The first three quarters of 2022 have brought a historic rise in mortgage rates and a rout of stock and bond market values. I have created charts of monetary aggregates and indexes, beginning with the 15-year chart below to put some context around what's been happening. Please feel free to skip to the recommendations at any point!
"We know where we're goin', but we don't know where we've been."
David Byrne, The Talking Heads
The Blue line in the chart below illustrates the dramatic response by the US Federal Reserve Bank (The Fed) to the onset of the global pandemic by increasing the money supply (M2) beginning in the first quarter of 2020. Monetary aggregates like M2 change primarily for two reasons,
Business borrowing (an indication of business confidence, increases M2) and
Management (manipulating interest rates) by central banks.
The red line shows the direction of the S&P 500, a good index of US Stock market performance. Notice how the direction of the stock market followed the dramatic increase in the US Money supply with a lag. Increases in money supply (borrowing) are typically associated with reduced interest rates, and 2020 was no exception. Reduced borrowing costs led to asset price inflation in stocks, bonds, and home prices.
This next chart (below) shows a 5-year perspective on M2, the NASDAQ 100 index, and US GDP. Again the direction of the money supply change from a year earlier is followed by the stock market and GDP.
This next chart shows the monetary growth in Canada followed a similar pattern to the US. What is apparent from these three charts is how the money supply growth has returned to more historically average growth rates or below. But just as increased money supply reduced prevailing bond and mortgage rates, the reduction of money supply growth has been similarly dramatic, with consequences for bonds and growth stocks (tech stocks) especially.
This next chart shows the dramatic turn in 5-year Canada bond yields. When bond yields rise, mortgage rates rise, and bond values fall. The dramatic, self-imposed rate hikes by the central banks subverted the diversification benefits that bond holdings have historically provided to balanced portfolios. The good news is bond yields haven't been this high since 2007 and are likely to plateau or fall soon.
This next chart illustrates the very rare fall in the Canadian Bond Total Return, -9.63% over the last 12 months, which is still better than the NASDAQ, down 30% YTD, but unpleasant, nonetheless. The silver lining is that these dramatic changes in money supply have been self-imposed by central bankers and will be unwound, to some extent, as soon as inflation mitigates or unemployment spikes, whichever comes first. I believe bonds will reclaim their safe haven diversification role. The real question is whether the central bankers will have raised interest rates so much for so long that fear takes over, which can be hard to redress (google "the paradox of thrift" for more on this).
As you can see from this next chart, higher interest rates are already taking their toll on home prices in Canada. This could get much worse now that the qualifying rate on new mortgages has reached 7%! If this trend continues, central bankers may have succeeded in replacing pandemic-related inflation with deflation or stagflation, which are both worse.
Harbingers of Stagflation?
Here is a screenshot of news headlines from late September 2022. The first headline indicates the hawkish treatment of interest rates and supply-related price increases are likely to result in reduced demand and corporate profits, which, together with interest rates, form the basis of stock market valuations.The second headline shows a positive trend of immigration with the potential to mitigate some of the labour shortages that have been driving employment costs and inflation.The third headline is another sign that raising interest rates and reducing the money supply may simply serve to erase demand from an economy already absorbing inflation caused by supply shortages rather than excess demand!
So What is an Investor and Mortgage Borrower to do in the face of such a mixed message economy?
First the mortgage question. It's apparent from the Canadian monetary aggregates chart above that money supply growth began its descent early in 2020 and approached negative growth early this year. Had we been watching the money supply more closely, we might have anticipated rates would rise. Labour shortages were the best early indicator. But these hawkish rate hikes have been a deliberate policy by central bankers, unusually fast and large and quite possibly overkill, so it was near impossible to predict the extent to which they have gone.
Locking in at this point, however, runs the risk of locking in near the peak of rates, given that the signs of an economic slowdown are already accelerating. There is a good chance that the variable rate mortgage will average lower than the current level of rates over the next five years.
The compromise position might be to lock in your mortgage for shorter periods of time, like two years? If we knew for sure, we'd be richer than Elon Musk! Personally, I'm still betting on variable rates being the winners from here at least.
For Investors, the question is how to take advantage of bear market valuations when the bottom of stock prices remains uncertain? Here are some guidelines and options I have recently implemented:
Don't forget the bonds! Thanks to rising rates, bonds are offering the highest yields in 12 years. The rate hikes have been largely self-imposed discipline, which will likely plateau and/or relent in the months and years ahead. This will make balanced solutions and hybrid funds perform better than in the recent past. I particularly like funds with automatic portfolio rebalancing.
Similarly, Dividend funds perform better in a slower economy while providing a simultaneous hedge against inflation. I have recently added a Canadian Dividend Growth fund to the model portfolio as Canadian stocks have held up better (lost less) than most in this bear market and provide unique diversification benefits. Canadian resources will be in demand as the world adjusts to climate change and its effects.
Infrastructure is another theme I have added to the model portfolio because infrastructure funds have been steady performers over the past decade and are likely to continue to do well as governments and others make major adjustments to address global warming and its effects.
NASDAQ 100 Tech stocks Technology companies play an outsized role in modern society and the economy, which is bound to be reflected in their stock prices in the long run. Unlike the dot.com boom, large tech companies now have real earnings and abundant cash. Current prices are down 30% from the peak and will look like bargains at some point, patience may be required, but as you can see from the chart below, it's historically been a good time to hold on or invest.
5. Dollar-cost-averaging. For new contributions to non-RRIF accounts, it is possible to take up new positions gradually with a DCA agreement that invests your capital incrementally over 12 months instead of immediately. I am recommending this to clients who are adding to existing positions in tech stock funds especially.
6. Participating Life Insurance (Par) adds new dimensions of security, and opportunity!, for the non-registered portion of a retirement/estate plan. This form of life insurance creates a tax-efficient and predictable payout to beneficiaries. However, it also gradually builds a cash value tax-free with the insurance company's own in-house investment portfolio that can be easily borrowed against (without tax consequences or payments!) for retirement income or investment purposes. Par life is also an efficient way to gain exposure to private equity assets, such as commercial real estate and mortgages. Target rates of return have been around 5.75% per year tax-free!
7. Batten down the Hatches; The goal of every financial decision should be to make you stronger. It's going to be a bumpy ride for the economy. Unemployment can turn on a dime, see my previous blog post, and usually peaks right after it troughs! The world economy has been on stimulus for so long, it's going to take some time to return to a more stable equilibrium, if there is such a thing.
8. The importance of being liquid. The general advice is to maintain liquid assets i.e. cash of 10-20% of your financial portfolio (three to six months living expenses). This can be in checking, savings, or short-term GICs. Another option here is market linked certificates (I can offer all these). But this does not include available lines of credit! At the bottom of the great recession in 2008 many client received letters from their banks, "Dear Mrs. client, remember that line of credit you have been counting on as a safety net? It is now converted to a term loan with fixed monthly payments. Have a nice day."
9. U.S. Dollar denominated assets. Like it or not, the United States remains the largest, most diverse, and stable economy in the world. When times get tough, the tough get dollars, U.S. Dollars. Holding US weighted funds has already mitigated at least some of the downside swings for most portfolios.
10. Be Patient. Never underestimate the ability of human beings to make a buck. The point at which things are worst is usually the best time to invest. We just have no idea exactly where or when that will be, which is why diversification, automatic rebalancing mechanisms, and patience are key.
If you are still awake after all that, please feel free to contact me with any questions you may have.
Layth Matthews, MBA, CIM