Three Portfolio Managers Walked into a Bar…

An American, a Chinese and a European portfolio manager walk into a bar.  Taking a break from their investment conference, they had decided to take in a bit of Canadian culture, and settled on their bar stools to watch Hockey Night in Canada.

“What can I get you?” the bartender asks.

“Bud light,” says the American.

“Your best cabernet,” requests the European.

“Club soda,” replies the Chinese.

The American glances at the Chinese portfolio manager.  “I thought you would want something stronger, with all the troubles your country is having.”

The Chinese manager sits up a bit straighter.  “My country is doing well – in fact, better than any of yours.  Growth is still expected to be 3.3% this year and 4.6% next year.  Plus, our central government is stimulating the economy.  None of you can boast of such success.”

“What about your property market?” asked the American.  “It seems to look a lot like the U.S. housing market in 2007.  Too much speculation with the banks holding too much debt.  How do you deal with the millions of people paying for houses that won’t be built?”

The European nodded.  “I read an article in The Economist recently indicating that 60% of houses sold between 2013 and 2020 have never been delivered.  An additional $5 trillion of properties have been sold since 2020.  It is no wonder people have taken to the streets in protest.”

“The protests are greatly exaggerated!” declared the Chinese manager.  “The Party has a plan.”

The American snorted.  “Yeah, the plan so far has been to dump the problem on the over-indebted regions, add a lending programme that at best would complete 10% of the houses, and drop mortgage rates to encourage your housing bubble to reflate.”

Sales of Chinese Properties Collapsing

China: A long climb back up

Sales of residential properties (square meters)

Source: NBF Economics and Strategy (Bloomberg Data)

“Don’t forget, begging people to buy more houses,” the European added.

The American nodded vigorously. “It seems the Central Government wants to dump the problem on the regions, but the regions get most of their revenue from property development.  How can the regions bailout the system when their revenue from development is already down over 30%?”

“The Party has a plan,” reaffirmed the Chinese manager.

A grunt from the end of the bar distracted the three portfolio managers for a moment.  “Dictators always have a plan,” the large, grizzled man grumbled.  He held up his glass to the bartender.  “More vodka.”

“Who is that?” the American asked the bartender.

“A Russian oligarch that likes to hang out here sometimes.  Says the Canadian cold reminds him of home.”

The European turned her attention back to the Chinese portfolio manager.  “Does The Party also have a plan for youth unemployment that has reached 20% or the rapid decline in the Yuan?”

The Chinese portfolio manager cast a superior glance at the European.  “I’m not sure how you could judge China on a declining currency.  The Euro has plunged to par with the U.S. dollar, and the United Kingdom – what a mess they have created.”

The European portfolio manager held the wine glass between her fingers, tilting it from side to side, studying the legs of the wine as they slid down the side of the glass.  “Yes, those fools in England do seem to have created a bit of a problem for themselves.  Confidence is the key to any economy, something the new leadership failed to recognize.  The U.K.’s plan that includes massive tax cuts while also increasing spending through energy subsidies would be challenging at any time.  But to do it when the country’s debt-to-GDP ratio is already approaching 100%, the economy is struggling and inflation is soaring, its hard not to create fear in even the most docile of bondholders.”

The American shook his head.  “What were they thinking?  I’ve heard estimates that the tax cuts could be as much as 10% of GDP.  Add to that the £40 billion being spent on energy subsidies, what did they expect?”  (Note to reader: post quarter end and the writing of the update, the U.K. government backtracked on some of the planned tax cuts.)

The Chinese portfolio manager nodded in agreement.  “The policy is so contradictory.  The Bank of England is raising interest rates to slow inflation and the Government implements a highly inflationary fiscal policy.  I’ve heard that the Bank of England is now expected to raise interest rates by 1.75% in November.  With the pound down 18% year-to-date – 8% in September alone – and 10-year bond yields up 2.7% since early August, this could become a crisis.”

Great Britain 10-Year Bond Yields in 2022

From 1.0% at the start of the year, to 1.8% in early August, to 4.5% at the peak

Source: Refinitiv

The European portfolio manager continued to stare into her glass.  “The Bank of England has been forced to intervene in bond markets as the instability was creating issues for the pension sector and many were on the brink of collapse.”  She shook her head.  “These are not good times.”

The bartender placed a shot of vodka in front of the European portfolio manager.  “From the oligarch at the end of the bar.  He also understands tough times.”

The European pushed the vodka away with disdain.  “We Europeans don’t drink with those who start a war by invading another country, murder civilians and hold false referendums.”

“Not war,” mumbled the Russian at the end of the bar.  “Special military operation.”

The bartender removed the offending shot of vodka.  “Our Russian friend may find Europe just as comfortable as Canada this year.  It seems like it could be a frigid winter.”

“Maybe,” the European manager agreed.  “But we have replenished gas inventories and the available storage is almost completely full.  With the additional sources we have been able to come up with, some challenging work on reducing demand and with luck, a warm winter – we might get through it okay.”

“Might!” gloated the Chinese manager, while thinking of all the cheap Russian gas available for Chinese markets “But with gas prices having risen tenfold at their peak, the European economy will certainly be damaged.”

European Natural Gas Prices (5 Years)

Source: https://tradingeconomics.com/commodity/eu-natural-gas

The American nodded.  “A recession in Europe is almost a certainty, even before you consider the impact of the European Central Bank raising interest rates to battle inflation.”

“What about you?”  asked the European manager.  “It isn’t like America will be immune from the global issues.”

The American took a long swig of beer before placing the bottle heavily on the bar.  “So true.  There are so many issues to deal with.  Inflation remains a problem.  The Federal Reserve keeps raising the target for interest rates.  Equity markets are spiraling downward. The strong dollar is going to hurt corporate earnings, and potentially the economies of emerging markets.  Add to that geo-political tensions that are running high and it hurts confidence in financial markets.”

“There is still a strong employment market,” the European manager said offering a bit of support.

“True,” said the American.  “But that is both a blessing and a curse.  Strong employment may keep the economy from slowing too much, but if wage inflation remains stubbornly high, the Federal Reserve will have to raise interest rates further to control inflation.  The higher the Federal Reserve raises interest rates, the greater the chance that the economy stumbles into recession.  The forecast is now for a Fed Funds rate of 4.6% in 2023.  With 2-year government bond yields at 4.2%, this is mostly priced into bond markets, but the economy hasn’t begun to feel the full impact of rate hikes yet.”

U.S. Wage Inflation

Source: https://www.epi.org/nominal-wage-tracker/

“The availability of pent-up savings to support consumer spending may allow households to manage higher interest rates and high inflation, giving the system time to rebalance supply and demand naturally,” offered the European manager.

“True,” agreed the American.  “When you combine that with low household debt levels, the American economy is likely one of the best positioned within the developed world.”

“What do you expect for your financial markets?” asked the Chinese manager.

The American took another long swallow of beer, taking a moment to ponder the question. “Coming into this year, markets were overvalued.  That has mostly been corrected now.  The price/earnings ratio has come down from 23 times earnings to 16 times earnings.  That’s a good start.  What hasn’t happened is an adjustment to earnings growth expectations.  The market still expects over 8% earnings growth for 2023. Yet, the strong dollar alone is likely to reduce earnings growth by as much as 10% – without even considering the possibility of a slower economy.”

The three portfolio managers shook their heads. “Tough times,” they all agreed.

“We Russians good at tough times,” said the man at the end of the bar as he waved at the bartender to get his bill. The bartender passed the tab to the Russian who threw a handful of rubles on the bar.

“We don’t accept rubles,” said the bartender. “I told you that last night.”

The Chinese manager raised his arm. “You can add it to my bill.”

The Russian nodded appreciatively at his new Chinese friend, before heading toward the door.

The American looked at the bartender. “What are your thoughts?”

The bartender shrugged. “We are dealing with a period of both elevated economic and geo-political risks. Financial markets have started to sell off, but that move probably isn’t complete.  As the American said, earnings expectations need to adjust, and the risk of a financial accident is the highest it has been in a decade.  In Canada we are benefitting from the strong energy market, but our economy is vulnerable due to the elevated levels of personal debt.

As earnings are the concern, own companies where you can count on earnings growth and that are less sensitive to the economic cycle.  Bond yields are high enough now that it is likely safe to buy short-term debt.  But keep some cash around as there may be better opportunities to buy equities over the next few weeks or months.”

The three portfolio managers looked at each other. “That seems about right,” said the European.  The Chinese and American managers nodded in agreement.

“It’s getting late,” said the American as the trio rose to leave.

As they exited into the Canadian autumn evening, they noticed a crowd gathered on the sidewalk. As they approached, they could see the Russian from the bar lying on the sidewalk.

“What happened?” the American asked someone in the crowd.

“He tripped over a crack in the sidewalk and hit his head as he fell,” said the stranger.

The American and European managers looked at each other skeptically, and back to the poor Russian.

The Chinese portfolio manager just shook his head. “These oligarchs seem to be accident prone.  Must be all the vodka.”

Final Thoughts from Logan Wealth Management

2022 is turning out to be the most difficult for investors in decades.  Although equity declines have been worse during other periods, this has been the worst bond market since at least 1976. This can be particularly painful as bonds are supposed to be a safe haven for investors.

 As you can tell from the quarterly report, there are numerous short-term issues facing the global economy of varied significance and potential impact. This leaves us cautious in the near-term.  However, experience has taught us that when equity markets turn positive again the key part of the rally tends to happen quickly.  We are also painfully aware that sometimes we can be wrong, and when managing your money, we must balance our expectations for the future with the consequences to you if we are wrong. 

 An analysis produced by JP Morgan in 2019 showed that missing the best 10 days of the market between January 1, 1999, and the end of 2018 reduced a portfolios total return by a whopping 65%.  Perhaps more importantly, six of those ten days occurred within two weeks of the worst 10 days.

 The commitment we make to our clients is that when markets are bad, their portfolio will not feel the full pain. It is with a sense of relief that we can say that so far that remains true.  And we thank you for the continued trust that you place in us, to help you navigate through a challenging year.

Logan Wealth Management

October 3, 2022