Sifting through financial information online is becoming quite onerous with so many opinions out there, so we've consolidated what we believe to be informative and insightful into one Market Commentary.
Market Commentary – Spring 2023
The first quarter of 2023 has been significant in many areas. From a banking crisis brought on by the collapse of Silicone Valley Bank (SVB), market volatility, and new technology (like A.I. tools) becoming a part of daily conversation. It feels like the world is changing fast!
It’s times like these when many people are tempted to predict what will happen next.
As always, I like to put instances into context with respect to a larger picture so that we can step out of the daily/weekly/monthly noise and focus on a broader, longer-term view.
Some context
Coming out of the global financial crisis in 2008-2009, interest rates were lowered to assist in stimulating the economy out of a massive downturn and break in economic confidence. Lower interest rates allow for easier and freer access to borrowing, which stimulates consumer spending and corporate investment (growth endeavours, capital expenditures, hiring, etc). These lower interest rates persisted for a long time as the effects of the financial crisis were quite widespread and long-lasting. In essence, it took a lot to come out of the mess.
As asset prices and the economy recovered, interest rates began to increase slightly, signaling the economy was healthy again. But… then in March of 2020, a global pandemic wreaked havoc on all of us. In my career as a financial planner and asset manager, this was only the second time we had faced global uncertainty; we had entered into a time where we could not make any sense of what the future held.
When government-imposed lockdowns pulled the economy to a grinding halt, central banks needed to stimulate the economy once again. Large sums of money were borrowed and dispersed into the economy, and interest rates were again lowered to increase consumer and corporate spending. This had an immediate upward impact - specifically on tech companies, who were seen to both profit from the work-from-home environment, as well as being more easily able to fund lofty growth initiatives due to lower interest rates.
As the economy began to recover from the Covid crisis, the more stable companies began to follow suit in asset price increases for the remainder of 2020, as did real estate prices everywhere.
As mentioned above, both lower interest rates and freer access to money (CERB, CEBA, etc) created upward pressure on asset prices (more demand for things like stocks, real estate, etc), and this phenomenon persisted through 2020 and 2021.
Overnight, it seemed paper millionaires appeared everywhere (“I can’t believe my house is worth over a million dollars! I’m a millionaire!!!”).
With all the borrowing that governments and central banks undertook, there was bound to be a reckoning at some point. I wrote about this in July 2020 in an article titled “National Debt Explained”, which you can access here: https://www.adamschacter.com/post/national-debt-explained.
When a government borrows, it has a liability and an obligation to repay just like you and me. In the interim, a government makes interest rate payments in order to service its debts. If a government runs a deficit, it does not have the means to repay, and so needs to cut funding to other public initiatives. As this is the case with most governments in recent history, a government has a few options for how it can assist repayment:
1) Increase income taxes – This would essentially increase the revenues of the government at the expense of those who work and earn income.
2) Increase sales taxes – This imposes taxes on those who spend within the economy.
3) Inflation – This is the most covert way to pay back what you owe; allow the dollar value of what you owe to be worth less over time. All citizens and consumers foot the debt bill without really knowing that it’s taking place.
In hindsight, I think we now know which route was chosen…
This notion of inflating debt away is a careful balancing act by governments and central banks.
On the one hand, if you owe a lot of money and the interest rate is low, it can be easily carried forward into the future since it does not cost a lot to service it, and you would not want to raise interest rates on yourself!
On the other hand, if inflation runs too high, consumers start to take notice, and this is not good public policy if you want to get re-elected!
So, what do you do here? If you have debts, you want interest rates low and inflation high, for a time. And as such, you would want to keep interest rates artificially low for as long as you can until inflation makes enough noise and public opinion eventually dictates that intervention to manage inflation is needed.
Some side notes on inflation:
Inflation is the increase in the aggregate price of things over time, caused by a gap between supply and demand.
Governments and central banks typically have a target inflation rate of 2% (between 1% and 3%) because if inflation was too high (if prices were increasing too quickly), then consumers would buy too many things today and not save for tomorrow. If inflation was too low, or was negative (if prices were decreasing over time), then consumers would not spend today in favor of lower prices tomorrow.
Inflation is the increase in the aggregate price of things over time, caused by a gap between supply and demand.
In 2020 and 2021, supply chain issues became a disruption due to global Covid pandemic restrictions, trade tensions between China and the USA, a blockage in the Suez Canal, and a war between two of the worlds biggest suppliers of commodities; Russia and Ukraine. When supply is suppressed and demand remains unchanged, the gap between supply and demand widens, and the price of things tends to increase. When both supply and demand are suppressed, (demand, in this case due to global Covid restrictions; less travel, driving, etc), it has a net neutral impact on prices since no gap between supply and demand persists.
This takes us to 2022.
In 2022, the world opened back up. Canada took a couple of months longer to do so, but most of the world opened up in early 2022. Consumers woke up from a 2-year Covid coma and wanted to make up for lost time by going back to restaurants, returning to the office (for some), driving places, travelling, hosting and attending gatherings again – all things that create increases to demand.
Fueling these increases in demand was the previous 2 years’ increases in asset prices (2020 and 2021 - particularly real estate), which created paper millionaires overnight, making people feel richer and more apt to spend more.
But… the supply chain issues described above still persisted; and remain even today.
As such, 2022 produced a significant spike in demand, while supply remained suppressed. This discrepancy/gap between demand and supply saw an immediate increase in the prices of consumer goods, and continued to do so as the gap between demand and supply widened.
And this is exactly what governments and central banks likely intended; to inflate away their debts.
But inflation that runs too high isn’t good public policy. As things became more expensive for consumers, there was more pressure on governments to “help” the new inflation problem. And as such (and right on cue), central banks began to impose policies to fight inflation; again, no easy task. To fight inflation means to narrow the gap between supply and demand, but with the stubborn and immovable supply issues persisting, the demand needle was the only part of the equation that could be tampered with.
But how do we decrease demand??? We need to make people and entities feel poorer and therefore, able to spend less. As such, central banks kept inflation running for a time to increase prices (and to lower the value of the debt they owed), then proceeded to increase interest rates, making it harder for consumers and corporations to access spending, making them spend less and putting downward pressure on asset prices (lower demand typically means lower asset prices).
The idea was that suddenly, the overnight paper millionaire might think twice about making reservations at the spa or going to that expensive restaurant. With home prices plateauing (and in some regions going down), and the cost of non-discretionary expenses (consumer goods that we require) going up, things needed to be tightened up at the household and the corporate level.
We now see less spending at the household level (less travel, less restaurant, etc) as well as the corporate level (less hiring or layoffs, less spending on lofty new corporate initiatives, etc). This decrease in demand is supposed to bring the gap between supply and demand closer, reducing the rate of inflation. And it’s working.
I hope the explanation above does an adequate job of how these 2 financial metrics (inflation and interest rates) are intertwined.
So where do we stand today?
A government can’t raise interest rates too much higher since it would be doing so at the expense of itself. Complicating matters further is that governments still require high inflation in order to inflate its debt away.
This is the difficult and delicate balancing act that is taking place today. Cracks are beginning to show in the economy and a “recession” is a likely outcome for the scenario I described above. But don’t let that word scare you too much. A recession is defined as 2 consecutive quarters with negative GDP; there is no distinction for how negative. A recession with 2 consecutive quarters of -0.1% GDP growth is as much a “recession” as a recession with 2 consecutive quarters of -35% GDP growth.
The term “recession” invokes fears and uncertainty over our economic outlook, which puts further downward pressure on asset levels and on demand over the short-term.
The term “soft landing” has also been bandied about, which means that in a perfect world, the balancing act described above – all of which puts downward pressure on demand and asset prices – doesn’t do too much acute damage, but rather minimal damage over a longer period of time (the mild recession, versus the deep recession).
Investing in this environment:
In the shorter-term, changes in public perception invoke changes to public market values (seconds, minutes, days, weeks, months). It’s important to detract from the short-term noise when determining the value of your investment into a business, a debt instrument, or any other productive asset. The current value of your asset (the market value) may fluctuate from time to time, but as long as you are not buying or selling that asset, the current market value is not relevant to you.
Now, more than ever, owning quality businesses (quality of cash flow and earnings, good competitor advantages, prudent internal decision-making processes, reduced sensitivity to interest rates, longevity of management, insider ownership, etc) versus speculating on the next great thing (cryptocurrency, psilocybin, metaverse, AI, etc) should help to reduce both your systematic risk (volatility) and non-systematic risk (the risk of something being inherently wrong with what you own).
Owning quality debt instruments (credit quality, risk versus yield, longevity/duration, etc) should assist in reducing volatility and diversify your portfolio further.
In addition, a continued investment into alternative asset classes (infrastructure, real assets, real estate, private companies, private income strategies, etc) will further help to manage risk in order to adequately round out a portfolio.
Your portfolio
Of course, I try my absolute best to ensure my human outlook does not spill into your investment strategy.
As a strategic asset allocator (decisions made based on past outcomes) versus a tactical asset allocator (decisions made based on future outlook), my belief is that future short-term outcomes are not yet known, and that past outcomes are a matter of fact.
Based on this framework, we were recently able to reduce your overall equity/stock holdings in July of 2021, then increase them in July of 2022, and have been standing pat since then as no changes to the asset allocation were determined to be needed in quarters October 2022, January 2023, and again in April 2023.
A graphical representation of what I describe above, contrasted against the S&P 500 index over the past 3+ years, can be found below, whereby green dots represent a shift into equity, and red dots represent a shift out.
From a historical perspective, you may find that this strategy has yielded results that had your portfolio overperform in 2020, underperform in 2021 (shifting out as stocks went up), and overperform in 2022 (despite the down year).
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We continue to monitor any potential new holdings on an almost daily basis, and continue to evaluate your existing holdings to determine if the reasons we bought them in the first place remain true today.
I hope you find this both interesting and informative in keeping pace with the events of today’s financial world.
If you have any questions about your financial plan, would like our opinion on what this current financial landscape means for long-term investors, or would like a refresh on the framework we have in place for times like these, please never hesitate to reach out.
This publication contains the opinions of the writer. The information contained herein was obtained from sources believed to be reliable, but no representation or warranty, express or implied, is made by the writer, Designed Securities Ltd. or any other person as to its accuracy, completeness or
correctness. This publication is not an offer to sell or a solicitation of an offer to buy any securities. The
information in this publication is intended for informational purposes only and is not intended to constitute investment, financial, legal, tax or accounting advice. Many factors unknown to us may affect the applicability of any statement or comment made in this publication to your particular circumstances. Hence, you should not rely on the information in this publication for investment, financial,
legal, tax or accounting advice. You should consult your financial advisor or other professionals before
acting on any information in this communication.
Embark Wealth is an investments trade name of Designed Securities Ltd (DSL). DSL is regulated by the Investment Industry Regulatory Organization of Canada (www.iiroc.ca) and Member of the Canadian Investor Protection Fund (www.cipf.ca ). Investment products are provided by Designed Securities Ltd. and include, but are not limited to, mutual funds, stocks, and bonds. Adam Schacter is registered to provide investment advice and solutions to clients residing in the provinces of British Columbia, Alberta, Manitoba, Ontario, Quebec, and Nova Scotia.