Episode #131: David Rosenberg, Rosenberg Research, “If Next Year is Not a Recession, It’s Going to Feel Like It”
Guest: David Rosenberg. David is Gluskin Sheff + Associates Inc.’s Chief Economist and Strategist with a focus on providing a top-down perspective to the Firm’s investment process and Asset Mix Committee. Prior to joining Gluskin Sheff in 2009, David was Chief North American Economist at Merrill Lynch in New York for seven years, during which he was consistently ranked in the Institutional Investor All-Star analyst rankings. Prior thereto, he was Chief Economist and Strategist for Merrill Lynch Canada, based out of Toronto. David is also the author of Breakfast with Dave, a daily distillation or his economic and financial market insights.
For a complimentary one-month trial to Breakfast with Dave, please contact Marcel Aulls firstname.lastname@example.org
Free download from Gluskin Sheff: “Paradigm Shift” Gluskin Sheff + Associates Inc. November 2018
Date Recorded: 11/20/18
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In Episode 131, we welcome economist David Rosenberg.
We jump right into David’s view of the current economic landscape. David talks about the global economy, especially the US looking classically late cycle, as the economy is running low on skilled workers, and states “If next year is not a recession, it’s going to feel like it.”
Meb asks about the indicators he relies on. David discusses that there are 15 equally weighted indicators he’s looking at, 14 are screaming late cycle, and two stand out the most. Two of the most important indicators for the US are the lack of skilled workers, with a lot of growth coming from people with no better than a high school education, and an immigration policy that has decreased the pool of labor.
This leads into a discussion about inflationary pressures. While the strong dollar has been deflationary, more and more companies are passing on costs to customers. Services, which dominates the consumer spending pie, is sensitive to labor costs, and the inflation we will see going forward will be from wages.
Meb then asks David about his thoughts on how this plays out for investors given the nature of the late cycle. David tells us that historically, the S&P has annualized an average of 17% per year in bull market conditions, however, this time around, it has done so with nearly half the typical economic growth rate to back that up. He suggests investors be defensive, focus on liquidity, have some cash on hand, and emphasize quality. For fixed income investors, be mindful of duration, and if focused on credit, be thoughtful of upcoming refinancing risks.
The conversation then turns to sentiment. David draws parallels to the dotcom bubble, with FAANGM making up 17% of the S&P 500 market cap at September highs, which is similar to the late 1990s when there was a concentration of about six stocks making up a large chunk of the S&P 500 market cap.
Next, Meb asks about David’s views on corporate bonds. David sees this in two lights. First, corporate balance sheets are the weakest they have ever been. The BBB component, which is a downgrade away from being rated “junk,” has grown from 30% of issuance to 50%. The alternative, more positive view is that companies are anticipating a lack of bond issuance coming up.
Meb then asks about the health of the Canadian economy. David explains it is meandering; the oil price has been a drag and has traded at a significant discount to WTI due to a glut of production, and lack of pipeline capacity. In addition, an overinflated housing market that is deflating, and overextended household balance sheets serve as big impediments. Provinces are tending toward a pro-business direction politically, so that could serve to be a positive going forward. As a strategist, he is seeing much of the bad news priced into financial assets as the TSX is trading down to a 13 multiple, in line with emerging markets, and a discount that has been seen only 5% of the time historically.
All this and more in Episode 131.
Links from the Episode:
- 0:50 – Welcome to the show
- 1:45 – David’s take on the current economic environment
- 3:13 – What variables David gives weight to when assessing the economy
- 7:44 – “Paradigm Shift” Gluskin Sheff + Associates Inc. November 2018
- 7:56 – Signs that inflationary pressures are on the horizon
- 11:20 – Implications for investors
- 11:40 – “The Economist” October 7th-13th 2017
- 19:11 – Sponsor: EquityZen
- 20:38 – Sentiment on this bull market
- 20:58 – Betterment’s Consumer Financial Perspectives Report: 10 Years After the Crash – Betterment
- 21:24 – Howard Marks Podcast Episode
- 21:50 – “Paradigm Shift” Gluskin Sheff + Associates Inc. November 2018
- 22:48 – ICI
- 25:56 – Bob Farrell’s 10 Market Rules To Remember
- 27:07 – David’s take on the corporate bond situation
- 33:43 – Return expectations
- 33:52 – “What if 8% is Really 0%? Pension Funds: Investing with Fingers-Crossed and Eyes Closed” – Meb Faber
- 37:10 – Rob Arnott Podcast Episode
- 37:27 – What the Canadian market and economy looks like these days
- 41:54 – Best ways to connect with David: (416) 681-8919, firstname.lastname@example.org, daily email offer
For a complimentary one-month trial to Breakfast with Dave, please contact Marcel Aulls email@example.com
Free download from Gluskin Sheff: “Paradigm Shift” Gluskin Sheff + Associates Inc. November 2018
Transcript of Episode 131:
Welcome Message: Welcome to “The Meb Faber Show,” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing, and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the Co-founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions, and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: Welcome, podcast listeners, and happy post-Turkey Day. I’m actually recording this pre-Thanksgiving, but it will come out post-Thanksgiving, so hopefully you had a great one. We got an excellent show for you today, our guest is the Chief Economist and Strategist at Gluskin Sheff and Associates. Prior to that, was consistently ranked as one of the top institutional investor all-stars while serving as Chief North American Economist at Merrill Lynch. He’s also the author of “Breakfast With Dave: A Daily Distillation of His Economic and Financial Market Insights.” Welcome to the show, Dave Rosenberg.
David: Great to be on.
Meb: Where are you dialing in from now. Are you in Canada? I know you’re on the road quite a bit, are you in the Great White North?
David: I am in the Great White North, and actually it’s pretty white outside right now. Had about of snow overnight, and calling you from downtown Toronto at the moment.
Meb: Very cool. I haven’t been, but it’s on my to-do list. I’ve been to almost everywhere else in the borderlands of Canada, love it, but let’s get started.
So been a long time follower, bit of a fan-boy for your work for many, many years and figured we’d take a step back before we get to detail, but if we’re Elon Musk, Tesla Man out in space, looking down on the world today, and the various economies, global economy, how do things look for you, 10,000-foot view? What’s the economic situation look like to you?
David: Well, in two words or less, very late. We are classically late cycle, especially in the United States. From my perspective, that’s still what drives the bus globally, and from my perspective, we are somewhere between the bottom of the eighth and top of the ninth inning in baseball parlance. So very late cycle, and my sense is that looking at the tea leaves, is that recessionary pressures are building. I know that people are saying, well, they don’t see a recession coming, and that’s because recessions are like an odourless gas, you don’t see them until they’re already behind you.
It makes perfect sense that looking at the liquidity conditions of the marketplace, where the yield curve is going, all the leading indicators, including housing, which is the quintessential leading indicator. And the fact that the U.S. economy has run out of skilled workers, and it doesn’t look to me as though the Fed is stopping anytime soon, and the lagged impact next year from the Fed tightening, both on the balance sheet and interest rates and the mass of fiscal policy stimulus withdrawal we’re gonna see. If next year is not a recession, what I’ll tell you is it’s gonna feel like it.
Meb: You know, what’s funny is I was listening to a podcast with you from a few years ago and you said there’s nearly a 0% chance recession in the next year, and it’s interesting to kind of hear the different perspective. And we have a chart book, I’m a sucker for chart books, and I believe your firm has graciously allowed us to post one in the show notes, so listeners go check it out, and you can sign up for a free trial on our podcast page. We had a great chart, it says 14 of the 15 variables suggest we are in the final innings in the U.S. Are there any in particular that you look to that have a little more weight, as far as the indicators on the economy? Any that you’re particularly fond of?
David: Well, there probably is, and I’ll get into it. You know, each one of those 15 indicators, they’re weighted equally. And what we did is we looked at the contours of these indicators, and they are capacity indicators, they are market indicators, and broad economic indicators, and we look at them through the contours of historical business cycles and how they’re trading and how they’re moving along their business cycle lines in relation to the past, benchmarked against where we are in the cycle.
So it’s as an average, weighted equally… But if you’re taking a look at the 15 variables, 14 are screaming late cycle. So it’s not as if, well, there’s eight and there’s six, no, this is actually fairly broadly based. Look, I would say that there’s two that stand out the most, and it’s very interesting because the St. Louis Fed came to a very similar conclusion, based on where we are in the cycle. St. Louis Fed and the San Fran Fed, by the way, they do the best research among the Fed District Banks.
So I like to look at the yield curve, I know that it has been much maligned, as it is every cycle. We’re told late in the cycle not to pay attention to the yield curve by the permabulls, yet it always seems to work. And if I had one tool in the kit on a desert island, and a lot of people wish I was on one, it would be the shape of the yield curve. It is not infallible, but the most reliable. And it’s not even so much that it has to invert that you get a recession, it’s the direction of the yield curve and the flatter it gets. And it’s gotten a lot flatter this year. It’s flashing at least slower growth in the next year. So as I said, it might not be a classic recession, but it’s gonna feel like it. There’s no get-out-of-jail-free card, things are gonna be a lot slower next year than this year, so even if you don’t have the recession call, it’s gonna be very close, I think something close to stagnation. So the yield curve is an important one.
And I would also say the unemployment rate is also very important. And I know that people say, “Well, but the unemployment rate is a lagging indicator,” and yes, I know that it is a leading indicator. But, you know, when you get to extremes, like a 3.7% unemployment rate, it’s interesting, because I gave a speech last night where a woman in the crowd said, “But isn’t 3.7% good?” And I said, “Well, the last time we had 3.7% was in 1969.” And she says, “Well, that’s really good, isn’t it? Lowest since 1969.” And I was trying to be polite and I said, “Yeah, but you do know what happened in the next year, don’t you?” She says, “No,” I said, “We had a recession in 1970.”
So the bottom line here is that we have run out. We have run out of skilled workers in the economy. Half of the growth in employment in the United States in the past six months has come from this tiny group of people that don’t have anything better than a high school education. And I don’t want to sound elitist, I probably will, but I just don’t know how many busboys, bell-captains and barmaids the U.S. economy needs. But if these people are writing code, then I’m just wondering as to what that’s gonna mean for productivity growth, it’s not a good story.
We have run out of workers, the administration’s immigration policy that has led to a 6.5% decline. How often does that happen, in legal immigration at a time when the pool of available labour in the United States is at its lowest level in 12 years, by the way, and depleted 10% in the past year, is creating a supply wall on labour. And there’s only two factors of production. As an economist, there’s only two factors of production, capital and labour. Labour’s pretty important and we’ve run out of it. And so I would say the unemployment rate at 3.7% and the yield curve getting very close to being flat as a pancake, which I’m sure it will after the FOMC meeting on December 19th, where the Fed pulls the trigger again. Those are the two most important components of those 15.
Meb: Well, it’s interesting, you know, one would think that, looking at the state of the economy, and you had a great chart where you show the front end of the curve, and he says, “The front of the curve has had a coronary,” and its two-year yield is just ramping up, it almost looks like a Bitcoin chart from last year, just kind of going straight up. But at what point does it start to have increasing inflation pressures, or any thoughts in general on kind of what’s going on there, if you see a bigger risk of this? I mean, oil has been taking a dirt nap over the past month or two, and just nose-diving, but anything on the horizon as far as inflationary pressures?
David: That’s a great point. You know, we have a couple of cross currents. I mean, it’s hard to decipher really how much of this move in oil, which is moving to an official bear market very quickly, it’s really demand-related, and how much of it is supply related? And then do we get another inflection point on December the 6th if the Russians back the Saudis and they embark on a production cut?
And there’s no doubt that, you know, beyond oil, look at the CRB metal index is down more than 10% from the highs, and probably telling you something about the state of demand in China, which still consumes at the margin half of the world’s basic materials. And you battle that against a strong dollar, which has been dis-inflationary, but I think that the balancing act is the tariffs, no doubt a cost on doing business. Those costs, as you could see in droves in the last Fed Base book, more and more companies are passing on those cost increases from tariffs, notwithstanding the deflationary impact of lower commodity prices.
So we’ve got that tug-of-war on the good side, and the good side is 40% of the consumer price index. What about the other 60% called services? Services are the dominating influence in the consumer spending pie, not goods, and services are much more sensitive towards labour costs. And wage growth is accelerating, this is actually one of the new paradigms, is that for the first time in probably a decade, the proletariat, the working class, realize that they are in a great bargaining position. Everybody thought the Phillips Curve was dead, everybody thought that workers were too scared to go to their bosses to ask for a raise, but guess what is happening? That’s what happens when you start seeing uneducated people getting hired, when you start seeing the surveys showing very clearly that the quality of labour is the number one issue among companies. And all of a sudden, companies are paying up to keep their existing staff.
I think that’s great news from a social policy perspective. For Main Street, higher wage growth is wonderful. For businesses, though, it’s a margin cramp, and of course, it puts the Fed in a bit of a box. Because it means they have to stay cautious longer than they otherwise would have in the face of what we’re seeing right now, which is a return to financial asset deflation. But the inflation we will see going forward will be from wages, this is the last part of the puzzle, classic late cycle, and this will be the last part of this cyclical inflation that we’re seeing right now, and I think it paints the Fed into a bit of a box, as it usually does late cycle.
The risk for the economy is not that the Fed is gonna raise rates too quickly, it’s gonna be that when it comes time to easing, they’re gonna be way too slow. That’s what happened back in 2000, 2001, that’s what happened back in 2007, 2008. The Fed was too slow to act. And the inflation pressures will probably reinforce that trend this time around as well.
Meb: What’s interesting is, you know, you talk a little bit in the “Breakfast with Dave,” and then this chart pack about how inflation has actually showed up a lot in assets with equities, particularly U.S. equities being one of the best-performing assets since the global financial crisis. And I love it, you had a magazine cover-indicator from “The Economist,” which was at the end of 2017, which had a cover of the bull market and everything.
And so as the cycle nears its later stages, you have a comment about, “So should your portfolio.” So maybe talk a little bit about some of the implications of where you think we are, and how that plays out for investors on a practical side, as far as what they should be thinking about as far as positioning.
David: Okay. So let’s first talk about the front cover of “The Economist” in October of last year, which had a picture of a bull, and the title was, “The Bull Market in Everything.” So as you had mentioned. And look, I’ve been in the business 35 years, and I’ve been around long enough to know that when something makes it to the front cover, you want to sell it, it’s already in the price. You want to sell the front-page news, and you want to buy the page B16 story on the way to page A1. But you want to fade the page A1 story, it’s no different. The most classic example was “The Death of Equities” on the front cover of “Business Week,” just ahead of what was a 20-year powerful secular bull market in the 80s and the 90s. “The Death of Equities,” that’s a famous one, you can google that. Google “The Death of Equities, Business Week,” and see what that looked like. Great, great contrary signpost.
So that got me thinking a year ago that all the news is priced in, and I remember giving my first speech of the year, second business day of the year at the Royal Oak Hotel in Toronto, where I had that chart up, and then the very next chart was the bars of every single asset class globally, everything was up last year. And not just Bitcoin, but the utility stocks were up 20% last year. The worst performing asset class in 2017 was the Barclays Global Bond Index that generated an equity of like an 8% return.
And I said at the time, “I don’t need a disclaimer for this particular chart, or what I’m about to say. I’m about to say that this is a once in 50-year event, what happened last year, 2017, and my forecast is that we will not be drawing this chart again in 2018, and we may never draw this chart again, have everything going up simultaneously, even asset classes that move inversely. We will not see this again, to this extent.” And maybe to some extent, 2018 is this classic Bob Farrell Rule #1, Mean Reversion, maybe it was really last year that was the insanity and this year is just the year of the Mean Reversion.
But the point that I was making in my presentation, I don’t have the slide package in front of me, but just back to first principles. When you’re taking a look at the post-World War II experience, and you look at what a traditional bull market looks like, the S&P 500 goes up 17% per year. People say, “Well, my broker told me the stock market goes up 9% per year.” Yeah, yeah, that includes the bear markets, I’m talking about just the bull market condition. And there’s been, say, almost a dozen of them. You’re up 17% at an average annual rate.
This time around, since the ’09 lows, the S&P, heading into the peak of this year, was up at, guess what, a 17% average annual rate. And so people would say, “Well, so what’s the big deal? We’re up 17% on an average annual basis, that’s the average, why are you bearish?” I say, “Well, because historically, you achieve the 17% per year increase in the S&P 500 with 4% real growth and 8% nominal growth in the economy. And this time around, we had an average stock market performance with real growth averaging 2% and nominal averaging 4%.
So let’s just get this straight. We had an economy, the economic fundamentals, running at half the rate it normally does, but we had a normal stock market. So if I’d actually superimposed, if I’d actually constrained the stock market rebound this cycle to the traditional relationship that the economy has with the stock market, I have constrained it to the traditional relationship, the S&P 500 would have peaked this cycle at 1800, not at 2940. So the question becomes, you know, that other, that excess, that delta of 1,000 points, where did that come from? That came from liquidity. Had nothing to do with the economy, it had to do with the construct of the Fed bribing companies to buy back their stock by keeping rates so abnormally low for so long.
So we have a situation where, yes, earnings per share did wonderfully well, because the share count went down to an 18-year low this cycle, that was a defining feature. Now look, I’m not gonna say we never would have had a bull market this cycle, of course. But if it was just about the economy and not about excess liquidity, we would have peaked at 1800. The market would have tripled instead of quadrupled.
And I’m pretty sure back in March of ’09, the 666 lows, so if I told any listener on this call that I would actually guarantee you that you would triple your money this cycle when everyone was hiding under the table screaming, “uncle,” I would have probably had everybody and their mother saying, “I’ll hit that bid.” And so, of course, in the case because of the extremes we have fear, in the extremes we have greed, this stock market went on to get repriced 1,000 points above what the underlying economic fundamentals would have justified. So if you get a drift as to where I think we’re going, I think what’s happened this year is an appetizer for what we’re probably going to get next year.
And so when I talk about, you know, late cycle investing, because I say we’re heading into the ninth inning, it means that you want to be defensive, you want to be focused on liquidity, you want to have a lot of cash on hand, you want to place more emphasis on the quality of the portfolio, that means heightened emphasis on sensitivity toward cyclicality, or GDP sensitivity, to keep that minimal. Earnings visibility carries on that much more of an emphasis in this situation, and in your fixed income portfolio, be mindful of your duration, but at the same time, especially if you’re in corporate bonds or credit, being very mindful about refinancing rests. Considering that, starting next year, we have a four-year tsunami where $3.5 trillion of U.S. corporate bonds get repriced at higher interest rates, at a time when 50% of the investment-grade market is rated BBB, or just one notch below junk.
So I call it, in terms of investing, it’s more about style, QLDS, Quality, Liquidity, Defensiveness and Sell Activity, in the sense that in the beginning of a cycle, you could have 60 stocks in your portfolio, abundance of opportunities towards the end of the cycle. And I’m not telling anybody you don’t be in equities, you just have to be smart about it. You have to call the portfolio and get it down to a handful of blue-chip liquid names out of your best and most high-conviction ideas. And that’s how you’ll survive over the next several months.
Meb: There’s a lot wrapped in that that I thought was really excellent. Let’s pause for a moment to hear from our sponsor.
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Meb: What’s interesting is you talk a lot about sentiment, and more of technical indicators than most economists we follow, which I like by the way, that’s a compliment. But it’s funny, you were talking about going back 2009, and I was referencing a recent study that our Betterment friends did, which is the automated digital platform, where they asked their… I don’t know if it was they asked their clients, or just did a broad survey, but asked how much people thought the S&P was up since the lows, and two-thirds of people said they thought the stock market was actually flat or down. Which is astonishing, you know, obviously because it’s up a lot.
But it’s been sort of a weird bull market to me in the sense that we had Howard Marks on the podcast and we were saying, “Hey, do you think a mania, euphoria, is required for the bull to end?” And it’s been sort of weird, because you’ve seen pockets of mania, certainly with crypto-currencies, and probably closer to you a lot of the cannabis companies, you know, but it hasn’t felt like the 1999 sort of party, blow-off top. But you did mention in one of your pieces, sort of a technical set up of a double top. Any thoughts on general sentiment? Has the conversations you have with CIOs and pension funds and all these other institutions, it felt more like a situation where everyone knows that the stock market and other assets are expensive, but they didn’t really do a whole lot about it. Any general thoughts on the topic of sentiment in general?
David: Well, you know, firstly, for people to say that this wasn’t like a wild party like in 1999, I mean I would never say this is like the dotcom bubble. No two cycles are ever the same, although patterns do emerge, and as Mark Twain taught us, that there is a certain rhythm to these cycles. You know, there was a popular notion that this was the most hated bull market of all time. And of course, this is a view promulgated by the bulls, but was basically just not the case, it’s just not true. People looked at the ICI data, at the mutual fund data and made that assessment, that people missed out on the rally. You know, there’s no way that they missed out on the rally because if they did, you wouldn’t have had the bloom in ETFs. How do you explain, how do you square that circle that people are underexposed to the equity market, or that there was no big party going on when you had the ETF industry balloon this cycle, in nine years, by a factor of 10? You know, how is that possible?
When you actually take a look at the Fed full funds, and you look at the household balance sheet, and you look at the representation of the household asset base in equities, it’s almost at the same level it was in 1999. It’s at the second highest level on record. So you really didn’t even have to buy a whole lot of equities, just re-balance off the lows, and the equity-asset share of total household assets has hardly ever been as high as it is today. The only other time was at the peak, back in ’99 and 2000.
You know, the survey data will bounce around a lot, but households are very exposed to equities. You know, there might be a skew to that distribution, I don’t have the data by region in the United States, or by income strata or wealth strata, but exposure in general is second highest than it’s ever been. We also look, when you go through a cycle and you start developing new acronyms, it doesn’t have to be an acronym, it could be even a nifty-fifty, you know, back in the late ’60s, the nifty-fifty stocks. We had something the cycles called FAANG, right? FAANG. We had indices that were linked to FAANG. We had a situation heading into the third quarter of this year where we had six stocks, so I’m including the FAANGM, so Facebook, and Apple, and Alphabet, and Netflix, and Google, and Microsoft, those six stocks accounted for 17% of the S&P 500 market cap back at the highs in September. That’s exactly the represent share that the six flashiest growth stocks of the late ’90s had going into the peak when NASDAQ rolled over in 2000, otherwise known as MILCOD, Microsoft, Intel, Lucent, Cisco, Oracle and Dell, hit 17% share.
And so actually, there might be a few more similarities than meets the eye in terms of what the breadth of the market was looking like. We headed into the peak this year where six stocks that were up roughly 50% accounted for half of the market gains, and we had what I called at the time the S&P 494, which at the peak of the market in September were up 3%. And anybody that follows my mentor, who was Bob Farrell, who famously said in his “10 Market Rules to Remember,” and I’m talking here specifically about Rule #7, markets are strongest when they are broad, and weakest when they narrow to a handful of blue chip names. And I’d say that for most of this year, that made it into my daily practically every single morning.
Meb: There’s a sentiment survey that we reference on Intelligent Investor, which has gone back to the ’60s, and our friends at Leuthold analyses on a slightly different time horizon, which is average sentiment yearly, and in 2017 actually clocked in as the second highest average sentiment year back to the ’60s. I mean not surprisingly, like the top 10 highest sentiment, the average S&P return the next year was like 0, and the worse sentiment was like 17%. But it’s interesting, you mentioned the percent of equities ownership, which it’s funny, we spend so much time building fancy valuation models here and all sorts of other things that that one simple indicator, that’s like the highest R-squared of any indicator we know of future 10-year stock returns, and it also, totally independent of evaluation, gives U.S. stocks basically zippo over the next decade.
All right. I wanted to shift a little bit because you mentioned a comment that I think is important and I would love to touch on is a lot of the commentary I’ve heard in the past from you is focusing a fair amount on fixed income. And you talked a little bit about corporate bonds and the situation going on there. Can you expand a little bit on what’s going on there? You mentioned a fair amount of the BBBs are a pretty big part of the corporate landscape, and there’s a fair amount coming due. What are your views on the corporate bond marketplace in general, and where is it going?
David: Well, I would say that actually for our next year, it’s a worrisome or bad news story, but a potential good news story. I know that sounds like an economist on the on hand, but on the other hand, but let’s just set up the table. I said before that corporate CEOs and CFOs were incentivized a cycle, and the arithmetic was simple, to embark on a spree of debt issuance to buy back stock. And we never did. I mean, even the numbers under Donald Trump, the capital spending growth numbers, have been no better, no worse than they were under Obama, we’ve never really had much of a CapEx cycle despite all those debt issuance. So it’s not even, you can say, “Well, this went into capital spending and it’s gonna earn some rate of return to more than cover the debt interest costs. I mean, this went to buy back stock.
So to the point where the corporate balance sheet in the United States is the weakest it’s ever been. We have a situation where the investment grade bond market has ballooned to $6 trillion, but the BBB component, and I mentioned this earlier, which is one notch away from being downgraded to junk, started the cycle 30% share as investment-grade, it’s now over 50%. We’ve never had this condition before, and it’s a $3 trillion market. I mean this is bigger than subprime was a decade ago.
So you have half of the investment-grade market on the cusp of being downgraded to junk, which would represent really a huge financial market tightening. And back on the economy, if you saw a preponderance of these companies get downgraded to junk, if they don’t get their act together, because, of course, once you get downgraded to junk, insurance companies and pension funds can’t hold your paper, and your cost of capital, your debt cost of capital and spreads are gonna widen out, it would be a cascading effect right through the rest of the financial markets, including equities, and back into the economy.
This is one of the principle risks going into next year, is the number of fallen angels, which is a term we’re gonna hear a lot more of. How many of these companies will get downgraded to junk, and then what’s the corresponding impact on your cost of credit? Now, the good news story is this, and I find what’s very interesting is that only 5% of this BBB debt, notwithstanding the fact, by the way, I should add, that the median debt to EBITDA in this BBB space is now 3.4 times, it’s never been that high. It started the cycle at 2.1, 3.4, and yet, only 5% of this BBB debt, which is enormous, I mean, you’re talking $3 trillion. Only 5%, mind you, are rated, have a negative rating outlook by the three major rating agencies.
Now you can sit back and say, “Well, there go the rating agencies again, they always just look after the issuer, who cares about the investor? Same old credit agencies.” But what I am seeing more and more of, lot of meetings going on between these BBB companies and the rating agencies. And what I find is gonna be a theme for the coming year, and the reason why the rating agencies have been patient is what these companies are telling them. And what they’re telling them is that the coming year is gonna be a year of three things. One of them is gonna be a total lack of bond issuance, you’re seeing it already. I mean there’s hardly any bid right now, liquidity is dried up in the sector, new issue activity in the corporate bond market, “Well, you couldn’t have sold this story a year ago,” has dried up completely. That’ll be a theme for next year. That should actually ultimately be good news for credit. But on top of that, you’re gonna find that the craze towards dividend payouts, the craze towards stock buybacks, is coming to an end.
So I think there’s a bit of a mean reversion, I know the folks on the call that are still on the equity market, and that’s their mandate, or maybe they just constantly love the equity market, those fund flows delivered tremendous returns in the equity market this cycle. I think that’s what’s changing. I think that’s old paradigm. New paradigm is that for the first time this cycle, companies are gonna be more sensitive to the needs of the bond holders than they are to the equity owners. So I think next year is a far less aggressive year for dividend pay-outs, far less aggressive year for stock buybacks, I think they actually come to an end and I think it’s gonna be a very limited year for bond issuance.
So you may actually find that even the spreads are widening out right now, and a lot of that is because investors, whether it’s in commodities or currencies or fixed time or equities, we are repricing it to a slower-growth world next year, there’s gonna be some nice opportunities, I think, in the corporate credit market. But there’s no get-out-of-jail-free card. Either we’re gonna have, especially given the ballooning refinancings next year at higher interest rates, which companies are gonna have to cover with their cash flows at a time when they’ve got to pay their people more, think about what that means for all the competing demands on cash flows next year. I think that’s gonna come at the expense of the equity market, that’s my sense.
But there’s no get-out-of-jail-free card, as I said before. Either we get a tsunami of either defaults, haircuts, fallen angels, and that’s gonna be deleterious for the corporate bond market. Or if they manage to stave it off, and if we go back and we say, “Aha, the reason why the rating agencies weren’t more aggressive is because they had assurances that this is what the companies are gonna be doing in the BBB space.” And they actually do what I think they’re gonna do, that will come more at the expense of the stock market next year than the corporate bond market. So interesting anomaly, gonna be very important to be positioned around that.
But my sense is that if we’re gonna come up with an underlying theme from what you just asked me on corporate bonds for next year, and I think it’s gonna have an impact on aggregate demand growth on the Fed, on pretty well everything, I think next year, we will look back as the year of corporate deleveraging.
Meb: You know, and so you talk a lot, you mentioned pension funds and the various ilk, and the thing that I consistently scratch my head about, we actually wrote a paper about this years ago, is if you look at investor expectations, and pension funds universally assume, I don’t know, 8%, I think they’re now conservatively moved down to 7.5%, but even institutions around the world survey after survey after survey, including individuals, even have higher return expectations, the most recent one I saw was 10%, with millennials up around almost 12%.
How does this play out? You know, so many of these pension funds you talk to, and you outline this kind of case for the way the world looks, and we agree pretty much with a lot of the things you’ve outlined, how do these pension funds, one, plan on achieving this 8% rate of return? Is it the saviour of private equity, or are they just totally delusional?
David: Well, look, it’s like what goes around, comes around. We were having this conversation 10 years ago. And so what happens, of course, is you go through a down cycle like we did, and then the pension funds end up re-balancing through the bull market. And so, I mean, a lot of pension funds got skated on-side big-time from what happened over the course of the past nine years. You know, maybe that was, again, one of the Fed’s goals. I mean, when you’re thinking back to QE2, QE1 by the Fed, I think even the most ardent libertarian would say, “Well, we had a market failure in mortgages, we have to do QE1, fine.
QE2 came out of nowhere. It’s interesting, when QE2 came out in 2010, it was like nobody was expecting it. On the day that it was unveiled, the market was flat. And then the very next day, the S&P was up 2% because Bernanke had planted an op-ed in the Washington Post telling people we’re doing quantitative easing to juice the stock market to get an equity wealth effect on spending. So it’s all about the stock market.
So the stock market under Bernanke, as much as it was under Greenspan, if not more so, was all about getting the stock market up, that’s all it was. So a lot of these pension funds, you know, managed to rebalance and cure a lot of their…shore up their liabilities dramatically by what happened this cycle. So basically, as I said before, at 8% total return expectation in March of 2009 was totally acceptable when you think that a balanced mix would easily have done that.
To have it today, mind you, at the multiples we have today, notwithstanding the fact that they’ve compressed some, depending on your time horizon, 8% is gonna be extremely difficult for the next several years. Now, look, we’ll have to keep an open mind, depending on how you’re positioned, but we may reach a point where we get those multiples way down again in the next few years, and we can then rebase those return expectations off of a more reasonable multiple and cheaper assets.
So it’s a bit of a moving target. But as it stands right now, it’s a low-odds bet that you’re gonna get an 8% total return over the next several years based on where the evaluations are right now, whether it’s cap rates, real estate, whether it’s the level of interest rates across the spectrum, or where the valuations are. So right now, that would be a totally unrealistic expectation, but I think we’ll probably revisit that. And when we get to the lows in the next 12-24 months, we’ll be able to rebalance back into an environment where those returns will get back to 8%. So it’s literally a missing target is what I’m saying, and it’s intertemporal in the sense that it’s time sensitive.
Meb: Interesting. Rob Arnott had a great phrase that he used on our podcast, which was talking about the concept of having a valuation mindset when you’re doing your asset allocation, and as opportunities arise, where things are stretched, he called it the concept of “over-rebalancing” towards valuation, which I think is a pretty interesting idea.
All right. Dave, we only have time for about two more questions. And so there’s so many things I wanted to talk about today, we didn’t even get into cryptocurrencies at all. We’ll save that for episode two. How do things look like in Canada? I got a lot of good Canadian friends, they love going skiing in Canada. I just went to the largest cannabis conference in the world, which is overstated, as you could probably assume it would be, would probably understate the reality of what the scene was there. What’s the Canadian economy and opportunity set look like these days?
David: Well, you know, Canada has so much potential, and yet we find a way to shoot ourselves in the foot. So I think right now the economy is meandering, you know, we haven’t had the fiscal stimulus here as folks in the U.S. had, so our economy’s lagged behind. And let’s keep in mind that maybe the biggest deal, I mean, I know everybody focuses on what’s happening in weed production, which may be at 20 basis points to growth on a very near-term basis, so it doesn’t really spin the dial. And then the next round of opportunities are probably more in the U.S. from an investing standpoint than in Canada, that’s my thought process anyway.
But it’s really this incredible discount between the benchmark oil price in Canada, the Western Select at $13, $14. And you know where WTI is, and although oil prices globally have come off, and we talked about that earlier, you have WTI at $53, and it’s been smoked today, but the Canadian benchmark is trading about $40 lower, and the discount is about triple what it normally is. And that, of course, has a huge impact on the royalties and on the revenues and on the economy here. It’s a dead weight drag, and it’s because we have a glut of production here that we can ship out because we don’t have the pipeline capacity just yet, and there’s only so much you can do via rail. And so that’s a big impediment in Canada right now, and I think it’s gonna take, ultimately, tremendous political leadership to finally get the ball rolling, if it’s not too late.
And I suppose the only good news I could say on that, as far as political, is that we’re only 11 months away from an election in Canada, and if you have a pro-business conservative bent, the good news is that Quebec has gone that direction, Ontario recently went that direction. You know, by the time the Alberta election happens a year from now, over 80% of Canadians will be under conservative rule. I think that might be a leading indicator for political change in Ottawa, we’ll see. I’m just talking about it strictly from a markets and business perspective.
But Canada’s got some big impediments. We have an over-inflated housing market that is now deflating. It hasn’t been destabilizing so far, but it’s certainly a detriment to growth. We have overextended household balance sheets and consumer credit here is slowing down, which is probably a good thing, but that comes at the expense of economic growth. The oil price situation is a dead weight drag on the resource sector in Canada, so the news isn’t all together that good. But you know, that’s the economist part of me talking. The strategist part of me talking is, “Well, as bad as the news is in Canada, how much is priced in the financial assets?” And when taking a look at the forward multiple on the TSX is down to 13. I mean, Canada’s starting to trade like an emerging market. And as bad as things are, we are not the Philippines, Malaysia or Indonesia.
And so we have a 13 multiple, it’s only been this cheap, Canada’s only been on sale this multiple level 5% of the time in the past. So call this a 1 in 20 event. So there’s a lot of bad news priced into our market here, there’s tremendous valuation support. You know, the U.S. multiple is closer to the 16, just a little below that, and you can count on your hands historically the number of times that the Canadian market, for better or for worse, was trading at this sort of a discount relative to the S&P 500. Last time we had a multiple discount this high, close to three points, was all the way back in the middle part of 2004, and to everybody’s surprise, the Canadian stock market pulled a rabbit out of the hat and outperformed the U.S. market by 1,000 basis points in the next 12 months.
So I would say that it comes down to the “front cover effect” once again. It works in the opposite direction in Canada right now. The front-page news is very negative. It’s reflected in very depressed multiples, and I think Canada right now, especially when you consider where the Canadian dollar is at 75, 76 cents, looks like a very attractive turnaround story, I would say especially for foreign investors.
Meb: I promised to get you out in good time, I have like nine more questions, so we’ll keep them in the back pocket for your return. Where is the best place for people to find you, follow you, want to read more? We’ll post, obviously, these links to the show notes at mebfaber.com/podcast, but where should people follow you?
David: So you can call me directly on my Toronto line, 416-681-8919, or just feel free to email me as well, it’s firstname.lastname@example.org. So I know that’s a mouthful, but it’s email@example.com, and we’d be happy to strike up a relationship. Anybody wants to get a copy of… I know we’ll do a trial of the daily that I’ve been doing since 1998, I’d be happy to oblige.
Meb: Very generous, maybe not very wise of you to open that up to all of our listeners, but listeners, be thoughtful before you spam Dave with all of your questions and ideas. Dave, thanks so much for taking the time today.
David: Great. All of the best to everybody. Thanks for having me on.
Meb: You guys, we’ll add the show notes, all of the free trial information as well as the free download, mebfaber.com/podcast. You can subscribe to the show on all of the various platforms, iTunes, Overcast, Stitcher, Breaker, my new favourite, as well as leave us a review, we love to read them. Thanks for listening, friends, and good investing.