Chairman’s Letter Q4 2019: The Roaring Twenties Starts With the Year of the Rat

A look ahead to the 2020 financial market




January 1, 2020

First, The Good News

Globally, all central banks are easing interest rates and pumping money into their banking sectors. This is always bullish for stock prices. Everyone agrees that the economic cycle is long in the tooth. Everyone knows that investing in the later stages of economic activity can be very rewarding and very risky.  

In the U.S., the Fed has eased rates aggressively and will not raise them this year. In fact, some are betting they will lower rates again. Wage growth is strong. Savings are strong; the savings rate is 8.1% of disposable income. The household debt to asset ratio is the lowest since 1985. Debt to service costs are 9.7% of disposable income, the lowest in 40 years.  Personal debt levels are moderate and lower than at any time in 10+ years. Consumers have lots of firepower.

The global manufacturing recession is now 18 months old and signs point to a mild reacceleration of growth because of the reflationary activities of central banks. Trade tensions seem to have shifted to the back burner and will likely stay there until the next election is over.

Corporate profit margins are very high.

Now, The Bad News

Globalization of trade seems to have peaked. Populism and anti-trade policies are likely to retard high profit margins. Increased tech sector regulation is threatening leading technology companies.

Business balance sheets are a major concern. U.S. corporate debt has never been a larger share of GDP in history. Credit quality has been on a negative trajectory and debt has been steadily increasing at a rate greater than sales and profits. Businesses have levered up their balance sheets buying back a lot of stock and boosting dividends. Vigorous competition has limited the capacity for a business to increase prices. Companies that are growing slowly, have low pricing power, have aggressive competitors, and a lot of debt are risky. 

Small firms, the biggest contributors to economic growth in America, are increasingly reporting that it’s hard to find workers. Wage inflation is hurting their margins. The popular refrain is the U.S. doesn’t want immigrants but soon they will need them. 

The U.S. government is running $1 trillion-dollar deficits and there is no end in sight. That’s 4.6% of GDP! The dollar amount of the current deficit is dwarfed only by the deficit in 2009 during the Great Financial Crisis. And yet unemployment is 3.5%. Why are they stepping on the accelerator with unemployment so low? Why is growth so slow in spite of such stimulus and low unemployment? 

Inflationary pressures, rising debt loads of government and business are on unsustainable trends. Already, inflation in services is 4.5% and medical inflation is 5.9%. Eventually, inflation, a default, or financial event causes problems. It always happens. We just do not know when it will happen and we never see it coming until it has already happened. It’s like dropping an egg. You don’t plan on it. Once broken, it’s the clean-up that is hard. Inflation is a big risk. Starting in 2021 we will likely need to worry about this more. 

The last time we had rising rates because of fears of inflation, the market fell 20% in 90 days. That was September of 2018. Stocks are 11% higher now than when that episode started, so risk has clearly gone up because things are more expensive.  

The Situation

Presently, the issue facing investors is that most stocks look pricey given the risks both well understood and debated. Stocks have advanced 22% over the past two-years and yet profits are only ahead by 1%. Can we keep that pace given the weak profit growth we have experienced?

The late phases of an economic expansion can be the most dynamic for stock market performance. Most agree that the economic picture looks bright for the next 18 months with inflation, and thus interest rates, remaining low and that being the fundamental support for stocks. There is no alternative, the saying goes. The problem is that when the next down leg inevitably comes, caused by any of the previously mentioned ‘bad things’, it could get ugly. Most companies are very negatively levered to higher interest rates because of soaring debts, sluggish sales, and muted profit growth. Should rates go higher because of inflationary pressures, concerns over credit quality, corporate profit margins being squeezed by a lack of available workers, or an overheating economy, stocks would likely fall. 

Some posit the Fed could cut interest rates further, pressured by Trump wanting to win re-election.  More corporate borrowing, budding inflationary pressures, more levered balance sheets might be fun for a while, but bubbles never end well. 

The Solution

Late stage investing entails investing in cyclical companies like industrials and banks. Banks benefit from rising rates. Their customers are healthy consumers. The banks’ balance sheets are strong. Their credit risks are small. Their dividends are high and growing. Their valuations are cheap compared to most slower growing areas of the market. Meanwhile, the drift away from globalization favours more political unrest and favours defense companies. The advancement of AI will disrupt the healthcare, financial services, and consumer sectors of the investable universe leading to many winners and losers. 

Millennials are the largest cohort in America representing 80 million people. With an average age of 25, they are only now beginning to dominate the political and economic landscape. Millennials will drive more environmental, social, and governance (ESG) investing resulting in dramatic investor outcomes. Climate change and its resulting impacts will ripple through the investing roadmap.

We believe we are well diversified and conservatively positioned to be well compensated over time, considering the balance of risks and rewards. 

On a personal note, as the decade turns this marks my 10th year at Davis Rea Ltd. Many of you have been clients longer than my tenure and some of have joined the family more recently. I want to extend my, and the team’s, gratitude and deep appreciation for your support over the years. Our wish is that the next 10 years brings more health and happiness to you and your families.