Expect more and more “bad news” headlines related to the global economy. CIO & Founder, Scott Morrison, discusses stagflation and other macro challenges in this month’s commentary. Morrison dives into Wealhouse’s collective strategies and how they are akin to a modern-day balanced fund – which are best suited to manage today’s environment.
It is surprising to me that, since founding Wealhouse in 2008, the current cost of debt has never been lower while the issuance and accumulation of debt has never been higher. I cannot readily think of examples of assets whose prices have increased along with the level of their supply – except, of course, if demand exceeds that supply. As I have noted previously, though, the price of debt has decreased due primarily to central bank manipulation of the bond market since supply has been growing so rapidly.
As evidenced in the chart below, the amount of debt added by the U.S. since 2008 has essentially tripled from $10 trillion to $30 trillion. I am very confident in saying that without central bank manipulation of the price of debt, politicians would not feel so emboldened as to have policies that increase debt at such large clips as, for example, the recent tax cuts in Britain or the student debt relief in the U.S. Perhaps the fact that the UK’s new Prime Minister backtracked on tax cuts after seeing currency and bond markets sell-off will serve as a warning to other politicians: the granting of fiscal incentives in trade for voter support is counter-productive to the efforts of central bankers trying to stamp out inflation.
This bond-market manipulation pause is over for the time being, however, which is causing equity market selloffs around the world–except in countries such as the Middle East and Africa, where markets are benefitting from energy-price increases on the back of the Russian invasion of Ukraine. As central banks stop buying their own debt, bond markets are correcting as politicians keeping increasing their deficits to support consumers hurt in part by higher energy and food prices. An exception to this is Japan, which is still in the grips of quantitative easing (QE) and bond-market buying (note how low the Japanese 10-year bond is below versus other major economies). We are also seeing commodity markets correcting from their highs as the global economy rapidly slows. This in turn is leading to a rapid rise in the US dollar, as is illustrated below. For example, the Japanese currency has depreciated over 20% versus the US dollar year-to-date. This is going to cause problems for many U.S.-based companies with overseas sales this coming earnings season. Sincere congratulations and thanks to my colleagues Andrew and Justin, who are navigating these very difficult markets fabulously for clients through their funds, Amplus and Lions Bay.
U.S. Dollar Index Spot Rate
I have been contrarian-minded with respect to overseas markets, which has resulted in a downturn in performance for Panorama and Voyager funds. In Panorama I did get it right in that I was correctly short many parts of the bond markets as we entered the year, and I avoided high-multiple companies in sectors like technology. However, our investments overseas have been particularly challenged for a couple years now versus North American assets. We have had too many investments positioned to benefit from a re-opening of China after Covid which to this day has simply not occurred to the extent that we have experienced here in North America. And even though the UK and Europe have re-opened post Covid, they are still suffering from the effects of BREXIT and the war in Ukraine resulting in an energy crisis and collapsing consumer confidence.
As you can see in the below chart, the earnings yield (price-to-earnings ratio simply inverted) in the U.S. is still the lowest when compared to other global markets. Low means most expensive. You can also see at the other extreme that Hong Kong-listed stocks are the cheapest I have ever seen versus the U.S. and rest of the world. I would argue that foreign markets are already discounting a recession, whereas the U.S. markets have yet to fully reflect this scenario and are at risk of further valuation market multiple contraction.
Equity Yields Still Trump Bond Yields
10 Year Gov’t Yield Today
10 Year Gov’t Yield Apr ‘11
Source: Wealhouse, Bloomberg October 10, 2022.
We selectively remain invested in certain rock-solid business franchises with strong balance sheets trading at some of the lowest valuations of my career. We continue to focus on balance-sheet strength in case macro events get worse, so these companies can emerge on the other side stronger and gainful of market share. As I reflect on these comments over Thanksgiving weekend, I am very grateful that my family and friends are not living in war torn Ukraine. However, after a career of travelling the world for research purposes, I do believe that overseas businesses will have their day in the sun again. The powerful U.S. dollar has moved higher, as shown above, which highlights that investors are repatriating their investments from overseas out of fear of being invested globally. Eventually this fear will peak, meaning that well-run and undervalued assets will re-attract investor interest.
When I meet companies for due diligence purposes over the last 25 years of my research career, I typically ask almost every company where they may be seeing cost pressures in their businesses. Over the last few decades, I can remember in very rare cases hearing that a business was having trouble attracting labour. Generally speaking, the world has not been short labour, in part due to favourable demographics, technological productivity gains, temp staffing agencies and very cheap foreign labor from countries like China, which joined the World Trade Organization in 2000. Suddenly, and on the back of Covid, we are collectively facing some very serious labour shortages, which are wreaking havoc on companies and causing central bank heads like Chairman Powell to comment after raising interest rates 75 basis points in September:
“No one knows whether this process will lead to a recession or if so how significant that recession would be,” Chair Jerome Powell said Wednesday September 21st. “That’s going to depend on how quickly wage and price inflation pressures come down, whether expectations remain anchored and also if we get more labor supply.”
Simply put, the U.S. Fed has made it clear that it feels the need to cause job losses in order to increase its supply of labour. Until this happens, or something economically breaks, we doubt the Fed will cut interest rates.
In our previous comments we expressed a desire to “buy bad news.” Well, the bad news before Thanksgiving weekend in Canada was that the U.S. jobs number was strong–too strong. Please understand that we do not wish to see people to lose their jobs. Indeed, we at Wealhouse donate monies to help when families in our local communities struggle, because we know that economic cycles happen, companies will be disrupted or relocate, and a host of other unfortunate scenarios sometimes play out. Ultimately, however, we have a problem as investors when Chairman Powell’s comments are triangulated with both a report that shows a drop in the unemployment rate in the U.S. to 3.5%, and an increase in non-farm payrolls of 263,000. This is why we are seeing wage inflation at their highest levels of my career. As you can see in the below chart, we are also experiencing the steepest and fastest monetary tightening cycle of my career. It was only six months ago that the U.S. central bank was still doing QE in the U.S. bond market!
Change in FED Funds Rate
This, in turn, has led to the worst bond market returns posted in any given year. Our fear of this potential becoming reality prompted Wealhouse to bring on board Andrew Labbad, in order to help build a better bond solution for our clients. Historically, there have been decade-long stretches where investors lost money in traditional bond structures. In consideration of the present levels of inflation and the low yields on bonds, it was inevitable that investors would eventually see the negative impacts of inflation on the real returns of their bonds. Andrew’s ability to short underlying government debt and be long high-yielding, well-underwritten, investment-grade corporate credit is delivering much better performance than would the traditional, fixed-income funds in which most clients typically invest. This is one reason why we have been short, for example, the equity of Blackrock–because they are globally one of the largest owners of government bonds in their passive, exchange-traded fund business. We benefitted from this short in part because the new UK government put in place very aggressive fiscal policies—ones that included tax cuts and extending programs in order to shelter spikes in energy costs to UK consumers and businesses. Again, this meant increasing the supply of government bonds while demand was decreasing, since their central bank–in battling inflation–had stopped buying those bonds after years of QE. This sell-off in the UK government bond market was called the “gilt” market. Here is how it was explained in an article from Bloomberg: “Firms including Blackrock, Legal & General Plc, and Schroders Plc. … were forced to post more collateral after receiving margin calls when gilt prices collapsed. The central bank stepped in Wednesday after the calls threatened to push the gilt market into a downward spiral. The BOE had been warned by investment banks and fund managers in recent days that the collateral requirements could trigger a gilt crash, according to a person familiar with the BOE’s deliberations before they stepped in.”
Earlier in the year we were short the mortgage-backed security market and as you can see below, we have seen a huge spike upwards in the cost of debt for homeowners. The second chart, below, shows how the cost of that debt relates to hourly earnings for homeowners. This, we believe, is causing a significant slow-down in U.S. consumer spending and is in part why we saw FedEx and Nike lower earnings expectations in September. Companies that sell to consumers are looking to work down inventories. For example, FedEx management made these comments on a recent call:
“From October to June, the real inventory to sales ratio excluding automotive, increased 14 basis points, which was the fastest gain over an eight-month period in the 25 year history of the series. Also, real retail sales including auto after growing 4.6% and 10.8% in calendar year ’21 and ’22, respectively, are now down 3.1% year-over-year through July, and are pacing to have the worst decline since the great recession.”(Source: Q1 2023 FedEx Earnings Call Sep 22, 2022.)
U.S. 30 Year Mortgage Rate
U.S. Mortgage Payments Divided by Average Hourly Earnings
If I was an economics professor, I would encourage students to understand how supply and demand works in the real world, since it is the main driver of asset valuations. I do not think you need a crystal ball to anticipate how, in the above and below housing charts, the price of houses in the U.S. is going down. Simply put, if demand-to-buy is decreasing and supply of houses for sale is increasing, then the theory holds that prices will correct lower. So, for any clients that are looking to buy a property in the U.S., your time is coming. Once it becomes clear that the Fed no longer has a need to raise rates, we will want to be buyers of companies correlated to the recovery in housing purchases. For example, we sold our position in Shin Etsu from Japan, a company that makes chemicals which go into building materials for home construction. Since Shin Etsu is a low-cost producer with net cash on its balance sheet, we will look to add this industry best-of-breed leader into our portfolios once the down cycle is mostly behind us.
Ratio of Houses for Sale to houses Sold, Months Supply
We believe that we will continue to see more and more “bad news” headlines related to the global economy. The key headline that will cause markets to rally in a counterintuitive fashion will be a negative jobs report released on a Friday in the near future. It is important to remember that we saw unprecedented fiscal and monetary stimulus happen from the spring of 2020 until the end of 2021. Central banks are waged in a war against unintended inflationary consequences. Hence, central banks are likely to keep raising rates until there is more pain in the economy. However, as we saw in the UK when their pension system was threatened, the central bank stepped in with more QE. As pain hits the U.S. employment and housing markets, there will come a point where the U.S monetary authorities will back-off raising interest rates 75 basis points, as they have done at their last three meetings.
Again, I praise my colleague Justin Anis and his Lions Bay Fund for having profited from these negative macro headwinds. In the process of diversifying my family’s money into his and Andrew’s funds, I have concluded that they are akin to a modern-day balanced fund, which is better suited to manage an environment that is more like that of the 1970s. We are most definitely in a period of stagflation, and this suits well Andrew and Justin’s nimble structures in order to trade around the volatility in their quality core holdings. This ability is unlike that of other managers, for example Blackrock, who run too much money to be so nimble.
Ultimately, we encourage investors to stay diversified in the face of the many macro headwinds out there. Macro challenges such as the war in Ukraine and the energy crisis are providing our team with opportunities to invest in fantastic businesses at prices we have not seen in a very long time—particularly as interest rates return to levels not seen for over a decade to fight inflation. I assume China will stop curtailing economic growth to try and stamp out Covid at some point. It’s frustrating to know that if I wanted to visit a city of Shanghai where I have been many times before with a population base over 25 million people, I would have to show a negative Covid test 24 hours before I arrive and take another for the next 3 days in a row.
Since we assume we are in a period of stagflation, we want to own businesses that have pricing power. One such example would be Louis Vuitton. It is a very profitable company with mid-20% operating margins, and has the ability to pass along higher input costs on its high-end products for discerning clientele. The company has over a 5% free-cash-flow yield at today’s valuations and is at a 10-year low, price-to-earnings multiple—this despite being better diversified and stronger in its leadership positions in such areas as wines and spirits, cosmetics and perfumes, jewelry and leather goods. Many of you will know it as the company that owns brands like as Dom Perignon, Tiffany, Christian Dior and Sephora. Their balance sheet has net cash of over 10 billion euros, which will allow it to make counter-cyclical investments to emerge from this recession stronger. When the whole world is scared about the equity markets, we love to buy into best-of-breed companies on sale. We doubt that you will ever find many of their products on sale, so we like to buy the stock when it is on sale.