Picture yourself in a macroeconomics class two hundred years in the future. The professor asks if you read the chapter on the early 21^st century and explain what you thought were the key episodes of that period. You would start with the tech bubble implosion of 2000 and how the euro fell out of bed only a year after being introduced. You would talk about the battle with the 2001 recession and how the Federal Reserve took its key policy rate down to the unheard of level of 1%. Your discussion would shift to the resulting boom in real estate, subsequent monetary policy tightening and then the Financial Crisis. You would comment about a long journey out of that crisis (or the Great Recession), pitted with things like GREXIT and then BREXIT and ultimately the pandemic.

 

Through these first 21 years, the analysis would suggest that economies and markets were able to recover from duress because of trust in the leadership of economic authorities. But, suddenly in 2022, trust looks like it broke down. Investors began to doubt leadership’s ability to combat old-fashioned things like excess demand and rising inflation. Authorities suddenly started to act as though they were being led around the ring by markets, and not the other way. Even when they went back to the 20^th century playbooks and tried to appease markets, faith was lacking. Class adjourned.

 

This week encapsulates how easy it is to go from traditional fundamental analysis and reaction to a situation where logic is thrown out the window in favour of kneejerk investment decisions. As I noted on Wednesday, the Federal Reserve did what the market wanted and hiked interest rates three-quarters of a point. Markets liked it, but then mind-warped into another dimension because of the belief that this latest monetary policy action had increased the odds of recession. I am going to cover a number of areas today, so please bear with me.

 

 

Let’s start with the Fed hike. As I discussed, this week’s move on rates makes this tightening cycle the fastest in a long time (so far). It is urgent, not gradual – just like the late 1970s. Still, the Fed funds target rate is only 1.75%. True, that is above the 10yr moving average of just over 0.75% and the 20yr average closer to 1.5%. The fact that these averages are so low is testimony to the fact that the Fed funds target has been at 0.25% for 67% of the time since December 2008. Yes, we are leaving the era of ultra-easy money; but that doesn’t mean we are going into another era of ultra-expensive money. The law of debt physics still applies. More debt means more sensitivity to rates and that means economic response times quicken.

 

Ally and I have talked about this countless times over the years, but it all seemed like a hypothesis – until now. Rates only started going up in March, yet economic indicators are already bending. I don’t care what macro class you attended, but that is a very, very fast lag time response. I constructed many models back in my university days and then in the economics departments of banks and none had a response time like this. Manufacturing sentiment is already fading, as are retail sales and even key price measures. Consumer price inflation in the US, excluding food and energy, has fallen over the past two months and producer price inflation has already started to decline. I won’t go through the entire list of recent indicators, but the economic slowdown is here as we head into the second half. The market wanted central banks to halt demand and adjust supply-demand imbalances to combat inflation? Wish granted.

 

 

 

Why market participants are surprised that things are gearing back is unclear. Have recession odds gone up? Absolutely, but that doesn’t mean a recession is on the doorstep. Yet, many global equity markets are in “bear market” status now (a decline of 20% or more from the previous peak). Indeed, these markets are implicitly forecasting close to a 75% probability of recession. They might be correct given that it is hard to turn an economy, much like changing the direction of a massive tanker ship. As we have discussed, the ultimate indicator is the unemployment rate. Based on the path of initial jobless claims in the US, that rate is about to start heading northbound from its 3.6% level today (just a tenth below where it was before the pandemic). Okay, so we know western economies are starting to fade. We have been there before, and we have seen 20% plus declines in stocks before. As much as I hate to say this is normal, it is.

 

What isn’t normal is how markets are reacting these days. Take, for example, how folks took the news of a surprise rate hike by the Swiss central bank (SNB). Years ago, on the trading desk, we would pay no heed to this country’s central bank, unless it had to do with foreign exchange intervention (usually because the currency was getting too hot since it is considered a “safe haven”). This Thursday, the SNB raised rates half a percentage point and the street was shocked. Really? Swiss inflation is running at 2.9% with rates at minus 0.75% and we don’t think the country’s central bank is going to sit while other monetary authorities ante up on credibility?  Oh, by the way, the main rate in that country is still negative 0.25%.

 

 

 

I’m going to sound a little harsh here, but Europe dug this rabbit hole when it decided to venture into negative rate territory. That is why the bond market performance has been even worse there than on this side of the pond, however, not a lot worse. As I was listening to the business news Thursday morning, where they lamented over the “shocking” Swiss rate move, someone said that the damage to the Italian bond market was multiples over the US market. Not sure where he got his numbers, but the 15% total return loss since the start of the year is on par with Europe and 3% worse than the US. You see, sometimes what you hear isn’t exactly accurate.

 

I want to leave this discussion of what has been happening in the markets this week and shift to how individuals are dealing with these developments. The catalyst for this pivot stems from a chat we had with a relatively young investor at a recent seminar. The question was simple and echoed so many online, radio and television advertisements seen over the last few years. In short, why not just adopt a low-cost passive on-line approach (aka robo-advisor) in managing one’s portfolio? It was an interesting moment and considering the demographic, I was careful in how I approached the answer. We talked about having access to advice that may not have anything to do with the portfolio, though things like tactical tax-loss selling (especially in times like this) were mentioned. But the main answer is routed in the current market environment.

 

When sentiment shifts aggressively to one side, like it is doing now, most experts will tell you that selling into an aggravated decline is the wrong thing to do. Crystallizing a loss leaves you with just that – a loss. Stay invested according to a disciplined strategy created between the client and advisor and regularly reviewed, and you will weather these episodes and stand a better chance of achieving long-term goals. Unfortunately, the robo advisor doesn’t tell you not to sell. A portion of the overall selling seen this week came from passive investments – some held in accounts under the “low cost” online platforms. Indeed, one such company announced it was laying off 13% of its staff in the midst of heightened market volatility. Without personal advice around the issue of whether this an appropriate time to liquidate an investment, some will just sell. That means an outflow of capital from passive funds. In an environment like today, where liquidity is lower than normal, this can result in exacerbated swings in the market.

 

 

More importantly, without sound advice, an investor may sell at the worst time in a market cycle and then potentially miss the next upswing. This is especially true today, given that a larger percentage of portfolios have experienced compression because a majority of portfolios have a mix of equities and bonds. As the above chart shows, the Sabrient Global Balanced Index has lost 15% since last October. That is just a little less than double the decline seen in financial crisis. The reason is that bonds actually held up very well during that episode and helped offset some of the decline in stocks. Selling out of that index today crystallizes a significant loss, but it also leads to another dilemma for advisorless platforms. When should one buy back in. The financial crisis showed us that many individuals who had sold near the bottom waited months and years to get back in, missing an opportunity to recover their lost capital in a reasonable amount of time.  

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew

 

CIBC Private Wealth consists of services provided by CIBC and certain of its subsidiaries, including CIBC Wood Gundy, a division of CIBC World Markets Inc. “CIBC Private Wealth” is a registered trademark of CIBC, used under license. “Wood Gundy” is a registered trademark of CIBC World Markets Inc. This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. © CIBC World Markets Inc. 2022.CIBC Wood Gundy, a division of CIBC World Markets Inc.

 

These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.