A Regime Change?

 

Looking back at some of the missives that we have written this year we have spoken about optimism, war, inflation, interest rates and staying the course among other things. I wanted to take a little more time on some of these topics but also discuss one of the most important aspects of being a steward of other people’s money, investing for tomorrow not today. As 2022 is now over, the World we’re living in looks significantly different then it did a year or two ago, let alone 10 or 20 years ago and we believe that we are going through a regime change.

 

Let us first ponder what the world has looked like since the early 80’s. The 1970’s were a lost decade for investing. I’m lucky to have a partner and father who started his career back then and can tell us first hand about his early days with Merrill Lynch. That was the decade where solid investment returns were possible but not with a buy and hold strategy. In an industry where most professional money managers were either in diapers or not even born during that period, this insight gives us a tremendous advantage. So what were some of the causes of that “lost decade”? An energy crises caused serious geopolitical shifts as well as an initial spike in inflation. This caused a rapid upward spiral in cost of living and since there was such a high % of unionized workers, wages increased with inflation. The central bankers of that time weren’t able to reign in inflation as they eased off the throttle before waiting long enough to really tame it. You have to remember that inflation is a year over year number so unless you are able to really destroy demand over an extended period of time it makes sense that it would ebb and flow from year to year. It wasn’t until Volcker took over the Fed in 1979 that inflation really was tamed, as he kept rates high until 1982. As many of you who had mortgages at that time will remember, he took the terminal fed funds rate to 22%. It was painful and caused a recession but it did eventually help to crush inflation. What ensued coming out of that period of time was one of the greatest bull markets we may ever see.

 

From 1982 to 2022 interest rates fell from 22% to essentially 0%. This provided the stimulus and fuel for the S&P 500 to grow at a rate of north of 10% a year from its lows of August 1982 to its peak in 2022. Howard Marks from Oaktree Capital came up with a great analogy around this downward move in interest rates and I will paraphrase from him. Think about those moving sidewalks you find in airports. If you’re tired and stand on them you get to your destination, however, if you walk at your normal pace you make it to the end significantly faster. The S&P 500 over those 40 years of dropping interest rates was like someone walking on those moving sidewalks. The markets have their natural growth over time, but the tailwind provided by dropping interest rates which allowed investors and companies to leverage up, put the market onto that moving sidewalk. We believe that the days of 0 interest rates are behind us for at least a very long time. So let’s get to the why.

 

Vockler crushed inflation but it was able to stay low for decades for other reasons. In our estimation there were three main drivers of deflation over the past 20 years. Globalization, technology and cheap energy. Lets dig into each of these a little bit and where we see those trends moving over the coming few years.

 

Globalization – Since the late 80’s, we have seen a move towards global supply chains. As I wrote in a letter back in the summer, globalization is akin to a marriage of convenience. In general terms, the East and the West, or China and the USA, may not see eye to eye on many common values and beliefs but working together was beneficial to both economies. From a western standpoint, globalization meant that we outsourced most of our manufacturing in search for the lowest cost of production. In most cases that meant China with their massive growing population and huge work force of cheap labour. This is no longer the case. The trend away from China had already started but the COVID supply chain issues sped up the process. Companies and countries realized that relying on just in time inventory using a global supply chain with the bulk of the manufacturing coming from China wasn’t the smart move. You’re now seeing companies such as Apple moving iPad and iPhone manufacturing away from China. You’re also seeing companies start to hoard inventory of critical parts so not to be left short- handed if there are more supply chain hiccups. These moves will no doubt increase costs that will be passed along to consumers helping to keep costs higher then we might like.

 

Energy – We have benefited over the years from the relatively low cost of fuel driven by our reliance on abundant and cheap fossil fuels. As we all know, the West is moving away from fossil fuels. This is something that is needed for the long term and I for one believe that if we can power our lives using the sun or wind, then we’d be foolish not to try and harness that power. That being said current global demand expectations for fossil fuels continues to go up year over year but I still hold out hope that the transition will happen. The transition to renewables will however cost a significant amount of money. In fact, according to a recent study done by Mark Jacobson at Stanford University it will cost $62Trillion to move the World off of fossil fuels and onto renewable. That same study also states that the pay back period would only be 6 years. If that is the case, then there would be significant costs for the foreseeable future as this transition were to happen. Partner this expense with the lack of investment over the past decade in traditional fossil fuels which has caused a severe supply and demand imbalance, then this has the potential to add significant costs to our energy bills while this transition occurs.

 

Interest rates and monetary supply–  The head of the Fed bank is a gentleman by the name of Jerome Powell and he has stated time and time again that he is going to keep interest rates higher for longer and we for one are taking him at his word. Powell believes like Volcker did, that in order to fully beat down inflation you will need to keep the terminal rate of interest rates above inflation in order to tamp it down. Higher rates dampens demand and it also makes people and companies think twice about their use of capital. If interest rates are effectively at 0, then there is no real risk to borrow money and use that capital to invest or buy. This has allowed whole industries like private equity and real estate to thrive. You borrow as much money as possible at 5% and buy an asset, that asset grows in value and interest rates fall to 4% you can then refinance and you’ve just generated a significantly higher return on your investment as your cost of financing just fell 20%. The math changes in a rising or variable interest rate environment so the amount of prospective buyers also changes.

 

As you can see there are a number of challenges out ahead of us but we must remember that challenges create opportunities, we just need to know where to look. For the past number of years we’ve been talking about the 4th Industrial Revolution. None of the above changes that, in fact, in some ways it will help to bring it forward even quicker. We believe there will be some long term themes that will play out in regards to green energy, robotics, AI, automation and others. That will lead to investment opportunities in the commodities that are needed for the electrification of the world. I was just reading that McDonalds just opened the first fully automated restaurant just outside of Fort Worth Texas, so there will be opportunities with the chip manufactures or robotics companies. Google, Microsoft and Amazon amongst others are all in a race to have the best AI and will be implementing it into every day lives. The oil and gas companies who are making record profits are no longer investing it back into the ground, looking for more oil, so we expect to see continued increases in dividends and special dividends. So although we have a cautious view for the economy and the immediate term, we are excited about what the next chapter holds.

 

We believe that the Lacas Advisory Group is in the best position we’ve ever been to navigate the years to come. We’ve invested in our service side and believe we now have the best team we’ve ever assembled. We’ve improved our internal processes to ensure our service continues to level up. We’ve also invested more then ever on external resources to help us on the investment management front. Using our new coaches we’ve worked over the past number of months to learn from our previous successes and mistakes and make the necessary tweaks to our process. We look forward to sharing these with you all over the coming months and seeing how the next year unfolds.

 

One final note, we’ve had some questions around our year end charitable giving. Thank you all who submitted suggestions. We tallied up the submissions and Feed Nova Scotia and Souls Harbour Mission were the two leading charities. So they, along with the St. George’s Youthnet were the three chosen for this year.

 

CIBC Wood Gundy

Andrew Lacas, CFP, CIM, RIAC

Wealth Advisor

Portfolio Manager

Lacas Advisory Group

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