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How To Invest In Q4: The Cheatsheet


Fiscal spending: is it too much?

  • With Covid we need a huge fiscal impulse to provide support to the economy.

  • In Q2 the federal, provincial and municipal governments borrowed 20% of GDP. This is outrageous but needed.

  • In Canada, Debt-to-GDP (including corporates and households) was 250% in 1990, 350% last year, and 450% this year. We’ve never seen levels like this.

  • Unfortunately, there’s no happy medium as this stimulus will continue to be needed for some time.

Inflation

  • US interest rates will be suppressed, not just short term rates but out the curve for an indefinite amount of time.

  • With so much debt, raising rates even a little will bankrupt everyone.

  • How do we get out from under this debt burden? David points to 3 ways:

  • Grow your way out… seems unlikely.

  • Default your way out… also unlikely.

  • Inflate your way out… seems MOST likely.

  • With respect to concerns of deflation, David notes that with this constellation of factors (high levels of debt, monetary policy, printing money) the risk is inflation over time -- not deflation

How does Canada look vs. the rest of the world?

  • Generally, we’re in the same boat as the US and Europe in terms of monetary policy and the Covid crisis.

  • However, the challenge is slightly worse in Canada because we started at a point of imbalance:

  • Too reliant on household spending with increasing household debt.

  • Consumer and housing markets have been our sole driver of growth.

  • The undertow of an impaired energy sector.

  • Now with COVID, the overall Canadian economy is further challenged by the hole that is being filled by government debt.

The Canadian dollar

  • David believes the CAD has room to weaken substantially in this environment.

  • Putting aside issues of household imbalances and even the debt issue, David points to the downgrading of Canadian debt in 1992-95, which saw the CAD depreciate 21%.

  • Today’s debt levels and the rate of borrowing are worse than in 1995.

  • This isn’t getting a lot of attention, but it's setting up more vulnerability in the economy.

  • The USD is in an environment of being weaker than stronger.

  • The supply of USD is what governs the global exchange rate regime, and the Fed is now spewing out dollars, which means supply is not restricted.

  • This USD will probably continue to go down.

  • The CAD can still depreciate against the USD, but the more likely scenario is weaker North American currencies against others such as the Yen or the Euro.

  • This is reflected in the positioning of funds managed by the GAA (Global Asset Allocation) Team.

Europe

  • Europe seems to be getting its act together vs. the rest of the world, which is surprising.

  • The fiscal authorities and governments recognize they must work together to provide a stimulus

  • This consolidation and the issuance of bonds backed by the Eurozone is a big deal.

  • Parallel to the Yen:

  • The reason the Yen has been strong, despite weak growth, is because of Japan’s current account surplus.

  • They’ve got a lot of savings that they push out to the rest of the world.

  • Europe is in this position now.

  • There’s flow into Europe and constant support to its currency, that can get invested back out.

  • It’s a structural setup where Europe can absorb a lot of outflows from places like the US, and therefore will see its currency appreciate.

MMT - Modern Monetary Theory

  • This theory has been around for a while but is only now entering the news.

  • The core tenet of MMT is that inflation is the only constraint on an economic system where a country issues its own currency.

  • David doesn’t totally buy into this theory.

  • We will test this theory by keeping policy stimulative until we run into the inflation constraint.

  • In his view, when it comes to inflation, it’s a matter of when not if.

Portfolio defense

  • For the last 30-40 years, you could play defense with government and corporate bonds.

  • Now we’re moving into an environment where the 60/40 setup won’t work nearly as well.

  • With rates at zero, there’s no cushion for bonds to perform well when stocks are performing poorly.

  • Nominal bonds are vulnerable to increasing inflation.

  • Need to be more creative in terms of diversification, risk reduction, and portfolio defense.

  • This means moving away from nominal bonds.

  • They’re looking at inflation-linked bonds (TIPS, RRB).

  • Currencies can also play a defensive role:

  • CAD is a pro-cyclical currency and varies with risk appetite/equity markets.

  • So pushing capital to counter-cyclical areas is a way to manage/reduce risk.

Equity component of a portfolio

  • We’re in a position where policymakers must spew money, and the money has nowhere to go but financial markets, and equities are the only game in town. This means the money will flow to equity.

  • Markets have gone up despite human and health challenges.

  • So as long as this persists for some time - you can’t be short equities.

  • Our Team is taking a barbell approach to equity, with a tilt toward growth.

  • In the US, they’re focused on more growth/tech names.

  • They have value, particularly outside of the US

  • They have also allocated away from Canada to emerging markets.

  • EM has good fundamentals and will benefit from a weaker USD.

Are we beginning to see a rotation from growth to value?

  • There’s been a lot of head-fakes from growth to value over the past few years.

  • Value will eventually work better, but it requires a robust economy.

  • When economies are weak, growth companies are more valuable.

  • We recognize that making these calls is very difficult.

  • Our team has a growth tilt but maintains exposures to value managers.

US election

  • Our view is that this will sort itself out.

  • The goal is not to pick the winner or to call when we’ll have the results, as these are both unknowable.

  • The highest conviction call you can make is that the aftermath will be messy, and this will lead to uncertainty.

  • This uncertainty can produce volatility over the last few months of the year.

  • If we get panicked selling at end of the year, they will take the opportunity to add to risk positions.

  • Because the US is the issue (ie, source of uncertainty), the normal case of buying more US equities might not apply.

  • This may ultimately benefit other parts of the world, rather than the US itself.

Canadian housing market

  • Within Canada, the our Team has been concerned about valuations relative to household incomes for years.

  • However, we are less worried about this today than we were two years ago for several reasons:

  • Interest rates have gone down further and will stay down for some time.

  • Around the world, governments are taking the debt burden from households as they borrow and give to households.

  • Household debt actually went down recently.

  • We're more worried about the economy as a whole with the unsustainable mass accumulation of debt.

Financials and low net interest margins (NIM)

  • This is one reason why our team has been shying away from value stocks, as they are largely composed of financials.

  • In a world of financial repression with low NIMs, it’s hard for banks to make money.

  • Canadian banks are relatively resilient, but will still face this hurdle.

  • They’re cheap, but cheap for a reason.


Key takeaways:

  • Interest Rates: US interest rates will be suppressed, not just short term rates but out the curve for an indefinite amount of time.

  • How do we get out from under this debt burden?

  • Grow your way out… seems unlikely.

  • Default your way out… also unlikely.

  • Inflate your way out… seems MOST likely.

  • With respect to concerns of deflation, with this constellation of factors (high levels of debt, monetary policy, printing money) the risk is inflation over time -- not deflation. Our team believes the CAD has room to weaken substantially in this environment. The CAD can still depreciate against the USD, but the more likely scenario is weaker North American.

  • Now we’re moving into an environment where the 60/40 setup won’t work nearly as well.

  • With rates at zero, there’s no cushion for bonds to perform well when stocks are performing poorly. Nominal bonds are vulnerable to increasing inflation.

  • Our Team is trying to be more creative in terms of diversification, risk reduction, and portfolio defense.

  • This means moving away from nominal bonds.

  • They’re looking at inflation-linked bonds (TIPS, RRB).

  • Currencies can also play a defensive role.

  • Have added gold positions to manage both volatility and inflation.

  • Financials and low net interest margins (NIM): This is one reason why the Our Team has been shying away from value stocks, as they are largely composed of financials.

  • In a world of financial repression with low NIMs, it’s hard for banks to make money.

  • Canadian banks are relatively resilient, but will still face this hurdle.

  • They’re cheap, but cheap for a reason.

Discipline is what it takes to block out the noise, commitment is what it takes to walk the path to financial success and patience is what it takes to reach the goal.


Clement Chung, CFP, CLU

Certified Financial Planner

www.clementchung.com


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CLEMENT CHUNG, CFP, CLU

Certified Financial Planner

Fee-Based Financial Planning
Burnaby & Metro Vancouver

©2018 by Clement Chung.