360 Private Wealth Management: 2021 Q3 Investment Commentary
Keep your eye on the Punch Bowls…
Market returns were pretty flat in the third quarter. Year to date, though, most major global equity market indexes are up. The Canadian equity market, represented by the S&P/TSX Index, led the way through the end of the third quarter with a YTD price return of 15.1% (CAD). It was closely followed by the U.S. and Europe, with the S&P 500 Index and MSCI Europe Index returning 14.7% (USD) and 14.0% (USD), respectively. Emerging markets, however, have struggled, represented by the MSCI Emerging Market Index with a return of -3.0% (USD).
Certain factors, including the COVID-19 Delta variant, seemed to weigh on investors over the summer. Here in Canada, the combination of higher vaccination rates and additional health safety measures seem to be flattening this latest wave in all but the least vaccinated areas of the country. Hopefully, this can make the newest chapter of the COVID pandemic less of a factor going forward. However, concerns about breakthrough COVID infections and waning vaccine efficacy over time continue to keep COVID a central theme in life and investing. We are on the cusp of winter and more indoor gatherings. Public health professionals are saying it's not time to put the masks away just yet.
Aside from COVID concerns, other factors weighing on markets are the ongoing shortage of microchips, the supply chain squeeze, and the ongoing labour shortage dogging many companies.
Micro-chips are found in a high percentage of consumer goods, from cell phones to vehicles. Many companies are scaling back production because of ongoing chip shortages. Chip manufacturers dialed back production in the spring and summer of 2020 only to be caught flat-footed by the rebound in consumer demand as 2020 unfolded. The problem got worse in the first half of 2021. Most analysts expect the issue to persist at least through the end of this year if consumer demand for goods requiring micro-chips continues at the current pace. Tesla, a manufacturer who has fared reasonably well in the face of the shortage (largely because of its ability to pivot its chip requirements), is now planning to bring its chip manufacturing in-house. That said, even Tesla, as nimble as it appears to be, is looking at least a couple of years to make that a reality.
Ports around the world are dealing with transportation bottlenecks, and manufacturers are dealing with container shortages. What was, as late as the fall of 2019, an apparent glut of shipping containers, has now become a critical shortage. Containers were being sold at ridiculously low prices for many years and repurposed as storage rental units or even welded together and turned into housing. That situation has entirely reversed because the turnaround time on getting containers back to manufacturers and other exporters is being pushed out because of a lack of port handling facilities and truck drivers to move containers to the containers' ultimate destination. It is an apparent perfect storm for manufacturers trying to get their goods to market.
Port facilities and ground transportation companies are only two areas facing workforce shortages throughout the world economy. From restaurants and retail to healthcare, trades, tech, and transportation, "Help Wanted" ads are everywhere. There is a shortage of skilled help in almost all areas of the world's larger economies, and the shortage is forcing businesses large and small to cut output.
I have become a big fan of chaos theory and systems thinking as I sort through seemingly endless data points that flow across my desk every day. The Butterfly Effect is a real phenomenon. The Butterfly Effect suggests that the mere flapping of a butterfly's wings in say, Brazil can contribute to some future weather event here in North America. A stretch? Maybe? But the theory might well be true. When politicians, bureaucrats, and central bankers pull fiscal levers, the intended consequences often come with parallel and often, unknown, unintended consequences. This makes it very hard to stay in the "sweet spot" of growth for economies. On the contrary. It seems we are experiencing increasingly more severe surges and retractions in economic activity and business fortunes driven by short-term thinking and more recently, the psychology of the now COVID cash-flush crowd as they flip from depressed to euphoric, from fear to greed and back again. Throw in climate change and maybe the impact of a demographic age wave, and things can and will get messy…
Oil prices are surging, and oil companies can't get wells uncapped and new drills into the ground fast enough. From near-zero new drilling activity in the spring and summer of 2020, Western Canadian drilling activity has rebounded substantially. Does this mean that oil and natural gas are redeemed as energy sources? No, not likely in the longer term. Economies are in energy transition mode. Like most other transitions though, nothing happens smoothly. There are jerks and stops and surges. Transitions are messy affairs. The drought this summer in Western Canada affected water flows here in Manitoba, forcing Manitoba Hydro to cut back energy export sales. This will increase the need for carbon-based fuels to generate electricity for hydro customers to whom Manitoba Hydro would otherwise supply electricity. Increased electricity usage where electricity is generated by coal and gas-fired generation plants contributes to higher carbon fuel pricing. Systems thinking in action…
Fiscal and Monetary Policy Challenges
Interest rates have been declining now for more than 30 years. It would have been pretty reasonable to assume that we might have seen rates starting to move higher last year based on how things were looking already at the start of 2020. Then COVID struck… Central banks around the world eased interest rates even further and started buying bonds in the open market to create additional liquidity in economies. Governments layered on liquidity in reaction to the effects of lockdowns using a fire hose approach, pouring cash out into the larger economy without considering the ultimate impact. In their defense, they likely did not have much choice about how to do it, mainly because collectively, "we didn't know what we didn't know" about the disease and the ultimate impact on citizens' lives and their economic well-being. Many people's lives were being dramatically affected on so many levels. Governments and central bankers had to act. Did they overreact? Maybe and when we look back a few years from now, likely yes.
There will be a lot of data and material for economists to chew on coming out of this pandemic. They will be mostly wrong again in their collective analysis and recommendations for the future. The reason is that economists try to take the past and project how things will act and react to various economic stimuli in the future without completely understanding how small, seemingly minute factors can upset assumptions. That's why, as I "mature" in this business, I have less and less respect for traditional economics. Economic reports and projections are just another source of "noise", it seems. The track record of investment company economists has been downright abysmal. I have come to be far more practical in my approach to building and managing household portfolio wealth including my own, choosing simplicity and resilience over the complexity and fragility which comes from the search for outsized returns.
Government spending exploded to cushion the economic shock caused by lockdowns, shutdowns, and the resultant drop in economic activity worldwide. As a result, government debt in many countries has mushroomed to levels not seen since the end of the Second World War. As economies reopened and economic activity surged, the need for massive government safety-net spending has diminished. However, notably here in North America, there is a push to fix physical and human infrastructure and move things in a more socially progressive direction as we emerge from the COVID economic chill! Doing so comes with a BIG price tag if you are trying to do it all at once! In the U.S. they are wrestling with significant infrastructure spending initiatives and more progressive social programs for families and individuals. Here in Canada, we are debating broad-based childcare programs and other social initiatives. All will require significant expenditures and sustained deficits to accomplish, adding to the already ballooning debt. The bigger the debt, the less control, and choice we and future generations will have to react to unforeseen economic and social challenges.
Higher taxes for large swaths of the electorate are very likely. It will be sold as targeted at the "rich", a sort of "wealth tax". Expect things like the capital gains inclusion rate (presently 50% of a gross gain) to be increasing, effectively increasing taxes for many small business owners and investors in the process. Policymakers and politicians will shrug and call it collateral damage in the bigger picture, but the impacts will be significant to savers and investors. Not all small business owners and investors are wealthy…
Inflation
Central bankers and monetary policymakers are watching inflation trends with a very keen and fearful eye. At first, the surge in inflation was attributed to the unexpected resurgence in economic activity when vaccines were released, and economies opened up. They saw the primary driver of inflation as the producers' and manufacturers' inability to ramp up their production fast enough to offset surging demand. The feeling was that demand and supply gaps would narrow, and prices would steady. There seems to be some concern now emerging that the sources of the inflation we are seeing maybe more structural (read that "sustained!") in nature and may not dissipate as quickly as first thought.
This will likely drive central bankers to start turning the monetary tap down sooner and more forcefully than might have been the case otherwise. Look for their liquidity levers (central banks buying bonds in the open market and low central bank interest rates) to get pulled back starting later this year and accelerating in the first half of next year.
The result could be the next "taper tantrum" like the one in the last quarter of 2013 when bond prices declined, and interest rates rose sharply. This will have a negative psychological effect on equity assets, particularly in growth stocks which have driven equity indexes higher over the last couple of years. The second casualty in such an atmosphere will be real estate prices. Watch the residential real estate market, particularly here in Canada. Rising rates could finally put a pin in the bubble that has been building there…
Watch out for the dreaded "Stagflation!
The post-COVID recovery in China appears to be losing steam. There may be several reasons for this, including what seems to be a concerted effort by the centralized communist government and policymakers to cool the entrepreneurial zeal sweeping the country, targeting the fortunes of the business elite in the country. People in all walks of life are worried about getting in the sights of local communist party officials. Jails are not great places to spend time in China. Ask the "Two Michaels"…
There are now signs of slowing economic recovery in Western economies as well. At least some of this can be linked to the previously discussed supply chain bottlenecks and to the computer chip and labour shortages. The latter situation is particularly notable. You need people to make things and provide services. A shortage of skilled people can seriously curtail an economy's ability to generate activity and collective wealth.
A phenomenon I have been revisiting for a while now is the demographic age wave that was made famous by demographers like Ken and Maddy Dychtwald and U of T professor and author David Foot some twenty 20+ years back. "Baby Boomers" are well into transitioning into retirement in one fashion or another. The "Echos" (the Gen-X and Millennial cohorts; the children of Bay Boomers) do not makeup enough of a population wave to take up all the jobs left behind by the retiring Boomers. This is creating a gap between available employees and the number of positions that require filling as Boomers leave the workforce. There is a lack of people to step in and fill the void and, of those available, there is a lack of skills and training.
In short, countries around the world have a productivity problem; a lack of people to fill jobs. This will trigger "wage-push" inflation when people demand more pay and prices go up to cover the higher wages paid to manufacture goods and provide services. In economics, scarcity (lack of qualified employees) causes prices (wages) to go up. These prices have to be passed along in the form of higher goods and services prices.
It has been determined that countries need a fertility rate (number of children born per woman) of 2 children per "family unit" to keep the population stable unless a country actively seeks immigrants to make up for a lower rate. A quick Google search will show that the birth rates of many developed economies have now dropped below that level. Even China has slipped below 2 children per family unit, largely because of the overly successful one-child policy brought in to curb population growth there, along with improving conditions for women in the country. It has gotten serious enough that the country is now denouncing the one-child policy and is now urging families to have more children. Chaos theory and systems thinking in action, again. Parallel consequences, intended and unintended…
The birth rate implosion that is unfolding in developed and developing countries is likely a key driver of the increasing push into artificial intelligence (A.I.) productivity solutions. Think about how robotics has transformed and increased productivity in manufacturing and you will see where we might be heading with A.I.
Environmentalists say we need to stabilize and even shrink the world population to take the pressure off the planet's ecosystems. This does make sense unless one of us must go into a hospital where there is a shortage of doctors, nurses, and staff to attend to our needs. Then such a policy will have long-term unintended consequences unless we can figure out solutions. This is an example of the consequences in health care. Think about all the other parts of the economy and society, and it's easy to see we have a problem.
"Stagflation" was an economic phenomenon that emerged in the 1970s. Back then, it was a combination of high inflation, slowing economic growth, and resulting in high unemployment. Stagflation might look different this time. The elements and outcomes might be reversed. This time around, it might well be caused by a low unemployment rate caused by a lack of workers, which will lead to lower overall economic output and an output-demand gap which will lead to higher inflation from increasing wage demands from the workers available. If you look around carefully, it's already happening.
Now about those two punch bowls…
Oh yes. About those two punch bowls… Let's pretend we attend a party. At the party, the hosts put out a punch bowl for their guests and maybe add a little rum to the recipe to loosen everyone up a bit and create a more fun atmosphere for the guests. If the party gets a bit out of hand (too much punch is consumed by the guests!), the hosts might take the punch bowl away (or at the very least, not wanting to be seen as poor hosts, dial back the rum content!).
Let's take that analogy and apply it to what we have been experiencing over the last 18+ months and counting. To counter the effects of the COVID lockdowns and business shutdowns, governments around the world turned on the fiscal firehose. At the same time, central banks worldwide started buying bonds and lowering interest rates to keep the financial systems "lubricated". Government fiscal policy was one punch bowl. Central bank policy was the other. The punch was consumed by a very large swath of citizens and companies, driving the formation of what many might see as excesses (i.e. equity market valuations and Canadian residential real estate prices). Now, the proverbial party is getting a bit "long in the tooth". COVID-19, at least for the time being in highly-vaccinated countries like Canada, seems to be abating (we only hope it will continue to do so!). It's time for everyone to go back to work. It's time to dial back the amount of rum in the punch and, even take the bowls away.
What remains to be seen here is how the collective "crowd" (businesses and citizens) will react. What happens when government COVID support finally ends? Will workers still on the sidelines return to the work they did pre-COVID, or have they pivoted and gone in a different employment direction? Will companies be able to stand on their own two feet and grow again or will some of them succumb to poor business prospects or staffing issues? What about all the cash that is out there? Not all of it was used to pay rent and buy groceries. How much of that cash found its way into the stock market? What happens if that source of cash dries up?
What about when central bankers start "tapering" their bond-buying in the open market? Less demand for the bonds out there will cause bond prices to drop, which will have the effect of raising interest rates. Remember the bond price-interest rate teeter-totter; as bonds rise or fall, the associated interest rate will do the opposite! Central bankers also manipulate interest rates by changing overnight interest rates and bank reserve requirements. The effects of all these activities used to control economic activity and inflation will increase interest rates charged by banks to borrowers. After 30 years of steadily declining interest rates and rising asset prices (i.e. real estate), we may well be at the bottom of the rate valley and a rate hill may well lie just ahead. How will asset prices be affected? If history is a guide, there will be "volatility" and the likelihood of downward price pressure on some assets. If it came to pass, it would not be the first time a house sells for less in the future than was paid for it. One has to look back to 1989 in Canada for evidence that this can happen. Our American cousins had it happen much more recently, in 2008-2009. The problem is that many first-time Canadian buyers this time around were in elementary school or not even born when it last happened here. Canadian real estate prices suffered nary a twitch in the U.S. housing crisis in' 08-09. If rising rates trigger a correction in residential real estate here in Canada, how will homeowners, both buyers, and sellers, react? I hope my realtor clients saved some of the commissions from the last 20+ years. That said, if things get ugly, price-wise, there may be a flood of sellers seeking the services of a realtor. So they might be OK after all… unless of course A.I. and web-based solutions supplant realtors in the declining price marketplace. There's that chaos theory and systems thinking again!
We are here to help guide you and your family
Dizzy yet? We went pretty deep here. I needed to. This is important stuff. We are heading into territory that countries and economies haven't seen in a long, long time. The confluence of the pandemic and the high levels of debt incurred by governments is colliding with climate change and supply change disruption. Demographics are impacting productivity. Inflation is again a headline item. And, interest rates in all likelihood, are about to start rising. Households will need some good navigation skills when it comes to financial and investment decisions in the coming months and years as the terrain and water levels change.
Of course, you can process all the data and make good choices, given enough interest and time. The vast majority of you have the intellect and financial smarts to chart and steer a course. That said, do you have the interest and time to consume and process the information needed to make good decisions? Your work, family, and lifestyle activities might suffer. Get distracted and take your eye off the map and surroundings too long and like a Lake of the Woods sailor you could end up on a reef!
Paying attention is what we do here at 360 Private Wealth Management, day in and day out for our client households. Our clients are the captains of their ship, we are the navigators and, the financial and investment tool quartermasters. Our job is to help you provision your financial ship with the right products and services and navigate life's waters safely and efficiently. That is how we earn our keep.
Do you have questions? We have answers and, if we don't, we know where to find them. There are lots of things to consider for you, your family and, if applicable, your business as things unfold. Let us know where you need help and direction, and we will do our best to deliver the advice, tools, and service you need to reach your destination, your Vision.
Kindest Wishes,
David J. Luke, CFP, RFP, CLU, CH.F.C., CIM | Financial Advisor
360 Private Wealth Management | Manulife Wealth Inc.
Unit 1 – 25 Scurfield Boulevard, Winnipeg, MB R3Y 1G4
Main Office 204.925.5868 | Direct 204.925.2073| Fax 204.925.2263 | Toll Free 844.688.3656
Email david.luke@manulifesecurities.ca
This publication is solely the work of David Luke for the private information of his clients. Although the author is a Manulife Wealth Inc. Advisor, he is not a financial analyst at Manulife Wealth Inc. (“Manulife Wealth Inc.”). This is not an official publication of Manulife Wealth Inc.. The views, opinions, and recommendations are those of the author alone and they may not necessarily be those of Manulife Wealth Inc.. This publication is not an offer to sell or a solicitation of an offer to buy any securities. This publication is not meant to provide legal, accounting, or account advice. As each situation is different, you should seek advice based on your specific circumstances. Please call to arrange for an appointment. The information contained herein was obtained from sources believed to be reliable; however, no representation or warranty, express or implied, is made by the writer, Manulife Wealth Inc., or any other person as to its accuracy, completeness, or correctness.