December 22, 2022
Since my last post, the world has continued to glide into a slowdown. Markets are being impacted by higher rates, layoffs, inventory excesses, and political unrest. The variables, the confusion is well beyond anything that has been seen in the past 20 years, and it is probably going to get worse.
My last post was almost a month ago, and at the time, bad news was being perceived as good news, and markets were showing signs of rising. With the massive amounts of money sloshing around in the hands of the population, there was a good chance it would turn into a year end rally. The opposite happened. The TSX is down about 5% since then, and the S&P is down about 3%.
This leads to further bad news, and I suspect it may not be treated as good news. The economy has been bumping along either in a minor recession or very close to one (both in the US and Canada), but the effects of rising rates will start to seriously bite in the early part of 2023. The outlook is therefore not so bright.
In a moment, we can come back to the indicators that are worrisome, but for a moment, let’s focus on what to do, given this uncertainty.
If you are a long term investor (ten years or more), then simply buying steadily is probably not a bad choice at this point. Many of the excesses caused by the COVID pandemic have been taken out of the market at this point. There is still a lot of room for markets to fall, but the declines of 2022 remove the ridiculous part of the valuation.
For investors looking for income, it is probably safe to start dabbling in high quality bonds and dividend stocks. It is important to stay away from riskier bonds. Banks have been left holding a lot of poor quality debt and they will be spending 2023 trying to make it look exciting. It isn’t likely to be exciting, at least not in 2023. At the same time, a lot of strong companies that pay dividends are likely to continue being successful in 2023 and beyond. Of course the caveat is that if the dividend looks too good to be true, it is likely either going to be cut, or the company is in serious trouble.
If your investment horizon is much shorter (i.e. retired, buying a house within the next year or two), then being far more cautious still makes sense. There are a lot of risks that can reduce valuations further in the next year, and the climb back out will not be like it was when central banks were engaging in quantitative easing at every turn. Over the long term, good quality companies will make money and assist with recovering any lost valuation. Poor companies may never recover. The growth that was experienced during past recoveries may not materialize without returning to quantitative easing.
Caution Is Advisable – Money Supply
The conclusions here, as always, are speculation of course, but based on some pretty decent data. Over the past two years, the vast and somewhat puzzling moves in the market (think ‘meme’ stocks) all appear to be based on a massive over supply of capital. The amount of capital still in the system is shocking to say the least, but it is at least being withdrawn with some urgency.
Below is a chart of M2 money supply and the decline in money supply is barely starting, but following the comments by the federal reserve last week, market participants have now given up hope for a ‘pivot’ that would see more money unleashed to support asset prices.
Despite this decline (and expectations for a continuing decline) in money supply, investors have a lot of cash on the sidelines. Here is a long term view of cash assets held by banks. Note that banks cash balances are falling quickly, but are still significantly higher than before the 2020 COVID outbreak and dramatically higher than before the mortgage crisis.
This isn’t just company money. Its investors of all sorts. Here is a similar chart showing the cash at brokers and dealers. The amount of money available to invest is dramatically higher than it was in 2019, 2009, and almost three times higher than during the 1999/2000 market peak.
Before the Federal Reserve began signaling a withdrawal of money from the system, the assumption was that this money could be put to use to raise asset prices. That risk isn’t completely gone, if asset prices get ‘low enough’, but over priced assets are still deflating (for example, homes, stocks, bonds) and undervalued assets are undergoing inflation (consumables primarily, such as food, rent, fuels).
This process is very messy and may take months or even years until an equilibrium is reached where prices are well understood.
Caution Is Advisable – Interest Rates
The withdrawal of money supply (quantitative tightening) was a significant factor driving the reduction in asset prices in 2022, but interest rates will start to bite in 2023 and beyond. Mortgages, consumer loans, corporate debt will all start to become dramatically more expensive now. In a recent report, the interest portion on debt payments in Canada jumped by 17.8% in the third quarter!
The chart below offers an update on the rate of return for the 10 year US treasury. For a while in November, yields began to fall as the Federal Reserve presidents spoke of a need to slow down rate hikes. Last week, rates were raised by just 50 basis points (a half a percentage point), but it was clear that the Federal Reserve thinks rates will go much higher still. They are targeting a 5.1% rate by the end of 2023.
The market is already discounting this 5.1% interest rate, because it is clear that the US will enter a recession in 2023, even if you assume it isn’t already in a recession. However the more important factor to consider is that the ‘pain’ of higher rates is being forecast for at least the next year. For a world that is used to being saved by the Federal Reserve at every sign of economic malaise, it may be up to individuals and companies to rely on their own resources to manage what they have.
Another key factor to consider, is that last time markets saw a 5.1% yield was just before the housing collapse of 2007. At that time, the S&P was at 1200 (it is now 3,822). The US debt was $9 trillion (it is now at $31 trillion) and this time more of the US income (taxes) will be required to make interest payments. All of this points to a significant slowing of the economy.
Caution Is Advisable – Profits
With consumers facing rising costs due to inflation, higher borrowing costs and the ongoing effects of the pandemic, there will be a drop in spending. That will also happen to corporations who will stop investing as the returns on investment fail to reach an appropriate ‘hurdle rate’. Spending will slow and profits will decline. This is a key focus of the Federal Reserve’s fight against inflation. It will increase capacity and reduce demand. As profits decline, prices that are based on earnings, growth or cash flow will also decline (valuation compression).
When it comes to investing, making decisions about which companies will be hurt most is much more difficult and dependent on individual company circumstances. Picking the ‘right’ companies in a declining market is fraught with risk and is one reason to stand aside until there is more clarity.
Caution Is Advisable – GeoPolitics
Finally, the world of geopolitics is extremely busy currently. The war in Ukraine is only tangentially affecting markets, but there are knock on effects in the oil markets as well as political rivalries. Countries assessing sides (China/Russia/Iran vs. Europe/USA for example) may lead to some difficulties in assessing risk.
China is currently under a lot of pressure due to COVID concerns as well as imposing their will, both financial and political on a variety of countries around the world.
Another incident of interest is the ‘upsets’ that are happening in central and South America. Peru is under siege as the battle for the presidency (perhaps democracy) unfolds (risking supplies of various metals) and in a far more minor incident, Panama has forced the Canadian miner, First Quantum to shut down a copper mine in a dispute over royalties. Interestingly, the US seems to be cozying up to Venezuela again so that they can access their oil reserves. These sorts of upsets can dramatically change the investment landscape in a short period of time, but they can also alter world supplies of commodities which are currently very, very tight.
It’s Not All Bad
Despite all of this, it isn’t all bad news. Some businesses are doing very well, and will continue to do so, so staying at least partially invested in high quality companies is wise. Over the span of history a lot of bad things have happened and the world continues to eat, sleep, celebrate and mourn. The arc of time offers many examples of innovation, excellence, and of course blind luck even in the worst economic circumstances.
Taking advantage of these incidents requires taking some risk and of course, perseverance. Taking those risks in modest quantity is probably the right approach currently.