What’s Old is New Again

There was once a generation of people, that for simplicity’s sake, we will refer to as “Boomers”.  The Boomers were a hard-working, resourceful group of people.  They got married, had a couple of kids (but no more than a couple!), paid off their mortgages and then began to save for retirement.

However, problems were stirring for this fiscally prudent generation.  These investors in Canada Savings Bonds (remember them?) and GICs (Guaranteed Investment Certificates) were about to face a significant challenge.  Interest rates began a slow and steady decline.  Within a decade, interest rates had collapsed to the point that GIC rates were less than half of the level of a decade earlier.  How were these people ever to save for a successful retirement with interest rates plummeting?

But not to worry, there was a solution!  A new wave of investment products was becoming rapidly available to the average investor.  These investments were supported by a booming economy and a new wave of technical innovation which was going to change the way people lived and businesses operated.  There was money to be made and for once, the average guy and gal could be part of it.

It wasn’t all smooth sailing, however. Occasionally a shiver of nervousness would strike markets, but those concerns could be quickly eased by a central bank that was prepared to lower interest rates at the first sign of trouble, allowing the wave of prosperity to continue.

And continue it did. Asset prices soared.  Valuation levels rose to heights never experienced before.  But that didn’t matter they said, as this was a new era.  Boomers attended dinner parties where conversation quickly turned to their biggest investment winners.  At the local pub, stocks were debated with the same intensity as any internet chat room or CNBC episode.  The party rolled on – until one day it didn’t.

One morning the Boomers woke up, turned on BNN, and instead of the futures market indicating a positive open, the numbers were all in red.  They shook their heads in disbelief.

The party had ended, and day after day, the numbers on the stock ticker were red.  Dinner party conversation turned from Boomers competing to demonstrate their wisdom by bragging of their winners, to mournfully comparing losses.  Some of the Boomers lost their jobs in the following months as a short recession was triggered.

But the Boomers overall were a resilient lot, and they picked up the pieces of their portfolios, and moved forward with a more prudent investment plan.

This story, of course, flashes back to the technology bubble of the late ‘90’s and its eventual crash in March of 2000.  There are many parallels from that era to more recent events, the most important of which has been lost over the years.  Although equity markets from top to bottom tumbled roughly 50% in the unwinding of the technology bubble, a well-balanced, diversified portfolio was able to stumble its way through that decline with only nominal losses.

Why was that the case?  It was the stocks that were unrealistically pushed higher on the upside that faced the greatest day of reckoning on the downside.  Those of you that diligently read our quarterly updates will recall that, throughout last year when equity market valuations were getting pushed back to valuation levels last experienced in the technology bubble, we were consistently harping on the need to not overpay in an expensive market.  Now you  can see why.

Price / Earnings Ratio of S&P 500 – July 1998 – June 2022

Source: Refinitiv

What the story really reminds us of is that current events are not particularly different than the past.  There are a few different twists in the plot, but the storyline is the same.

The main difference between the late 1990s and today is that while in the earlier period inflation was stable, we are currently facing a wave of higher prices.  During the tech bubble, central banks began raising Interest rates about a year before the markets began to tumble, with rates rising almost 2.0% from their lows.    This is a little less than is currently expected from the central bank’s current round of interest rate increases.

It has been a difficult start to the year for investors.  Year-to-date, the Canadian bond market as measured by the Refinitiv Overall Universe Bond Index, has declined 12.7%.  The S&P/TSX Composite Index has declined 9.9% so far this year, despite the strong gains in energy stocks. The S&P500 (in Canadian dollar terms) has declined 18.3%.  Beyond oil prices which have gained 40.6%, it has been difficult to find safe havens this year.

Inflation is the Main Storyline

The key to much of what happens next lies in the inflation numbers.  In simple terms, inflation is triggered when too much money is chasing too few goods.  A perfect storm for inflation was created during the Covid-19 pandemic, as governments and central banks around the world flushed trillions of dollars into the economy and financial markets, at the same time that supply was disrupted due to labour shortages and dysfunctional supply chains.  This was then magnified by the war in Ukraine, which created further disruptions to both energy and food supply.

So, how do we get out of this mess?  Let’s break inflation down into three broad categories.  1) Food & Fuel, 2) Consumer Goods, and 3) Services.  Food and fuel have by far been the greatest contributors to overall inflation.

Food and Energy Inflation

Let’s be blunt, food inflation is going to be difficult to resolve without a resolution to the war in Ukraine.  It is hard to figure out where the additional food supplies will come from, to replace those not grown or not shipped from that region.

There is more hope for energy.  Typically, when energy prices rise, demand starts to decline.  We are seeing some signs that energy markets are experiencing the first stages of demand erosion created by higher prices.  Anecdotally, we hear people talking about carpooling more, driving their smaller vehicle when they can, taking transit more often, and in some cases, even looking to switch to an electric vehicle.  We are also seeing signs of this in the data.  Global demand for energy has been slipping, coming off its highs from late 2021.  Europe is moving aggressively to eliminate its dependence on Russian oil and gas, seeking to increase alternate energy supplies and, unfortunately for the environment, restarting some old coal-fired plants.

We are also seeing North American energy drilling activity rising.  That should provide some additional global supply over the next year.

Remember, to eliminate the inflationary impact of energy prices, we do not need to see prices go down, we only need to see them stop going up.  If oil prices trade between $100 – $120 over the next year (the range of the last 4 months), the impact on inflation a year from now is zero as prices will not have changed.

The risk to energy prices is further disruptions to supply as Russia has publicly contemplated reducing its supply to global markets.  As the war in Ukraine and the global reaction to it remains unpredictable, that risk can’t be eliminated, although we suspect governments around the world (including Russia) wish to avoid such a scenario due to the economic damage that would be triggered.

Next, let’s look at the simplest case – global goods inflation.  The steam is already running out here.  As consumers switch from over-consuming goods during the Covid lockdowns to spending more money on services, inflation pressures in most product categories have eased.  Companies are finding solutions to many supply chain issues, and the risk now is surplus inventory.  Inventories are rising and we have already seen companies such as Walmart and Target get caught offside on their inventories and forced to clear merchandise at a discount.  There may be more of that to come.

Last is inflation in service industries.   This is primarily a labour market issue.  Although we have not been able to confidently explain (nor has anyone else as far as we are concerned) the labour shortages that seem to be persistent across every industry, the fact is, there are not enough workers to meet the current demand.  The combination of inflation and higher interest rates will certainly resolve this issue over time.

As households face the pressures of higher food, fuel and housing costs, inevitably something will have to give in the household budget.  That will be discretionary spending, such as dining out, travel and other non-necessity services.  As demand for services declines, the demand for labour should follow, reducing wage inflation and the resulting price increases.

Recession or Just a Slowdown?

This discussion leads to two key questions, which are also the two questions we currently hear most often from clients.  Will this lead to a recession and how long will it take for equity markets to recover?

The point of raising interest rates is to slow the economy.  There is much debate about how long it takes for the impact of higher interest rates to be felt on main street, with most economists estimating somewhere in the range of 6 – 18 months.  By the end of 2021, interest rates in the bond market had already risen approximately 1.25% (although that varies by the time to maturity).  This is important as most debt is priced from the bond market, not central bank rates.  Only debt linked to prime rate is tied to central bank rates.

So, the economy should already be feeling the impacts of that first wave of higher interest rates, and the data suggests it is.  If we look at the U.S. ISM Manufacturing numbers, which is one of our best forward indicators for the economy, it has peaked and is trending lower.  The latest reading was 53.0, down from 56.1 last month.  (Any number above 50 reflects an expanding economy and below 50 suggests a contraction.)  The weakening outlook is even more pronounced when looking at the new orders sub-component, which dipped to 49.2, down almost six points from last month.  By the end of the year, the economy should be feeling both the impact of the bond market moving interest rates another 1.7% higher so far this year, as well as the tightening by central banks.  As markets move in anticipation, the market is already weighing the potential negative outcomes.

Will the economy tip into recession?  We do not know.  We worry that, given supply issues are the primary source of inflation, the central bank will be forced to aggressively suppress demand (as it can’t fix the supply issues) to restore equilibrium.  However, we are also aware that the surge in goods demand last year, which sent prices spiking higher, was short-lived.  If re-opening economies are simply facing the same short-term issue for services, it may make re-balancing supply and demand much easier as demand naturally wanes.

As we stated earlier, we don’t know if the economic slowdown will result in a recession, and we aren’t certain it matters whether growth slows to just above or just below that somewhat arbitrary line that says recession or not.  What matters is the direction, which now seems to be towards slower growth.

To wrap up, we will get to what really concerns most of our clients – financial markets.  After a disastrous year so far in bond markets, there are two things that can restore stability.  First, the belief that inflation has peaked.  Once markets believe inflation will no longer trend higher (again, not necessarily going lower, but stabilizing), the pressure on interest rates should ease.  Similarly, if bond markets begin to suspect a recession, which would be foretold by a flattening yield curve (the difference between long term and short-term interest rates narrowing or turning negative), bond prices would stabilize or recover.  In the chart below, you can see how the blue line (current interest rates) has started to flatten compared to last year in the green line.

U.S. Yield Curves – Current and 1 Year Ago

Source: Factset

Equity markets need two things to fall into line before a sustainable recovery can be made.  First, bond markets need to stabilize.  As valuation levels for equities are closely tied to interest rates (higher interest rates lead to lower valuations), it will be hard to establish normal, stable valuations while bond markets remain volatile.  The good news is that most of the excess in valuations has already been stripped from equity markets.  If current earnings estimates remain intact, the S&P500 is back to its normal range and the S&P/TSX Composite is below its 15-year average.

The problem, and  this leads to our second factor, is that  we believe the 2022 and 2023 profit estimates will have to be  lowered.  However, with the increasing signs of slower economic growth, we are beginning to see signs that analysts are beginning to rethink the optimism built into these numbers.  The commentary provided by companies when the second quarter earnings are released in July, may be critical to reassess these forecasts.

We don’t expect lower earnings growth expectations to have as significant an impact on financial markets as the valuation reset.  But if you look at earnings growth over the last decade, it has averaged 7.5%.  For 2022, the expected growth rate is 10.0%.  Inflation has tended to support corporate earnings, and there are still many industries that are booming, so an above average year may be reasonable, but we are concerned that companies will not be able to maintain the momentum through to the end of the year.

On this second point, we recognize we could be wrong.  It is possible that the strong employment situation allows consumer demand to remain more robust than we are currently predicting, and earnings growth will stay stronger than we expect.

The first half of the year has been the toughest market in an exceptionally long time.  Although investors have been taught to expect a quick recovery from a downturn as central banks rush in to save the day, that is less likely this time.  Recovery is more likely to come from continued corporate earnings growth, rather than a rush of money provided by central bankers designed to push valuations higher.  In other words, this time markets will have to earn it.

Based on history, the areas of the market that experienced the wildest excesses will be the last to recover and much like in the days following the bursting of the tech bubble, well-diversified, balanced portfolios should demonstrate the greatest resilience.

In general, client portfolios are currently holding an above average level of cash.  This has contributed to mitigating downside risk, but also offers stronger recovery opportunities if deployed at lower prices.  At this point, we probably   need to be patient, and wait for some of the signals discussed above before becoming too aggressive.

Logan Wealth Management

July 1, 2022