This quote from Michael Caine, while a little extreme, does translate well to investing in an uncertain market. The asset value of Avenue’s portfolios moved up a bit in the first quarter of 2023, and our investments were relatively stable, given the swings in interest rates, currency and many sectors of the stock market. At Avenue, we are staying calm and analytical and working hard to make sure we can stay invested while avoiding areas where profit margins might be under pressure. As the economic landscape shifts, there are many new opportunities as other investors pull back.

The economy is finally feeling the effects of short-term interest rates rising to levels not seen since 2007. Short-term interest rates are significantly higher than long-term interest rates, a situation known as an inverted yield curve. This situation occurs near the end of an economic cycle when a central bank raises interest rates to slow the economy down. Because interest rates are higher many individuals are making the simple decision to move their savings from bank deposits to short term treasury bills. Also, some investors are making the same decision to reduce risk in their investment portfolios. We would argue that much of this money always should have been invested in safe short-term securities, but because of zero interest-rate policies of the last decade, investors were encouraged to seek out more risk.

While stating the obvious, that many investors are seeking safety and lowering risks in their portfolios, the net effect on the financial system has been dramatic. In just the last month we have seen bank runs in the US leading to bank failures and rapid central bank intervention. (See Case Study: Is the Market Broken?). In times of turmoil, investors need to continue to be focused because while there are many businesses that should be avoided, there will be many that are unnecessarily discarded. As events unfold, we make sure we are actively getting our positioning right in a fast-changing market. Many of Avenue’s stock market investments made new highs this quarter and the businesses are doing very well.

Many of our investments also continue to grow their dividends and repurchase their shares. One such business is Andlauer Healthcare, which we were happy to see implement a share buyback program this past quarter. The Avenue team had previously advocated for this during our meetings with management.

Where we are seeing opportunity

We believe real estate, infrastructure and financial services are fundamental building blocks of a long-term compounding investment strategy, except for in this higher interest rate environment. Therefore, we have reduced our exposure in these three areas of the portfolio. The valuation of hard asset businesses should decline, and the cost of new construction is uncertain. We have moved our real estate and infrastructure investments to businesses where the current valuation is reasonable and where we do not have construction and financing risk. As well, we halved our exposure to Canadian banks over a year ago. Our latest effort to reduce risk and improve profitability was to sell TD Bank outright and replace it with National Bank because of its more isolated and quasi-monopolistic position in Quebec.

The intention of our investment strategy is to protect our current investments from potential losses and make new investments where we find the most opportunity. As money is coming out of parts of the stock market and the market breadth is contracting, we are finding high-quality businesses at fair valuations in the industrial and consumer areas, both in Canada and the US. This might seem like a contradiction given that the words ‘impending recession’ are everywhere. Once again, because there is a fear of recession, potential investments are trading at more reasonable valuations.

Slow motion contraction in money

We have been writing that we have been defensive for over a year. We have actively moved the portfolio to what we have characterized as essential businesses where profit margins can be maintained and where there is not a reliance on a need for raising money in financial markets. We are also maintaining a cash position and for many clients we have the Avenue Tail Hedging strategy.

When we look at the M2 Money Supply, we see it has now contracted for the first time since the 1930s.

The banking events of the past few months have further accelerated the decline in bank deposits, which are now contracting 5% year-over-year. From our historical research we have determined that the only other time this happened was 1930-32 and in 1921. Both were times that experienced major deflationary recessions.

We are observing a slow-motion correction of asset prices. The reason it is taking so long and why we have not had a major stock market drop is because we still have major competing economic forces. Short-term interest rates are being increased by central banks with the goal to slow the economy. However, the central bank balance sheet is no longer being reduced and the continuing deficit spending by government is providing plenty of liquidity to the economy and financial system. As a result, some of our industrial companies are experiencing record backlogs as a by-product of the fiscal policy spending on infrastructure in the US.

We would like to share with you some charts to illustrate the scale of the competing monetary forces at work in the last quarter. We live with the contradiction that what should be an end-of-cycle credit crunch, where business loans become harder to refinance, is set against the central bank raising interest rates while government deficit spending resulting in excess liquidity.

To illustrate the tension, we will start with the negative economic scenario caused by higher interest rates, then follow with the contrasting positive financial market scenario caused by central bank balance sheets expanding again. We will use the US figures as opposed to Canada’s as they are the main drivers of overall bond and stock market prices.

Interest rate hikes mostly over

Probably the most important data point is that central bank interest rate tightening is mostly over. The following chart shows expectations for the US short term interest rate decreasing from its highpoint in February of this year. When we assess our investments, we have to make sure they remain healthy when paying this level of interest on the money they have borrowed.

Source: John Aitkens, TD Securities Research

Yet another banking crisis

The banking crisis we have recently experienced was brought on by two factors and we would argue that while the crisis is fixed at the individual banks, the original problems remain. The first problem was the flight of deposits to short-term treasury bills that we highlighted earlier. The second problem is shown in the slide below whereas interest rates have gone up, the value of bond type investment held by banks has a negative value.

Source: FDIC

While the largest banks in the US are covered by legislation that protects them as ‘too big to fail,’ the policy for protecting smaller banks is ambiguous and arbitrary.

This next chart is more esoteric but worth showing because it best depicts the epicenter of the storm US banks just experienced. Banks make money by taking in deposits and paying what is usually a small interest rate and lending the money for longer terms and charging a higher interest rate. Most of the time this relationship remains stable. The following chart shows a histogram of weekly changes in the relationship between 2-year interest rates and 30-year interest rates in the US, otherwise known as the 2s 30s spread. After the effective bailout of depositors at Silicon Valley Bank (SVB) in California on March 10th, there was a 6 standard deviation weekly move in this relationship. It illustrates that financial institutions are navigating extreme interest rate volatility.

The economy is gradually slowing

Our conclusion is bank lending will become restrictive as deposits leave the banking system. Many bank loans which were made at low interest rates will take time to mature and interest rate volatility will discourage banks from taking risks. This is a classic set-up for a credit contraction which is already reflected in banks tightening their lending standards. We are worried about the ability of businesses to refinance existing debt. It is probable that regional or small businesses will be the most affected, but this tightening will incrementally slow the overall economy.

Central bank and government deficits provide liquidity

The US federal government deficit spending continues to supply financial markets and the economy with liquidity, despite the restrictive effect from higher interest rates and tightening credit. Because there is still lots of money in the financial system, we have not experienced a major decline in the US stock market index.

Of all the economic factors affecting the level of money in the financial system, it is the US Federal Government’s borrowing that eclipses any other influence. To truly fight inflation and inflation expectations, yes, interest rates had to go up. But taxes should have gone up too and government spending should have gone down. But nobody will vote for austerity, either in the US or Canada.

Even as we are writing this, we are aware that given the scale of federal pensions, medicare and defence spending in the US, this is not likely to happen. The US is now a $23.6 trillion economy where the federal government has borrowed almost $32 trillion. Having $22 trillion of debt just prior to the onset of COVID, the US has added over $10 trillion of debt in 3 years. This is new money that has been borrowed and spent into the economy. This is the main reason why we have seen higher inflation.

The US Federal Government’s borrowing supplies money to the economy and financial system, and for the time being there is lots of it. Structural deficit spending is likely to remain systemic no matter which political party is in power. With a sustained $1.5 trillion + annual deficit, $10 trillion more debt will be added in the next 6 years.

If you compare corporate profits to total debt you can see a similar pattern in the below chart. As more money gets borrowed and spent into the economy, it has the knock-on effect of making the economy and business profits look better in the short run. How should investors think about this relationship?

While this ever-increasing debt might seem alarming, it is better to be clear eyed about how it will impact asset prices. Bond and stock market prices are just as much influenced by the amount of money in the financial system as they reflect underlying earnings of a particular business.

To conclude, we remain cautiously positioned due to the slow-motion tightening of the credit cycle but hard at work knowing the only way to compound our money is to be invested in dynamic businesses over the long run.

A Case Study on Is the Market Broken?

In the last month we met with a client who spent their career in financial markets and before we even said a polite hello, they asked flat out, ‘is the market broken?’ After taking a moment to put together what was hopefully a thoughtful response, we answered, yes. However, we still need to be invested in high quality businesses to compound long-term to protect ourselves from inflation and currency devaluation.

The most obvious example directly impacting our Avenue portfolio strategy was the Bank of Canada supporting corporate bond prices in March of 2020. Buying high quality corporate bonds in a market liquidity vacuum was key to Avenue’s successful investment navigation of the 2008 financial crisis. However, in 2020 this opportunity was taken away from us as the financial risk was effectively nationalized. We are forever moving to a banking system where profits are privatized, and losses are socialized. More than ever it really matters what we own, and we must acknowledge that the rules are constantly shifting. The motivation to construct Avenue’s Tail Hedging strategy came out of this experience.

Since this conversation with our client, we have had yet another week where major financial institutions collapsed. Both are new examples of how established financial system regulations are fluid in the time of a crisis. In the case of Silicon Valley Bank (SVB) in California, there was no resolution process for winding up an insolvent bank. There was deposit insurance of up to $250,000 per depositor but this policy was ignored, and all depositors got their money back. This is an example of socializing losses.

In the case of Credit Suisse bank of Switzerland, which was founded in 1856, there was an insolvency resolution but then the Swiss regulators ignored it. About $3 billion of equity value was salvaged while $17 billion of ‘special insolvency contingent’ bonds had their value wiped out. The core belief of our financial system is that the equity holder gets to profit when the market is positive and is the first to take the loss when the business fails. Bond holders are limited to their interest payments, but they get to be converted to equity holders in the case of insolvency. If these fundamental rules of capitalism are not followed, then we start to question the system itself.

The following is now a notable March 16th exchange between James Lankford, the Senator for Oklahoma, and Janet Yellen, the Treasury Secretary, about the recent bank bailouts.

James Lankford:

“Will the deposits in every community bank in Oklahoma, regardless of their size, be fully insured now? Will they get the same treatment that SVB just got or Signature Bank just got?”

And Janet Yellen’s answer last week was “not necessarily.” That kind of extraordinary help would only be extended, she said, if it looked as if there were a danger of a more widespread bank run. Now, that worried a lot of community bankers because it might encourage their biggest customers to pull money out of small banks and move to a bigger bank where they might be more likely to get government help.

In summary, in normal times we are told everything should function just fine. The problem is that it is the ‘not normal’ times that we are worried about. What has made Western financial markets so successful is their predictability of the rule of law and fair regulation. The events of the last few weeks will definitely have an ongoing effect on who gets to borrow and who doesn’t. For Avenue it is yet another reason to focus on the quality of the underlying business and avoid unnecessary and arbitrary risks.

The saying, ‘stay the course’ has a long military history but it is Ronald Reagan who repurposed ‘stay the course’ as a catch phrase for resetting the economy post 1970s inflation. At Avenue, we have a strategy that incorporates bad markets as well as good and we plan to come through this current weak period stronger than when we started.

The message we would like to convey is a positive one. While 2022 has been hard for investors, we believe a significant amount of damage has already been done. Bond and stock prices are at a much better level for us to accomplish long term compounding. But we caution that the central banks have no quick fix so our expectations of recovery will be gradual and accompanied with larger short-term price swings.

As long-term investors, we know that while there are strong markets, there will also be weak markets. As we have written in our last three quarterly reports, 2021 was about excess financial stimulus and 2022 was the year stimulus was taken away. We have been positioned defensively in terms of what we own and how much cash we have raised for most of the year. Now interest rates are at a level where we can build a bond portfolio which gives us a decent return. As well, while we believe many stocks are still too expensive, Avenue’s portfolio of stocks are trading at a good level relative to the cash flow these businesses produce.
We are going to share with you a few charts which show how weak the bond and stock market has been this year. But what we take away from these statistics is that because prices have been bad, we should be closer to a bottom, and going forward the returns will be better. While our strategy has been defensive throughout 2022, we must start thinking offensively and look for high-quality businesses we can invest in.

This year feels particularly bad due to the combined effect of weakness in both the bond and stock markets at the same time, while the cost of living is going up. For the last forty years, when stocks fell due to the financial crisis of the day, a central bank was able to lower interest rates and the bond market was seen as a safe haven for investors. So, if stocks went down, bonds went up. A balanced portfolio with a mix of bonds and stocks would counterbalance each other.

What we can see in this chart is how unusual an event it is that bonds and stocks went down in the same year together. Above all, this year has been about interest rates going up. With higher interest rates, stocks valuations came down. Again, as you can see from the chart, returns have been bad, and under these circumstances, history predicts that positive returns are more likely sooner rather than later.

Inflation is commonly expressed by the consumer price index (CPI). In our last letter we laid out how CPI is a complicated term often describing conflicting economic concepts. For simplicity’s sake, this quarter we would like to focus on the rise in prices for food, fuel and rent. To point out the obvious, the rise has been dramatic as this year’s CPI increase is coming off a low base. While the CPI headline number is jarring, central bank behavior and economic weakness tells us the CPI will be much lower this time next year.

Our current economic circumstances are unique and so is the behaviour of the central banks. It is very unusual, if not unprecedented, to have 28 central banks all tightening interest rates at the same time. The result is that globally there is less money and liquidity in the financial system. From having too much liquidity a year ago, we now have very little. But we anticipate that the next swing will likely take us back in the other direction.

When global financial markets have stress, the safe haven remains the US dollar and short-term US treasury bills. The Canadian dollar relative to the US dollar has fared better than most major currencies, because Canada’s main exports are commodity related. While US dollar cash is not part of our strategy at this time, we do maintain US dollar exposure through our stock market investments which make money from their businesses in the US. Currently we measure that exposure as 45% of the cash flow of our equity portfolio. As well a Canadian business like Canadian Natural Resources produces oil with their costs in Canadian dollars and sells their product in US dollars. Currently the Canadian price per barrel of Edmonton Par is $118 Canadian. The last time we had high oil prices the Canadian dollar was valued at one to one with the US dollar. Our current period of high oil prices is accompanied with a Canadian to US exchange rate of $0.73, as of this writing.

Avenue’s Bond Portfolio

Our conclusion from the chart below on the historical return of the global bond index is that this might be the worst annual return in our lifetime. We have described 2022 as the year where we have experienced the tearing off of the band aid of low interest rate policy. It is the speed measured in months and the magnitude measured in percentage terms that is so extreme. Over the decade of the 1970s, the last time interest rates went up dramatically, yields started at 4% which then doubled to 8% which then doubled to 16%. With today’s much higher level of debt and a more mature economy we have just experienced the same impact where 1% interest rates doubled to 2% which then doubled to 4%, but within the space of a several months.

The benefit of having bond prices fall this past year has been the resetting of bond yields to level where we can receive a more rational return. We expect inflation to come down from our current elevated levels but remain higher than the past few years where inflation sat at only 1.5%. If inflation was to average 3% for the next decade, Canadian government bonds should offer an added return of 1% for a total of 4%. Corporate bonds should offer an additional 1.5% for a combined yield of 5.5%. Historically, Avenue’s bond portfolio has had a majority weighting in corporate bonds. At this time, we are still being patient as the stress in the credit market might still affect credit spreads between corporate and government bonds. If credit spreads widen, we would like to take advantage of the opportunity to invest in higher yields. The main point we wish to make is that Avenue can build a bond portfolio that gives us a decent return, now that we have a break from the era of ultra-low interest rates.

Avenue’s Equity Portfolio

Stock market pricing is the result of two simple components: the amount of earnings and the multiple that investors will pay for those earnings. Let’s start with the stock market multiple which itself is a function of liquidity. Liquidity is the financial term for how much money is floating around in the system. As interest rates have risen this year, liquidity has dried up. As a simple example, investors are less likely to borrow money to buy stocks because the cost of borrowing has risen. Less liquidity, by definition, means that investors have less money to buy stocks with. The term used in the financial industry is ‘the market multiple will compress.’

The good news is that much of this compression has happened. While many stock valuations still can come down, we just need to focus on the ones we own. We have worked hard over the last year to make sure we don’t have any investments where the valuations are overly expensive. As well, we are keeping a cash position in case we get an opportunity of a further sell off. However, we need to be aware to the potential that much of this stock market weakness may have run its course. We showed the chart below of financial market liquidity in our Q1 letter in April, when global liquidity was at its peak and beginning to fall. This key indicator is now closer to the bottom. We don’t have a time frame for how long it may take to get to the bottom as it might take months or even a year. That doesn’t mean we run out and spend our cash, it just means we are now looking for opportunities as opposed to forcing ourselves to sit on our hands.

Stock market earnings, and thus profit margins, are very hard to generalize when inflation rises to this degree. The chart below shows how historically inexpensive the Canadian TSX index is based on analysts’ estimated earnings for 2023. To be clear, the price earnings multiple might increase from this level, not because stock prices go up but because profitability may start to fade in coming months. While this valuation gives us a general view on the overall Canadian stock market, it is much more important to focus on the earnings of each individual business. As we have stressed this year, we are focusing our investment strategy on simple and essential businesses that can maintain margins and do not need additional stock market financing. Whether the company we have invested in continues to pay a dividend or buys back stock, Avenue’s underlying portfolio will become more valuable as we go through what we believe will be an extended period of economic weakness.

This famous quote from Pericles was made in the context of readying the Athenian people for the unpredictability of war. During the last two months we are witnessing what seems like a throwback to a past where despots were intent on brutal conquest. This behaviour seems completely irrational within our globally integrated world of business and finance.

At this point in early April, we don’t know how long the conflict in Ukraine will last and we can’t predict the outcome. This is the point Pericles is making: the future is always unpredictable. The investment industry attempts to forecast the level of an interest rate or the price of a stock in six months’ time, but really there is not any way to know for certain. We need to focus on being prepared for whatever environment we find ourselves in.

In our last quarterly letter, we described a tapering pandemic and how we have positioned our portfolio for a very complicated economic recovery. Excess money and gummed up supply chains have resulted in surging inflation. Adding a war in Ukraine is a completely different geopolitical challenge, but it exacerbates the same investment themes exposed by the pandemic. In summary, our investments remain oriented towards businesses who can maintain pricing power and we are avoiding businesses where margins are at risk of shrinking.

Geopolitical events usually affect bond and stock prices in the short-run, but the long-term prices are much more affected by major financial and economic trends. We have adjusted the portfolio for a financial system where liquidity is now declining and a global economy is contracting.

Only a few months ago, we wrote that asset markets would change if interest rates rose above 2%. Central banks have only just started to increase short term lending rates, but it is expected that short term rates will be 2.5-2.75% by this time next year. Subsequently, we have seen a sell-off in bonds and a real shift by stock market investors from growth stocks to more stable businesses of the type we like at Avenue.

In the face of the highest inflation in decades and rising interest rates, Avenue’s bond portfolio remains defensive. We have a higher cash weighting and our bonds have a shorter average term to maturity. From a long-term compounding point of view, higher interest rates are always better. It was going to be very hard to get a reasonable rate of return when interest rates were so low. We believe that in the next few weeks or months interest rates will reach a level where we can invest our cash and reinvest as our bonds mature, at much better rates.

What we don’t know is how much central banks will actually move interest rates to combat inflation. Even though the market is anticipating 2.5% to 2.75% interest rates next year, this has not happened yet, and a lot can occur over the course of a year. One of the indicators of economic health is what is called the shape of the yield curve. When we put all the current interest rates on the same chart (3-month, 2-year, 5-year, 10-year and 30-year interest rates), we look at what the relationship is between the interest rates over the different time periods.

Currently, the yield curve in Canada and the US is unusually flat. The consensus of many investors is that they anticipate short term interest rates will have to go up to a level where inflation is contained. This is a polite way of saying our central banks will have to raise rates to a level that creates an economic slowdown. This in turn, is keeping the longer maturities like the 10-year bond interest rate from going up because investors are anticipating a recession. As the year progresses the shape of the yield curve will give an indication of how big a future slowdown might be.

Declining liquidity will be a continuing theme throughout 2022. Interest rates are going up. Central banks will not be buying their own bonds, which is now being referred to in financial language as quantitative tightening. As well, direct Covid subsidy cheques are no longer being handed out.

We are already seeing indicators that point to much less liquidity in the financial system. There has also been a commensurate amount of damage in the high valuation growth stocks as the market digests this information.

For example, last November the e-commerce stock Shopify was the largest company in Canada with a valuation of $275 billion, compared to the next largest which was Royal Bank valued at $190 billion. Shopify in now down 70% in just the last four months.

At the beginning of the year, we were nervous that the entire stock market was vulnerable to a price decline. But what we have experienced is investors shifting from high valuation growth stocks like Shopify to more traditional stable businesses like Bell Canada. Avenue’s equity portfolio has held up well given the repositioning we did last year with the view that certain traditional businesses are able to cope with inflation better than others.

                   

Global supply chains remain a problem. China is still locking down major cities and ports. Shipping is getting easier but that might be because there is less to ship. We are seeing signs in North America that trucking is slowing. This could be an indicator that the overall economy is not as strong as investors are expecting and we should be cautious.

A Cold War II scenario is a much bigger and longer lasting risk affecting investing. It appears just-in-time inventory management on a global scale will contract to a level more typical of previous decades. Russia is a source of raw material and China is the global supplier of manufactured goods. What is being called reshoring, bringing back manufacturing to North America and Europe, will have a negative impact on economic growth and the margins of many businesses.

To give some perspective, during the height of the Cold War in the early 1970s, the Global population was 3.5 billion people. However, due to the constraints of the Iron Curtain and China’s cultural revolution there were only about 1 billion people participating in what we describe as the Western economy.

Globalization exploded shortly after the fall of the Berlin Wall in November of 1989. Today, the global population is closing in on 8 billion people. But what is significant is that it is estimated that about 5 billion people now participate in the global economy. This is a 500% increase in the global participation rate in just 30 years and all the prosperity that goes along with open trade. Now, businesses are facing higher costs with less supply availability and less efficiency. As investors, these are very important points to study when we consider where to put our money.