Where are we at with recessionary risks?

We currently find ourselves in unprecedented times, economically speaking. The pandemic saw governments physically inject cash into millions of Canadian’s and American’s bank accounts in an effort to prevent a deep economic recession. An exercise that has NEVER happened before. That reality paired with the fact that the first year and half of the pandemic most citizens were more or less stuck in their homes. As a result we witnessed a major shift in household consumption patterns away from the service side of the economy (travel, eating out, movies, concerts etc.) towards buying “stuff” (bikes, patio furniture, boats, RV’s, home renovations, etc). That shift in consumption patterns helped stoke the fires of inflation that we are dealing with today. Of course, this is only part of the inflation story, the war, ongoing Chinese lock-downs, and firming energy prices globally have also contributed to the inflationary backdrop.

 

The actions that central banks are taking to curb inflation historically have a proven track record of working. The problem with interest rate hikes as a policy tool is that typically the end result is that the banks tighten too far and push the economy into a recession. We have had 13 interest rate tightening cycles in the post-war era, and 11 of the last 13 cycles ended with the central banks pushing the economy into recession. This fact is why the stock markets have been down throughout 2022 as they are trying to discount today the potential for slower economic growth in the future.

 

Interest rate stress caused significant market disruption in the second quarter of the year. The Bank of Canada, in its battle against inflation, raised its target interest rate by an eye-popping 100 basis points (bps) or 1.0% on July 13th. The Bank’s overnight rate stands at 2.50%, which is 2.25% higher than the beginning of the year. The story has been similar south of the border with the Federal Reserve. Despite these historic rate increases – and the expectation that there are more rate hikes to come before year-end – 10 and 30 year interest rates in Canada and the U.S. are barely over 3%.

 

Why is that important? The bond market is telling us that once this period of adjustment passes, interest rates are expected to settle back to historically low levels, which should be very conductive to businesses in the long-run.

 

 

Near the peak inflation window?

The interest rate tightening has already been effective impacting credit conditions. On a positive note we have seen the inflation data show some signs of improvement. The Canadian Consumer Price Index for the month of July came in at 7.6% on a year over year basis, below the 8.1% level seen in June. Meanwhile, the U.S. CPI reading for July showed a similar decline, moving from 9.1% to 8.5%. Frankly, these figures are still very high in absolute terms, suggesting households and businesses continue to grapple with elevated pricing pressures. Nevertheless, it marks a subtle but important shift in trend that may continue, at least within North America, as we move through the rest of the year and tighter financial conditions work their way through the economy.

 

Part of the more optimistic tone that has emerged over the past month stems from an expectation that central banks, like the Bank of Canada and the U.S. Federal Reserve, will be able to moderate the pace at which they have been raising interest rates in the not too distant future. While both are expected to raise rates meaningfully once again in September, there is a growing view that any increases beyond that will be tame in comparison.

 

 

Added caution is warranted in the face of today’s volatility

Markets have a rich history of frequently disconnecting from fundamentals both to the upside and the downside. For example, at its peak Tesla shares were trading at nearly 100x for every dollar of earnings before interest, taxes, depreciation, and amortization (EBITDA). At such a rich valuation the market was giving Tesla a lot of credit for things it planned to do but hadn’t actually done. As markets go through these phases of normalization we have always been anchored in our investment approach buying and holding great businesses for long periods of time. One challenge with this approach for many investors is that it requires patience and seldom provides instant gratification many investors crave. I am a great believer that in the long-run the price of a security will gravitate towards its long-term earnings power. As the great investor Charlie Munger noted “Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns”.

 

In the short-term, for many reasons, the price of a business often does not match the value of long-term earnings power (or value) of the business. The stock market provides a daily mechanism that allows us to know the quoted price of our investments at any given point in time and that quote is heavily influenced by investor’s general feelings about the markets (sentiment), the news of the day, and availability of capital. I have often wondered if individuals would do as well in real estate as they tend to do, if a similar mechanism existed which provided by the minute pricing on the value of their principal residence.

 

Despite some more positive inflation data of late it is our view that the risks facing investors still remain elevated, but they may be transitioning from strictly inflation oriented, towards risks that are more closely tied to other fundamental issues such as economic and earnings growth. We believe this is where some vulnerabilities may emerge, as they often do when the growth outlook is deteriorating. Whether central bank actions cause a recession or not is both unknowable and ultimately not overly important in the long-run. On the positive side of things balance sheets for both households, and publically traded businesses are in a good positions to withstand any potential temporary recession.

 

We have felt it prudent to reduce some of our exposure to businesses whose earnings profile is highly dependent on robust economic growth. As such, we are currently underweight the Canadian banks. Banks are only going to perform as strongly as the economy in which we are operating in. Given the potential for slower loan generation in the coming quarters we decided to pair back our exposure to that group in favor of businesses with a more visible earnings and cash flows. As such we started building a new position in a previously held company, Loblaw (L). We see two benefits to the grocery store business model. First they have the ability to pass on inflation to the consumer, and second, the bulk of their revenue comes in the form of non-discretionary spending. In good times or bad we all need to eat and buy cleaning supplies. We also added capital to Waste Connections (WCN), another business model that has great visibility on cash flows. In good times or bad people still need the garbage trucks to come haul their waste away. As an added benefit, waste removal contracts often have built-in price escalators that allow them to push cost inflation back to the municipalities or businesses they serve.

 

Finally, we exited a long-time position in Honeywell (HON) in the U.S. given its overall economic sensitivity. We took advantage of the market weakness in late June and doubled our position in Home Depot (HD). Admittedly Home Depot’s business model is also economically sensitive, however valuations for the company were trading at levels we have not seen in 10 years. I am reasonably confident that we will look back on that decision to increase our position size at those valuations, and be thankful that we did. Home Depot possesses a best in-class retail business for both professional contractors and do-it-yourself shoppers. It is also a business model we believe will have limited impact from the secular shift of consumer budgets away from traditional brick-and-mortar retail to online channels.