Are We Having a Recession or Not?
Most think so. Some foresee a soft landing—where the economy barely skates through. Few have no opinion. It’s one of the most important questions investors must ask because stock markets usually fall dramatically from the impact of a recession. Will we have one? We think so.
Globally, growth is waning, though at a tepid pace because of the prior avalanche of government stimulus, rebuilding of supplies, and extremely low unemployment. Will central bank restraint lead to a mere petering out of growth, if inflation is quickly perceived to have been ameliorated, or is recession inevitable from one of the fastest tightening responses on record?
Even if there is a change in perception that inflation has been tamed (which we believe should be the case), the authorities likely won’t loosen since they’ll be worried about reigniting inflation, as they did in past cycles.Therefore, while short-term administered interest rates may be close to peaking, we don’t expect declines in the near term, unless the economy experiences a harsh decline.Meanwhile, food prices remain stubbornly high, and a good portion of the recent slowdown of inflation was attributable to the dip in gasoline prices, which are now rising again since the oil market is tight.Even excluding food and energy, inflation is too high.
Gone are the days of zero-interest rates policies, and the negative rates that absurdly occurred in some jurisdictions. Yet security valuations have not sufficiently adjusted, especially considering the prospect of a recession and already declining corporate profits. And central banks certainly don’t wish to rekindle the speculative fervour that accompanied such low interest rates.
Good News Isn’t Good News
Remarkably, despite most believing a recession is imminent, investors’ attitudes could best be described as nonchalance. Perhaps because inertia is a powerful force, and most are reactive. Or while unemployment is so tame and consumers are in such good shape, most aren’t worried about its impact on themselves yet. But good news is bad news, at least economically right now, because for example, central bankers are concerned that a tight labour market (near record-low unemployment) could lead to undue wage inflation (ADP figures just showed a 7.3% annual increase and much higher for those changing jobs), and a further overall impact on prices generally, especially in services where inflation is still rising.
Corporations have been able to pass along price increases.Customers have accepted them.A psychological shift that we haven’t seen in years.The services side of the economy represents about 60% of the CPI.Though it’s terrific, despite the triple-threat of covid, RSV, and the flu, illnesses are down from last year, the services economy is now flying with everyone emerging from their covid cocoons.Expect central bank tightness to remain, leading to lower aggregate demand.Unemployment bottoms just 2-3 months prior to a recession—risk of one remains high.
Central bankers keep saying they’re not done raising rates. Fed Chairman Jay Powell just said, “We're not yet at a sufficiently restrictive policy stance, which is why we say that we expect ongoing hikes will be appropriate.” And the Fed minutes show unanimity against cutting rates this year. In Europe, Central Bank President Christine Lagarde noted that they intend to aggressively raise rates until inflation is below their 2% target.
Dislocations have started from higher rates. New home building cancellations in the U.S. were extremely high in Q4 as buyers opted out. Astonishingly, prices of detached homes in Toronto have declined by 18% in the last 12 months.
The World Bank is forecasting for 2023 the weakest global growth rate in 30 years, other than the Great Recession of '08/09 and the 2020 covid-lockdown. While the Atlanta Fed, who’s proven to be rather accurate, estimates real U.S. GDP growth this quarter of 2.2%, economists, on average, expect the U.S. to grow by only 0.1% in Q1 and contract by 0.4% in Q2. Already, 27 U.S. states are experiencing negative growth versus an average of 26 at the beginning of the last 6 recessions.
Companies are feeling the pinch. And while rightsizing has begun in the form of hiring-freezes and layoffs, profit margins should be impacted by slower sales volumes and higher input costs. Each of Wal-Mart, Target, and Amazon have increased hourly wage rates for front-line workers (we can almost tell the kids to stop rallying for minimum wages since capitalism is working). Many tech companies have been announcing substantial layoffs to both right-size for the current environment and contain costs generally.
Demographics in most developed countries still point to slow growth as population growth is anemic. Even in China, the primary global growth engine, its population fell in 2022 for the first time since the '60s.
Debt at all levels of government in most developed countries remains way too high, and more burdensome as rates rise. Despite this, government spending remains excessive, especially relative to the prospect of lower recessionary-induced tax receipts. High debt levels also act to stifle growth since there’s a limit to its expansion. At the corporate level, lending standards have already tightened which should impede new debt financing and, in turn, growth.
Excess savings of U.S. consumers are expected to dry up around the middle of this year. And industrial commodity prices as well as used car prices have fallen significantly in recent months, both indicators of a recession.
Our Economic Composite (TEC™) triggered a negative signal in October for the U.S. TEC™ has historically forewarned of a recession, on average 10 months prior to the peak in the business cycle without a false signal. We’ve also had negative signals for Canada, Germany, and the U.K. A synchronized slowdown in many nations around the world is concerning.
Historically, when the LEIs (U.S. Conference Board’s Leading Economic Indicators) were negative and falling, as they are now, a recession invariably occurred, and the stock market declined at an annual 11% rate. However, when the LEIs are still negative but start rising, returns average 30%. Hopefully that infection point isn’t too far off. Our optimistic nature is trying to find the silver lining, but we’re grounded by realism and continue to err on the side of caution.
Currently, all 3 major components of calculating fair market value (FMV)—earnings, growth rates, and interest rates—are heading in the wrong direction.
Even more reason that our preferred investments are self-sufficient—those that have free cash flow, a solid balance sheet, competitive advantages, and an attractive growth profile. Not companies that are dependent on the markets for success. Last year, many businesses that were unprofitable or over-levered suffered material share price declines when their access to capital evaporated. While an investment should benefit from others ultimately bidding it up in price as the underlying fundamentals justify so, it should not be reliant on other people’s money to keep the business afloat, with the mere perception that it’s an exciting opportunity—that’s a speculation.
We look to benefit from a gravitational pull up toward fair value. And avoid the eventual plummet in speculative companies when hype fades and FMV support is absent.
But we are concerned about a recession which brings job losses, falling asset prices, and credit issues (i.e., debt defaults).
For the Nasdaq and S&P 500, the current price-to-earnings multiples of next-12-month estimated earnings is about 25% and 13% above their respective 20-year averages, despite higher interest rates (which lowers values), the prospects of a recession, and earnings estimates that are already down 10% from last year’s peak for the Nasdaq, and just over 5% for the S&P 500.
And few sectors are beaten up enough to pique our interest. One analyst we follow is warming up to Ukrainian real estate. Don’t worry, even we aren’t that contrarian. He’s serious, and it’s an interesting argument for many reasons, once the war ends. Again, don’t worry, there’s enough in our opportunity set closer to home.
Our relative indicator of momentum, TRIM™, which normally triggers after our Economic Composite, signaled for a market decline in the U.S. starting in May of last year when index prices fell below key levels. The recent market rebound has been testing the top of our TRIM™ bands, but prices appear likely to turn back down.
Markets are richly valued and remain too high particularly relative to interest rates.Call option buying is at a record high—speculation has picked up again, leaving most markets overbought.
The U.S. dollar is oversold. The Euro is overbought. Gold bullion is overbought, and too high relative to the average cost of production. Bitcoin has run up suddenly. And the most heavily shorted stocks are this year’s winners, up over 30%. None of this is healthy for stocks.
And surprisingly, the credit spread between U.S. high-yield and government bonds has only been this narrow (i.e., overlooking risk) on 5 other occasions over the last 100 years, and all preceded a recession where spreads then widened dramatically.Furthermore, investment-grade corporate bonds now yield less than T-bills, which is extremely unusual.Yields on cash balances finally offer a decent return, though not a real return—still below inflation.
While most believe a recession is coming, it appears few have yet to react. For us, it paid to be defensive last year when markets declined. By way of example, U.S. stock indexes and U.S.
10-year government bonds both fell by double digits—a first.
The bear market has paused over the last several months.Stock markets have rallied strongly while the economy has held up, despite high valuations and the potential for recession.
With our TEC™ alerting us to a recession and our TRIM™ alerting us to a bear market, we remain with reduced exposure to the market. We expect to keep a hedge in place until markets have declined sufficiently to discount the impact of a recession, or the macro environment has a complete about-face.
It would be precedent setting for next-12-months’ earnings estimates for tech stocks to have fallen, as they have, without a recession ensuing. Thus, we expect earnings to decline further as the economy worsens.
That said, most of our portfolio holdings have growing earnings, generally because the businesses we hold aren’t cyclical. And our holdings are also undervalued compared to our FMV estimates. We hold and continue to add positions in companies that we believe can withstand an economic downturn and be even more valuable after a recession. We have prized businesses with essential products or services, whose balance sheets are clean or manageable, and returns on capital are attractive.
We are always on the lookout for quality companies that have detached from their underlying FMVs, usually because of short-term issues or misconceptions. A declining economy should bring uncertainty and market dislocations—opportunities to invest in high-quality companies that have been temporarily discarded.
The following descriptions of the holdings in our managed accounts are intended only to explain the reasons that we have made, and continue to hold, these investments in the accounts we manage for you and are not intended as advice or recommendations with respect to purchasing, selling or holding the securities described. Below, we discuss each of our new holdings and updates on key holdings if there have been material developments.
All Cap Portfolios—Recent Developments for Key Holdings
All Cap portfolios combine selections from our large cap strategy (Global Insight) with our small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and lower volatility. The smaller cap positions tend to be less liquid holdings which are more volatile; however, we may hold these positions where they are cheaper, trading at relatively greater discounts to our FMV estimates, making their risk/reward profiles favourable. There were no material changes in our smaller cap holdings recently.
All Cap Portfolios—Changes
We made changes among our large cap positions summarized in the Global Insight section below.
Global Insight (Large Cap) Portfolios—Recent Developments for Key Holdings
Global Insight represents our large cap model (typically with market caps over $5 billion at the time of purchase but may include those in the $2-5 billion range) where portfolios are managed Long/Short or Long only. At an average of about 70 cents-on-the-dollar versus our FMV estimates, our Global Insight holdings appear much cheaper, in aggregate, than the overall market.
Global Insight (Large Cap) Portfolios—Changes
In the last few months, we made several changes in our large cap positions. We bought Walt Disney, Bank America, Onex, Stellantis Brookfield, and Koninklijke Ahold Delhaize. We sold some positions for tax-loss purposes prior to year end and sold Comcast and Electronic Arts when both increased toward our FMV estimates. Altice was eliminated because our outlook for it soured relative to other investment opportunities.
Disney’s heavy investments in its streaming platform have crushed its once-attractive operating metrics. Return on invested capital dwindled to low single digits, a far cry from the mid-teens the company used to consistently generate. We watched Disney’s streaming adventures from the sidelines, believing the stock to be too pricey. Finally, after a 50% decline from its early '21 peak, Disney shares reached a price sufficiently below our estimated FMV of $120 where we felt the risk/reward was in our favour. After our purchase, 3 notable activist investors took sizeable positions, intending to influence Disney’s return to its former glory. We see streaming losses peaking this year and revenue growth accelerating on price increases and a new ad-supported subscription tier. The rest of Disney remains strong, with travel to parks at pre-pandemic levels, Marvel and its other studios churning out blockbuster movies, and ESPN dominating global sports viewership. A recession will likely hurt its ad-supported businesses and dampen movie and park ticket purchases, but we see cost cuts and strategic initiatives offsetting demand destruction.
Bank of America, the second largest U.S. bank, should enjoy tailwinds now that most of its legal and regulatory issues, stemming from its acquisitions of Merrill Lynch and Countrywide during the '08 Financial Crisis, are behind it. The focus will now be on the performance of its banking franchise where business looks promising, especially with higher interest rates boosting interest margins. Q4 revenue grew 11% year-over-year and return on tangible equity reached 16%. Customer satisfaction is at an all-time high. Net growth of new accounts is growing at twice the pre-pandemic rate. A recession should hurt its capital markets and investment banking businesses; however, its core bank customers have strong balances that are several multiples of pre-pandemic levels. Our FMV estimate is $38.
Onex has been impacted by equity and credit market volatility which has raised questions about its fundraising ability for new credit and private equity products. While capital deployment has slowed—and management has acknowledged that fundraising is taking longer for its new funds—we believe the appetite for private equity and credit opportunities should remain strong. Onex’s disciplined approach, supported by a strong 40-year track record, should continue to make it an attractive option for allocators when markets stabilize. Meanwhile, new leadership for its Gluskin Sheff wealth management unit seeks to turn around the firm’s uninspired performance. We believe Gluskin Sheff could be an important distribution channel for Onex’s private equity and credit products. Onex share price slumped by about 35% in '22 to trade at its steepest discount to its sum-of-the-parts value since '08. On its recent earnings call, management took note of the large discount of its stock price to invested capital per share of $123. We expect stock buybacks to accelerate. Our FMV estimate is $90.
Stellantis was established in '21 when Fiat Chrysler merged with PSA Group. The combination created the fifth-largest automobile company in the world with manufacturing facilities in over
30 countries. Brands include Dodge, Ram, Maserati, Alfa Romeo, Peugeot, Citroën, Jeep, and Chrysler. The company’s premium U.S. brands have the highest average transaction price per vehicle among peers. Stellantis’ market share is a solid 11% in North America but is really dominant in Europe and South America where it commands market share in excess of 20%. Like many peers, it experienced supply chain challenges throughout last year. Management sees its supply chain returning to full strength by the end of this year. We see a long runway of growth ahead as the company introduces electric vehicles under its popular global brands. A recession and higher rates are near-term headwinds but a lack of new car inventory over the last couple of years has created pent-up demand. Furthermore, with over €24 billion of cash on the balance sheet, it has the financial strength to weather a downturn, and it’s priced well below our estimated FMV of $41.
Brookfield is somewhat complex in that on December 9 it changed its name from Brookfield Asset Management and distributed to shareholders 25% of the asset management business taking the name Brookfield Asset Management.The original company was renamed simply as Brookfield Corporation, which owns 75% of Brookfield Asset Management, and significant stakes in Brookfield Property, Brookfield Energy, Brookfield Infrastructure, as well as an insurance arm and other private assets.The new structure should provide Brookfield with the flexibility to pursue value-creating transactions.Our estimated sum-of-the-parts valuation is $41 with conservative valuations used for Brookfield’s publicly-listed entities.
Koninklijke Ahold Delhaize (Delhaize) is one of the largest food retailers in the world, operating over 7,400 stores in 10 countries. The company has over 1,100 Food Lion stores in the Eastern U.S., while Albert Heijin is the largest supermarket chain in the Netherlands with a similar number of locations. Other European brands include Delhaize, Etos, Alfa Beta, and ENA. The company’s profitability metrics are amongst the best in its peer group globally. With over
€4 billion cash on its balance sheet, multiple value-based brands, and tight cost controls, Delhaize should be able to navigate a global recession. Its European operations should benefit from stabilizing energy prices, after rising energy costs hurt operating margins last quarter, mostly because of the war in Ukraine. Despite numerous macro challenges last year, management was still able to hit its €2 billion free cash flow target. Our FMV estimate is €35.
U.S. high-yield corporate bonds (ICE BofA Index) yield 8.0%. Yields were as high as 9.5% a few months ago, over twice year-ago levels. However, these corporate yields could lift if government yields keep rising, or more likely if defaults rise and spreads versus government bonds widen, as a result of economic decline. Our income holdings have an average current annual yield (income we receive as a percent of current market value of income securities held) of about 6.4%, and most of our income holdings—bonds, preferred shares, REITs, and high-yielding common shares—trade below our FMV estimates.
We completed some tax-loss selling at the end of last year but once again bought no new positions in the last few months, mostly since we remain in a defensive posture. However, some appealing opportunities have surfaced which are likely to be included in Income portfolios shortly.
All Bad Things Must Come to an End
We expect a recession. Our Economic Composite, TEC™, has warned us that the business cycle is about to peak. It alerted us in 2019 to the pending 2020 recession—and in a backtest dating back to the '60s alerted to all 8 previous recessions. Central bankers continue to tighten, essentially trying to engineer a recession, just not a severe one.
Oddly, market valuations remain relatively high. Therefore, we continue to have patience during a period that feels particularly elongated. We have been culling certain holdings and adding other ones—undervalued high-quality businesses—when the risk/reward setups are favourable.
Markets rarely fall for 2 consecutive years. And it may be the case that this isn’t a down year. However, the path to us still appears highly uncertain with the prospect of a recession soon and the lower market prices that traditionally accompany economic declines. And while markets might be anticipating the peak in interest rates, the material portion of the market’s decline isn’t typically until the central banks first lower short-term interest rates, in response to economic decline.
The good news is that recessions don’t usually last very long as the cleansing period is relatively quick. In the interim, we’ll wait for the onset of a recession, for the bad news to be discounted, sufficient investment opportunities to be presented, the prospect of higher returns to be resurrected, and our portfolios to once again be fully invested.
Randall Abramson, CFA
Generation PMCA Corp.
February 14, 2023
All investments involve risk, including loss of principal. This document provides information not intended to meet objectives or suitability requirements of any specific individual. This information is provided for educational or discussion purposes only and should not be considered investment advice or a solicitation to buy or sell securities. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. This report is not to be construed as an offer, solicitation or recommendation to buy or sell any of the securities herein named. We may or may not continue to hold any of the securities mentioned. Generation PMCA Corp., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities named in this report. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. E.&O.E.