Marching Forward Through Tough Times

‍Inverted Yield Curve?

Marching into April the market has bounced off a bottom in February to give the indexes a positive return, after two straight months of negative returns. This gives a bad start to 2022 which was anchored by the Russian invasion and reduction in monetary policy from governments around the world. The last time we had two consecutive negative months was September and October of 2020. Therefore, this correction was well overdue.

Now that winter has thawed, we can begin to turn our focus to the summer months. Also, some current and upcoming events that should dictate the rest of the year.

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Review of the first quarter

While most indexes were down the S&P/TSX (The main Canadian index) was up due to a surge in oil and commodity prices which still holds a 25-30% weighting in Canada. We are a commodity-driven nation and ride or die based on their prices. While south of the border the indexes were mainly lower as their markets are more diverse and filled mostly with Technology and Services. In Canada, this growth in our major sectors pushed the number of employed people PAST OUR PRE-COVID HIGHS. As you can tell this is a major development as many travel and leisure industries are just getting up and running, therefore there is still room to improve on those numbers. In the US they are approaching their 2020 highs but are still about 3-6 months away given the current pace. Right now, the markets are indicating an upcoming slow down as they are usually about 6 months ahead of the economic picture.

The major declines in the first quarter came from the companies of the future that spent a lot of 2020 and 2021 raising money at high valuations. Investors are now realizing those new areas are still a bit of a way off. This is coupled with an environment that is expected to become more costly going forward. Both companies and consumers will start to feel the drag of rising rates and inflation as their expenses climb higher and higher.

Current State of the Market

Right now, despite the headlines in the news, everything is relatively stable. We continue to grow GDP, adding jobs, higher incomes, more efficient production levels, etc. The chance of a recession happening this year continues to be low albeit growing. As long as the economies have room to improve that investor optimism will remain. While we remain optimistic it is important to remember that it has been 14 years since the financial recession of 2008. Since the market has seen tremendous growth and going forward the growth is expected to be less and therefore returns will not be as strong as we have seen in the past say 4-5 years.

Rising inflation and interest rates are something we have not seen in a long time in combination and create more volatility in the market. It will be important to remain nimble and choose the right investments going forward.

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Below are the 5 things to watch in this market

Rates and Yields (inverting yield curve)

March brought this little indicator back on the radar. The yield curve (difference between short- and long-term treasury rates) inverted towards the end of the month. This indicator has predicted the last 8 recessions with a recession coming 6-24 months after the yield curve inverts. The last time it failed was in the 60s. This, of course, is not a guarantee and many of those times there were sectors of the market rallying prior to the recession but nonetheless, it is something to pay attention to going forward.

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Why this time might be different

This time may be a little different though because of one aspect. The current abnormally high inflation rates might make this time the exception. While the top line interest rates show an inversion of the yield curve the “real” interest rates are far from inverted. The “real” interest rate is the current rate minus inflation. Given that the short “real” rates and grossly negative, the longer-term rates are much higher than that. Therefore, this may be the scenario where this signal is wrong and in reality, the yield curve is very healthy.

Russia/Ukraine War

The top news item of the month (besides Will Smith and Chris Rock) is the Russian invasion of Ukraine. This is not only a humanitarian disaster from every aspect but also an economic disaster with Russia supplying a large amount of the energy sources to the Eastern world and Ukraine and Russia both supplying a large amount of the food sources to the Eastern World. This further disrupts supply chain issues and causes more global inflation and resources to become scarce. At this point it is difficult to see a quick and immediate reversal of what is going on, therefore that dream scenario is most likely out the window. While the war may be over any day the economic ripples effects may continue for some time after those bombs stop flying.

In terms of energy prices, countries are rallying together to find alternative sources opposed to Russia. They are getting creative pulling from national reserves and big investments into alternative energies for the future. This should pull forward that transition into green energy if there wasn’t already a huge push. This should help the green energy names that helped bring this market down.

Right now, Ukraine cities are being decimated with billions of dollars worth of damage. While on the Russian side the losses are also piling up. The estimates of Russian military deaths are anywhere between 15,000 and 20,000 as of the end of March. The chart below shows how that compares to other well-known wars and attacks/wars/invasions.

Given the high death rate of Russian soldiers, this war cannot go forever at its current pace. Russia will need eventually need to come to a resolution or face the reality of running out of troops.

Real Estate

Housing prices have seen a huge growth in the last 20+ years as they have become bloated off their two most influential factors. Money supply and interest rates, both have been going in a positive direction for a very long period.

Money Supply - When the money supply is increasing housing prices go up. In simple terms, the money supply is the amount of available money in the economy. As an example, imagine the money supply is $10 and a house is worth $2, now if the government increases the money supply to $20 those houses should be worth $4 based on the same number of houses but more money. Going forward both the US and Canada expect to be decreasing the money supply, not increasing it.

Interest Rates - Generally, as interest rates rise housing prices decrease as the cost of borrowing goes up. Going forward both the US and Canada expect to be increasing interest rates.

They are not the only factors in determining real estate prices, but they do have a big influence, therefore this is something to watch.

Global Division

Left or Right? West or East? Up or down? The division of people continues to rift and countries are protecting themselves more and more by decreasing globalization. This generally is not good for growth. These social and political views do start to deteriorate company revenue growth and profits and therefore end up affecting the stock price. It will be more important going forward to pay attention to each company's global initiatives and understand their effects. This will fluctuate depending on the division and the risk in that rift.

Earnings

At the end of the day, this is what a company's stock price comes down to, the cash flow of that company's earnings, and what someone is willing to pay for them. In February the forward PE of the SP500 fell below the 5-year average, which remained elevated since 2020 as earnings were stuck down with government shutdowns. With rising rates, we may remain below the historical average, but the increase in earnings should help keep prices near the current levels going forward. We will need to see how growth goes in the face of rising inflation/rates and global impacts.

There is room for future earnings to grow as economies come back online but we will need to see that transition and each company's ability to handle the new environment we find ourselves in.

Summary

There are reasons to be optimistic going forward but investors need to start looking at the market differently than they have since 2008. Volatility will be here for a while, that does not mean the world is falling apart but there will be greater fluctuations in the market and that will spook some investors as they flee to safer investment environments that may create lower index returns. It will be more important than ever to choose the right areas to invest and right now cash is not investable given inflation is so high, cash has created a negative return of about 3-5%. The best place to be invested until inflation subsidies are assets whether they are stocks, gold, real estate, etc.

Sincerely,

Justin, Konrad and Merriel