David's Weekly - July 2-8, 2022

The Big Picture: The Fog of War and the Fog of Markets

The above phrase, from the German “Nebel des Krieges”, is the uncertainty in situational awareness experienced by participants in military operations.?(It’s also the title to a brilliant, TIFF award-winning film by Errol Morris.) In that context, the “Fog of Markets” aptly describes how investors can feel even when experts struggle to get things right.?In the last couple of years, pundits have mispredicted everything from disease control, stock market returns, the impact of globally-interconnected supply chains, to inflation.

The Fog of Trading, 1970 New York Stock Exchange

The Fog and uncertainty will come and go.?So, this week’s theme is the importance of focusing on what we can control and recognizing what we can’t control.

We’ve witnessed an absolutely stunning and difficult-to-predict string of events since January of 2020.?And, the story is not over. COVID was unexpectedly brutal on the health front, but also had a massive, unexpected impact on the markets.?With rates dialed to zilch across the world, markets that were initially thought to be doomed eventually careened opposite lock, going parabolic to the upside.

Then, with AMZN, GOOG, and other lesser tech stocks seemingly on the way to the moon, and discussion of “supply chain” becoming almost yesterday’s news, we started to see inflation.?Serious inflation.?With central banks now cranking rates higher at an unprecedented pace, the market has responded, and we have now given up much of the stock market gains.?In fact, the consensus, at least at RBC is that we will see at least a “mild” recession.?Of course, that is prediction, while we focus on planning.

When it came to Ukraine, covered below, again we saw The Fog of War.?What began with a common international belief that Putin “wouldn’t do it”, a sentiment which played into his hands, Putin himself was caught in the fog and launched a giant failing attempt to capture the whole of Ukraine, only to settle for lesser goals.?We know the story since then and we’ll cover a few details just below.

With that intro, in this week’s letter, we'll start off with a quick update on the situation in Ukraine. We'll then touch on this week's theme of our approach to wealth management which is a case study in adding value by controlling what you can, and recognizing what you can't. We'll then examine how a sell off in commodities might start to nip inflation in the bud, ahead of rate increases. The relative attractiveness of the stock and bond markets will then be reviewed, just to get an idea of where things stand. Spoiler alert – things are looking a lot more attractive than they did a few months ago.? We'll wrap up with this weeks Global Insight Weekly, courtesy of the Portfolio Advisory Group of RBC Dominion Securities.

Ukraine - Slipping in the Headlines While Still Hugely Impacting The World

The horror has slipped into background noise in the media but not for those very unfortunate thousands killed and maimed and millions displaced - some to new countries, some forcibly to Russia.?Summarily, the Ukrainians are outgunned massively but have the moral basis and motivation to fight.?The human toll on both sides is enormous and continuing.

What’s changing recently in terms of support for Ukraine are the delivery of shore-protecting anti-ship missiles, Norwegian anti-missile defense systems, long-range multiple rocket launchers that can hit behind enemy lines, and additional long-range artillery.?One issue is the depletion of soviet-era arms that form the bulk of Ukrainian defenses. Weapons systems and ammo are running short in Ukraine, but as pointed out at defenddemocracy.org, there are a number of Non-NATO countries that could theoretically supply additional Soviet-era weaponry as a stop-gap while Ukraine gradually moves over to NATO-based systems. The list of 23 countries that might help is shown below.

Source: Foundation for Defense of Democracies, July 2022

There is also considerable unity amongst the allies.?It also appears that Russia, according to Putin, needs to take a breather, possibly giving Ukraine a chance to counter-attack.?Another positive aspect of the war, in general, is Putin’s one redeeming quality, and that is that he is mortal.

On the negative, Russian Security Council Secretary Nikolai Patrushev has restated Russia’s maximalist goals of protecting civilians from “genocide” and “denazifying” and demilitarizing Ukraine.?That is, they still want the whole country and plan to keep trying to capture it.

Successful Wealth Management - Focusing on What We Can Control

With the tremendous uncertainty we’ve experienced recently, it’s important to remember what we can and cannot do.?We simply cannot predict the economy, the markets, pandemics or wars with any accuracy and consistency. However, one needn't successfully predict which stocks or funds will outperform, or which markets will rise and fall for successful, long-term investing and planning. Our approach to managing money for our clients includes setting a proper strategic asset allocation based on understanding our clients' needs and goals, properly diversifying portfolios, because we don't know which sectors and geographies will perform best, and rebalancing as allocations within a portfolio as they under and outperform.

As we’ve covered many times, with the typical over-focus on market returns amongst investors and advisors, we feel that it makes more sense to put our energy towards helping clients by leveraging the factors that we CAN control.?The figure below highlights this approach. On the left are the things that most people care about such as retirement goals, planning a business succession or protecting one's family.?On the right, we consider all of the strategies and factors we can control and use to achieve what matters including working on spending, saving, tax planning and risk reduction.?The overlap of the things that matter and the things we can control is our primary focus as advisors. Only when the plan is in place do we select and a manage a portfolio of assets that are in our clients' best interests and not driven by the desire for generating revenues for our practices.

Source: David Crotin, RBC Dominion Securities, July 2022

The Markets and Economy – This week’s fun charts

Signs of inflation ebbing – the prices of stuff we need have really come down recently

Commodities (things like oil, gas, corn, pork bellies – did anyone see Trading Places?), are things we need to own to make stuff.?They trade on futures markets to provide ways for companies to hedge their needs for the inputs required in their own businesses.

With calls for a recession, we are seeing some significant retrenching in commodity price gains.?Here’s some recent fogginess in prediction:?Citibank on June 5 predicted Q2 Brent oil prices would hit $113 per barrel.?Just yesterday, 4 weeks later, they called for $65 oil. Talk about not knowing what's going to happen next!

As you can see in the first chart below, the last month has seen huge changes in prices for most commodities.?Again, this is happening because of fear of recession.?So, just the fear of recession on its own has caused inflation-sensitive things like commodities to sell off, thereby reducing inflation.?It’s the tail wagging the dog. Looking at the chart below, we can see many commodities such as copper, tin, iron ore and nickel, key ingredients in many electronics, manufacturing and construction businesses, sell off by 20% or more in just the last month.

Source: BMO Nesbitt Burns Capital Markets

Have a look at the next chart below which shows that the price of oil has now returned nearly to the price pre-Ukraine war, even though we are not producing more oil.?Demand destruction is expected because of recession fears.?I’m sure some readers have already noticed prices at the pump have come off from about $2.50/liter down to about $2.20 in a very short time.?That’s more than a 10% price drop. Let’s hope it’s just the beginning, but plan for things to stay tough.

Bonds and Stocks – the bread and butter of our portfolios

(Mmm.?Yummy).

Let’s call the bonds the bread because most people find they are a bit bland to talk about.

We’ve regularly discussed how bond markets have become much more attractive to the extent that returns for investment-grade corporate bonds, especially in taxable accounts, are approaching the 4-6% range.?They lack the unlimited upside and inflation protection of equities but are helpful both as portfolio ballast and safe, income-generating options for retirees.?One can now whip up a nice stew of investment-grade bonds over a 2-3 year period and season with a selection of GICs returning north of 4%, and, voila, Bond Bourguignon for your portfolio.

To give you a better picture of how things have changed, have a look at the chart below which shows the yield to maturity of bonds in July of 2021 (blue), July of 2022 (black), and the last 20 years' average (tan).?Have a look at the corporates (third from the left).?That’s your roughly 5% bond return.?High Yield Bonds – which are much riskier, and were returning only 2.5% just a few months ago, are now hitting close to 9%.?(See the second graph from the right.)?Those that were chasing the last bit of yield when rates were zilch through purchases of high-yield bonds are now licking their wounds.?This is why we PLAN to be safe and back off on risky investments when people are clamoring for them.?It’s also why we rebalance portfolios as some assets grow beyond their allocation targets.?Certainly, high yield bonds can be a part of a balanced portfolio but when prices run-up, the plan is to ring the register, not add more.

As our old friend, Dennis Gartman used to say, “When they’re crying, you should be buying.?When they’re yelling, you should be selling.”

Let’s talk Butter (Stocks)

Ok, let’s have a look at how attractive stocks are today, through the lens of our domestic index, the TSX Composite.

The chart below graphs the forward P/E of the index.?P/E, or, price-earnings ratio is just the price of the stock divided by the total dividends for the year.?In this case, this is a future estimate (i.e. prediction).?The index itself is based on the value of a basket of the largest publicly traded stocks in Canada including stocks like Royal Bank, Enbridge, TC Energy (TRP), and another 250 or so stocks.?(I won’t bother explaining how they come up with the actual value of the index but can tell you that trading this index for the firm and for institutional clients while on the desk at RBC Dominion Securities in the late 90s was a lot of fun).

The horizontal dotted line on the chart shows the 1 standard deviation line above and below the average P/E over the last 20 years as indicated by the solid middle line.?The P/E ratio would be expected to be in the range of +/- 1 standard deviation 2/3 of the time.?The last 1/3 are what we call fat tails – unusual events shown by more extreme movements.

With an average forward P/E of 15X, we can see that we are now well below range, indicating that, by this measure, Canada is cheap.?Whereas in 2020, we can see that it shot above the range, making it expensive.?And, as we often see in the stock market, extreme moves are usually followed at some point by a reversion to the mean.

There are risks though.?If earnings forecasts are still too optimistic, then the P/E ratio should actually be higher, closer to the median, indicating, we’re paying retail, not wholesale prices.

Source: RBC Dominion Securities

To summarize today's letter, we don't know what is going to happen next, but in the longer-term, the ups and downs in the market have tended to play out to the positive. But in the end, we need to focus on what we can control through careful planning using the things we can influence and working around the ones we can't.

Finally, we’d like to wrap up this week’s Global Insight Weekly.

Mixed signals on U.S. recession risks

The risks of a U.S. recession appear to be rising. For equity market performance, the more important consideration is the degree to which the market has already factored in these risks. We weigh the data from several indicators and discuss why there’s no “one-size-fits-all” market response to recessions.

Regional developments: Canadian economy forecast to be in a moderate contraction in 2023; U.S. banks, Energy stocks may offer market clues; Energy crisis in the EU, political crisis in the UK; U.S. reviewing tariffs on Chinese imports

Please take some time to review the Global Insight Weekly.

If you’d like to meet to obtain a second opinion on your situation, please get in touch.?I’ll bring the coffee.

Thanks for reading and have a great weekend,

David