“I don’t feel that Wimbledon has changed me. I feel, in fact, as if I’ve been let in on a dirty little secret: winning changes nothing. Now that I’ve won a slam, I know something that very few people on earth are permitted to know. A win doesn’t feel as good as a loss feels bad, and the good feeling doesn’t last as long as the bad. Not even close.” – Andre Agassi
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,
Everyone feels great and like a bit of a genius when markets are going higher, but when things turn and volatility strikes, emotions take over and bad investor behaviour can rear its head. This is when some perform the cardinal sin of investing – selling when they shouldn’t. I can’t guarantee what future returns will be in the stock market, but I can guarantee there will be teeth-rattling losses in stocks along the way.
This can be addressed – by building institutional portfolios that incorporate more than just plain stocks and bonds. And it can be empirically shown that volatility can be reduced at a target return and risk level. Think of it this way – if an Advisor makes $10 when the market goes up $10, and loses $10 when the market goes down $10, are they adding value? No, that is called ‘closet indexing’, and I’d bet this is where 95%+ of investors are exposed. What about if the Advisor can make $20 when the market is up $10, and down $20 when the market goes down $10, is that value add? No, that is just a levered return. How about if they can garner $10 when the market is up $10, and down $5 when the market is down $10? Now you have some value-add. This is the holy grail of investing and is a rarity. So, choose wisely.
As usual, there are lots of conflicting signals out there. So we position and navigate things accordingly.
Firstly, the economy is a mixed bag – have we avoided recession? That’s still the million dollar question. Interest rates are dropping, and the Fed in the US dropped rates by 50 bps in September. Many are mixed on whether this is the right move or not, and this risks inflation coming back with a vengeance. I believe Fed members are asking themselves: “If inflation was caused by the pandemic, stimulus and spending and all those are gone and inflation is quickly falling back to 2%, then why do we have rates so high?” To use a simple analogy, it’s like we’re in a car going down a steep hill. The Fed had to ride the brakes going down the hill to stop inflation and make sure the car didn’t get out of control. But now the economy is back on a flat road (normal) and the Fed is still riding the brakes. If they won’t let off, the car will stop (recession). This matters because if I am right about the Fed’s logic, then it is possible the Fed has made its second policy mistake regarding inflation: The first policy mistake was believing inflation was ‘transitory’ for too long and not hiking rates. And now, the second policy mistake may be not believing inflation was transitory and keeping rates high for too long. So, they’re trying to get ahead of that before it’s too late. Expect rates to keep going lower from here in both Canada and the US. How low? TBD. Did the Fed cut in time? TBD.
Here's the other side of the argument: inflation could reignite again if growth reaccelerates. There is the US election coming up, and without getting political, do you think either of these candidates is going to help temper inflation? Definitely not – they are perhaps the two most inflationary candidates possible. Either Kamala implements her price controls or Trump his tariffs (and pressure on the Fed).
The markets are pricing in aggressive rate cuts by the Fed in the US and the Bank of Canada. The market does not seem to be putting much weight on the possibility of a 'pause' at some point over the next 6-8 month period. Central banks may see growth/consumer/fiscal spend hold up better and opt to pause briefly to see how initial cuts play out. Additionally, any uptick in inflation will surely spook the central banks and it harder for them to continue to cut rates at a strong pace given the dual mandate.
This all means that volatility will abound, but that doesn’t mean that markets are on a one-way trip to the gutter. The Fed has cut rates with stocks near all-time highs 20 times. The S&P 500 was higher a year later 20 times with an average return around 15%. It is also worth remembering that equities typically rally following the first Fed cut if there’s no recession. In fact, at just under 2 years after such cycles the median move has been almost +50% higher. That would put the S&P 500 at 8500 in late 2026…
Source: Goldman Sachs
But are you going to bet your portfolio on that? No way. I understand I’ve been talking about growth risks for a while, but I was talking about it slowing long before it was the consensus chatter on Wall Street. I do not think we’ve seen the end of the slowing growth risks, but when I do, I will change my stance and advocate allocating accordingly. I am not a permabear and I’m not hoping for a slowdown, but I need to heed what the facts are telling me, and it’s my job to prepare, not predict. And we need to prepare and position for a number of outcomes – a barbell approach. It has served us and our clients very well and should continue to.
The market narrative will always work to confuse. Pessimists miss opportunity, optimists get caught up in the fervor and crowd excitement and get slaughtered in the turns when they’re over their skis, but cautious optimists are the true winners.
A Few Interesting Events To Highlight
We hosted an intimate and private client event in north Toronto last month where we addressed private credit, which is topical currently as there is a large dispersion of quality and exposure in that strategy. Our panel was a powerhouse – we had two fly in from NYC for it: Fadi Abdel Massih, Associate Managing Director in Moody’s Financial Institutions Group and Christine Pope, Managing Director, Global Private Debt Strategy at Oaktree Capital Management. Elizabeth Mpermperacis, Partner, Financial Services at Osler, Hoskin & Harcourt LLP rounded out the panel which was insightful to say the least.
I am proud to once again be the presenting sponsor for the Georgian Triangle Humane Society’s marquis event – The Furball Soiree. Join us on Oct 19th for a wonderful cause and evening. Our two dogs are more than pets – they are integral members of our family. And I know other pet owners feel the same way about the animals in their lives. After all, animals bring light, joy, comfort and unconditional love, which we can all use some days! They contribute undeniably to our well-being, health and happiness. The Georgian Triangle Humane Society supports not just animals, but our communities and families that are better for them. I am very proud to support the GTHS and look forward their continued positive impact in our community. Click on the logo below to see event details and tickets:
Starting Oct 2nd, RBCDS is offering a few different Virtual Advice Events for you. These sessions will cover:
- U.S. Economic Update and Outlook
- The Tax and Legal Considerations of Buying and Selling U.S. Homes
- Immigration and Cross-Border Financial Planning: What you Need to Know
- Cross-Border Essentials: Your Guide to U.S. Home Financing, Banking and More
You can sign up for those HERE.
Just Get A Basic Will Already
We help our clients with Will planning and structuring as part of our services, and many don’t have a Will. Don’t feel guilty, it is very common – only half of high net worth Canadians even have a Will. But ensure you get on it.
If you don’t have a Will (or your adult kids don’t), just ensure you get even a basic one in place to hold you over until a fulsome one is drafted up. RBC has collaborated with Epilogue Wills to offer an affordable online option to create a legally-binding Will. The collaboration is part of RBC's ongoing focus to provide individuals and families with modern and innovative estate planning solutions, tailored to their needs. Our clients can speak to us on that initiative.
Still The Million Dollar Question – Is A Recession Coming Or Not, And How Will That Effect Markets?*
Now that the Fed (and Canada’s Central Bank) has started its rate cutting cycle, the only question that matters going forward is: Did they cut in time? As equities are still signaling all clear, but the bond market is pricing in a recession-like slowdown and expecting that central banks are going to cut interest rates significantly from here (2% more in rate cuts by fall of 2025). If stocks are wrong, they have a long way to fall:
Source: Trahan
Not to scare you, but think of the worst-case scenario this way: If we fall into recession, the market is richly priced based on even optimistic assumptions, then the S&P 500 falling to a 15x multiple and having zero earnings growth (or even earnings declines) isn’t just possible, it’s likely. In reality, that means a 15x multiple and a $245-ish/share S&P 500 earnings, which equates to 15*245 = 3,675. Now, I admit seeing a “3” handle in the S&P 500 is jarring and it may seem ridiculous, but a 3,675 number on the S&P 500 would reflect a ~34% decline from current levels. That’s basically the same decline we saw in 2000 and 2007, the last two times the Fed fell behind the curve. Point being, it’s not quite as ridiculous as it may seem.
On the brighter side, while economic growth has decelerated, there are few signs of outright recession on the horizon – so far. But things are certainly slowing. Fed Chair Powell observed at the recent press conference that “GDP rose at an annual rate of 2.2% in the first half of the year, and available data point to a roughly similar pace of growth this quarter”. The current reading of the Atlanta Fed’s Q3 GDPNow is 2.9%, which is well above the pace cited by Powell. As well, productivity remains strong, which is supportive of growth. Finally, both US presidential candidates are growth supportive and expansionary in their fiscal policies (neither party has been strong advocates of austerity).
Moreover, the labour market is likely stronger than indicated by the rise in the unemployment rate. The number of people losing their jobs due to layoffs is extremely low, and almost all of the rise can be attributed to a growing pool of workers looking for employment. From an economic point of view, this is much less serious than rising layoffs and will probably help lower pressure on employers to raise wages, slowing price rises.
The consensus view across fund managers is that monetary policy is the most restrictive since 2008. The only other times policy was viewed to be this tight was around previous crises:
But the majority of institutional fund managers do not expect a recession.
So, the question that’s been out there since the pandemic is, “is there a recession on the horizon?” RBC Economics runs a recession scorecard and there’s a couple of things that have been pretty reliable in the past. Notably, the yield curve and Conference Board leading economic index (and a couple of other indicators) have said that a recession was probable and some of these have perfect track records, so we’re inclined to pay attention to them.
Admittedly, it feels like it has already been a long wait, and we’re really still in the sweet spot of a recession hitting. If you want to look at it on a monthly basis, the recession usually starts 25 months (10 quarters) after the 1st Fed rate hike. We’re in that zone now — so we are far from a recession being long overdue.
Finally, let's remember that the U.S. economy, which is the bus that drives the market, is 75% consumer. It’s very hard for the U.S. and most major economies to sink into recession if the consumer, especially the American consumer, has decided to go on spending. You need them to, in some form or fashion, pull in their horns and reduce spending.
The consumer is still spending, but it’s not robust and is certainly slowing. The consumer has been growing and spending at, somewhere between 2% and 2.5% for almost three years now. Real disposable income, which was rising and was supporting that spending, is now reversing. We’ve had two consecutive quarters where real disposable income is below the rate of consumption spending.
So, people are dipping into savings and taking on credit to maintain their spending. While they can go on doing that for a while, credit card balances are rising, delinquencies are rising quite sharpy. And we know that interest rates on credit cards are now eye-watering. Two years ago, consumers were paying ~9% on their credit card debt; now it’s over 20%! Over the same time, car loan interest rates have doubled, the mortgage rate has doubled, and debt service costs are on the rise up to where they were around the start of the pandemic. But lower rates should help on this front. Case in point, the debt service ratio sits at 10% and in the last 2 recessions, signs of consumer stress only seen when this exceeded 13%. The Fed cutting rates is delivering lower cost of money for credit cards, auto loans, adjustable rate mortgages and even installment debt which is a positive in all of this.
This is all to say, we’re not out of the woods yet on recession risk falling away. Plan accordingly.
There Are Positives As The Markets Climb ‘The Wall Of Worry’*
Markets climb the wall of worry…
Today, we need to assess how stocks typically perform following initial rate cuts. While markets have been higher in six of the last eight rate cycles, with an average return of ~11%, there has been a fair bit of variability to those returns (see chart below), as the macro context behind the moves matters a great deal. As long as nothing ‘breaks’ in the economy, stocks should remain firmly within a bull market, but with such strong trailing performance heading into the rate cut, look for more muted returns ahead:
Source: BMO
And perhaps a recession is still quite a ways away….
Selected stocks may continue to offer superior long-term return potential compared to fixed income – even in the U.S. large-cap market where valuations are most stretched. Shiller’s cyclically adjusted price-to-earnings ratio (CAPE) has been helpful in forecasting long-term returns for U.S. equities and, at its current reading of ~30, suggests stocks could return 5% to 6% annualized over the next decade. Not what it has been, but not terrible. In markets where valuations are more appealing, return potential could be greater in the high single digits or low double digits.
It's Time To Reassess Significant Cash Holdings*
As interest rates drop, something I’ve been making clients aware of is reinvestment risk – that 5% GIC you purchased a year ago that felt like it could last forever now comes due, and the average GIC rate is ~3.5%. This barely beats inflation, if it does at all. And in another year it will be worse still.
One place to put cash to work is in bonds. Bonds, particularly those with longer durations, typically appreciate in value when interest rates fall. This is reflected in the chart below showing the cumulative returns of U.S. bonds compared to cash following the Federal Reserve’s first rate cut. Historically, bonds have consistently outperformed cash. Over a five-year period after the initial rate cut, bonds outpaced cash significantly: 32.8% compared to 16.2% for cash. This performance underscores the advantage of holding longer-term bonds in a declining rate environment.
Maybe You Need To Invest In Things Outside Of Stocks & Bonds… And You Can*
Visualizing diminishing forward returns as you invest at higher valuations: Returns are expected to be uninspiring over the next 10 years.
And here are KKR’s expected returns for the next 5 years, one of the most reputable financial institutions. I tend to agree with them. Equity returns expected to be lower.
Investors have been conditioned to think US markets only go up, but lost decades do happen.
We access private investments for many of our clients – private infrastructure, private equity, private credit and private real estate. It makes sense if you consider that most big companies are private and not publicly listed. There are 2,000 public companies in the US with annual revenues >$100mm. Compare that to 18,000 private companies with >$100mm revenue – public markets access to only 13% of the companies in the US with >$100mm in revenue!
Alternative Investments: Announcing A Reputable Private Equity Fund Launch in Canada - Blackstone Private Equity Strategies Fund (BXPE)*
In the world of alternative investments, private equity has been one place that has had better returns than public investment for some time. Though I have been cautious on the strategy overall in the past couple of years, this is an interesting product and structure that is launching in Canada and worth assessing near-term if one is contemplating a private equity allocation within the portfolio construct at this point. Please touch base for more colour and details.
Note: Canadian accredited investors only, expected to be registered and non-registered account eligible. Offered in USD or CAD hedged. Series F or A. Minimum US$25k.
Summary:
The product: We think this open-end (i.e. perpetual life/evergreen, not capital call model, quarterly liquidity) private equity fund is a well-structured product from a reputable firm in an increasingly crowded category.
Why care now: There is a benefit to making a timely (but informed) decision on whether to participate in the first close (mid-December deadline) given how Blackstone is structuring the pricing concession on the fund. After caution on the sector for a few years, it is selectively interesting again - the relative value of private equity versus public equity looks the best it has in nearly 3-years.
The fund, which targets a 12%-15%+ annualized net return, invests primarily in 15+ equity strategies with a focus on privately negotiated, equity-oriented investments, diversified across sector, geography, and place in the capital structure. With first in line priority access to all deals executed at Blackstone, BXPE has the right but not the obligation to participate in all private equity deals done by Blackstone. The platform has generated a blended net IRR of 15% across its spectrum of private equity investments over 38 years (a/o Q2 2024).