Why investors should worry about rising debt levels in all quarters
The level of excitement about the market has recently abated somewhat as the rise of the latest COVID-19 variant appears to be shocking some pundits into making correction warnings, but perhaps a much greater threat is whether those worries will also begin to permeate within the United States Federal Reserve.
Equity markets are heavily influenced by loose monetary policy, since low rates and increased money supplies inflate asset prices, forcing investors to take on riskier assets than they normally would and pay a higher price for them.
For example, in today’s ultralow rate environment, the Global Wealth & Investment Management equity allocation has reached an all-time high. Specifically, the Bank of America’s private-client equity holdings as a percentage of assets under management reached 65.2 per cent, well above the long-term average of 55 per cent. Not surprisingly, this is also directly reflected in the performance of the S&P 500 and the Fed’s balance sheet, both of which have been soaring.
Looking ahead, we wonder how long this reliance on easy money can continue, especially if inflation takes root, because of both out-of-control government spending and undercapitalized supply channels that remain disrupted and, therefore, are unable to meet recovering demand in a POSTCOVID-19 world.
There is also the risk that long-overdue wage hikes may not be enough to offset the emerging cost-of-living crisis and will only end up getting passed along to the consumer, further contributing to inflation.
We are already starting to see this type of scenario playing out in emerging markets such as Brazil. In the 12 months to July, Brazil’s inflation rate reached 8.99 per cent, forcing its central bank to raise its benchmark interest rate to 5.25 per cent from an all-time low of two per cent.
Central banks, including our own Bank of Canada, are well aware that such a move could create a terrible scenario for governments, corporations and households that are overlevered, like those here. They will no doubt try to hold off on raising rates for as long as possible, but there may come a point where, like Brazil, they have little choice.
This would not be ideal for the many heavily borrowed Canadian homeowners or our current federal government, which may be forced to raise taxes to offset a large increase in its debt-servicing costs, given that the astounding level of deficit spending may soon prove unsustainable.
In our view, a rising tax burden is a key factor to watch for during this election and we’re not alone. According to a Twitter survey I ran last week, 70 per cent of the 6,891 votes cited the cost of living as their biggest concern.
As an investor, rising rates are terrible for growthier sectors whose sky-high valuations imply ultralow forward discount rates. This could especially apply to companies such as Tesla Inc. and others in the cleantech space. Meanwhile, areas such as energy, materials and agriculture should be protected from such a stagflationary environment due to their strong pricing power and commodity exposure.
From a tactical standpoint, the traditional conservative 60/40 portfolio will also underperform, particularly those with a longer duration exposure in their fixed-income weighting. This also includes those chasing high yield, since 85 per cent of that market currently yields below U.S. CPI.
Consequently, investors may have to adapt by looking at lower-correlated, long-short alternative strategies, and reallocating equity exposure to regions that can do a better job of growing their economies in an inflationary environment, which will be reflected in a more robust currency. Some may think Canada fits that bill, but, think again, since our economy has gone all in on levered real estate speculation.
Some may want to even start looking at segments of the market that have stable cash flows that are not yet reflected in current valuations due to their lack of a “narrative” given that story stocks are so dominant in today’s environment. Finally, we also have a reasonable weighting in custom-built structured notes as a partial outside-the-box fixed-income replacement.
Markets appear to be complacent about the risk of stagflation, but you shouldn’t be. Now is a great time to identify the potential risks to your portfolio, and it’s also as good a time as ever to start rebalancing if you do not have any insurance.
At a minimum, it certainly isn’t the time to be onboarding more debt like your neighbours and government are doing. At the very least, consider this old Brazilian/ Portuguese proverb: In a land of the blind, a one-eyed man is a king.
Financial Post Martin Pelletier, CFA, is a portfolio manager at Wellington-altus Private Counsel Inc. (formerly Trivest Wealth Counsel Ltd.), a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax and estate planning.