanthropy and leaving a legacy. We explored how one can create a positive impact on the world, while securing their financial future. We touched on tax advantages around gifting of securities, leveraging RRSPs/RRIFs/TFSAs for giving, donor advised funds, harnessing Life Insurance for giving and tax benefits associated with other planned charitable gifting. Let me know if you would like to receive my presentation deck from this event which goes thru these items.
On a related note, November is ‘Make a Will Month’, so is a good time to assess whether you have an up-to-date Will and Power of Attorney, a cornerstone of an effective wealth and estate plan. It can be simple at any stage of life to get your affairs in order, yet the majority of Canadians still do not.
The negative consequences of not having a legal estate plan can be enormous – usually for the very people we love and leave behind. There are a number of reasons behind why many Canadians avoid end-of-life conversations and estate planning. We bring in our specialists where applicable to help our clients at any stage of life to complete their powers of attorneys, Wills and estate plans.
How Do I Know If A Manager Is Adding or Destroying Value As An Investor?*
Investing is not all about returns believe it or not – it is all about how much risk is taken to achieve a certain return. I will quote Noah Blackstein (CIO of Outcome) on this as he lays this out clearly and concisely:
“A manager who delivers twice the returns of their benchmark but has also experienced twice the volatility neither creates nor destroys value. They have simply robbed Peter (higher volatility) to pay Paul (commensurately higher returns). Since markets tend to go up over time, clients may marvel at the manager’s superior long-term returns. However, this does not change the fact that no value has been created – clients have merely paid in full for higher returns in the form of higher volatility.
If this same manager delivered 1.5 times the benchmark returns while experiencing twice the volatility, not only would they have failed to add value but would have destroyed it – they would have simply robbed Peter by exposing him to higher volatility while paying Paul less in the form of excess returns. In contrast, if the manager had produced twice the returns of the benchmark while experiencing only 1.5 times its volatility, then they deserve a firm pat on the back. They would have achieved asymmetrically positive results by paying Paul far more in outperformance than what they stole from Peter in higher volatility.”
Investing is not gambling at the casino – exceptional portfolio management is all about achieving acceptable risk-adjusted returns.
Caution Remains Warranted Out There*
It is difficult to argue that stocks are particularly attractive relative to the level of interest rates, something I have noted here for a number of months. 2024 EPS growth of 12% presumably implies the U.S. won’t enter a recession next year, and if the U.S. is not going to enter a recession, investors should expect interest rates to stay higher for longer. Stocks excluding the M7 are not an across-the-board buy at 17X forward EPS if interest rates are to remain at or near their current levels throughout the majority of 2024. As long-only investors have learned of late, there are limits as to how long investors can have their cake and eat it too.
One of the few things holding up the bullish narrative on the economy is employment remains solid. But that may or may not hold up – once the unemployment rate starts moving it tends to cascade:
Source: Piper Sandler
Another negative data point is the money supply which has been shrinking, and in concert with yields moving higher and credit spreads wider, financial conditions are tightening at an increasing pace. Monetary policy is a blunt instrument that works on a delay; it is starting to bite finally. A sudden move in financial conditions is unsettling:
Source: Purpose
Will something in the system soon ‘give’? Bond bear markets rarely end with a whimper, and most often with a bang. If bond yields go high enough fast enough, usually sooner or later something somewhere breaks. We saw this earlier this year with the regional bank blowup, and that crisis was quickly swept under the rug by the Fed… but what if something happens that is harder to fix?
Source: BCA
This is an underfollowed metric that is very important – when lenders pull back, that is not good for the economy. Credit fuels the economy ultimately:
In conclusion, the market continues to trade like there’s no recession. And to be fair, a lot of the US data continues to turn in like there’s no recession coming (for now…). The interesting implication from this chart is that if there is no recession, it lays out the path higher, but also: if there is a recession — where things likely head (down to that bold green line).
There Are Always Positives To Note – Let’s Climb The Wall of Worry*
There is always something to worry about in the markets, which is why the market is famously known to almost constantly ‘climb the wall of worry’.
Source: Macrobond
As I have noted recently, stocks have become especially expensive when compared to bonds. But note that this may be just the beginning of stocks remaining expensive to bonds for an extended period. The 1980s were an environment when the inflation-hedging nature of nominal earnings awarded stocks with a valuation premium over fixed income and ERPs hovered around zero. Isn't that sort of what we have now?
On the geopolitical front, these events tend to be short-lived in terms of market volatility, as JP Morgan shows:
If we have entered a new bull cycle, it may just be early days if history is a guide:
Source: NBF CIO Office
Valuations aren’t necessarily off the charts high, and current levels bode relatively well for future returns:
Source: NBF CIO Office
The Opportunities May Lie More in Credit and Bonds Than Stocks*
I agree with Howard Marks that many of the opportunities today lie in credit and bonds, and have noted that for months in my Partner Memos (HERE) as noted in my opening remarks. In the past decade or so, stocks have had a heck of a run versus bonds, are we at a tipping point the other way? (hint – I believe we are):
Equity investor justification for sky high valuations in 2021 was the CAPE yield, the inverse of the CAPE, relative to bonds. The higher the yield, the cheaper stocks are. The graph below charts it with the 10-year bond yield. The last bull market in 2009 commenced with stocks way cheaper than bonds, while the 2000 bear market started with stocks wildly more expensive. That pattern is not remotely on display today:
