The economic and financial era of lower inflation and lower interest rates may be coming to an end. Given this major shift, it is important to understand that there is no quick fix for the current financial situation. This framework will then help us determine where we want to invest and what price we would like to pay. A weak stock market presents us with opportunity but given the scenario where lower interests rates are not yet on the horizon, it really matters what we buy.


It has been our shared experience for the past 40 years that central banks generally cut short term interest rates at the first sign of weak financial markets. But this time the stress in the financial system is being caused by higher-than-expected inflation. The central banker’s main tool of dropping short term interest rates and adding liquidity to the financial system would actually make inflation worse. It may take six months to a year of higher interest rates and a slower economy before inflation comes down to a more desirable level.


With an active war on inflation, a war on globalization and an actual war in Ukraine, there are few if any bright spots. But stock market investing is at all times perverse. If we are not worried about anything and the world is great, we should definitely be worried. If we are worried about everything, then that is when we are most likely to get good prices on new investments. We only get good deals when investor sentiment is uniformly negative.


A key sentiment indicator we like: the ratio of stocks trading below their respective 200 day moving average. Currently only 10% of stocks are trading above their long-term trend line. This is getting closer to a “wash-out” level. So, while the outlook for the economy is negative, everyone else knows that as well and most investors are already negative. In financial industry jargon, ‘the negative sentiment may already be in the price.’

 

 

Even though there is no quick fix, we know we cannot compound our money unless we are invested. History tells us the best time to buy is when everyone else is negative and worried about the future. Then, we will be able to buy great businesses trading at a depressed price.

 

 

 

 

The words ‘this time is different’ are often referred to as the four most fatal words in investing. What seems new and fresh may lead many to conclude that different rules should apply.

Commodities are often considered to be cyclical in nature. If demand is higher than the current supply, then the price goes up until it reaches a level where investors have incentive to drill or mine for new supply. If too much money is invested in any one commodity this results in over supply, the price drops and investment in new capacity goes away, sometimes seemingly overnight.

However, this time there is something different. Traditional energy investments in oil and natural gas were limited, in the normal way, during the price decline driven by the pandemic. Now that demand has recovered and the price of oil and natural gas has increased, we would expect that investments in new production will follow.

 

This time, the world has changed and the pressure for a low carbon economy is restricting companies from reinvesting in their business and investors are reluctant to put up money for new projects. If oil and gas executives and investors don’t have clarity on where the industry will be ten years from now, then money doesn’t get invested to meet current demand.

This is a very new situation where instead of prices rising to where new supply comes on, rather prices will rise until many people stop using the commodity. People will drive less or travel less or buy one car instead of two. While cars may be optional for some consumers, a similar scenario is happening in the food supply chain and that is a very serious concern.

In the very near term, this is a recipe for sustained higher prices in most commodities. And a Western ban of Russian commodity supplies will only make the situation worse.

 

 

 

 

To quote every young child on a long car trip, “are we there yet?” When we look at the valuation of many markets, it is much the same when we ask the question, are we in a financial bubble yet? The three biggest markets, where most wealth is stored, are residential real estate, bonds, and many parts of the stock market. All three markets have valuations that are stretched in comparison to previous historical levels. While these three market valuations are elevated, there are certain collectibles that fall into the category of extreme bubbles. We will stick our neck out and call this type of collectible a mania.

The historical example of a mania that is often sited is the Dutch tulip bulb frenzy of the 1630s. The tulip craze became popularized as a cautionary tale for investors in the 1841 book by Charles Mackay called Extraordinary Popular Delusions and the Madness of Crowds. Excessively easy monetary policy accompanied by a strong economy led to one of the oddest, speculative, price increases ever.

In the Netherlands, between 1634 and February of 1637, tulip bulbs became a sought-after collectable item and a way to display one’s wealth. Over the course of a few years, bulbs that sold for a few guilders rose in price to a high of 200 guilders. Rare bulbs, like The Viceroy tulip bulb pictured here, sold for over 3,000 guilders. This price was the equivalent of ten times the average person’s annual income.

The tulip craze was as much a cultural phenomenon as it was an easy money mania. Similar tulip bulbs can be reproduced so there was no real limit to the supply. As well, financial conditions can tighten. In the case of the tulip bulb mania, the record states that the prices hit a peak and simply declined abruptly as interest dropped. Only a few months after the market topped, the bulb prices fell to where they started. Once again, one could buy a beautiful, flowering garden plant for a few guilders.

With this story in mind, we present to you that 2021 saw the broad adoption of the Non-Fungible Token (NFT), a unique and non-transferable unit of data. NFTs look like they will transform the way we own assets, and they will complement the use of blockchain, a form of digital ledger. But there is a practical use and then there is mania. Below is an image of the NTF ‘man with a pipe’, not to be confused with Paul Cézanne‘s 1892 original. This digital art property named “Crypto Punk #7804” recently sold at auction for $7.56 million US dollars.

That’s correct. The ownership rights to this digital art above sold for $7.56 million US dollars in 2021.

The parallel to the tulip bulb mania that we would like to draw is that NFT digital art is as much a cultural phenomenon as it has to do with an easy money mania. Digital art can be reproduced so there is no real limit to the supply. As well, financial conditions can tighten.

At Avenue, we continue to argue that given the high level of debt and easy money conditions, we need to have our money invested in hard tangible assets and businesses that generate excess cash flow. As a way to store one’s assets and compound one’s wealth, we will take a pass on “Crypto Punk #7804” and be very wary of the excess money around us as we begin 2022.

China’s economy appears to be slowing.  This is a big deal in itself but how will we be affected as Canadian investors?  Our honest answer is we don’t know, but we should be thinking about it.  China is now of a size where it has a major impact on the global economy and financial markets.

China is in the news on a daily basis.  The military activity around Taiwan is just the latest.  The Chinese central government in the last year has moved to integrate Hong Kong, rein in corporate excesses, and intimidate trading partners.  But we are now at a point where the Chinese Communist Party’s need for control is slowing the dynamism of their economy, and given the overall debt level, looks likely to negatively impact financial markets. 

The point we would like to highlight, which is often missed, is that China did not stimulate their economy in the way that our Western governments did to offset the economic effects of the pandemic lockdown.  The chart below shows that China is potentially already in recession.  This should obviously have an impact on the demand for raw materials.  However, it is hard to tease apart what are supply disruptions and shipping delays from an actual Chinese domestic consumer pullback.

Coincidence or not, China’s economic weakness is aligned with the failure of China’s largest property company, Evergrande.  This company has borrowed $300 billion against a very large property portfolio.  This in itself should not be a problem.  The creditor should take possession of the property business, where hopefully there is some hard value, and the equity holder is wiped out.  The problem is that China does not have a transparent court system and bankruptcy law is in its infancy. 

We believe the Western banking system should be able to take this in stride.  The Chinese banking system is not integrated with the Western banking system. China maintains many layers of fire walls and capital controls to keep flows of capital from moving freely across their border.  China could have a minor meltdown, but it appears that a meltdown should stay contained within China.

Large amounts of Western money have been invested in China and this money doesn’t really go over the fire wall.  Over the last few weeks, we have seen money being actively pulled out of Chinese stock and bond investments.  But once this money is out of China it has to go somewhere, and the most likely outcome is once again even more money pouring into the perceived safety of US mega technology stocks. 

The question many investors are asking is, given this increase in money supply, is a period of higher inflation upon us? While we at Avenue believe higher inflation is likely this year, we will soon revert back to an economy with low growth and low consumer price inflation.

Velocity of money is an esoteric economic term that we have mentioned in past letters at the risk of being too technical and quite frankly, pretentious. At Avenue we are always attempting to write about investing in as clear and understandable a language as possible. However, velocity of money is now an extremely important concept to grasp, and we feel most investors are missing it. One cannot understand where economic growth and inflation are going without understanding the historic decline in the velocity of money.

Velocity of money is described by the Equation of Exchange which economic students bump into in university level macroeconomics then promptly forget. It just has not been relevant until this last decade. Many classical economists believed it was a constant and something you could disregard. And this was the case for most the 20th century.

The Equation of Exchange : GDP = Money Supply x Velocity of Money.

The concept is that the value of a country’s Gross Domestic Production is simply a function of how much money is in the economy multiplied by how fast that money circulates between people and businesses. We can see that the money supply has increased through 2020. But is this inflationary?

What is clearly revealed by calculating the velocity of money is that for every increase in the money supply there has been a commensurate decrease in the velocity of money. The money in the economy is circulating at a decelerating rate. There are all sorts of reasons for this. The main one being that there is just too much debt in our modern economy. But the conclusion is the same, it is really hard to get any lasting inflation if we can’t get the velocity or the speed with which money changes hands to increase. Velocity can only come from making productive investments that generate an income stream to pay back both principal and interest, or from a complete loss of faith in a currency.

While we will have a temporary increase in inflation as the economy recovers from the pandemic, we believe inflation will return to the 1 to 2% level over the next few years. Therefore, bond yields will remain low, and the stock market multiple will remain high by historical comparisons.

After a forty-year bond market rally from a high of 18% in 1982 to the current 0.70% low today, we struggle to get excited about bonds in the short or medium term.

Now What to Do?

Bonds have always been there to diversify from the volatility of the stock market.  The idea was, and is, when stocks go down, bonds go up, and vice versa.  In 2020, we saw that historical relationship break.  When stock markets crashed in March, the Bond Market went down as well until the Federal Reserve and Bank of Canada “saved” the Bond Market.

Another attribute is that bonds are there for capital preservation despite having little yield, which is a very important attribute to have when dealing with risk or asset allocation of clients’ wealth.

When we look beyond those two benefits, we struggle to find many opportunities in the credit or interest rate market due to historically low interest rates. As well, we have seen the central banks’ interventions into the credit markets suppress credit spreads.

Where Do the $300 Trillion in Global Debt Markets Go From Here?

For the past two decades, analysts, economists and central banks have forecasted incorrectly that global bond yields should yield at higher levels. The ongoing combination of technological disruption, global free trade expansion and our aging population has caused deflationary pressure, therefore causing yields to be suppressed.

Why It’s Different This Time

For the past decade, central banks have “pumped” the system with a massive injection of money for two reasons.  Firstly, for the public markets to function properly.  Secondly, they are trying to keep businesses afloat (large and small).  The former worked wonderfully, the latter not so much.

When central banks increase liquidity, they release funds to the banking sector. The problem has been that this money doesn’t leave the bank and get lent out into the economy. The banks are too scared to lend or it is too expensive (from a capital perspective) for them to lend. So, the money never gets into the hands of main street and the commercial banks just buy government bonds to keep on their balance sheets.

For the economy to recover, the commercial banks need to get money into people’s hands. This could happen.  More on that later.

The Central Banks are also trying to reflate the economy. To get inflation, you need several conditions in place. Or to say it differently, you need specific ingredients to bake an inflation cake:

1. Central Banks Are Slowly Losing Their Independence

With record amounts of sovereign debt, there is very little chance that central banks will not be influenced politically. There is a view that the only way out is to inflate the debt away.  This occurred in 1948.  After WWII, the Allied countries were left with a massive amount of debt.  They had little chance of paying it back.  So, they used inflation as a monetary trick.  After the war, there was tremendous pent-up demand resulting from rationing, consumer high savings rates and European rebuilding (Marshall Plan). All this caused inflation over several years. They used higher inflation to lower the outstanding debt since future dollars are worth less than present dollars, thereby dropping the real debt ratios.

2. Labour Market and Class Division

There will be a new agenda focusing on closing the divide between the upper class and the middle class.  We have started to see wage increases. As an example, minimum wage workers have seen their wages double. We believe we are going to hear more of new labour union creation for the working class to extract more profits from their companies. An example is the organizing of Amazon workers.

3. Global Trade

a) Modern Trade Agreements and Reshoring

We have seen so much deflation coming from global trade agreements set in the 1990s and 2000s. The Agreements in place are starting to unwind.  We are seeing western countries renegotiate trade deals that encompass not only economic benefits but must have social benefits as well, which will lead to higher prices for goods.  Manufacturing is also looking to bring back their production to their own country, which is called reshoring. Goods will be more expensive.

b) Cold Trade War with China

Western economies are starting to re-evaluate their relationship with China due to trust issues. Cybersecurity, political intervention by the Chinese state and uneven access to their markets is causing the West to re-evaluate our relationship.  This will mean that companies will try to find other options such as reshoring manufacturing.  This will lead to higher prices.

4. ESG (Environmental Social Governance), Social Lending, Justice and Green Programs

This type of policy is now in vogue. Even though it is just and honourable to consider these social lending polices, from an economic perspective the policies will force higher prices since these policies have a cost which must be shared throughout society.

5. Central Banks’ Policies Mandate Inflation

Most central banks have abandoned low inflation policy.  The US Federal Reserve has now installed a policy where inflation targets should be at minimum 2%.  Central banks have said they will not tighten monetary policy until they see a complete recovery.

6. Asset Prices Are Now Inflationary

Whether it is housing, the stock market or bitcoin, all asset classes are now reaching bubbling levels that will trickle down into the Consumer Price Index (CPI) inflation calculation.

7. Interest Rate Curve Suppression (Not Happened Yet)

There has been recent discussion on central banks trying to control and pin down long-term interest rates by purchasing unlimited amounts of bonds to keep the interest rate curve low. If this does happen, inflation will certainly rise.

8. Macro Prudential Regulation (Not Happened Yet)

As previously mentioned, central banks will be pressured politically.  The main issue is that money expansion is not getting to the consumer or small business. There is early talk that governments could force banks to lend by guaranteeing all loans to their customers.  Or governments could force their central banks to buy outstanding federal debt, thereby creating money by fiat.  (Most modern currencies are fiat or paper currencies that are not based on a commodity such as gold.) Regardless, if this does happen, inflation becomes a real issue.

In Summary

We do believe reflation is on the horizon.  We believe that inflation will easily move from 1.5% to potentially 3.0% in six months. Over time, we think that higher inflation is a bigger risk than lower inflation. If that occurs, it is a headwind for the bond portfolio.

With this in mind, we have been in a defensive mode since mid-2020 with our bond portfolio by doing the following:

  • Lower term-to-maturity (shorter duration):  3.5 years versus 7 years for the index
  • Credit exposure primarily in the 1 to 3 year area
  • Larger weight towards REITs – sector trades at a discount to its Net Asset Value
  • Lower weight to High Yield – sector shows little value versus risk.
  • Possible purchase of inflation index-linked bonds in near future.

(As a reminder we can own 20% of the bond portfolio in higher risk assets such as convertibles, real estate investment trusts, preferred shares, and non-investment grade bonds.)

An examination of the valuation of Apple’s shares is an excellent way to demonstrate the extreme divergence that has taken place in the stock market in the last six months. Not much has changed in the underlying profitability of Apple. What has changed is that investors are willing to pay a mania-type multiple not seen since the 2000 dotcom bubble.

To be fair, the present era is different from the dotcom era. Apple and its ‘Mega Cap’ siblings are very profitable. More importantly, Apple is an essential provider of smart phones and services which are helping us get through this global pandemic. As we have discussed in our Q3 Letter, financial markets are awash with money looking for a safe place. Apple fits the bill as a low debt company with a consistent and slightly growing income stream. But we argue that the valuation is now extreme.

Looking back at our internal estimate of Apple’s future earnings from four years ago, we believed that then current earnings of $9.00 per share could rise to $14.00 by the year 2020. This has turned out to be exactly what has happened and for the most part this was a consensus view among Wall Street analysts. When we initially purchased Apple in 2015 at around $100 (split adjusted $25) we were paying roughly 10 times 2016 earnings with our expectation that earnings would grow to $14 in 2020. We made our purchase with a good margin of safety in the valuation.

Since that time the stock has delivered great returns, but it is not because the business is growing. Rather the business has been consistent in that it has a high profit margin and then it takes that excess profit and buys back its own shares. Revenue and profit have increased slightly but earnings per share have gone up over 50% because the numbers of shares outstanding have been reduced.

What has happened since then is the multiple that investors are willing to pay for Apple has increased dramatically. Last month at its recent high share price of $535, Apple traded at 38 times this year’s earnings of $14.00 per share. And now the market capitalization for Apple is $2 trillion dollars. This is the highest value that any company has ever traded at and is closing in on the value of the entire Canadian Market. Yes, you can either have an entire country the size of Canada or a company that makes a cool phone.

When we made our initial investment at 10 times earning a lot could go wrong with the business and we were still ok with our decision. Now at a multiple in the high 30s, a lot must go right for us to be comfortable owning Apple. A stock that trades at a multiple of earnings this high implies that the future must be better than today. We argue that Apple’s earnings need to double to justify its current share price. Apple’s business is not perfect. China makes up 15% of sales and the US and China are embroiled in a tepid trade war. Much of Apple’s supply chain is China dependent. There is also a battle being fought over fees paid by app developers to access Apple’s App Store, where there is threat of margin erosion.

Our point here is not to say that Apple’s stock cannot continue to go up or that collapse is imminent. Rather it is an effort to make sense of what has been an extreme run up in the share price, and because of Apple’s relative size, this has created a distortion affecting the valuation of the entire stock market. As investors we are trying to avoid taking unnecessary risk. We can find other equally profitable and growing businesses where the stock is trading at a much better multiple. We have now sold our shares in Apple and have added to our existing technology investments that trade at a more reasonable multiple of earnings.