“Watch your thoughts for they become words. Watch your words for they become actions. Watch your actions for they become habits. Watch your habits for they become your character. And watch your character for it becomes your destiny. What we think, we become.” – Margaret Thatcher

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.

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Friends & Partners,

We are in that unique market mood when bad news is good news, and where any economic data on the weaker growth side is welcome news for the markets. Here’s how it works – weak economic data encourages folks to assume that central banks will lower interest rates, which helps bond yields come down, softens inflation fears, and this all allows the stock market to trade at a higher valuation multiple. But we need all the pieces to keep working together for this to roll on. Perhaps it will.

Propping up optimism has been the strength of the consumer, and on a related front, the strength of the job market. Both of those have shown early signs of waning potentially – credit card delinquencies are at levels not seen since the financial crisis in 2008, job gains have been slowing, wage growth has been slowing, and spending has been slowing. Not cause for emergency yet, but reason to be cautious.

Many in the market have ‘given up’ trying to forecast economic weakness, and a recession in particular – it has just refused to show up so far, despite a number of indicators pointing to one on the horizon. On this point, one of the most ardent ‘bears’ threw in the towel in May – Morgan Stanley’s popular strategist who made headlines in 2022 when calling for weak markets has remained bearish, until now. He and others have basically stated that the confusing persistence of the strong markets is unforecastable.

Understandable I suppose. We’ve had a massive increase in interest rates, and the yield curve has been ‘inverted’ for quite some time (and has a near-perfect record of forecasting recessions). But, structurally strong labour markets, locked-in mortgages, distorting supply shocks from COVID, and excessive fiscal stimulus have worked together to stave off that recession so far. Combine that with speculation out there in stocks and an AI theme pushing selected stocks higher, and we’re still in a bull market. But, the participation from the average stock has been lagging for some time, which isn’t great.

Economic data is very clearly showing a loss of momentum and while, for now, that’s reinforcing the “soft landing” narrative, it’s important to point out (and I will) that every hard landing started out a hope for a soft landing…

Every recession has its own unique triggers, which are often in plain sight, but people underestimate their importance. In 2007, it was pretty clear that mortgage risk was out of control.

So, optimism still prevails out there – the (US) market isn’t cheap by any means, the narrative is that interest rate cuts are coming (though less than originally anticipated), and in Canada before we see them in the US. The widely accepted 'soft landing' narrative continues to roll on, and investors are getting back to the FOMO days again.

Bottom line, markets are in a sweet spot right now as growth is slowing but still positive, and ‘disinflation’ has slowed but not stalled. For now, investors are cheering this cooling of growth as making the Fed more likely to cut rates and indicative of a soft landing. However, I will caution that every economic slowdown I’ve seen in my 25+ year career (and prior) began with investors cheering slowing growth, looming Fed rate cuts and a soft landing – yet none of them actually worked out that way.

As always, my focus on what’s next and the facts are clear: the outlook for growth isn’t terrible, but there are clear warning signs to be aware of. That doesn’t mean that a major slowdown is coming, but it does mean we can’t ignore that possibility.

To put things into context from a higher level, consider that we’ve had 4 tailwinds at our back for the past 40 years:

• Rates going from high to low
• A lot of money printing
• Massive fiscal borrowing
• Globalization

Moving forward these tailwinds will likely be absent, or look quite different at the very least. Why would we think the investment strategies that have worked over the past 40 years are going to work moving forward? Are investment track records from the past decade relevant moving forward or did many investors/Advisors get ‘lucky’?

These are some of the reasons to remain vigilant. As Howard Marks said, “we can’t predict, but we can prepare”. And that we should.

 

 

Some Other Things to Highlight

I was honoured to be a featured panelist at an event in Toronto entitled “State of liquid alts in Canada”, hosted by BMO Capital Markets. Liquid Alternatives are a fancy term for hedge funds that have been made accessible to the regular investor, much like a mutual fund is (rather than only to accredited investors as it was in the past). The event was organized by the Alternative Investment Management Association (AIMA), who is the global representative of the alternative investment industry, with 2,100 corporate members in over 60 countries and whose fund manager members collectively manage more than US$3 trillion in hedge fund and private credit assets. I shared the stage with some esteemed figures in the institutional finance world, and we discussed the state of liquid alternatives in Canada as the asset under management in alternative mutual funds and ETFs surpasses C$25B across over 250 funds in time for the 5-year anniversary of this structure.

We hosted a great group of clients, partners and friends at Gibson & Co in Collingwood to discuss Behavioural Finance and AI. It was an insightful, stimulating and entertaining discussion, led by Noah Solomon, CIO of Outcome Metric Asset Management. He highlighted how some AI-based investment processes even sometimes outperform their human counterparts, as well as in a number of other fields like medicine, etc. The future is bright for the potential across multiple fronts.

 

 

The Economy Just Won’t Break… But Why, And Will It?*

The Fed hiked rates above 5%, and yet the US economy doesn't break. The yield curve inverted in 2022 and has stayed there ever since. We even had a fairly major event/break in the markets with US regional banks and nothing really happened there. How is that?

High interest rates often ‘break something’ in the economy because an overly indebted economy will have to service a mountain of debt at expensive rates and it will have less money for income and spending.

But one argument I have seen is that people may be looking at the ''wrong'' debt. This is because private sector debt levels and trends are more important than government debt. And the private sector can’t ‘print’ money when they get into trouble. We’ve seen examples of private sector debt causing major pain in various countries over history – and the most recent example is China today.

So, the main thing to assess is debt service ratios, which measure the amount of disposable income which is used by non-financial corporations and households to service their outstanding debt payments. And in the US, those levels are manageable. So, higher interest rates won’t be as painful nearly as quickly.

In Canada, the opposite is true unfortunately.

Source: Macro Compass

The IIF notes the same in saying that “the health of U.S. household balance sheets should provide a cushion against ‘higher for longer rates’ in the near term.”

This is helped by home ownership in the US, which has a positive wealth effect. Axios notes that “the economy looks pretty great for Americans who own their own homes—that's nearly 66% of the population. Homeowners with mortgages hold just under $17 trillion in equity, a record high. A record $11 trillion of home equity is ‘tappable,’ meaning homeowners can borrow against it while still maintaining at least 20% equity in the house.”

So, here’s where things stand:

David Rosenberg is usually quite cautious, but he notes that 11 of the 14 Fed hiking cycles since 1950 (excepting the current one) led to recessions. Dave noted the last few recessions began an average of 26 months following the first rate hike (which would mean we are almost there) and sometimes longer.

Source: Rosenberg Research

 

 

Interest Rates Are Poised to Drop Sometime – What Does That Mean?*

We are likely at or near peak interest rates from Central Banks. Is the peak fed funds rate good for the economy? Statistically, four of the last five fed funds peaks have preceded recessions. The exception was the “soft landing” of 1995, a time when the yield curve was notably not inverted:

However, markets can act OK around this period. This chart shows the S&P 500 performance around the Fed’s last rate hike:

Source: JPM Asset Management

 

 

Perhaps We Can Keep Going Strong From Here?*

Highs in markets can beget new highs. After all, over time, the market goes higher. In fact, if you hold equities (and even some bonds) for 10 years or more, you’ve always made money, without fail.

We’re still in a bull market, full stop. The chart below maps out the path of some previous cyclical bull markets, and the takeaway or bullish suggestion would be that this cyclical bull is relatively normal, and also mid-lower pack… and most of all, looks like it still has time and space to go up to the right if history is any guide.

Inflation always feels bad, but it may not be that far off of historical experiences. Looking back at 318 inflationary episodes across 50 countries since 1920, inflation is tracking in the 25th percentile of best outcomes.

I would note however that the market has all but eliminated the tail risks of a recession or inflationary shock – discounting things to near zero should call for some level of caution, as that is unlikely to be that proper risk assessment…