"Life is like riding a bicycle. To keep your balance, you must keep moving." – Albert Einstein

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,

There are so many forecasts out there it will make your head spin – everyone’s got one, and almost everyone will be wrong to some degree or another. With this note, and in conversations with my clients, I try to do my part to explain what is happening in the economics and finance world, and to make my part of things better than how I found it, and help a bit along the way.

Forecasts can be useful even when they’re wrong – their value is not so much in the precise accuracy but in spurring us to consider the possibilities. A recent Financial Times column noted rightfully that “thinking seriously about the future can be a worthwhile exercise, not because the future is knowable but because the process is likely to make us wiser.” Even though forewarned is not necessarily forearmed! The wisest response is sometimes to do nothing, though as many investors know, staying on the same course can be surprisingly tough.

Usually, a 1 year forecast for a target on the TSX or S&P 500 is pretty much meaningless. The economy can do well, and markets still rise or fall for a variety of reasons. But assessing the moving parts is still very much informative to position things.

And nowadays, just like in politics, the market gets divided into distinct camps. And too often, we are pushed to declare our allegiance. The best traders and portfolio managers are those who can hold two opposing opinions in mind at the same time, and understand that it is a messier world than just "inflation" or "deflation" for example. This is why I show both the positives and negatives, and adjust accordingly and tactically along the way.

So, there are two elephants in the room to be aware of and concerned with at this point – the amount of US (and other countries) amount of debt, and the tariff overhang. An honourable mention goes to a third consideration – the current level of optimism that abounds, and therefore accordantly high valuations in both stocks and bonds generally. We got a taste of the potential fallout from that overly positive sentiment on January 27th when tech stocks freaked out about DeepSeek AI out of China. It pays to be diversified…

People are generally pretty optimistic right now – optimistic that Trump will cut the size of government, slash regulations, and lower taxes, which will result in an accelerated economic boom. But, for markets the question is ‘how much of this is priced in’? Likely a decent amount.

Here’s a chart showing how there was a similar setup in 1980, when the free-market Reagan got elected and the stock market rallied into the election, with expectations that there would be an economic boom. Sounds familiar. For those of you who were alive back then, you may recall that the first few years of his term were not good for stock returns.

Source: McClellan Financial Publications

I wrote about the coming debt crisis last fall (having written it in the summer), when few were talking about this risk (you need to read that, it’s short and sweet and can find it HERE). This is now becoming a daily storyline and headline news in the financial media, as interest rates are starting to consider and struggle with this prospect. It may not happen this week or this year, and there is actually hope under Trump on this front. Many think it’s an unsolvable problem, but the US has a very sharp guy as incoming Treasury Secretary, and if anyone can figure it out, he can. This guy was CIO of Soros (one of the most respected and successful macro firms on the planet) and is probably one of the best FX/rates/macro traders in the world. If Bessent can’t figure it out, then it is likely an unsolvable problem.

Interestingly, there are even conversations starting around US interest rates going higher in 2025! That won’t be the case in Canada any time soon, and wasn’t in the market’s lexicon as recently as a few months ago, but is interesting to see how things are evolving.

Bottom line on this front is that If Trump and the Republicans manage to support current growth (so GDP growth between 2%-3%) and credibly address reducing spending increases, it would be demonstratively positive for markets. The dominant trends would be strong economic growth, falling bond yields and declining inflation.

DeepSeek was headline news last week, but by itself, I do not think DeepSeek is a bearish game changer for the broader market, as long as 1) economic growth remains solid and 2) the Fed is still in a rate cutting mode. Yes, a pullback of 5% to 10% in the S&P 500 (and 10% or more in the Nasdaq) is possible if the fears around DeepSeek prove to be true. But as long as the decline in AI enthusiasm isn’t accompanied by either 1) the Fed abandoning its rate cutting cycle or 2) economic growth rolling over, then the AI-related pullback is likely temporary and not something that would derail the entire market rally. And remember, cheaper and more efficient AI is positive for most companies outside of the big US tech names!

Will the US see the return of “bond vigilantes”?! This is a term coined by strategist Ed Yardeni in the 1980’s referring to the global bond investors who punish countries that have toxic combinations of surging debt and lackluster economic growth. And after a nearly 50-year hiatus, they have returned to punish the United Kingdom (and, if Trump and the Republican’s aren’t careful, U.S. Treasuries will be next). This should have our attention… More on this in the section below, but their return to the U.S. will likely depend on Republican plans for tax cuts (they need to be extended) and, just as importantly, credible plans that make the global market believe 6% deficit-to-GDP ratios are not here to stay. If they can provide both, that will be a material positive for risk assets. If they fail to provide both (and just one and not the other) then the bond vigilantes will likely attack Treasuries, and as bond yields rise, stocks will sink.

On top of this, bonds and stocks have become positively correlated, something I have harped on about for a couple of years now. This is BAD. When one goes down, the other should go up, and vice versa. This is why so many investors hold just stocks and bonds, and think that’s ‘conservative’ – think again.

Finally, tariffs remain a significant overhang and source of volatility (and will for quite a while I expect). The lack of any actual, hard tariff news so far has caused stocks to remain resilient. But that’s mostly because tariff fears were too aggressive, not because the risks associated with improperly executed tariffs (which would be higher inflation and slower growth) have diminished in any way. More detail in the section on this below, but bottom line is that if tariff headlines will continue to be a volatility-inducing event for markets until we have full clarity on the Trump administration’s plans. And given that markets are pricing in near-perfection on many fronts, we need to remain vigilant and position accordingly.

 

 

 

Other Interesting Things To Highlight

Our inaugural podcast was recorded a few weeks ago, and something I think you’ll find interesting. I plan to keep these brief and succinct and on a fairly steady cadence. I also plan to record a shortened version of my monthly memo via podcast as well in the future. As of writing and release of this note, the initial episode is finalizing post-production (disclaimers, etc) so will be out for next month’s memo. Stay tuned. Like the Partner Memo, I hope to add some value, keep things brutally honest, and hopefully add some insight for some folks.

Proud of the kids who have been busy on the provincial tour and doing well with a few podiums so far! Stanley taking the gold in slopestyle on the left, and Rae taking gold in her category in slopestyle on the right.

 

 

 

Is There A Coming Debt Crisis? And What Are ‘Bond Vigilantes’?!*

As I have written about in the past HERE, I have a thesis that an excessive government debt crisis could well force a form of a global financial crisis. Most developed countries have excessive government debt (Canada government debt levels are not so bad, but consumer debt is very high in Canada), so the crisis could begin elsewhere, which has happened historically.

Canadian households remain vulnerable with the highest debt to disposable income levels in the G7. Debt represents future income brought into the present, making Canada’s situation less sustainable moving forward.

There is a lot of talk about ‘bond vigilantes’ – a term coined by strategist Ed Yardeni in the 1980’s referring to the global bond investors who punish countries that have toxic combinations of surging debt and lackluster economic growth. And after a nearly 50-year hiatus, they have returned to punish the United Kingdom (and, if Trump and the Re-publican’s aren’t careful, U.S. Treasuries will be next).

Put simply, the bond vigilantes have returned to markets because the pace of government spending increases isn’t slowing as expected and “temporarily” high deficits are at risk of becoming permanent. And, unless bond markets start to see restrained spending increases, they will punish various countries in the form of higher bond yields and weaker currencies. We are seeing this punishment being exacted on the United Kingdom right now.

If you think of it like a lender, and you’re going to give out a long-term loan, you want assurance the borrower will be able to repay along the way right up until the end of the loan term. Rates are higher for longer term loans simply because uncertainty grows over time of course. Government debt is similar, though they can issue currencies and control legal systems, but the general principle still applies. A borrower whose debt is growing faster than their ability to repay is considered riskier and must pay higher rates, simple as that.

We may be seeing initial signs of this reckoning, time will tell. The UK is feeling it now. It may get better or worse. Let’s hope for the best.

With the new Trump administration in Washington plan on fixing this problem as the former governments increased spending to deal with Covid and produced the rising deficits. It could go well on this front, or go sideways. Finance writer John Mauldin notes that “hopeful” case has several elements, including:

• The DOGE effort identifies a lot of wasteful programs and ways to improve efficiency, and Congress will pass legislation to address them.
• We avoid wars, recessions, pandemics, or other crises that would produce higher spending.
• Congress gets serious about reforming entitlement programs and has the votes to do it.
• Any tax cuts produce enough economic growth to replace the lost revenue.

The good news is that the ‘bond vigilantes’ don’t expect immediate results, they just want to see progress in the right direction and reasons to believe it will continue. Whether it can happen should become apparent in the next few quarters. So we position accordingly.

 

 

Trump’s Tariffs – What Gives?*

Markets haven’t worried much about tariffs so far because “Day One” of the Trump administration contained no blatant and additional tariff threats, as investors had feared, and they are extrapolating that out to imply that tariff risks were exaggerated and that tariff threats are just that – threats, but not material action. However, I think it is a mistake for folks to relax on tariff threats and I think that tariff headlines will remain a consistent source of short-term volatility in markets through 2025.

First, despite nothing happening on “Day One,” tariff threats have not diminished. To that point, it’s not a surprise that Trump didn’t announce any new tariffs yet. While presidents have wide authority to impose tariffs once a trading partner has been found to be doing something uncompetitive, he does not have the power to just decree tariffs on trading partners, especially ones with which they have a current, legal trade treaty (which had to be approved by Congress).

For proof of this, just look back at the first Trump administration, where it took a long time for tariffs to be applied against China because the administration had to build the case for tariffs. They haven't done that yet with other trading partners. However, what Trump did do is instruct the various federal agencies to study trade relationships to determine if any trade partners are acting in less-than-good faith. The findings of those investigations will be delivered on April 1 and it’s really after that date that tariff risks will increase.

Second, when Trump announced tariffs on China in 2017, it caused a solid market pullback. But, there’s reason to think any tariff related pullback could be worse this time. In 2017, the S&P 500 was trading at a much more reasonable valuation than now and it’s fair to say that, at these valuations, any tariff-related declines could be substantially larger than before as we don’t have that valuation support.

To that point, during January a research team from Goldman Sachs released a note revisiting the market impact that tariffs had during Trump’s first administration, specifically the “trade war tariffs” with China. The GS analysts pointed out that the S&P 500 fell 5% when the U.S. first imposed the tariffs. Back then, the S&P 500 was trading with a forward earnings multiple of 17xX-18x. Given growth optimism from tax cut hopes combined with low Treasury yields (the 10-year yield was around 2.50% in 2017 compared to ~4.6% now), a 17x-18x multiple was fairly valued at that point so any pullback created compelling relative values.

Today, it’s a different story. The forward P/E on the S&P 500 is 21x-22x, which leaves essentially no room for error. And, if tariffs are draconian, it’ll increase inflation worries (higher yields) and hit growth expectations (possible hard landing), dramatically altering the “fair valuation” for this market. Point being, in a poorly executed, high-tariff environment that boosts inflation and hurts growth (admittedly a worst-case scenario) the S&P 500 could easily trade below a 20x multiple, which would result in a decline of more than 20% from current levels (could you imagine the S&P 500 with a “4” handle?).

Bottom line, the lack of any actual, hard tariff news has caused stocks to remain resilient so far. But that’s mostly because tariff fears were too aggressive, not because the risks associated with improperly executed tariffs (which would be higher inflation and slower growth) have diminished in any way. So, expect tariff headlines to continue to be a volatility-inducing event for markets until we have full clarity on the Trump administration’s plans.

 

 

The Market Can’t Possibly Go Up For A Third Straight Year – Or Can It?*

As we enter year 3 of this bull market, most are curious if this remarkable rally can continue. And there’s legitimate reason for optimism as there are positives such as solid economic growth, looming pro-growth policies from Trump and the Republicans and also soon to come in Canada, (likely) more rate cuts, and purportedly $7 trillion of cash on the sidelines waiting to be deployed. As well, inflation is generally remaining subdued (though is tough to completely annihilate).

Last year, all of Wall Street’s top 20 strategists’ price targets came in well below where the S&P 500 finished (the closest forecast was 9% off!) This year, they’ve largely ratcheted up their projections. The average Wall Street firm forecast predicts a 12% gain in 2025. Obviously, we can take that with a grain of salt. Interestingly enough, I wouldn’t take a gain like 12% off the table however.

Many think that we couldn’t possibly have a 3rd year of good gains…

Well, I did some digging because I want to dispel the notion that the stock market can’t have a good third year in a row. Here’s some of the research and data that has historical significance:

• Going back to 1950, there were 8 times where the S&P 500 delivered back-to-back 20% returns (not counting 2023 and 2024). The following year produced an average return of 12.3%, with positive performance in 6 of those 8 cases. (Carson Group)
• In the previous 3 instances where the S&P 500 went up by 25% in 2 straight years, the index was positive the following year 2 out of 3 times. When it rose by 53% and 33% in 1954 and 1955, respectively, it added another 7% in 1956. And when it went up 33% in 1997 and 28% in 1998, it jumped 21% more in 1999 (Ritholtz Wealth Management)
• Since 1988, investing at a “new high” led to higher forward returns than investing on “any day” over forward 6-mos, 1-year, 2- year, 3-year, and 5-year periods. In 2024, the S&P 500 set 57 all-time highs (JPMorgan Guide to the Markets.)
• The S&P 500 has recorded modest gains of 5.5%, on average, during the 12 months following the initial cut of a Fed rate-cutting cycle. The gains were typically double that in the absence of a recession (LPL Research.)

Bottom line, it’s natural to think that, after 2 years of 20%-plus returns, the market is due for a breather. But history pushes back on that natural assumption. So, while another 20%-25% gain for the S&P isn’t probable, I wouldn’t rule out another decent gain in 2025.

The economy is good, and optimism abounds (bad as an indicator for markets, but generally a positive when it comes to the economy, powered by small business. US small-business optimism extended its surge in December to the highest level since October 2018, buoyed by expectations of favorable policies under President-elect Donald Trump.

Finally, though valuations are sky high in many parts of the market, they certainly aren’t everywhere. There are selected pockets of opportunity, so solid active management will likely pay dividends moving forward.

 

 

The Multitude of Reasons To Remain Vigilant*

There are reasons to be cautious, including stretched valuations, concentration risk (Mag 7/AI stocks), a softer labor market (and eventual recession?), the chance of a Fed misstep, a bulging deficit, Trump-inspired tariff issues and geopolitical conflicts.

Let’s start the laundry list off, but not before a balanced summary of the risk probabilities from the eyes of Apollo:

Corporate insiders have never been more bearish. Publicly traded corporation insiders have been selling, bigtime. There’s been net buying since the beginning of the year at just 12.1% of those companies. Moreover, aside from consumer staples, insiders in the other 10 sectors are all negative. Insiders are negative on both growth and value. Additionally, insiders are pessimistic on small-cap, mid- and large-cap firms.

Many investors love the ‘no-fee’ passive indexing. That worked great for the last decade or more. Moving forward? I’ll take the other side of that bet. Let’s see how that goes…

Passive investors should be aware that they are systematically taking the other side of this bearish corporate insider trading activity. This is just one of several forms of index composition changes that can be costly over time. A recent research paper reports (via Matt Levine), "This rebalancing approach successfully captures the market as it evolves, but effectively buys at high prices and sells at low prices. A long-short portfolio capturing the intensive margin rebalancing trades of index funds has an average alpha of -3% to -4% per year." And to think investors justify the decision to go passive largely by pointing to low transaction costs… it’s complicated.

So, this extreme bearishness on the part of America's top executives may be due in part to the fact that stock prices are extremely expensive at current levels. In fact, the market, based on a broad swathe of measures, has never been as overvalued as it is today. If the price you pay determines your rate of return, then this suggests long-term returns from today's prices could be very poor relative to what investors have come to expect in recent years.

Stocks are expensive, and bonds are too. There is an apparent belief among bond market participants that Apple/Microsoft are as good as the US government in terms of willingness and ability to make good on debt payments. With the way the US fiscal situation has been going, maybe they have a point, but also it goes to show how complacent sentiment is on big tech and credit in general. One needs to find the opportunities in other places I would contend…

It’s not just big tech — complacency is prevalent in the market right now. High yield corporate bond spreads are back to 2007 levels, and the equity risk premium is closing in on multi-decade lows. That’s not good.

So, investors are wildly optimistic currently. As Ruchir Sharma notes, "momentum runs tend to reinforce the assumption that good times will roll, pulling in retail investors in the late stages. That’s happening now. American consumers have not been more bullish on US stocks since surveys began tracking this sentiment. Momentum investing looks poised to crash in a way that could hit many investors hard."

Overenthusiasm is often a contrarian indicator.

On the economic front, almost no one thinks recession is a risk. But don’t get too complacent there. Look at delinquencies:

As well, corporate profits are near all time highs as a % of GDP. Can that keep trucking higher? Maybe AI will say it does…

If Trump follows through on his threats, we will see tariff levels reach levels not seen since pre WWII. Could this reignite inflation? Even if jobs don’t come back, the US would be happy to see reindustrialization.

I have noted in the past that when you feel dumb going against a prevalent narrative, you may be on to something. Imagine saying that AI may fail to live up to the hype?!

So, decomposing return drivers over various time frames. In the short term, multiples can drive returns but in the long run, earnings do the lifting. That’s the million dollar question here:

Source: JPMorgan