Volatility has resurfaced over the past month. It’s been most evident in the bond market, with yields having moved meaningfully higher (and prices lower), reaching levels seen in November of last year. The move on the equity side has been less pronounced, but the weakness still noticeable of late. The culprit? Renewed uncertainty and debate over interest rates. We discuss this and more below.
Global economic data through the first few months of the year has been reasonably strong, defying many expectations for a softening in activity. In normal times, this kind of a backdrop would be cheered by most investors. But, recent developments have fueled concern that inflation, while trending lower, may remain stubbornly elevated and force central banks to raise rates further in order to cool demand.
Meanwhile, policy makers have started to offer some conflicting signals. The Bank of Canada indicated it was likely to soon pause with its rate tightening, and wait to assess how the economy was faring. More recently, the U.S. Federal Reserve suggested it wasn’t quite ready to take such a break. Instead, it telegraphed the need to continue to raise rates to get inflation convincingly under control. The bottom-line: investors are reassessing rate expectations, which has fueled the recent bout of higher volatility.
We don’t have high conviction on precisely where interest rates ultimately land when the hikes end. Nor do we think it matters as much as some pundits would suggest. In our view, what is more important is to prepare portfolios for the potential scenario in which interest rates stay high for a long enough period of time to cause economic pain. Through history, most periods of rate tightening have ultimately resulted in slower growth, or outright recessions. We don’t expect this cycle to be any different.
We do believe investors have to be patient though as it may take some time to unfold. There are a few reasons why. First, consumers still have the wherewithal to spend. Cash balances remain elevated, although they are admittedly on a downward trajectory. Moreover, consumers remain very willing to spend and experience the kind of activities – trips, outings, shows, eating at restaurants, etc - they sorely missed during the pandemic period, regardless of cost.
Most importantly, history has shown that it takes time for higher rates to work through the economy. The Canadian housing market is a good example. Canadians with mortgages make up about 35% of the country’s households (another 37% are renters and 28% don’t have mortgages). Only a fraction of households (2%) have variable rate/variable pay mortgages that would see mortgage payments fluctuate with changes in interest rates. A larger share of households either have variable rate/fixed pay mortgages (10%) or fixed rate mortgages (23%), and neither of these see any change to payments over the term of the mortgage. In other words, the number of Canadian households that have been impacted thus far by higher rates over the past year may not be as large as one would think. The bigger challenge will unfold over the next few years as homeowners who either purchased a home or refinanced their home in the past five years may have to potentially refinance at much higher rates. In other words, it’s upon the refinancing that households will have a potential wake-up call and be forced to reassess and reprioritize their spending and saving.
The scenario above is not guaranteed to unfold exactly as described, but it’s one we have to be prepared for. The trajectory of inflation and interest rates clearly remain very important to the economic and investment outlook over the next few years. We’ll continue to watch with great interest and recalibrate our own expectations as things evolve.
Charlie Munger
Charlie is Warren Buffett’s lesser known partner at Berkshire Hathaway.
On February 5, 2023, he sat down as the Chairman Emeritus of the Daily Journal Corporation to answer questions from shareholders and the public. We think of it as the question-and-answer session of the Berkshire Hathaway meeting with an extra serving of pithiness and wit. Many investors – including us - believe Mr. Charles T. Munger is one of the wisest people to walk the earth today, particularly in the category of worldly wisdom. We pay attention anytime he decides to opine on subjects. Below are some of the subjects he touched on as we believe they are helpful for our investors.
Rules-based investing vs. experiential investing
Early in the Daily Journal meeting, a question came in about the three evils that ruin people. Becky Quick (CNBC) said: Somebody else wrote in, and I don’t have the e-mail in front of me at the moment, but he wrote in quoting you, where you said the 3 things that ruin people are ladies, liquor and leverage. So why would you use leverage when you know that’s 1 of the 3 things that can destroy somebody?
Munger responded by pointing out that Buffett and he had both used leverage on arbitrage situations earlier in their investing career. He referred to the fact that Ben Graham (himself Jewish) referred to these as Jewish Treasury Bills. They would employ leverage on these arbitrage situations, but those opportunities are fewer today in a much more crowded space. Despite that, Berkshire is currently employing a Jewish Treasury Bill approach on Activision. Becky Quick went on to ask, “So is leverage the least evil of the 3 Ls?” Munger responded:
I think most people should avoid it, but maybe not everybody need to play by those rules. I have a friend who says, the young man knows the rules, and the old man knows the exceptions.
This kernel of wisdom got me so excited because it was a truth that we have already witnessed as investors. Generally speaking, the oil business is not the easiest business to get wealthy in. Also generally true is that companies with larger amounts of leverage don’t succeed. These are the rules of investing, in our opinion. Many investors will exclude the energy industry or other companies based on these rules.
Then the Spring of 2020 shows up in your life where you see investors leaving assets, like the commodity of oil, for dead. This is where the exceptions lie. (I personally made use of leverage to invest in March 2020 – why? Rates were so low that the yields exceeded my interest expense. Dividends are also taxed favourably and interest deduction comes off highest rate income so I was essentially being ‘paid’ to undertake this exercise. The lack of willing investors required the companies to conserve capital, a discipline they were not used to. This caused balance sheets to rapidly get repaired and caused the return on equity of these businesses to explode. Rules-based investors missed this opportunity and are still missing this today. Our investors and the Vice Chair of Berkshire understand this is an exception.
The problem with population
Becky asked a question that is being debated in the court of public opinion today: This one is an interesting question. It says, “The population of the world is thought to have increased by more than fourfold time since you were born. Mind you, I’m not holding you personally responsible, but there has been that magnitude of growth. Is there a point where the biggest existential threat to humanity is the growth of the population and humanity? If so, how do we discern when that point has arrived?”
Charlie responded:
Well, that’s an interesting subject. If you’d look at the way things have happened in the past, you would have concluded like Paul Ehrlich did that the world is headed for an absolute population disaster. But what actually has happened is quite different. What’s happened is that as the world has gotten more and more prosperous, including in places like China, the birth rate has gone down, down, down. And so there’s actually sort of a population shortage in a place like Japan. So the prediction of all the great experts based on extrapolating the past graphs, they turn out to be totally wrong. It now looks all the world’s population in the advanced countries will sort of self-limit.
Charlie Munger is rebutting a major argument when he says this. Paul Ehrlich, who was made famous for his 1968 book Population Bomb, set his thesis on Malthusian foundations. He explained that we would have unsolvable problems if we didn’t stop the growing population of the World. Ehrlich has only been wrong for 55 years so far. Charlie is just admitting the fact that having more people has created more prosperity, not less. We find this quite interesting as Charlie Munger has been a proponent of Planned Parenthood, which follows an Ehrlich-like ideology.
How to sum up such a contentious subject like this came in the next exchange when Becky Quick said, “I mean, that kind of puts you in the same camp with Elon Musk. He has made some of the same arguments that it’s really shrinking population that’s a bigger threat to humanity.”
Munger responded, “As I said, he’s a smart man sometimes. Sometimes, like all the rest of us.” We agree with Munger on Musk, but also know that Munger is a smart man…sometimes. We are glad that he is now right that to be a prosperous society, we need more people!
Loyalty to shareholders
In the later part of the meeting, Becky Quick asked a question about Warren Buffett as a learning machine. Munger replied by saying:
Well, Warren is not only a very good thinker and a good learner, which is important, but Warren has a big strong fiduciary gene. He cares about what happens to the shareholders. Warren and I were lucky in that the early shareholders that really trusted us, we were young and didn’t have a reputations and so on.
And naturally, we feel an exceptional loyalty to those people. And of course, naturally, they’re all dead now. We’re still loyal to them. Warren and I still care what happens to the Berkshire shareholders, a lot. And I think that helps us. I think that it helps if you’re good at loyalty.
Speaking for my dad, my colleagues at Smead Capital Management and myself, this tugged at our heartstrings. The trust shareholders have provided to Warren and Charlie, particularly the partnership investors of Buffett, whose estates are still owners, continue to sit heavy in the mind of Buffett. He views this almost as if they are still serving them directly today. While they are not, they are serving those same shares. They think in the best interest of Berkshire shareholders by acting in ways that are beneficial to not just them but all holders of the company. This is what happens when people have skin in the game. They have a higher level of fealty to the people that have joined them in the business risk they are taking.
Should you have any questions, please feel free to reach out.
J. Todd Kennedy, CIM, FCSI
Senior Portfolio Manager
613-566-4582
This information is not investment advice and should be used only in conjunction with a discussion with your RBC Dominion Securities Inc. Investment Advisor. This will ensure that your own circumstances have been considered properly and that action is taken on the latest available information. The information contained herein has been obtained from sources believed to be reliable at the time obtained but neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers can guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell or the solicitation of an offer to buy any securities.