And now for something completely different……
It is often said that the four most dangerous words for investors are “this time is different”. Although each wave in financial markets has its unique qualities, the underlying principles endure. En masse, human nature remains the same, which leaves markets prone to the recurring themes of excess excitement and excess pessimism.
Perhaps the New Year is making us a bit more philosophical, but we believe there is value in stepping back to look at the big picture. Perhaps that is even more important in today’s world when the daily news and most commentary is focused on the extreme short-term, based on vaccination rates and new case numbers.
Market Valuation and Earnings Growth
We believe one of the most significant questions to face investors over the next several years will be whether the U.S. stock market can sustain the valuation levels that have been reached. The chart below shows the Forward Price / Earnings ratio for the S&P 500. Outside of the tech bubble in the late 1990’s, the U.S. market has not experienced valuation levels equivalent to those of recent months. We will note that although other countries outside of the U.S. also have experienced this expansion in valuation multiples, the impact in Canada has been less widespread.
For perspective, let us add some statistics. From April 1996 through to April 2020, the U.S. equity market traded above 20 times its expected earnings less than 30% of the time, including the lofty days of the tech bubble. Since the end of March 2020, the S&P500 has not traded below 20 times earnings. Again, going back to the same time period beginning in 1996 and ending as central bank stimulus created a market rally in late March 2020, the U.S. equity market has only traded above its current valuation (23.5 times earnings) 10% of the time.
Investors should recognize that a significant portion of the return earned on U.S. stocks since the recovery from the financial crisis has been due to investors willingness to pay more for the same dollar of earnings. Given the numbers above, the odds of repeating that feat over the next ten years appear to be low.
Source: Refinitiv
Now, as always, there are many justifications as to why valuation levels should be at these levels. The main argument is based on low interest rates. When estimating the current value of a company’s future earnings you must discount that value based on an assumed rate of return, as a dollar received in 5 years is not worth as much to you as a dollar received today.
The problem, of course, is that interest rates are expected to rise. In fact, the current estimates are that the Bank of Canada will move short-term interest rates from the current level of 0.25% up to 1.5% in 2022. The U.S. Federal Reserve is anticipated to move slower, only hitting 1.0% by year end. Government bond prices have already moved in anticipation of this, with 10-year Canadian government bonds now trading with a yield of approximately 1.5%, only slightly lower than the 1.6% level of early 2020. U.S. government bonds have a slightly wider spread to the pre-pandemic trading level, but the story is essentially the same. Which leads to the question, if interest rates are back (or rapidly moving back) to levels prior to the pandemic, how does the market continue to use lower interest rates to justify higher valuations?
Canada 10-Year Bond Yields
Source: Factset
A further argument made to rationalize these high valuations is that the central banks are prepared to accept higher inflation and therefore won’t raise interest rates, stimulating further earnings growth. As another wave of the pandemic sweeps across the globe, it is possible that central banks will blink and defer raising interest rates. Although notably, the Bank of England has already raised its lending rates once. It is also worth stating that a modest increase in inflation can also help improve profitability as companies push through price increases. However, despite these potential catalysts for higher earnings growth, the market actually anticipates slightly lower earnings growth in 2022 and 2023 compared to the 2018 – 2019 period.
If central banks don’t raise interest rates as anticipated, and companies see earnings growth equal to or above current earnings expectations, it is quite possible that this combination could drive valuations higher in the near term. We learned in the tech bubble and again during the U.S. housing bubble that excesses can go on much longer than common sense would allow. After all, it was at the end of 1996 that Alan Greenspan made his famous comment that markets demonstrated “irrational exuberance”. It took over three years and a more than doubling of the S&P500 before anyone listened to him.
What we do know is that a combination of interest rates held artificially low, combined with rising inflation and rising valuation levels is not a sustainable story.
The contra case to be made is that inflation is truly transitory, therefore there is no need to raise interest rates significantly and ergo the higher valuation levels are truly justified.
With central banks still appearing ready to backstop financial markets, it seems unlikely that a rapid adjustment to valuations is likely to take place in the near term. However, the odds suggest that valuations will move back into the teens at some point over the next few years, which will likely lead to lower average equity returns than those experienced by investors in recent years.
On a more positive note, the adjustment that has taken place in the bond market over the last 12 months, as bond prices declined to reflect higher expected interest rates is likely mostly complete and the drag on fixed income returns should ease into 2022.
Productivity and Labour Markets
Canada is facing a growth problem. Over the previous decade economic growth was slower than in the decade prior and the OECD is currently predicting even slower growth in the current decade. Corporate investment in Canada makes up only 40% of investment dollars, the lowest of any OECD country.
Data: World Bank and OECD
With lower levels of investment, Canada has not benefited from productivity improvements. Although this is a chronic problem in Canada, which has consistently lagged U.S. productivity growth, the pandemic has opened another gap. This may explain some of the labour shortages in Canada as the demand for labour appears to be higher, relative to GDP, than prior to the pandemic.
As Canada works towards a greener economy, this may only magnify the productivity problems. One of the most productive sectors in Canada is the natural resource industry. According to David Williams, vice-president of the Business Council of British Columbia, the natural resource sector generates over $300 of GDP for each hour worked, compared to the average across the economy of $54. If you narrow the focus to only unconventional oil and gas production, it generates $1,300 of GDP for every hour worked. Phasing out the fossil fuel industry, without increasing productive capital investment elsewhere, will create a drag on Canada’s productivity growth.
With wages rising and labour shortages reported across many industries, business may be incented to make the capital investments that have been lagging in recent years. We also find hope in the surge of new technology companies in Canada. Since the beginning of the pandemic 15 sizable technology companies have listed on the TSX. This is in addition to smaller corporate listings and numerous private companies that have been able to raise capital.
Canada’s increasing profile as a technology hub, brings us back full circle to the labour shortages. Restoring immigration levels will help fill some of these gaps as Canada has historically relied on newcomers to fill these rolls.
By all accounts, Canada is an economy in transition. For equity investors this means that over the next decade it is unlikely to be a case of “a rising tide raises all ships”, but a much more selective effect.
Stimulus and Government Debt
Times have changed since the mid-90’s when the Canadian government hit a fiscal wall and was forced to start dealing with its structural deficits and high levels of debt-to-GDP. The pandemic has pushed both Federal and Provincial governments to debt levels well beyond those contemplated 25 years ago. However, despite the higher debt levels, the cost of financing the debt remains well below that of the crisis years. Based on projections by the Parliamentary Budget Officer, that is unlikely to change, even under a higher interest rate scenario.
https://www.pbo-dpb.gc.ca/en/blog/news/BLOG-2021-009–analysis-federal-debt-2020-21–analyse-dette-federale-2020-2021
Canada is not alone in its rapid increase in debt levels as most developed countries have provided massive amounts of fiscal stimulus throughout the pandemic. The result of the spending has been an economy that stumbled its way through the worst days, without a crisis.
The large amounts of money pumped into the economy, particularly an economy that is hampered by supply chain constraints and labour shortages has created inflation pressures. The inflation pressures now appear to be leading to a decline in consumer confidence as consumers worry that wages will not keep up to price increases.
Although most forecasters are predicting a continued strong economy, based on the idea that much of the savings accumulated in the last 18 months will be spent, the data above suggests that the pent-up savings may stay in the bank a bit longer than currently expected. Consumers who are feeling insecure about their financial position may not be rushing to the check-out line. If consumer spending gains were to unfold slower than current estimates there are pros and cons. Of course, the lower demand is a negative, but it would also help to alleviate some of the pressure on supply chains, reducing inflation pressures.
Will it be different?
To summarize our view of the years to come. They will be different than the decade that has passed. Fixed income returns will likely be limited to the interest payments. A return to a high interest rate environment appears improbable, but the long cycle of ever lower interest rates that has benefited bond holders has also likely passed. Equity returns will be much more dependent on earnings growth as continued sustainable expansion of valuation multiples also appears to be reaching its limit. Luckily, the outlook for earnings growth currently looks quite good. With the removal of central bank stimulus, volatility will likely return (and has already). And although clients tend to dislike volatility, as portfolio managers we love it, as that is what brings opportunities.
Despite global central banks phasing out the most current wave of stimulus to financial markets, the era of active central bank intervention is likely to continue. Having greatly diminished the roll of private sector banks as liquidity providers following the Great Financial Crisis, the central banks have stepped in to fill that role. As long as the market retains confidence in central banks ability and willingness to fill that gap, the nature and duration of a bear market may be somewhat different from those of previous decades.
So, will the next decade bring something completely different as our title alluded? Yes and no. Taking a long view of the cycles in financial markets, this appears no different than cycles of the past. From a shorter-term view, the next few years will likely be different than the last few years as the market transitions from one phase of its long cycle to the next.
Transition always bring uncertainty and for investors we believe the security blanket comes in the form of having exposure to quality companies, as either stocks or bonds, that are bought at reasonable valuations. We continue to work hard to find those opportunities that will allow you, our clients, to continue to achieve strong risk-adjusted returns no matter what the markets dish out. So, that is not different at all.
We would like to thank all of our clients for the trust you place in us and for allowing us to help you reach your financial goals. It is truly an honour and pleasure to work with each of you. We would also like to thank you for your willingness to introduce your friends and family to our firm. Those introductions are a vital source of growth that allows us to continue building depth to ensure our team will be available to serve you for generations to come.
Happy New Year to Everyone!
Disclaimer: Please note that the publication is designed to provide general information only. It reflects the thoughts and opinions of Logan Wealth Management and should not be construed as financial advice, nor should the information be considered a substitute for personal advice. Information used in this publication has been gathered from sources believed to be reliable. Logan Wealth Management is not responsible for and assumes no liabilities or responsibility for any loss or damages suffered as a result of the use or misuse of, or reliance on the information or content of this publication. Please consult your financial adviser to determine whether the information is applicable to your personal situation.
