Panorama June 2022 Commentary

Interest rates have increased significantly, causing the economy and earning to slow. CIO & Founder, Scott Morrison, discusses how he reevaluates the portfolio continually to reposition assets and prioritize liquid investments.

Even though we were down this past quarter we are outperforming global benchmarks by staying focused on companies that have healthy free cash flow yields and are positioned to emerge stronger on the other side of this economic slowdown. Economic slowdowns have always been a time to minimize the steps back in capital in order to capitalize on the opportunities that come from financial asset price corrections. We are liquid, diversified and will get progressively more aggressive as bad news increases and the move up in interest rates looks to abate.

Our resource and real estate investments that performed very well during the first quarter saw meaningful pull-backs towards the end of the quarter, as underlying commodity prices and capitalization rates also checked back. We avoided most of the pain in the technology complex that was off so significantly. Our Asian investments outperformed versus their American and European brethren. We have covered our shorts in the U.S. treasury markets, as we believe there is a potential scenario that yield curves will flatten or invert. As you can see below, we truly feel sorry for so many investors who are overweight bonds.


Source: FactSet, Goldman Sach Global Investment Research.

The stock market did well in in the second half of 2020 and during 2021, when the economy was not doing all that well under Covid lockdowns. Thus, we should not be all that surprised that while the economy is performing nicely the stock and bond markets are not doing so well. In a counterintuitive way we suspect that eventually the upcoming economic bad news will eventually become good news once inflation and interest rates stop going up. We are very focused on investments that generate free cash flow and assume that inflation is peaking now but will be far higher, on average, over the next ten years than in the last ten years. As you can see below, long-term expectations are creeping higher but thankfully not nearly as high as where we find ourselves today. According to a recent Bloomberg article on the Bank of Canada’s quarterly business survey, “78% of businesses expect inflation to exceed 3% over two years.”


Source: University of Michigan, Federal Reserve, Haver Analytics, Goldman Sachs Global Investment Research.

On a positive note, I believe that the world is making progress to a post-Covid environment. However, there are many, many messy Covid implications causing agitation and negativity in people’s lives, volatility in the capital markets and significant disruptions to so many aspects of business. I am sure everyone is hearing about the travel nightmares out there as the world tries to catch up on delayed travel plans. Now everyone can perhaps better understand why so many companies have complained about supply chain issues in the last couple of years. As a family we celebrated Mother’s Day in May and Father’s Day in June with fewer Covid fears, and slowly we are returning to pre-Covid routines such as going to watch a play-off hockey game and see a movie blockbuster like Top-Gun: Maverick in a nearly-full movie theatre.

Over and over again during 2021 and early 2022 I heard from companies that they were having staffing problems due to absenteeism, early retirements, and a thin labour pool. When rising input costs are added to the situation, we are seeing major margin problems at many companies. In my career it is very hard to achieve success investing in companies with declining margins. For example, products made from natural gas are experiencing major issues since natural gas prices are up over 400% year-over-year in Europe and over 100% in North America. Further, natural gas is used in making fertilizers like nitrogen to help grow products such as corn and wheat. Therefore, corn and wheat prices are up over 20% and 80% respectively year-over-year. Grains are used to help feed cattle which shows up in our daily lives at the grocery store or in restaurants. As a result, when I went to dinner with my wife this past month, I noticed that a piece of steak now shows up on the menu at over $60. Ouch!


Source: BLS, Jeffreis LLC.


Source: Federal Reserve Bank of Atlanta, Current Population Survey, BLS.

Because of the trends mentioned above we have gone from the easiest monetary and fiscal policy conditions of my career to the fastest tightening cycle of my career. Interest rates in the U.S. were pushed up 50 and 75 basis points respectively in May and June by the U.S. Central bank.  The last time I saw a 50-basis point increase was in May of 2000 and the last time I saw a 75 basis point increase was in 1994. Central banks have done this to quickly slow inflation by slowing demand. As you can see below, major commodity prices have rolled over materially from their recent highs, which I am sure is bringing a smile to all central bankers since they cannot poke holes in the ground, harvest crops or build houses which have all seen major price increases off major lows during Covid. An important question in my mind is — Where does price inflation settle in medium and longer-term for these deep cyclical commodity markets? I personally believe central bank leaders like Chairman Powell in the U.S. should stop saying their target is 2% since he may not be able to deliver on that promise.


Source: Datastream, S&P Global Platts, Goldman Sachs Global Investment Research.

In a recent testimony before U.S. congress, Chairman Powell said that “the labor market is extremely tight and unsustainably hot and there is a mismatch between supply and demand there.” According to an article in May by the New York Times, “the economy has recovered more than 90% of the 22 million jobs lost at the peak of the pandemic’s lockdowns in the spring of 2020.”  For the last year, it seemed as if almost everywhere you went, you would hear small and large business owners alike complaining about shortages of labour and rising input costs. This is causing wage inflation and margin pressures for businesses. And in certain cases, we are starting to hear from companies that pass-through price increases they put in place over the last 12 or so months are being met by resistance. For those who studied economics, this is textbook “elasticity of demand.” If you stretch prices too far then demand snaps back. For example, as gas prices go up, people will drive less, or as mortgage rates increase, people will buy fewer houses and so on.

I anticipate that the shortage-of-labour issue is soon set to improve, as I am hearing more and more companies talk about hiring freezes and/or laying off staff. Stay tuned for more of these headlines during Q2 earnings season in July and August. Below is a snapshot of a website that tracks layoffs in techland, called Just imagine the economic spillover effect of all those software programmers and salespeople who saw double-digit salary increases and stock option price lifts in 2021, but are now worried about their jobs!?


Source: Note: Data is complied from public records.

All around us are signs that many aspects of the economy are slowing rapidly, and the much-feared stagflation scenario is upon us. We are increasingly hearing from companies that we talk to through our research process who are feverishly preparing for a recession. Back in the fall of 2008, I used a traffic light as an analogy on how the business and consumer worlds had gone into “red” light mode by stopping all spending and investing. We are nowhere near to how dire it was in 2008 because we see more of a mix of “yellow” light behaviour than absolute “red” light approaches to business. One important difference between now and then is that the U.S. housing market, which accounts for much of U.S. consumers’ largest assets, is in short supply. Yes, prices will roll over as mortgages rates have risen so much. But the equity cushion in most people’s houses is very positive versus 2008 where it was negative and caused people to hand the keys back to the bank. And banks have much better balance sheets today than back then, in part since they have stopped speculative lending practices in the housing market that led to the 2008 Global Financial crisis.

In the U.S. and Canada and many other countries, the biggest asset on most consumer balance sheets is their real estate holding. Therefore, as the central banks raise rates and the cost of debt increases, there will be a major headwind moving forward on many consumers’ discretionary incomes if they carry debt on their house. For example, if a consumer borrows $500K and the cost of debt goes from just 2% to 4% their monthly mortgage payment moves from $2,119 to $2,639. The simple math is that would be an extra $520 a month or $6,240 a year. That is real money for the average consumer which will surely slow down consumer discretionary spending. This will make it tougher on families to make ends meet and force them to cut back. As a result, as you can see below, consumer confidence levels are very low. This is what Central Banks want for consumers that make up two thirds of the economy. Businesses, on the other hand, are more confident due to the Fed manipulating the debt market and many, many companies extending their debt over the last two years to take advantage of near-zero level interest rates. Like the Nasdaq bubble burst in 2000, I believe that many of the bankruptcies will happen in the venture capital world and away from the public markets.


Source: Haver Analytics, Golman Sachs Global Investment Research.


Source: Haver Analytics, Golman Sachs Global Investment Research.

One asset class in which we hold a core investment position is the multifamily and single-family rental real estate sector. As always, we like industries where there is a shortage of supply and increasing demand. We do not believe that demand for apartments will decrease nearly as much as demand for Peletons, Skip the Dishes orders or fancy new clothes, since as you can see below, rents are moderating from last year’s very high levels. But, at the end of the day, people will choose to pay their rent more often and splurge on discretionary items. And since most of the world has struggled to construct new living accommodations for so long because of a shortage of labour and materials, we believe that the replacement value of the assets in the sector are materially underappreciated. Good luck selling that Peleton close to what you paid for it. Further stunting supply is governmental red tape. For those who have had to stand in line at a hospital or airport lately, you have had the same experience that real estate developers have had for years trying to get a new apartment complex approved before municipal city councils. We still believe there is more demand than supply for low-cost affordable housing and that the new supply coming is arriving to market at higher and higher cost points.

Below we show a couple of charts that explain why we are increasingly believing that it may be very difficult to expect a “soft” landing. Thanks to the very, very easy past monetary policies of central banks, one could argue that the U.S. consumer has a very strong balance sheet based on housing and stock price appreciation. Therefore, the U.S. Fed may be tempted to think that they can raise rates more aggressively than in past tightening cycles. This will create major economic volatility and cause a significant economic slowdown.


Source: FRB, Goldman Sachs Global Investment Research.


Source: Jeffreries, St. Louis Fed.

Obviously, the central banks have tried to stamp out the speculation that occurred as a result of the easy monetary and fiscal policies put in place during Covid. As always, investment bankers fed the frenzy by oversupplying new perilous investment opportunities in SPACs, unprofitable IPOs, cryptocurrency ventures, etc. Unfortunately, as we can see below, there will be many layoffs at investment banks since deal activity has collapsed. The positive news from investors is that there will no longer be an increase in securities which we believe will continue the secular trend of there being fewer public equities for investors to invest in. And as the prices of the public companies go lower, we would anticipate an increase in takeovers. For example, since 2018 we have had over a dozen smaller companies in our long-only Voyager Fund taken over and anticipate other quality small cap franchises we own to potentially get taken over in the future. 


Source: Company Data, Evercore ISI Research. Note: 2Q22 data quarterized as of 6/27/2022.

The good news is that many bubbles caused by access to free money have burst. Good luck getting an unprofitable business public today. According to a recent June article in the Financial Times, the once-acclaimed Tiger Global Hedge Fund has seen losses over $17 billion dollars year-to-date, which has essentially wiped out nearly two-thirds of its gains since 2001. According to a recent Bloomberg article, “Klarna Bank AB is in talks to raise new equity at a valuation as low as $6 billion, a fraction of the $45.6 billion it commanded last summer as it became Europe’s most valuable start-up… The Swedish lender which offers buy-now, pay later credit to more than 147 million global active users posted an operating loss of 2.54 billion krona ($245 million USD) in the first quarter and 6.58 billion last year.” We anticipate a lot of pain ahead in unprofitable businesses like this that will see a massive lift in their cost of equity and debt.

The really good news is that industry leading companies with track records of high returns on capital and free cash flow generation have seen massive multiple contractions this year. As I type these comments on Microsoft Word, I can reference that Microsoft’s earnings multiple has gone from trading at nearly 40X earnings last December when we exited our position, to 25X. The free cash flow yield for this best-of-breed software business has gone from just under 2% to just over 4%.

One question in my mind is: Have the best of best businesses such as Microsoft contracted enough valuation wise? To be honest this is always the toughest question to answer when you enter a bear market, since picking bottoms is so very, very tough. Shorter-term there will be many best-of-breed companies like Microsoft trade at above-market multiples but struggle to meet earnings expectations in a world of mixed “yellow” and “red” lights. Based on our experience, though, we will be ready to buy the “bad” news just as we were ready to sell the “good” news in 2021. We are salivating at the chance to buy back leading companies like Microsoft that are well-capitalized with significant competitive advantages that can survive and thrive on the other side. Hence, bad news economically for Microsoft will be great news for long-term asset allocators like myself. As investors get hurt in illiquid, overvalued private businesses that have lost money and need to raise capital to cover their financial burn rates, financial discipline will return again. I have seen it happen before and I am confident I will see it happen again.  

With that said, we do acknowledge that sometimes good companies do not always make good investments. Chipotle is a good company based on its fantastic growth track record that has allowed its multiple of earnings to expand from before Covid. Because of the above inflationary pressures and consumer discretionary spending headwinds we are still short Chipotle. I like a good burrito as much as the next person, and Chipotle has been a darling stock during Covid but over-earned in my opinion thanks to free money given out by governments. Unlike Microsoft, Chipotle does not have recurring revenues fees and dominant market share.

Before Covid, in the years 2018 and 2019, top-line revenue grew at 9% and 15% respectively while bottom line earnings grew a fantastic 38% and 71%. In 2021, top line grew over 26% after a low 7% growth in 2020. It is interesting to note that bottom line declined 25% in 2020. At present, Wall Street expects Chipotle to grow top line in the mid-teens and earnings in the low 30% range. With the stock trading at over 50x earnings, we believe there is very little margin of safety from a valuation perspective if fundamentals do not live up to those lofty expectations. It does not make sense to us to invest in a company this established with less than a 1% free cash flow yield, when the risk-free rate is hovering near 3% in the U.S. 10-year bond market. We highlight below a quote from their most recent quarterly results that helps our conviction:

“As we look to the remainder of 2022, there remains uncertainty from macroeconomic impacts as well as COVID and make it difficult to provide full-year comp guidance. Comps in April, so far, continued right around the same 9% we saw in Q1 and while it’s difficult to predict the comp in Q2 due to these factors, assuming current sales trends continue, we expect it to be in the 10% to 12% range as we expect the comp to increase throughout the quarter. Our restaurant level margins continue to be impacted by unprecedented levels of inflation.

Our Q1 margin was impacted by higher level of commodity inflation than we expected, primarily from avocados, tortillas and dairy, resulting in our Q1 margin falling below a nearly 22% guidance we provided on our last earnings call. To offset these rising costs, we increased menu prices over 4% at the end of the quarter. And looking ahead to Q2, we expect our restaurant-level margin to be around 25%, which will benefit from a full quarter of the new menu prices and assuming we don’t see additional inflation above our current estimates.”

– Brian Niccol, Chairman and Chief Executive Officer at Chipotle Mexican Grill

One could argue that the stock market’s collapse at present is in a major way due to government policies unwinding or government policies gone awry. The free money handed out during Covid because governments mismanaged the hospital system’s capacity to handle a pandemic is now responsible for many businesses seeing a significant drop-off in demand. German politicians’ decisions to become more and more dependent on natural gas from Russia while not meeting NATO defense spending targets is largely responsible for Putin’s confidence in invading Ukraine and surely cause food inflation and certain tragic food shortages in many poorer countries this summer. Trump’s policies to limit immigration five years ago after becoming President of the U.S. are contributing significantly to wage inflation spikes in the U.S. at present.

A recent speech from Bill Morneau, recent ex-Finance Minister of Canada, has confirmed my concerns that governments are slowly but surely becoming a more and more important force at determining macroeconomic forces and the overall volatility of the capital markets. At Wealhouse, we believe we are better positioned than many much larger competitors to capitalize on this secular trend towards more volatility.

I found it very interesting to hear what Morneau said in a speech recently: “So much time and energy was spent on finding ways to redistribute Canada’s wealth that there was little attention given to the importance of increasing our collective prosperity — let alone developing a disciplined way of thinking and acting on the problem, …There is no real sense of urgency in Ottawa about our lack of competitiveness. It’s like we’re the proverbial frog in the pot, not realizing what happens to us as the heat gradually rises.” When I read his comments, I immediately thought that he was trying to distance himself from more aggressive taxation policies he believes will come from Ottawa. Stay tuned.

As we all sit here waiting for inflation to peak, we are left wondering where inflation will fall to once it hits the new trough. Investors who have been used to investing in a world where secular growth stocks outperformed while interest rates systematically fell for over 40 years, maybe in for some nasty surprises if the new normal for inflation is somewhere between 3-4% for the long-term. If this situation plays out because of structural supply problems in the physical economy, many investments that have been made in digital business plans with no near-term hope for free cash flow generation will likely experience major valuation contractions and/or bankruptcy. This is why we will avoid money-losing businesses unless we have a clear line of sight to their profitability. Money-losing businesses and levered investors have been getting a “free pass” in my opinion since 2008 because government and central banks manipulated their bond markets by running up their government debt-to-GDP ratios and monetizing their own debt. Therefore, at Wealhouse, we have products that can be both long and short. If central banks continue to monetize their debt, then long-only funds should be fine. If not, we have a Plan B for our savings.


Source: Goldman Sachs Group Inc., Goldman Sachs Global Investment Research, Haver Analytics.


Source: Goldman Sachs Group Inc., Goldman Sachs Global Investment Research, Haver Analytics.

As I have always said, it is the job of the central bank to make access to money easier when the world is sad and take away that easy access to money when the world is happy. As we know, interest rates are being raised by central banks here in Canada and around the world. Unemployment is low and inflation is very high. However, we would advise investors to realize the stats on inflation and unemployment are lagging indicators. The decline in the stock market this year is telling you we will slow materially into next year. Counterintuitively, this is what we need to set up for the next leg up for capital gains for investors.

We continue to prioritize liquid investments and caution those who are heavily overweight illiquid businesses to have a Plan B in case inflation stays stubbornly higher for longer than anticipated. We will stay balanced between companies that are industry leaders in cyclical industries with secular tailwinds selling at low valuations. We will selectively buy best-of-breed companies as their multiples contract. Since it is hard to predict so many macro and geopolitical matters, we do not want to get overly concentrated in any one investment style. We want to be balanced between growth and value opportunities.

And again, I highlight to all Wealhouse relationships that my family allocates our savings monthly to my colleagues running Amplus and Lions Bay, who I am so proud to say, are up in what has been an environment so negative for bonds and equities this year.

We appreciate our clients’ trust in an investment world I have rarely seen, filled with so much negative sentiment. Overall, we believe there is much less risk today than there was a year ago today. Yes, commodity prices are higher and causing inflation but throughout my career if you get the price of something high enough eventually you will find supply. For example, and as you can see below, companies are starting to drill for oil and gas again. And more and more layoffs are being announced, rest assured this will help relieve some wage inflation pressures due to increase in supply of workers. In recognition of these hardships, we will continue to contribute funds from Wealhouse to help those in need from job losses.

In conclusion, inflation had a perfect storm of Covid-induced easy access to money and fiscal stimulus. Interest rates have increased materially and this is causing the economy and earnings to slow. We are re-evaluating our portfolio continually to position in the assets we believe have been unjustly mispriced the most in relation to their prospects. It is not easy to say exactly when interest rates will stop rising but as we see more and more assets in the public markets back to absolute prices, or pre-Covid multiples, we are hopeful that the worst is behind us.