Real vs. Nominal GDP

When inflation was at 1-2%, the mental adjustment from nominal to real GDP was pretty simple to calculate. If nominal was above 2%, it means you got growth. If it was between 0-2%, you got negative real growth. If it was below 0%, there would be a media panic about the end of the world.

Now with inflation at 8.1%, a nominal growth of 4% might sound good in ‘ordinary times’, but today is deeply negative on the real end. Since almost nobody is getting 8.1%+ wage increases, it means everybody without hard assets are falling behind in relative purchasing power terms.

If we get a 2% real GDP print, with the current CPI rates, it means things increased 10% in nominal terms. Just think of all the extra tax revenues that come out of this (although CPI-linked expenses will also rise, accordingly).

There is also the impact of capital gains taxes to consider. Say you purchased an asset for $100 last year, and today it is $108.10. While you made $8.10 in nominal terms, in real terms, your investment is still worth exactly the same as it was when you purchased it. However, when you go and dump the investment, you owe the government another $1.08 in taxes at Ontario’s highest marginal rate, so you’re actually sitting in the hole. You needed a 11.1% nominal return to ‘break even’! Compounded annually, inflation is a gigantic tax vacuum for the government – and whether you like it or not, we are all paying for it.

The differential in numbers from old times is significant. It will also have the impact of making financial statements from previous eras less comparable.

Effectively, if we string together 5 years of 8% inflation (I’m not saying this will happen, just for illustration), this produces roughly a 50% distortion from real to nominal statistics, comparatively speaking.

Needless to say, this is also very convenient for historical long-duration fixed debt issuers, namely the government. Returns on short-term government debt are still very poor (326bps for 1-year money as I write this, in nominal terms!) in relation to the erosion of purchasing power.

An poker analogy to this is higher inflation means that the casino (government) is taking more rake off the table for each hand. We are all forced to play this economic poker game, but with inflation, the ability to win net amounts of money decreases as the take rises. The big losers are those without assets – their purchasing power continues to erode.

Interest rates will tell the story

It is well known that inversions in the yield curve signal bad economic times coming ahead.

Why? Typically credit is extended by financial institutions that make their money by borrowing short and lending long.

When the yield curve is inverted, financial institutions will find it more difficult to make money since the interest spread capture is narrower.

JP Morgan, for example, has announced in their last quarter that they are suspending their share buyback program. Their politically correct wording was: “In order to quickly meet the higher requirements, we have temporarily suspended share buybacks which will allow us maximum flexibility to best serve our customers, clients and community through a broad range of economic environments.”

Just remember, they’re suspending share buybacks for your safety!

Certainly when JPM is deciding to go into capital preservation mode, I get suspicious. Indeed, when I look at the Canadian banks, I think most of them have a good chance of going back to the pre-Covid levels. Second-grade financial institutions (e.g. Equitable, Home Capital, etc.) are offering GIC rates of around 4.4-4.5% for two-year money, which is the highest I’ve seen in a very long time. If they have to pay that much for their short-term capital, good luck on the duration match when they are also charging 4.59% rates for a 5-year mortgage!

Presently, I’m looking at one of the weirdest interest rate outlooks I have ever seen. The markets are predicting an increase on the July 27th Federal Reserve meeting, and another rate increase in September. However, in 2023, rates are expected to drop again, presumptively modelling this economic slowdown and recession nearly everybody and their grandmother is talking about at this point.

It is the oddest recession on the planet where you have low unemployment rates (5.1%, which is about as good as it gets here), commodities are booming, governments are raking in record corporate income taxes, etc, etc.

The Canadian rate curve has a similar trajectory – September 2022 3-month Bankers’ Acceptance Futures are trading at 3.85%, while a year later (September 2023) they are at 3.30%. Right now that rate is at 3.18%.

Since this rise in rates in 2022 and the drop in rates in 2023 is all baked into existing futures pricing, it leads one to the question – where might this actually go?

A few scenarios:

1. We get our recession, but inflation persists – banks likely have to stand pat on a relatively low rate of interest (2-2.5%) and real rates will continue being negative for the foreseeable future.

2. We get a massive recession (e.g. the asset deflation scenario with QT and everything), inflation busts out due to demand evaporation (supply chains normalize, etc.) – banks will crank rates down likely to the zero bound and you can dust off your post-Japan 1989 playbook for another couple lost decades.

3. The economy is actually fine, capital gets invested, etc. – rates will steady and possibly rise even further as this would probably be inflationary in the short-run.

Since a lot of the inflationary phenomena involves psychological expectations, it is very difficult to predict how this is going to resolve itself.

Cash (take a mild amount of duration risk for a net 370bps YTM with TSX: XSB!) might be trash, but it might be less trashy than the alternatives. Perhaps taking the real rate loss and being able to purchase assets for 20-30% of a discount from present is a possible scenario for those that are patient. Quantitative tightening has just barely begun and the typical real world economic impacts of interest rate increases will take a year to permeate – we’re now four months from the initial March 2, 2022 quarter point increase. Perhaps when the collective amounts of all of the Covid handouts have been spent, there will be a significant belt-tightening process. There are many lines of speculation about the future.

2022’s second quarter results will be great, but watch out ahead

While looking at the red ink that has accumulated in my portfolio, I’ve been doing some deep thinking lately. The story is not going to be that good.

In the fossil fuel world, the second quarter results are going to look really, really good from a cash flow perspective.

I anticipate a speculative run-up as a result prior to the announcement of such results. “Buy the rumour, sell the news” is a cliche that has tended to have a better than 50/50 success rate in my investment life.

Indeed, posted metrics will be so ridiculously good that it will attract people/capital that are otherwise only vaguely aware that cyclical industries require a different mindset.

I will use Lumber as an example. It is a commodity that is much more used to ups and downs, and their physical capability has historically been punctuated by start-up and shut-downs that wax and wane with inventory levels and overall demand.

A random example of this would be the Jimmy Pattison-controlled Canfor (TSX: CFP), with my annotations on their earning history and estimated earnings:

You can see on this chart that an astute purchaser would have been able to pick up shares of Canfor at (the Covid crisis peak) half earnings. Yes, a P/E of about 0.5x.

Of course, hindsight is 50/50. Many people (myself NOT included) thought the world was about the end in March 2020. But instead, Covid created a huge boom for the underlying commodity price because of a huge culmination of factors: nobody was producing, inventory levels were already low, the supply chain was wrecked, and demand was increased because many decided that building a deck or doing home renovations in the summer of 2020 was a great idea while everybody was on lockdown.

With retrospect (which would have triggered at the Q2-2020 results), the shares were trading at around $16/share – about the price that Pattison tried to take over the minority shareholders.

The acceleration of lumber pricing continued and eventually the shares normalized at around $28, or roughly 2x earnings, but normalized to 2023’s estimate, about 5.5-6x earnings. Also note how the chart hardly moved despite the “second wave” of lumber pricing from end of Q2-2021 to Q4-2021.

The earnings multiple on a cyclical company is notoriously difficult to predict – whether it is the cash flow, reserves, perceived scarcity, etc., all have a bearing on the multiple the market decides to give.

The actual cash flows that are generated, however, is internal to the company and their capital allocation scheme determines whether shareholders actually receive any monies or not. In the case of Canfor, they repaid some of their debt and engaged in some acquisitions.

Going back to the fossil fuel world, most of the Canadian complex is trading around 5x free cash flow to EV, based off of US$100 oil.

We will be seeing very different capital allocation schemes going forward. Nearly all companies are aggressively paying down debt (Whitecap is the big exception), and some are engaging primarily in dividends as a return mechanism, while some are choosing buybacks (looking at MEG Energy), and some are engaging in a hybrid approach. Investors can align their approaches to capital allocation with the managements of the various companies out there, in whatever blend they so choose. For instance, I like where Cenovus (TSX: CVE) is going, by spending cash flow to concentrate their ownership in their assets, running them well, having an integrated production and refining business, keeping a modest debt level, and then balancing out buyback/dividends. It’s a good all-in-one stock.

However, all of this might be overshadowed by one gigantic blade over the necks of the market, and that is central bank monetary policy.

Central banks are clearly in panic mode. There is a “real” component to inflation, but the “psychological” component of inflation, just like in the marketplace, is nearly as relevant. Take a look at the Home Capital Group (TSX: HCG) fiasco half a decade ago for a good example how psychology is very relevant in markets.

The theory is simple. If people believe that inflation will be higher for longer, their behaviour will be changing in conjunction with the expectations. Wage demands will increase (a good example of how this is playing out is the upcoming strike with the BC Government Employers’ union where the government offer vs. the union demand is way out of line – who the heck wants to take a 3% increase in wages when CPI is printing at 8%????). People will be spending more money today than tomorrow because the rate of interest they receive for their capital is lower than the posted CPI rate. It is like a milder version of Argentinian economics, where you discover when you go to the grocery store to buy a bundle of toilet paper, that you can only buy one roll instead of a package because the storekeeper knows that the toilet paper bundle can be sold for more just by waiting.

At a certain point, it doesn’t matter whether the actual money supply is contracting (or at least holding flat), and it doesn’t matter whether the supply chains are restoring, and it doesn’t matter how much crap gets stuffed on the shelves of Costco, Walmart and Target – if the psychology is in an inflationary mindset, it is very difficult to shake off.

This is why central banks, in theory, are regarded as independent entities, and generally are regarded as knowing what the heck they are doing to keep inflation in check (their sole mandate). They are the ones to adjust the monetary levers accordingly to keep the currency relatively level, and this stability generally breeds confidence that businesses need to make long-range spending plans.

This confidence has been badly shaken over the past couple years. First, there was “no danger of inflation”, then it was “transitory”, and now of course it is full-blown “Oh ****, we really screwed this up and really have to fix things” mode.

Ordinarily all it took for central banks to have their desired effect was to talk big – because people took them seriously and with authority, central banks could talk market expectations in a particular direction.

But now their credibility has been shot and they’re desperately playing catch-up, not on interest rates, but rather to restore their credibility. This is probably the reason why we got a 100bps increase instead of a widely-expected 75bps.

The Federal Reserve might mirror this increase in the July 27th fed meeting announcement (right now the August Fed Funds Futures are a “lock” at a 75bps increase).

However, will this be enough to shake the psychology of increasing inflation? People normally associate fiscal competence with the elected bodies (in this case “I don’t think about monetary policy” Trudeau and “mental lapse” Biden), and confidence in both are at very low levels. Despite posting record revenues (especially as they are nominal and not real dollars), governments are still posting deep deficits. As they are heavily indebted, as they roll over their bond books, they will be paying higher and higher interest expenses out of the fiscal end.

At this point, the central banks at this point have little choice other than to keep increasing interest rates until they have broken the psychology of inflation expectations. I had argued in a prior post they had to “surprise”, and the Bank of Canada judged that going 25bps over a widely anticipated 75bps was a sufficient shock. I will claim it is not enough.

Currently, we have the expectations showing that 2022 will feature a few more interest rate increases (say to 3-3.25%) but in 2023 there is an expected easement of rates, in anticipation of a recession.

The question is whether this is sufficient to break the psychology of inflation expectations. I don’t believe it will, at least over the next half year. Just looking at the price of energy, there is still going to be higher year-to-year pricing of commodities going forward until probably February 2023 – while inflation may simmer, it will be nowhere close to the 2% target level – noting that inflation is measured as a year to year comparison.

This means in order to quell the psychology, rates needs to rise even higher, and this will surely initiate huge economic troubles going forward – a deeper recession than most people probably will figure at this point.

This does not impact North America only – it affects most of the world economy, where US-denominated transactions dominate foreign trade contracts, and when the US dollar is as strong as it is, it acts like a 16 pound bowling ball ramming through the economies of the world as they desperately seek US cash – which explains the state of the Euro, Yen and other third-world currencies.

Canadian currency has somewhat of a buffer because of its trade links with the USA and commodity exposure, but if the world economic picture erodes to the point where energy consumption declines below the supply levels, surely fossil fuel commodity prices will drop and this will not be good for Canadian currency.

Also, with the rise of interest rates, both floating and fixed rate mortgage payers alike, especially for those that purchased properties in the past couple years, will be causing a lot of financial stress in the market. Your typical 25-year amortization mortgages that are up for renewal will also be paying more on this credit cycle, and perhaps people over-leveraged will be forced to sell properties. If the projected interest rate increases go higher than expectations, this will surely create some scenarios where you may see financial institutions that specialize in non-insured mortgages see financial stress and this will create more ‘interesting times’ financially.

Ultimately this depends on reading the psychology of the masses, definitely an art and not a science.

It is incredibly difficult to foresee how this plays out other than to be aware of the scenario. All I know is that caution is warranted. Especially nearing the end of this year, we might see a situation where a lot of good-quality equities out there are going to get flushed down the toilet both for tax-loss selling reasons and also because liquidity is tightening up so badly (interest rates plus QT) that players are forced to reduce leverage.

Cash is the only defense in this scenario. Everything else (gold, bitcoin, commodities, corporate debt) will take a dive, with perhaps the exception of short-dated government debt.

However, there is likely to be a “bull-whip” effect if there is such a flush-out, where those extraordinary circumstances that initiated a panic selling will likely lead to impressive gains going forward. Now is the time to compile companies on your watchlists that will likely survive the upcoming carnage.

The bank liquidity drain continues

A simple snapshot from the Bank of Canada:

I am specifically looking at June 29 vs. July 6.

Assets held in the Bank of Canada by member banks dropped from $196 billion to $175 billion (-$21 billion).

Correspondingly, assets held by the Government of Canada at the Bank of Canada rose from $94 billion to $112 billion (+$18 billion).

What happens between June 29 to July 6?

It is the milestone for calendar year-end corporate tax returns to be filed (with the remaining balance of taxes unpaid due… with interest), and also a quarterly date for CCPCs to remit their installments.

Personal income tax installments are on the 15th of each quarter, although the drop from April 27 to May 4th (when the remaining amount outstanding is due by April 30th) was $20 billion off of the bank assets.

Back on a Late Night Finance episode, I explained how the government is going to reel back liquidity through finding some ways of taxing it out of the system. I speculated that it would be done through increasing the GST, but at the rate things are going, they just need to keep the existing taxes to achieve this.

Bank reserves in the Bank of Canada are at their lowest levels since the week of April 15, 2020. Quantitative easing started on the week of March 11, 2020.

The next upcoming maturities out of the Bank of Canada government bond portfolio is August 1 with $16.8 billion, and September 1 with $6.8 billion. The monetary noose continues to tighten, albeit very slowly in relation to the $397 billion in bonds outstanding. Over the next 12 months, a total of $92 billion is scheduled to mature, along with a billion in mortgage bonds.

When the market punches you this badly, step back and think a bit

When you get into an investment, you should always have some sort of view and pathway that will guide you to your valuation assumptions.

Clearly in the past month, a commodity-heavy investor has gotten punched very hard in the face. What we have seen is a February/March 2020-style of trading in the commodity complex – indiscriminate amounts of selling. Back in February/March 2020, it took me about a month to get my act together during Covid (when I realized that people were truly losing their minds over it) before I was able to adapt.

This again is one of those situations that is forcing an adaptation.

The previous underlying thesis, at least as far as late 2020 went, was that there was a significant under-investment in capital expenditures (who wants to invest in oil fields when WTI is at -40?), coupled with demand increasing, especially as a function of money printing by governments.

The party went on for about 18 months and now we are on the flip side of the story, starting June 7th. The past has seen inflation, everybody is worried about it, but markets do not value they past – they value the future.

Today, the August crude oil contract is down 10%, and is down about 20% from its recent peak on June 14th, where it traded at US$121.

While letting the market be your sole guidance is always dangerous, when there is a significant breakage to expectations beyond white noise, one should always re-examine your thesis.

Now that the Federal Reserve and the Bank of Canada are drilling the stake deeper into the heart of the inflation zombie, we’re witnessing the results of the convulsions, and this guarantees in 2023 we will be seeing significantly lower levels of inflation.

I especially note what has happened to copper in the past month. If demand is high and world GDPs are high, then the price action we have seen makes no sense whatsoever in an inflationary and expansionary environment.

My crystal ball is telling me that it is probable the rest of the commodity market is going to experience what happened to the lumber industry, except in slower motion.

Dusting off my dis-inflationary playbook, it means that fixed income is your friend. In Canada, already we have seen the yield curve drop roughly 25bps across the board to roughly 300bps for long dated tenors. Fixed income markets have already priced in July 13th’s rate increase (I suspect it will be 50bps just given what’s going on in the markets), but in 2023 things will stabilize, if not head lower again when the economy starts to depress.

The playbook also suggests that the Canadian dollar will drop with a commodity price drop – perhaps on the way to 70 cents/USD??

What happened? I think there were a confluence of factors, but one obvious data point is that industrial production in Europe is going to get slaughtered due to high energy price inputs. This is going to significantly slow down consumption of industrial commodities. Given the energy starvation strategy that Russia is currently employing, this one is already in the bag.

There is also the issue of China, which has partially shut down its economy in the name of Zero Covid, but in reality there was probably a political component to this concerning the default of their major real estate developers (Evergrande and the others). The halting of construction in the country would have a massive impact on global demand, including that for metallurgical coal and copper.

Domestically, real estate construction is going to come to a halt – with 5yr fixed mortgage rates at 5% and construction financing costs equally high, this will continue to suppress activity in the sector.

It just doesn’t look good all around and the market has woken up to it.

The dis-inflationary playbook also suggests that entities with significant amounts of debt will struggle. Conversely, those that took the actions to right-size their balance sheets during the previous boom will not do as worse going forward. We’re now going to go back to the grind of low cost producers being able to out-last the transient high-cost players.

Economically this is not looking good – with margins compressing, the “E” in a typical P/E ratio will be dropping and this suggests further broad equity price compression. There will likely be some sharp rallies here and there, but the trend is now clearly down.