Stocks have staged an impressive rally this year, thanks to a stimulative shift in monetary policy. From its low last December, the Canadian S&P/TSX Total Return Index has appreciated roughly 25%. The broadly based U.S. S&P 500 Total Return Index is up a similar amount, in Canadian dollar terms.
While North American stocks are near all-time highs, they are not as high as you might think. Much of this year’s rally has merely recouped losses from the latter part of last year. Stocks had a horrible fourth quarter in 2018, as investors started to worry that the U.S. Federal Reserve and other central banks would kill the economic expansion by raising interest rates too much. The major North America stock benchmarks experienced peak-to-trough declines of roughly 15% in the fourth quarter of 2018, and bottomed on Christmas Eve.
Investors have grown accustomed to central banks coming to their rescue, and so far they haven’t been disappointed. The U.S. Federal Reserve signalled early in the year that they would shift back to monetary accommodation. They lowered interest rates in July and September, and further reductions are expected. The world’s other major central banks have also transitioned to more stimulative policies, lowering interest rates and stepping up bond-buying programs. The Bank of Japan is even buying stocks to help stimulate their economy.
The worldwide shift in monetary policy has fuelled a significant drop in global interest rates. In fact, interest rates are negative in a number of countries.
In the near term, the meaningful decline in interest rates will likely provide the necessary economic adrenaline to keep the world economy on a muddle-through, growth path and stocks will probably continue to do well against that backdrop. As President Trump gears up for re-election, some resolution on the U.S./China trade war could also brighten the near-term economic outlook and buoy stocks even further.
Nonetheless, we are worried about the medium-term consequences of overly stimulative monetary policies and ultra-low interest rates. In particular, we are concerned about the build-up of debt in the world, and the seeming lack of a long-term plan – by central banks and governments alike – to move the world toward a healthier state.
Increased government debt and deficits, and extremely accommodative monetary policies (ultra-low interest rates), were absolutely necessary to stabilize the banking system and global economy during the 2008/2009 Financial Crisis. However, we believe authorities have over-used these stimulative policy levers during the recovery and have failed to learn from the past.
The Financial Crisis was caused by excessive debt and a poorly regulated and undercapitalized banking system. Since then, we have learned some important lessons about the banking system. The risk of a banking crisis has been reduced considerably, because regulation is now much tougher and these institutions are very well capitalized. Unfortunately, we have learned very little about the consequences of too much debt. The world has increased leverage significantly since 2008/2009.
The U.S. consumer is in much better shape financially, but government and corporations have increased leverage considerably.
Debt is one of the major factors contributing to slower economic growth. Demographics (a slower growing, working age population) and divisiveness (caused by growing income inequality) are the other significant factors that have restrained the pace of the economic recovery this cycle.
Debt is not bad per se, but too much debt can be deflationary, as debt used for excessive consumption today reduces society’s capacity to consume in the future. Ever since the Financial Crisis, central banks have endeavoured to keep deflationary forces at bay and stimulate economic growth by encouraging debt accumulation via ultra-low interest rates. But, if excessive debt is deflationary, and one of the major factors that is hampering global growth, aren’t we treating the patient with medicine that will ultimately make the patient sicker? We think so.
With US$17 trillion of global debt trading with negative yields and interest rates on the rest of the world’s debt otherwise extremely low, the central banks will have less ability to stimulate economic growth by lowering interest rates during the next inevitable economic downturn. As such, the authorities will likely have to rely on bigger government deficits, and turn to money printing to finance the larger deficits. Unfortunately, doing so will likely be controversial and challenging. As such, the recovery following the next global slowdown/recession could be weak and weigh heavily on investor sentiment.
Governments have expanded deficits and increased debt during the good times, and as a result, they will enter the next downturn in a weaker condition. Deficits naturally increase during downturns, as tax revenues decline and spending on social entitlements increase (i.e. unemployment insurance). In addition to these natural cyclical pressures, there is ongoing secular pressure on government finances due to the rising cost of providing entitlements to an aging population. Consequently, we believe governments will struggle to justify and finance discretionary deficits when the economy needs them most. If governments weren’t spending the rainy day funds during the good times, they would be in a better position.
Not only have ultra-low interest rates fueled an undesirable increase in global debt, but there are other very troubling consequences as well. Low interest rates have exacerbated income inequality, as the wealthy disproportionately own the assets that have risen in price as interest rates have fallen. Income inequality, in turn, is fueling social unrest and polarized politics. The situation is not likely to get better if ultra-low interest rates continue to drive asset prices higher. This is another important consideration, as social unrest increases the risk of policy mistakes.
Given that we see the world heading towards a challenging juncture in the medium term, we believe a more conservative balance between stocks and fixed income is warranted. There isn’t a universal asset mix that is appropriate for everyone, as investors’ goals, risk tolerance, time horizon and tax considerations vary considerably. For example, if you were comfortable with a 70/30 mix of stocks and bonds, you might want to consider shifting to 60/40.
Despite our medium-term concerns and regardless of the state of the economic environment, good businesses will continue to survive and thrive. Owning pieces of these businesses will remain a key pillar of preserving and growing wealth. In the long run, we have faith in the human race’s ability to leverage science and technology to improve our collective standard of living. Things that aren’t sustainable won’t be sustained. We believe adjustments will be made along the way, and that the world will ultimately find a sustainable path forward.
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