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Market Update - Increasing Greed Amid Recovery

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The equity markets in most developed nations continue their upward march this year. Year to date, the TSX is up <green>+23.15%<green> while the S&P500 is up <green>+23.71%<green> [1].

Economic Update

Overall, we believe the economy is recovering nicely from the depth of the pandemic last year. Consumer demand remains robust in the world’s largest economy [2]. The U.S labor market exhibits strong marks of resilience. As of October, the U.S unemployment rate fell to 4.6%, a remarkable improvement compared to the 14.8% reported in April 2020, during the height of the pandemic [3]. The Canadian labor market is likewise staging an impressive recovery, with the unemployment rate falling to 6.7% in October [4]. However, we are witnessing short term headwinds which are impacting the recovery in the near term.

For instance, as we have mentioned in our previous newsletters, renewed lockdowns and disruptions relating to the Covid-19 Delta variant continue to cause supply chain disruptions, making it difficult for supply to catch up with the resurgent demand. This shortage complication is the focus of the latest earnings call. For instance, Union Pacific, a railway firm, lowered its forecasts for traffic volumes as semiconductor shortages have led to lower car productions, in turn reducing rail shipping volume [5]. Apple, during its recent earnings call, also announced that it had lost $6bn due to chip shortage and manufacturing delays in the quarter. The company has also had to sharply cut back on its iPad production in order to allocate more components for the iPhone 13 [6].

The natural effect of a supply shortage and a robust rebound in demand is high inflation. The latest consumer-price (CPI) index from the Labor Department stood at 6.2%, the highest in more than 30 years [7]. In Canada, the inflation rate hit 4.7%, the highest in over 18 years [8]. This multi-decade high inflation is translating into higher input costs for businesses, many of whom passed the cost on to consumers. This in turn is affecting the consumer purchasing power, as wages have not risen as fast as inflation, which of course, translates into lower living standards [9].

Central Bank & Fiscal Policies

Furthermore, expiration of the fiscal support that was implemented during the peak of the pandemic is also slowing the recovery. The enhanced unemployment benefit and subsidies have expired in many countries including Canada and the U.S [10]. Adding to this, central banks are in the phase where they are either pulling back or considering pulling back their Quantitative Easing (QE) programs. The Bank of Canada led the pack by announcing tapering, and hinted at the possibility of raising interest rates next year [11]. The Federal Reserve also ended its aggressive pandemic-driven stimulus by agreeing to wind down its $120-billion-a-month asset-purchase program by $15 billion each in November and December, reserving the prospect of accelerating or slowing down that pace as warranted by changes in economic outlook [12].

Part of the Fed’s motivation for ending the QE program is because it wants to be in a position where it can act against inflation in case it becomes necessary to do so. However, as of now, the Fed still believes inflation does not pose a long term threat to the economy. The Federal Reserve also reiterated that it is not planning to raise interest rates anytime soon and that its tapering decisions are independent of rate setting decisions [12].

On the other hand, the highly debated and anticipated $1 trillion infrastructure package, passed November 5, out of Washington is likely to provide tailwind for the economy, offsetting some of these tightening fiscal and monetary policies. Roughly half of this amount is expected to be regularly budgeted maintenance, while the other $550 billion constitutes actual new spending, distributed over five years. From 2022 to 2026, federal infrastructure spending will rise from 0.8% of GDP to 1.3%, further cushioning the long term economic fortitude of the country [13].

GDP Slowdown

Some of the headwinds we highlighted have already shown up in the recent GDP results. America’s GDP slowed to 2% in the third quarter, a sharp decline from the 6.7% growth seen in Q2 [14]. And although we suggest taking economic forecasts with a grain of salt, it is interesting to note that global GDP estimates are also being cut in the near term. In its newest projections, the IMF cut global growth for 2021 to 5.9% from the 6% projected in July. Although this is not a sizeable cut in aggregate, the IMF does expect the advanced economies, including Germany, Japan, etc. to be more adversely impacted. These countries saw their GDP growth cut to 5.2% from 5.6% [15].

Market Conditions & Conclusions

In spite of slowing in recent months, we believe as it stands now, the economy is fundamentally sound and is moving in the right direction.

However, despite our optimism on the economy, we consider the equity markets as a whole, especially in the U.S, to be fully incorporating the upsides at current prices. Further, we see growing speculative excess in the market. Investors are highly bullish on stocks and fear missing out on any gains the market has to offer. This can be observed in a host of indicators, such as from investors moving up the risk spectrum in search for higher yields.

Investors are increasingly rotating from investment grade to junk bonds, while many are rotating out of cash and bonds and buying into stocks precisely at a time when equities are hitting all-time highs [16]. In fact, investors’ allocation to US stocks has eclipsed the level seen in the dot-com bubble and hit record highs of 52% in 2021, with some suggesting this number could go even higher [17]. This phenomenon is in part attributable to lower real returns for many asset classes due to their lofty pricing, forcing investors to move up the risk spectrum in order to obtain higher yields. However, we do not think this yield chasing strategy is prudent, and it could spell trouble if taken too far.

We also see corners of the market where investors are heavily speculating on future prospects, especially in the popular new growth industries that are the darlings of Wall Street today. We want to remind investors of the dangers of paying too high a price for speculative stocks: if you bought at the height of the dot-com bubble, before the market corrected, it would have you taken 13 years to simply break even [1]! Just to be clear, we do not believe the market is in a bubble, but we do see unreasonable valuation in some assets, and so we urge our investors be cautious.

Although we do see the market as being fully-priced, and the mood speculative, we do not know how long this might continue. We don’t try to predict when the market will turn the corner on us. However, we find it prudent to be patient with allocation of new capital in the current environment. We will only invest when we see a company trading below its long term intrinsic value.

Even if this may make us look foolish in the short run as it looks like we are not making as much money as others, we believe it is far more prudent to be able to help our clients grow assets consistently and to survive a severe correction in reasonable shape even when others suffer permanent and irreversible losses.

1 Factset November 10, 2021 Price Return – End of Trading Day