The following was adapted from Murray Leith’s remarks at Odlum Brown’s 29th Annual Address. View a recording or read the full transcript, here.
On the heels of a tough 2022, stocks have had a remarkably strong start to 2023. The Canadian and U.S. benchmarks were up 7.2% and 7.4%, respectively, through to February 15.
Investors are more optimistic for three reasons: (1) China’s economy has reopened; (2) Europe has thus far had a mild winter, which has taken a lot of pressure off energy prices and softened their energy crisis; and (3) the U.S. economy is holding up as inflation trends down.
With inflation continuing to come down from high levels, investors are also hopeful that the end of the monetary tightening cycle is in sight. To that end, after the latest 25-basis-point increase in the bank rate to 4.5%, the Bank of Canada suggested that they may be finished with rate hikes. South of the border, the federal funds rate is 4.75%, and the futures markets are pointing to only two more 25-basis-point increases, followed by lower interest rates later in the year. Investors are starting to believe the U.S. Federal Reserve won’t raise interest rates much more and that we might not have a recession.
While that is certainly possible, we don’t think it is probable. We also don’t think a recession is a bad thing. It’s the tough medicine that will curb inflation and put the economy on a much healthier footing.
We are emerging from a 40-year decline in interest rates that ended in 2022. For nine of the last 14 years since the financial crisis, the Fed has had a zero interest rate policy (ZIRP). Indeed, the fed funds rate was pegged at zero from 2009 to 2015, and again in 2020 and 2021 in response to the pandemic. Never in U.S. history has the cost of money been so cheap for so long. The Bank of Canada also lowered interest rates to zero during the pandemic.
Howard Marks, co-founder of Oaktree Capital Management, an expert manager of corporate debt and someone I admire, likened the impact of falling interest rates to the people-mover conveyor belts at airports. You cover ground a lot faster on a moving sidewalk. In similar fashion, when interest rates are falling, asset prices tend to rise faster than underlying fundamentals. Over the last few decades, we’ve had a lot of help from the conveyor belt.
Lower interest rates stimulate the economy and create new jobs in three important ways: (1) they encourage consumers to borrow and spend; (2) they motivate business leaders to expand businesses and launch new ones; and (3) they inflate asset values, magnifying wealth, which leads to greater spending.
Unfortunately, there are three damaging effects of low interest rates that fester: (1) they encourage excessive risk taking and debt, and we have unprecedented debt in the world today; (2) they promote a misallocation of capital toward unproductive activities; and (3) they cause inequality, as wealthy people own a disproportionate amount of the assets that are inflated by low interest rates.
If we fix the inflation problem, and more importantly learn from our mistakes, then we begin to quell these negative consequences. We get off an unsustainable path, and we start building a stronger economic foundation.
There is a short-term cost to putting the world on a firmer foundation. We will probably have a recession, and that likely will come with higher unemployment and lower corporate profits.
They say “turkeys fly when the wind blows,” and, boy, did a lot of turkeys fly during the pandemic. People are greedy by nature, and when they hear others are making money in Bitcoin and meme stocks, they pile in. Similarly, venture capitalists have raised billions of dollars for companies with questionable business plans and little or no profits.
The boom in speculation has contributed to a shortage of workers and wage inflation. Don’t get me wrong, I want my children to have better-paying jobs. But prices and the cost of owning a home have gone up faster than wages. The average person’s real income, adjusted for the cost of living, has actually declined. That is why so many people are angry and why we’re seeing greater political polarization.
Many of the turkeys that took off during the pandemic are now having to lay people off because the easy money has ended, and the businesses don’t generate enough cash flow to pay their employees. While I feel sympathy for those workers, it’s a positive step for our economic foundation. Many of those jobs were unproductive. Every business owner knows how tight the labour market has been. The good news is that it will get better as laid-off workers find productive jobs elsewhere.
Investors naturally think a recession is bad for the stock market, and they are both right and wrong. Timing is the issue. The stock market is forward looking, and it rises and falls in anticipation of what is going to happen in the future. In fact, stocks tend to drop the year before a recession and rise in the year of a recession. That doesn’t always happen, but it is what happens most often. A decent year for stocks in 2023, despite a recession, would be consistent with history.
What’s exciting to me now is that I once again see a path to a brighter world. We start making the world better when we stop doing the things that make it worse. Raising interest rates to combat inflation means the end of an era of monetary mismanagement. It means we stop instigating negative unintended consequences. We stop encouraging more and more debt. We stop inflating bubbles and the misallocation of resources. And we stop fueling inequality.
It also means that savers can once again earn a decent return on bonds, and as portfolio managers, we can utilize fixed income to better balance portfolios.
The authorities used the lessons from the Great Depression to avert disaster during the financial crisis and, more recently, the pandemic. They overdid it this time, but they are determined to set the world straight, and we are confident they will.
Despite this, worries persist that stocks will perform poorly if we have a recession. Further downside is possible, and investors may be inclined to sell. Consider these four reasons not to:
First, as mentioned, the market is forward looking; it discounts bad news in advance. When the bad news finally arrives, investors are normally focused on the recovery ahead.
Second, a ton of froth has already been expunged from the stock market. Most of the speculative turkeys that flew to the moon in 2020 and 2021 have experienced corrections of 70-90%. Even the huge and profitable so-called FAANGM stocks – Facebook (Meta), Apple, Amazon, Netflix, Google (Alphabet) and Microsoft – were down an average of 40% last year. Valuations of the great businesses we own in the Odlum Brown Model Portfolio1 range from outstanding to reasonable. We believe they will be bigger, more profitable and more valuable three to five years from now.
Third, we believe investors would be wealthier if they treated their stocks like their home. For most people, their home is their most valuable asset because they hold it through thick and thin. They don’t make the mistake of selling it when headlines are negative. At the beginning of the pandemic, I thought we were in for a long and nasty recession. If we had made a wholesale shift out of the market at that time, our Model Portfolio wouldn’t be up more than 35% since the end of 2019 – and that is despite last year’s drawdown.
One final consideration: Odlum Brown and our clients have prospered over the last 100 years despite World War II, the Great Depression, the inflationary 1970s, the 1987 crash, the bursting of the dot-com bubble, the financial crisis and the pandemic. Preserving and growing wealth is not about the economy. It’s about building a trusted relationship with your advisor, having a sensible long-term plan and, most of all, sticking to it.
1 The Odlum Brown Model Portfolio is an all-equity portfolio that was established by the Odlum Brown Equity Research Department on December 15, 1994, with a hypothetical investment of $250,000. It showcases how we believe individual security recommendations may be used within the context of a client portfolio. The Model also provides a basis with which to measure the quality of our advice and the effectiveness of our disciplined investment strategy. Trades are made using the closing price on the day a change is announced. Performance figures do not include any allowance for fees. Past performance is not indicative of future performance.
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