“Koreans came up from nothing in the auto business. They worked 84 hours a week with no overtime for more than a decade. At the same time, every Korean child came home from grade school and worked with a tutor for four full hours in the afternoon and the evening, driven by these Tiger Moms. Are you surprised when you lose to people like that? Only if you’re a total idiot.” – Charlie Munger

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,

At the time of writing this, I have returned from presenting at a conference on portfolio construction. There was a billionaire who also spoke, and he said something I loved – he never touches anything in business that can’t be described with a simple explanation. This is essentially Occam's razor, which is a principle attributed to 14th–century friar William of Ockham that says that if you have two competing ideas to explain the same phenomenon, you should prefer the simpler one. That holds true for most things in life, including the world of investing and wealth planning.

The reason I cite this is because, as usual, there are many conflicting signals out there, and there can be a compelling narrative built that is positive, and another negative. It always pays to be defensive and cautious in part, because after all, capital preservation usually tops the list of objectives for our clients and their wealth.

And many are struck by recency bias, spoiled by ~15 years of an everything-bull market (fueled by low interest rates). The period from the Financial Crisis of 2008 to 2021 could be one of the best return cycles in history for most assets. We likely don’t see a bull market like that again in our lifetime. A bunch of astute investors (both public and private market) and entrepreneurs did exceptionally well. Some were smart, some lucky. But too much capital overpaying for some things often can end badly, so we are in a different world now.

We are bombarded by information – our information sources are no longer limited to mainstream media. We are bombarded with opinions on our phones and email. Social media adds to the tumult. We are increasingly tribalized and, not surprisingly, we value the opinions of those in our tribe more than others. This is called ‘confirmation bias’. And this all produces significant tensions. It is emotional.

With Occam’s razor in mind, let’s try to cut through the noise and million data points and consider that:

• Economic growth in the US since the first Fed rate cut has been almost universally better than expected, with nominal annualized growth now running at 5-6%. Recent positive highlights include strong jobs report, retail sales, ISM Services PMI and GDP.
• The economy is not so strong in Canada however.
• Inflation has firmed up as the September CPI report was stronger than expected, implying the decline in inflation is slowing.
• Fed rate cut expectations have declined from (possibly) 75 bps of cuts in November and December to 50 bps of cuts, and now possibly no cut in November and just a 25 bps in December.
• We can expect lots of continued noise going into (and out of) the US election.
• Equity markets are strong, and is by some measures one of the most expensive stock markets that I have seen since the tech bubble of the early 2000’s. (But I am very hesitant to call it an overall bubble)

For now, the ‘soft landing’ for the economy is the most popular narrative supported by the data so far. Interestingly, the narrative plays an important role in influencing economic behaviour, markets, and even economic outcomes. Contagious ideas can shape expectations and even create their own momentum by serving as the lens through which investors interpret data. This is how inflation takes hold one direction or the other as well.

The economy could be in reverse in this part of the cycle, as argued by Jared Franz, Chief Economist for the Capital Group. We may now be in a “Benjamin Button” economy (after the 2008 movie where the title character played by Brad Pitt ages in reverse, transitioning over time from an old man to a young child). Instead of the typical four-stage business cycle — early, mid, late and recession — we have witnessed since the end of World War II, the economy appears to be transitioning from late-cycle characteristics of tight monetary policy and rising cost pressures back to mid-cycle, where corporate profits tend to peak, credit demand picks up and monetary policy is generally neutral.

The next step should have been recession, but we may have avoided that painful part of the business cycle (for now) and essentially moved backward in economic time to a healthier condition. How did this happen? Much like the movie, it’s a bit of a mystery, but the Benjamin Button economy has resulted largely from post-pandemic distortions in the U.S. labour market that were signaling late-cycle conditions. However, other broader economic indicators that may be more reliable today are flashing mid-cycle. So, if the U.S. economy is mid-cycle, then we could be on the way to a multi-year expansion period that may not produce a recession until 2028. In the past, this type of economic environment has produced stock market returns in the range of 14% a year and provided generally favourable conditions for bonds.

BUT, we always have to consider this: what if an unforeseen market event comes along, and the market takes a hit like it did in 2008, or 2020, or 2022? That kind of 30-50% pullback would cause devastation and crush many retirement plans. While the current environment seems flooded with liquidity, there’s no guarantee that dip-buying that has taken hold since 2022 will always be there to save the day. We consider these scenarios when constructing our underlying portfolio exposures that not all portfolio managers are aware of.

One big overhang that is finally starting to get some airplay is the amount of government debt out there, particularly in the US. I’ve been crafting up a piece on this issue for many months, but haven’t included it until now. This could be the next big negative ‘black swan’ event that causes some serious market and financial pain across the board. But timing it is difficult to say the least – who knows what and when the catalyst is on this, but something has to give and bigtime. Read more on that in the section below.

Legendary investor Paul Tudor Jones is right when he says that managing the last third of a great bull or bear market move is often the toughest. We may well be there now, so we position accordingly.

 

 

 

A Few Interesting Events To Highlight

Last Saturday night was the annual Furball Soiree, a wonderful event in support of the Georgian Triangle Humane Society in Collingwood, ON. I am proud to once again have been the presenting sponsor. Thank you to a wonderful organization, and everyone that came out to support such a wonderful initiative. See a great 60 second highlight video of the event HERE.

I was proud to be the keynote sponsor for the inaugural Escarpment Corridor Alliance (ECA) Nature Corridor Summit last month – what a huge success! It was a pivotal day for a wonderful organization and initiative. The venue (Alpine Ski Club) was sold out with over 200 attendees, and included thoughtful education on various conservation methods used worldwide to protect nature. We need to stand on the shoulders of those that have lead before us on this front – the Escarpment region hosts many areas of ecological significance which we need to consider and understand before we green light development projects. Follow what ECA is doing in the area at www.myescarpment.ca

 

 

 

The Coming Debt Crisis – You May Hear It Here First*

I’ve been working on this thought piece for months, and the topic is finally getting a bit of airplay given that both the US presidential candidates have zero credible plans to attack the massive deficit issue, and only fan the flames of it. This is the most critical problem facing the US, no question. But it’s virtually crickets out there on the topic.

For a douse of reality (and a giggle), click on the real-time US debt clock HERE.

Source: Mauldin

The US has a $2 trillion deficit and has $35 trillion of national debt (on the way to $50 trillion in short order, 6–7 years). U.S. national debt is a staggering 125% of U.S. GDP today (Canada is at 70% FYI). The US pays $1 trillion in interest payments every year, more than the spend on the military! And here’s the kicker – they project that for 2028, they US will have $46 trillion in total debt plus another $4.4 trillion in state and local debt! And interest payments will be more than the total combined amount of Medicare and defense spending!

Given the deep divide in views in the US, solving the eventual crisis won’t be easy.

Bond markets are saying there’s no real problem as of yet, but the day of reckoning will come. How am I so sure? There is almost no realistic chance that the next US administration will restore fiscal discipline, no matter who wins, because the masses don’t want fiscal discipline (though many may say they do). Many want a lower debt level, but that takes sacrifice, which won’t happen when specific tax or spending policies enter the conversation. Everyone wants to blame the former folks who dug the hold, it’s someone else’s fault and problem so don’t make me pay.

There’s one forced solution – crisis.

The limit to government debt is reached when investors will no longer purchase a country’s bonds at yields that the economy can tolerate or when debt servicing costs crowd out other critical spending. There are several examples of developed economies that have hit such a debt wall such as New Zealand in the mid-1980s, here in Canada in the early 1990s, and Greece in 2010.

Source: Congressional Budget Office; Office of Management and Budget.

The US clearly is not at that point yet. Long-term Treasury yields ~4% have not been high enough to significantly damage growth and interest costs which are currently at ~15% of federal revenues, so have been manageable. However, CBO projections show that interest costs will absorb an unacceptable level of ~1/3rd of revenues by 2050, and some think as early as 2034 or sooner.

“In the event of a bond-buyers strike, a crisis can be delayed by central bank bond purchases (quantitative easing), but that is not a sustainable strategy. Eventually, inflation would become a problem and it is doubtful that central bank purchases could offset a stampede out of bonds and out of the dollar if private investors completely lost confidence in government policy. There is a good chance that bond investors will lose patience if the next administration fails to restore some discipline to fiscal finances.” (Financial writer John Mauldin)

What kind of yield will investors demand to buy US debt with a $3 trillion deficit? No one knows. More to the point, what will inflation be with that kind of deficit and debt? Will the Fed be able to cut interest rates in the face of that kind of inflation? In a budding bond crisis, interest rates will rise faster than you imagine.

The Fed can’t just print money to cover deficits. And the supply of bonds coming from massive budget deficits is expanding even as a number of other traditional large buyers of U.S. Treasuries — including the Fed as well as China and Japan — have been reducing holdings.

The Treasury is currently using T-bills to finance spending, which is a sign that the government's finances are not healthy. This is something that is usually reserved for recessions.

Compromise on a Herculean scale is the best we can hope for. And we better hope that happens before it gets really ugly and forces a delayed compromise that will be even harder.

But in my core, I am still optimistic. Change always comes on slowly, then suddenly. As John Mauldin notes on the subject, we cannot accurately predict when the avalanche will happen. You can miss out on all sorts of opportunities because you see lots of fingers of instability and ignore the base of stability. And then you can lose it all at once because you ignored the fingers of instability. You need your portfolios to both participate and protect. Don’t blindly buy the market, or index funds and assume they will recover as they did in the past. This next avalanche is going to change the nature of recoveries as other market forces and new technologies change what makes an investment succeed.

But when it’s all said and done, we will end up in a better place. Because after we reorganize society in the midst of a crisis, history suggests we always come together around the new consensus and find a way to prosper – we always do. In a new, and hopefully better, version.

 

 

 

The Market May Rally For Some Time Yet … So Dance While The Music Plays*

Believe it or not, I am more optimistic now for the general market outlook (selectively) than I have been in some time. There are a number of reasons to think the music is going to keep playing for some time yet.

And the election shouldn’t matter for markets overall – it never does. Afraid of Komrad Kamala? Or Trump the Terrible? Don't be. The stock market tends to rise no matter who is in the White House and how much they've inflated the federal government's debt. Investors should avoid letting their personal political views influence their investment decisions.

Source: Bloomberg

And a bull market can go on for a very long time. We are in a short bull market currently versus most in history:

Source: Yardeni

We have started the interest rate cutting cycle. ‘Don’t fight the Fed’ as the old saying goes. The following chart shows the implications of Fed rate cuts on the S&P 500 during different states of the economy. We can see that if investors expect that rates are being cut because of a looming recession and that earnings are likely to be impacted, equities can sell off. However, if there’s a clear path toward continued earnings growth, equities often deliver healthy returns. This is what why we may see attractive returns from equities provided we avoid a recession (which is currently the base case forecast). This chart shows the S&P500 vs time when the Fed first cuts rates:

Source: RBC GAM

And the same goes for Canada:

Source: BMO

In addition, a slow Fed rate cut cycle can be bullish for stocks. In that sense, the market is looking for economic data that is neither too hot (less cuts) nor too cold (more cuts). If the economy is heading toward a soft landing, the Fed can afford to move gradually―like 1984, 1995, and 1998. Conversely, the Fed slashes rates rapidly if the economy is falling apart―like in the months after the 2001, 2007, and 2019 first cuts:

As I noted in the main section of the note, the economy could be in reverse in this part of the cycle. The next step should have been recession, but we have avoided that painful part of the business cycle and essentially moved backward in economic time to a healthier condition.

And the consumer is generally healthy overall too.

Household balance sheets are in much better shape in the US compared to Canada:

Source: Apollo

Contrary to what you may be hearing, as % of disposable income, credit card debt doesn’t look extended either:

Source: Apollo

There is volatility induced by the geopolitical events we’re seeing around the world, but the market usually discounts those as short term noise.

Source: Yardeni

Geopolitics have rarely derailed the US bull market:

 

 

 

Is Canada In A Recession? Likely.*

I’m always one to balance my views, and certainly respect all arguments, bullish or bearish. This goes for the markets, and the economy (though the two are often closely linked). Markets ain’t cheap, and the Canadian economy is sluggish at best. And likely already in a recession.

On a per capita basis, we are already in a recession. Canada has relied on immigration to support overall real GDP. We would likely be in a recession without it, but it is a band aid solution with GDP per capita slumping, revealing the actual state of the Canadian economy.

Source: Yardeni

Here’s an ugly chart, showing Canadian vs US incomes by state/province. Canadians are poor:

Source: Fraser Institute

The Canadian economy is also more sensitive to interest rates than the US, given elevated household debt. Canadian banks have done everything they could do to limit the damage.

 

 

 

Stocks: Respect The Warning Signs*

One of the more important lessons I’ve learned in my two-plus decades of watching markets is that bond markets can (and often do) lead stock markets. That is why we watch bonds so closely (not just Treasuries, but investment grade, high yield and credit spreads). And a recent technical breakdown in the high-yield bond market has caught our attention. The bond market has always been considered the “smart market” because there is almost no retail trader/investor interest as corporate and government bond volumes are dominated by seasoned institutional investors with vast research teams and analytical resources at their disposal. Because liquidity in the bond markets is historically much lower than the stock market (it’s much more difficult to get in and out of bond holdings relative to stocks), bond traders are required to make decisions with strong conviction focused both on the macroeconomic backdrop, including policy rates, inflation trends, and growth prospects, with recession risks always on the back of their minds.

Riskier high-yield bonds tend to have leadership qualities over stocks and other risk assets that have a much higher degree of retail trader/investor participation, another reason for the “smart market” moniker. Bond traders are more forward-looking as their number one objective is capital preservation, not long-term growth. That is why the recent heavy price action in the corporate bond markets has been so attention grabbing.

Looking at the most-recent relevant examples of JNK offering an early warning sign of a potential downturn in equity markets, late 2021 stands out in a meaningful way. And today we’re seeing similar moves down. Certainly some of this weakness is due to the back up in Treasury yields (as investors swap “riskier” high-yield corporate debt for “safe” Treasuries at a sufficient yield). But that’s likely not the only factor at play as substantial declines have previously been caused by budding economic weakness. Specifically, JNK proceeded to retreat from the late-2021 highs into the end of the calendar year before the intensity of the selling pressure picked up into 2022 where broader equity market indexes fell nearly 24% over the following 12 months through the October 2022 market lows.

Bottom line, the breakdown in JNK is curious given stocks remain just off all-time highs. This could be a signal that the economic outlook may be dimming, at least in the opinion of the “smart market.”

There is inherent risk in some US stocks given their valuations currently as well from here:

Source: BCA

And at current valuations, expected returns are closer to low single digits over a 5-year time frame:

Source: Purpose

Goldman was also out last week pouring cold water on the party. The average investor is anchored on the past decade’s performance but it is unlikely to continue. They estimate the S&P 500 will deliver an annualized nominal total return of 3% during the next 10 years (7th percentile since 1930) and roughly 1% on a real basis. Ouch. This is because of the starting point from a valuation perspective. Multiples are likely to be a headwind vs a tailwind. For the first time in 22 years, bonds yield more than the earnings yield of stocks.