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Strategy notes – June 1, 2019

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If, as and when there is a North American recession, how bad could it be? 

 Stock market outlook – introduction 

Our last Strategy Note dated May 15 endeavoured to interpret some macro conclusions arising out of our recent company interviews. We referred to indications from Canadian Tire’s customer base and from our discussions with bank managements that Canadian consumers as well as business customers were not yet showing behaviours that are typical at the early stages of a recession. That is not to say that we should totally rule out the possibility of a North American recession starting sometime this year. However, our conclusion was that the odds of recession had been lowered in the shorter term. 

 To quote from those same Notes: “Clearly, however, there are some significant downside risks on the geopolitical front currently: in particular, a continuing trade war with China, Brexit at the end of October and the Middle East – particularly in U.S. dealings with Iran. However, on the economic front, three months ago we thought that the risks of a recession within the year were about 50/50. That is still possible but, if we had to put odds on it now, we would reduce them to 20/80. Markets have recovered strongly – both globally and in North America – from the Boxing Day lows but they are not cheap. As we have frequently pointed out the U.S. market is particularly expensive using the Shiller P/E ratio, which is currently at 30.2 times. That is the third most expensive in the last 140 years – exceeded only in 1929 and 2000. 

 The TSX on the other hand is selling roughly at its 10-year average multiple on a P/E, P/CF and P/BV basis and modestly above those three metrics on a 2018 and a three-year average basis using consensus 2019 estimates. As mentioned, we stand ready to put cash to work if we develop more confidence in the global and North American economic outlook. If we had to guess as to at what point, if that did occur, that might happen, we would suggest it might be sometime in September/October when equity markets often reach their interim lows.” 

 If, as and when there is a North American recession, how bad could it be? 

As was evident in Q4 last year, investors can become very fearful very quickly about an upcoming recession. Triggered by the Fed’s apparent (at that stage in mid-December) intent to stick to its plan of steady interest rate increases and to its announced schedule of Quantitative tightening, investors quickly adopted a risk off mindset and U.S. equity markets declined almost 20% from the late September peaks. 

Leaving aside for the moment the timing of the next recession – and we will use our favoured indicators such as the Economic Cycle Research Institute’s Weekly Leading Indicators as well as the six-month growth rate of real M1 for the G-7 and E-7 nations to better determine the possible onset date of recession, we think it is worthwhile to contemplate how serious a North American or global recession might be when ultimately it comes. 

We are all conditioned by recent experience and we read frequent opinions in the financial press about the potential for an upcoming crash in markets. Inevitably, these articles talk in terms of the severity being similar to what happened in the Financial Crisis of 2008/2009. Investors certainly have shown themselves to be scared of a return to 2008/2009 conditions a number of times over the 10 years of this bull market. Defining a bear market as a 20% drop, we have seen three such occasions for the U.S. equity market since this bull market started (March 2009): in 2011/12, 2015/16 and Q4 2018. Those sharp pullbacks ultimately proved to be great buying opportunities. Such interim bear markets are unusual without a recession occurring. Indeed, it has only happened twice before in the last 50 years: in 1987 and in the 1998 Asian crisis. 

We think there are two reasons for this. The first is that the fears of another deep economic and financial contraction like 2008/2009 have constrained risk taking by investors for much of this long bull cycle. The second reason is that central bank engineered interest rates have encouraged a huge amount of company buybacks financed by debt – particularly in the U.S. This has been the single biggest source of demand for U.S. stocks and explains much of the current high valuation levels in that market. 

Again, without for the moment predicting the timing of the next recession in North America and globally, we suspect that it might be what might be described as a more common or garden recession: in other words, not particularly long or deep. Why would this be? Firstly, the U.S. housing market is not in nearly the same situation as in the last cycle. That saw a speculative frenzy amongst buyers who assumed that prices would never fall and became ridiculously over levered. They were aided by banks who lent indiscriminately, inflating the bubble with poor quality debt. When home prices fell, both households and banks were faced with a deflationary spiral, which took unprecedented measures by the central banks in North America and Europe to counteract. U.S. and European household balance sheets have recovered significantly through lowered home ownership and increased use of rental units so that the deflationary threat from this sector is much reduced (unlike some smaller economies such as Australia and to a lesser extent Canada). With the U.S. and European banking sectors generally in much better shape than in the Great Recession through updated Basel II and III capital requirements for banks (the European banks are three to four years behind the U.S. banks in this respect as the double-dip recession in Europe in 2011- 2012 retarded the return to higher capital and ROE levels achieved earlier by U.S. banks). The greater relative strength of the housing and banking sectors in both major economic areas in this cycle compared to the last argues for a much milder recession when it next occurs than what happened in 2008/2009.  

Much has been made of the sharp increase in government debt in this cycle. This is undeniable but if the next recession is more of the common or garden variety, there will be less of a requirement for the exaggerated effort to use fiscal policy to inflate demand that was so evident in the last recession. Also, consumer prices in the global economy have been creeping higher. Excess slack in the global economy has also largely dissipated and the major economies are closer to full employment. Thus, the need to combat deflationary fears through extreme monetary or fiscal measures should be much diminished come the next recession. Finally, although our call last October/November was for lower not higher long term interest rates, we stated that the next recession in North America would see cyclical lows in long rates but thereafter we were likely to see the start of a secular bear market in long bonds with U.S. 10-year treasury yields bottoming on a cyclical basis higher than the secular double bottom of 10-year Treasury yields experienced in 2012 (1.42%) and in 2016 (1.37%). 

As we have commented before, the deleveraging process in North America, Europe and Japan has been long and drawn out with consequently much less than previous rates of economic growth in this “recovery” cycle. However, if that process is largely at an end and the next recession is relative short and shallow compared to 2008/2009, then the GDP growth recovery in the next cycle should be more robust. This will be to the benefit of those sectors that are helped by stronger growth and higher inflation and interest rates. It could also well mark the transformation to value stocks outperforming growth stocks – the opposite of the last 10 years. 

As to the timing of the next recession, there are no clear signs of an imminent downturn in those two main indicators we follow: namely, the ECRI Weekly Leading Indicators and real six month M1 growth for the G7 and E7 countries. In fact, Lakshman Acuthan, head of ECRI, was quoted on May 30 as saying: “I don’t think there is a recession imminent but there’s also no clear sign – at least in the U.S. – of a strong revival ahead.”

In addition, the ECRI’s U.S. Future Inflation Gauge suggests the inflation cycle downturn is still fully in effect which augurs for continued downward pressure on long term bond yields and an ongoing desire on the part of investors to own quality dividend growth stocks such as we hold in our Infrastructure portfolio. 

Portfolio changes 

There were no portfolio changes in the last week. 

Nick Majendie 
Director, Wealth Management
Senior Portfolio Manager