Stagflation. It’s such an ugly word in economic circles as the consequences of it really aren’t anything we’d choose to endure. By definition stagflation means a period of time of high inflation partnered with slow growth. We haven’t seen stagflation since the decade I was born, the 1970’s, so many people reading this have never actually experienced stagflation and for others it is a distant and not too pleasant memory. The challenge with stagflation is that it can be sticky. As we enter into an inflationary spiral if our income does not rise as fast as inflation then our disposable income dries up. When our disposable income shrinks, we naturally have a higher percentage of it being used for necessities and less for all the extras. If we have less money for consumption then, that in turn, lowers revenues for numerous companies and therefore growth starts to slow. If growth slows, then companies start to pull in the reigns and layoffs increase, thereby decreasing the overall slow down as more folks have even less money. At some point, that cycle breaks and inflation gets under control and the growth cycle picks up again. The question is, when does that happen? We’ve spoken previously about why this inflationary could very well be different this time. Government spending, geopolitical issues ie. multi-polar world, energy policy decisions. Although CPI has gone down over the past few months, CPI excludes food and energy, two of the aspects that affect our day to day lives the most. Although they might not show up directly in the CPI numbers they certainly affect the wallet of regular Canadians. Oil has gone up almost 50% since May, from roughly $65 to low 90s today. This is re-inflationary, as that price then gets passed down the supply chain of all the goods we buy, bringing manufacturing and jobs back from overseas and no longer searching for the lowest cost of production. (because of supply chain and geopolitical turmoil is inflationary). These are just a couple of the reasons why we feel that inflation will be hard to stamp out in the next few months and why interest rates will most likely stay higher for a longer period of time.

 

On the flip side, generating overall growth will be a challenge primarily because of our level of overall indebtedness and interest rates. The longer rates stay high, the harder it is for people and companies to deal with them. Unfortunately as soon as the central bankers take their foot off the interest rate pedal, there becomes a sense of optimism which has fueled equity markets and the belief that we will have a “soft landing”, which further fuels spending and therefore inflation. With interest rates higher, more of not just personal income but also government budgets have to be used to fund those interest payments thereby further challenging growth. In the United States, $10k is spent for every person living in that country just on interest costs alone. For more info on the US debt please click here.

 

You can see above why stagflation is such a challenging period of time, but don’t despair, it’s not a death knell. What does this mean to you and your hard earned capital? It means what has worked for the past couple of decades of low interest rates and growth might not be what works going forward. Typically in a stagflation environment, hard assets that benefit from inflation, energy, gold and companies that generate real positive organic growth are the winners. The losers tend to be companies reliant on “debt and a dream.” To highlight this, when we look at the Russell 2000 which is an index of 2000 mid cap American companies, it is down roughly 35% from its peak. The Ark Innovation fund, was the darling of the COVID era, and quite often is used as an example of the profitless tech companies. The stock has fallen 75% from its peak and that’s despite having 10% of its fund in Tesla.

As such, we have been positioning our portfolios away from the higher growth expensive companies. NVIDIA, although surely will make lots of money from the AI fueled growth, at 40x sales doesn’t make any sense. In fact it has fallen about 15% from its late August peak. Apple, although an amazing company, trading within dollars of all-time highs, doesn’t make sense when iPhone sales are the lowest they’ve been in years and the company is growing 50% slower then it was just last year. It is also down roughly 15% from its summer peak. Not owning these names have hurt us relative to the index, in fact if you remove the 7 mega stocks that have benefited from the AI hype this year, the S&P 500 YTD return goes from 10% to roughly 1% as of the writing of this note and in fact, 55% of the S&P 500 are trading at one year lows. One of the rationales for Apple and Microsoft and the rest, is that they are now “defensive” companies with boat loads of cash. Roughly 10% of Microsoft, Google and Apple’s revenues comes from the high interest they are earning on their cash. Typically, earning 10% of your revenue from your cash reserves is more a sign of a mature stable company then a high growth early stage company. If they truly are “defensive” and no longer high growth companies, then traditionally, these companies should be trading at Price/Earnings multiples that are in the low to mid-teens, not in the 20-30x or higher range they currently are trading in. Because of this disconnect, we do think that caution should be the course of action right now as there are significantly more short term headwinds then tailwinds. That being said, we are finding alternate opportunities given the right time horizon.

 

When we look across our investable universe there are a lot of companies that are looking attractive. Bank of Nova Scotia hit a high of $95 in Feb 2022, $74 in February of this year and at the end of Sept 2023 it was trading just under $60. That’s a decrease of over 35% in about a year and a half. Over that same time frame Telus has fallen from $33 to $22. Enbridge has fallen from $59 to $45. On the US side of things, Nike has fallen from $180 to $95. CVS Health Corp has gone from $112 to $69. Over a little longer time horizon, Disney has fallen from $203 to $81. These are companies that we have either owned or currently own and will look to continue to own and are clearly at much lower valuations today then they were 12 and 24 months ago. They are a great example of the disconnect the market has between a handful of names that are holding up very well compared to the everything else.

 

We have been adding to our oil and gas holdings during moments of weakness. I know there are some people who aren’t comfortable with fossil fuels and we are firm believers in renewable energy but the hard reality is that fossil fuels aren’t going away in our lifetime. Even the most bullish green energy advocates have to admit that the demand for fossils continues to increase as the world consumes more energy by the day and the likelihood of it decreasing dramatically at a global level over the coming 10-20yrs will be challenged. According to the 2023 Energy Institute Statistical Review of World Energy the developed world with roughly 1B people consumes roughly 14 barrels of oil per person per year or a total of 14B barrels/yr. As an FYI, Canada and the US lead the pack with 21 barrels per year per person. The developing world, with 7B people consumes 3 barrels per person per year, so 21B barrels/yr. Lets assume it will be possible to cut western consumption by 50%, over the next 20 years, but also recognize that there are 7B people in this world who are living in the developing world with millions of them rightfully trying to move from poverty to lower-middle class. As they make that transition they will want air conditioning and to upgrade from a bike to a scooter and from a scooter to a car. So let’s assume they just increase their consumption to 4 barrels per year, well off what we in the developed World consume. With 7B people that equates to 28B barrels per year which would completely offset the decreased demand in the developed world. On the supply side of the equation, there has essentially been no investment to find new sources of oil and gas in over a decade, as governments have moved towards green energy mandates. We also have massive amounts of our fossil fuels in the hands of global regimes who are not necessarily aligned with western goals, such as Russia, Iran and Saudi Arabia. The West is, of course, at war with Russia and the Saudi relationship is a tenuous one.

 

The difference for Canadian energy companies versus previous cycles is that they are not reinvesting to find more oil. This is allowing them to generate significant cash flow. Combine that cash flow with the reality that most of them have barely any debt and an asset with a 20-30 year verified reserve is allowing them to pay out meaningful cash to their shareholders in the form of dividends and buybacks. In some cases this “shareholder” yield is coming in at north of 10%/yr and is sustainable well into the future. We feel that these companies make for very attractive long term risk adjusted investments even with the volatility in the underlying commodity price.

 

In our Alpha portfolio, based on the fantastic research that we’ve been able to gain access to, we have built a small position in both an India ETF and a Japan ETF as well as commodities such as uranium. When looking globally, both those regions have tremendous tailwinds behind them and on a risk adjusted basis look extremely attractive.

 

The investment world that we are entering is very different then what we have experienced over the previous couple of decades. Since 2008, we have experimented with a zero interest policy. This has fueled the demand for growth at the expense of savings. It has also allowed people to increase their risk by removing some of the downside protection. We truly believe that we are going back to a sustained higher interest rate environment and that the transition to that will be bumpy but necessary. I hope for the sake of my children that they will be able to learn the value of compounding interest and that there is a benefit to saving money. There has to be a cost to doing business and that poorly run businesses can’t continue to be bailed out with zero interest rates. With the changes in the market we are also adapting. As mentioned above, we have access to some fantastic new research. The team that is providing this looks at global data purely from a mathematical manner but they overlay about 90 data points from around the World to analyze the rate of change. They are correct way more then they are wrong. The new research we have as part of that group is run by a gentleman who has decades of experience advising roughly 800 endowment funds and family offices. Stay tuned for further details on how we are incorporating this research into our team and models.

 

Please feel free to reach out with any questions or concerns.

CIBC Wood Gundy

Andrew Lacas, CFP, CIM, RIAC

Wealth Advisor

Portfolio Manager

Lacas Advisory Group

 

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