Setting Sail

A Map and Compass: The Fundamental Power of First Principles?

We extend our exploratory analogy by first considering basic cartographic equipment: a compass vs. a map. While maps appear to be the obvious front-runner with context and completion seemingly delivering an obvious affirmation, at times choosing the road less travelled is exactly what makes all the difference. The idea that something has been seen before, mapped clearly in print (or charts) before your eyes is an often valuable but at times deceiving resource. Introducing Sandy Island: Sandy Island?

Sandy Island was discovered by British explorers in the late 1800’s, joining New Caledonia off the north-eastern coast of Australia. The island dotted atlases and nautical maps for decades, however, Sandy Island differed from its counterparts in one key measure: It did not exist! Despite initially being questioned in the 1970s, a century after its discovery, Sandy Island continued to be found in print until November 2012 when it was removed from sources including National Geographic and Google Maps.?

Just because something once was, does not mean that it remains today. As we navigate challenging currents, we must keep our eye on the horizon; looking forward with clear eyes and an open mind.?

A compass can be a valuable tool for navigation because it helps you orient yourself with respect to the cardinal directions, even when visibility is poor, and the terrain is unfamiliar. While seemingly basic in the world of Waze, Google Maps, and Rome2Rio, these technologies reflect the core differentiation between directionality and distraction. While a map may serve as a core tool in any explorer’s guidebook, without the skills and knowledge to use the most fundamental resources, a changing landscape, and treacherous terrain can prove devastating.?

The same can be said with markets, as today we explain how to chart a path through untested economic waters.?

The Atlas: Failing to Plan is Planning to Fail?

Despite our reflection on the unique environment and continued challenges which herald the onset of 2023, there are lessons which can be taken and opportunities to be realized. Just as our map and compass provide affirmation of the direction forward, our guidebook defines our journey and our expectations for the path ahead.??

However, beyond forecasting, our guidebook reflects our outstanding environment, with clues defining historic head and tailwinds. Just as moving with the wind enhances speed, investing ahead of market sentiment enhances performance. If one steers perfectly with favourable winds, they arrive faster than those who were battling crosscurrents. While no portfolio manager can capture each trend, just as no captain can control the sea, we can act on what we can perceive. Economic data and technical indicators may look just as confusing as ocean currents to many, but the key is not only where to look, but how to look, for example by considering the relative impact of leading vs. lagging indicators.??

The Telescope: Keeping the Future in Focus?

Leading indicators are believed to help predict future economic activity, based on their historic causal-link or correlation to economic after-effects. While interest rate spreads, the shape of the yield curve, and consumer confidence are all considered leading indicators, equity markets should be considered one too.??

Lagging indicators on the other hand are indicators of the economy that are following changes in economic activity. They are generally used to confirm the changes that have already occurred, including GDP, employment, and inflation. While confirmation and affirmation are valuable contributors to both fundamental macroeconomic research and modelling exercises, by the time lagging indicators have confirmed trends, often the market has nearly fully priced in the trend. Opening the sails just as the wind dies will provide a subtle boost but offers little gain relative to having captured the gust from the beginning.

The below image captures some of that divergence by comparing leading (generally soft data such as surveys and sentiment) vs more lagging data (reflected in hard data of economic activity). ?

As noted in our last piece, despite being the most unilaterally expected recession in modern history, the economy’s resilience has shocked many and re-introduced hopes of a soft landing. The Atlanta Fed’s GDP forecast shown below continues to project marginal growth, only briefly projecting negative values in July 2022. While these projections are by no means definitive, here we begin to explore the key measures which have many economists scratching their heads.?

Patterns, even those considering real world data, often fail to consider edge cases and potential correlation.??

The Logbook: Plotting the Pathways of the Past?

A key tenet of strong investors is the ability to focus on what is to come rather than what has happened. Keeping focused on the horizon, while continuously taking in new information is challenging, but critical.??

One major conundrum presented by the divergence in economic data has been the hyper-resilience of the labour market in the US, but also Canada. While wage gains have begun to taper (more on this later...) the employment and jobs data from recent months largely continue to outperform expectations. Whether this is measured using the ratio of job openings relative to unemployed people, or the sheer size of payroll gains seen, the labour market remains tight, without significant signs of letting up despite Fed’s aggressive rate hikes. While politicians and economists alike have recently questioned and criticized the classical “definition” of a recession, historically continued contractions in GDP have been paired with an increase in the unemployment rate. While potentially non-requisite, the question remains, when (or if) the lagging labour market may begin to weaken?

Despite what is expressed by Jack Welch's 20-70-10 philosophy from 1980’s General Electric, layoffs are costly and not taken lightly, particularly by major corporations. Most companies will only deliver systematic reductions in employment when the outlook is bleak. Beyond the value of loyalty, layoffs are costly to both productivity and the corporate bottom line. Despite negative sentiment, many companies hold the popular view, expecting a shallow/short recession, before a return to relative stability. As such, eventually these same employers will be challenged to find (and train) new skilled labor in a relatively short period, straining productivity via onboarding and investment in human capital. Lastly, many companies stressed by the impact of inflation upon cost of goods have managed to successfully pass-on price increases, worsening consumer inflationary pressure but supporting top-line revenue growth.??

One additional wrinkle that could be at play here too is: The climate of decision-making reflects a greater social impetus. In recent years, it has become increasingly socially unacceptable to deliver sweeping rounds of layoffs despite the challenging environment. While increasing consideration towards the interests of stakeholders vs shareholders may provide long-term systemic benefits; there is an established bias towards prioritizing short-term stability in challenging times. However, after years of historic compensation and breathtaking bonuses, major financial and technology companies are moving back towards tried-and-true trends. Goldman Sachs recently announced significant reduction in its workforce joining high-growth technology companies including Amazon, Salesforce, Meta, and Netflix. As these companies lurch for the bailing-buckets.?

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The Bail-Bucket: The First Sign of a Crisis?

Despite the resistance of the lagging indicators, several leading indicators have turned. Typically, this would indicate opportunity, however with the world’s increasing focus on regional and global recessionary pressures; there seem to only be a few drops left to squeeze. When Waze first emerged, the added insight provided unseen guidance on backroad shortcuts, however once the technology spread, so too did congestion. And crowded trades work, until they don’t...?

Old habits die hard, and humanity has had a habit of living beyond their means whenever possible. When reflecting upon when we may expect the labour market to turn, Michael Kantrowitz, CFA shared the below image in their research and on his Twitter account. The chart reflecting the potential direction of economic data collapse, ironically following the acronym “HOPE”?

Given that housing has already reacted, and new orders continue to plunge – we seem to be approaching the “P” part of the visual. The part where profits are taking a hit – most likely a necessary ingredient for the employment picture to weaken significantly. Consumers are witnessing a reduced wealth effect (equity, homes, other assets) paired with declining availability of credit (costly) and an increased incentive to pay down debt given the increasing burden it represents. These decisions increasingly redirect money away from consumption, joining debt servicing costs thereby reducing spending and profits.?

The initial phase of such an adjustment is typically financed by running down corporate reserves and household savings. While corporate balance sheets largely remain well-positioned, excess household savings have fallen significantly. Savings rate in the US and Canada have turned negative, with gross savings having declined by half since the 2021 peak; relieving much of the excess COVID 19 fiscal stimulus from the system. While some cushion remains – it is fading quickly, even with inflation beginning to reduce in severity.?

The reduction in savings will likely play a role in redirecting many who had left the workforce (whether voluntarily or involuntarily) throughout the pandemic to re-join the labour force. While such an idea quickly calls to mind the images of fast-food restaurants advertising $25 hourly wages, the economy has largely evolved; primarily through the cessation of government sponsored emergency benefit programs. While in 2022, employers were forced to compete with “work-free wages”, we have returned to a more conventional supply-demand relationship.?

As such, it is more likely that young workers are going back to the labour-force, not only because wage gains have made prospects more attractive, but because they can no longer afford to go without. This further justifies the recent decline in wage growth, given the increase in labour force participation, driven by lower-paying service roles, still recovering from the residual effects of the pandemic.?

Just as a supertanker takes more time to complete their turns, so too will the US job market, however, it is clearly already underway.?

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Captain’s Log: Blue Skies ahead for the Bond Market

As we highlighted in TINA to TARA series, 2023 brings with it exceptional opportunities with blue skies ahead, after facing challenging conditions. We are still in the midst of some bad weather, but the sky is clearing out in front of us and the winds have started to settle down. While not all ships will sail with the same success, for the first time in several years, bonds appear to have a solid path in front of them, with rising yields providing a favourable current, and tailwinds seemingly outweighing headwinds, particularly also in a potential recession-driven risk-off environment. Having navigated the roaring seas of rate hikes and seemingly escaping the icy chill of inflation, the winds are clear for capture.?

While we remain aware of the risks afforded by a seemingly imminent recession, these environments, while challenging for risk assets such as equities or riskier bonds, high-quality bonds often outperform. As economic downturns limit the potential for future rate hikes while generally favouring higher quality investments such as bonds.??

While any skilled captain maintains a diverse array of navigational tools, their expertise is best reflected in election to use each effectively. While in familiar waters, a GPS or similar technology may provide an optimal balance of value and efficiency, the ability to revert to first principles with our map and compass. As we face record divergence between hard and soft data, relying on a flexible framework which combines methods to analyze indicators and emerging risks – qualitative, quantitative but also macro, top-down and bottom-up - is paramount to build a relatable roadmap to navigate crosscurrents as we sail to shore.?

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Congratulations on making it to the end - I hope that you found this piece enticing and educational... We are presented with incredible opportunities in fixed income markets to start the year. As economic data continues to evolve, so will our views, expressed jointly within this piece and within our portfolios. As the global economy moves away from a single-narrative cycle formerly dominated by COVID, Inflation, and Rate Hikes, regional opportunities continue to emerge within Fixed Income and multi-asset markets. I hope that this piece provides yourselves and your clients with insight and confidence towards the direction of fixed income markets.??

If you have any thoughts, comments, or questions - please reach out.??

All the best,??

Konstantin?