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Macroeconomic Outlook: Hello, Chickens

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By Joel Clark, CEO of KJ Harrison Investors

To say that the past few weeks have been rough for financial markets might be the understatement of the year. From April 1 to mid-May, the S&P 500 declined by nearly 12% – a full-blown correction. Canada’s S&P/TSX composite declined by more than 7% over the same period, even though its high commodity weighting had previously insulated the index as inflation surged. Bond markets, which traditionally promise investors shelter during equity storms, have provided none. Yields are up and prices are down as monetary policy tightens. For investors, pain seems to be everywhere. They are caught between a rock and a hard place. Between Scylla and Charybdis. In a Catch-22. Pick your aphorism for “nowhere to hide” – they all apply.

So do two other sayings that speak to how we found ourselves in this challenging situation. One is, “The chickens have come home to roost.” The other is, “The fox is in the henhouse.”

Let’s talk about those chickens first. Back in 2020, at the dawn of the COVID-19 pandemic, governments around the world opened the purse strings to prop up their respective economies. The United States led the way, paying people not to go to work, which created some unusual labour dynamics. On the monetary side, the U.S. Federal Reserve ramped up quantitative easing (bond-buying) and dropped its benchmark interest rate to zero. At the same time, low rates and extraneous forces like the rise of the ESG movement, which focuses on environmental, social and governance factors, led to chronic under-investment in commodities industries. In short, the climate was perfect for runaway inflation, and when economies began to reopen last year, that is precisely what we got. The Russia-Ukraine war has only worsened the problem, and the “chickens” of easy monetary policy have come home to roost.

 

Now let’s talk about the fox: inflation. Until early this year, the Fed was adamant that rising prices were a transitory phenomenon, effectively assuring investors that there was no need to worry. But as well-above-trend inflation continued, the Fed was forced to change its tune. “Transitory” gave way to “persistent,” which has now become “structural.” So rates are going up, quantitative tightening (the reverse of easing, obviously) is coming, and the markets have been on a vicious decline ever since.

In fact, for as much as we’ve talked about chickens and foxes and havoc, these environments are where investment opportunities are born.

One problem with letting a fox into a henhouse is that it can be very hard to get it out, and this particular fox is wreaking havoc in markets. Case in point: the reaction to Fed chair Jerome Powell’s remarks after the central bank’s policy meeting in May. As expected, Powell set out the path for interest rate increases and quantitative tightening, but he also noted that the Fed was going to be “data-dependent” going forward. Equity investors interpreted that comment as a mildly dovish pivot, and stocks rose. But then, as the realization set in that any dovish turn would only give the inflation fox more to eat, stock markets turned sharply down and bond yields rose.

You can’t blame central bankers for trying to engineer a soft landing for the

economy, of course, but that is just not how the world works. The effects of years of easy money and investor speculation are probably not going to be unwound easily. Supply issues, created by the lingering effects of the pandemic, the war in Europe and the under-investment hangover in commodities, are important drivers of inflation right now, and there is precious little the Fed can do about those. So if it and other monetary policymakers really want to whip inflation, they really have no other choice but to focus on the demand side – and expressly destroy demand. Slowing down the economy is the only clear way out, even if it risks a (hopefully mild) recession. In other words, when it comes to tightening, the Fed may have to overdo it.

In the meantime, markets are normalizing, in both bond yields and equity valuations. Investors are scared; many are liquidating. This is part of the normalization process. Most people, when they see markets extremely volatile to the downside, shrink their time horizons and react to day-to-day events. Yet investors might do well to remember that a business’s value is a function of its long-term cash flow, and good companies usually thrive through environments like this one. Many businesses may even welcome a recession, if the short-term pain helps resolve supply-chain issues and structural challenges in the labour and commodity markets.

In fact, for as much as we’ve talked about chickens and foxes and havoc, these environments are where investment opportunities are born. Bond yields have backed up significantly, and if central banks are successful in slowing demand and inflation, then fixed income has the potential to become quite attractive. (On the other hand, if inflation proves sticky and the Fed slow-hands tightening, bonds will probably continue to struggle.) In equities, high-quality growth stocks tend to thrive independent of the macro environment, and they have been hit hard amid all the volatility, to the point where they are beginning to look like long-term values. This applies especially to commodities, where significant under-investment in reserves and production has led to shortages across a broad spectrum of commodities, including basic materials and energy.

When everyone else is panicking, smart investors should try to remain calm and look for opportunities, because leaving markets amid volatility is a recipe for destroying wealth. Normalizations are painful processes to go through in the short term, but over the medium to long term, the value of great businesses will shine through. To extend our already mixed metaphors just one last time: when the henhouse is full and the fox is let in, most people want to fly the coop. Think twice before joining them.

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