Is the Party Coming to an End?

 

Despite renewed turbulence North American markets gained close to 2% in the quarter, against a backdrop of lower rates and anemic yet positive economic growth.

The U.S. economic expansion is now the longest on record. But, the record breaking boom has proven disappointingly weak.

As of July 1st, the economic expansion that began in the U.S. in June 2009 has continued unabated for more than 120 months, making it longer than the decade long boom of the 1990’s (March 1991 to March 2001), and more than twice as long as the average of the past 73 years. This cycle has lasted longer than the Beatles were together, longer than the run of Seinfeld on network TV, and it is older than Instagram.

But the expansion has been decidedly weaker than the one in the 1990’s. The economy in the U.S. today is about 20% larger than its pre-crisis peak; economic growth was twice as fast during the 90’s recovery.

The business cycle has been lengthening for some time. Between 1945 and 1981, U.S. expansions lasted for three years and eight months on average. Since 1981, they have averaged more than eight years. But as they grew longer, they have become weaker. During the ten business cycles recorded between 1949 and 2007, the average economic growth was 4.7% a year. Since 2009, growth has averaged just 2.3%. Lower, but longer. The slower growth has extended the duration of the expansionary part of the business cycle (declines still average 13 months).

GDP per person, a measure of economic growth that strips out the effects of a growing population, has inched up by just 1.5% a year since 1981, less than half the average of 3.3% a year of the previous period. Again, slower growth leading to longer expansionary periods.

Periods when GDP exceeds potential are typically when workers enjoy the greatest wage gains and members of historically sidelined communities find jobs. As the job market in the U.S. has tightened, labour compensation has steadily accelerated. Average hourly earnings have climbed from an annual growth rate of roughly 2.5% in 2017 to 3% last year, and 3.3% in the first quarter of this year. With low rates of inflation in the U.S., workers are beginning to see significant gains in real wages. Similarly in Canada, wage growth is 2.9% above the year before.

Real GDP versus Potential GDP
1947 to 2019

Untitled
The economy has finally caught up to its trend growth after 10 years

Is the party coming to an end? That is the question on everyone’s lips today. On the positive side, professional forecasters surveyed by the Federal Reserve Bank of Philadelphia expect that there is only a 20% probability of a recession next year. The consensus view is that the economy will be growing 1.7% a year from now.

Naysayers point to the inverted yield curve (when the yield on the long-term bond falls below the yield on short-term bonds). The gap between the three-month U.S. Treasury Bill yield (currently 2.23%) and the 10-year Treasury bond yield (2.04%) has been negative before every U.S. recession of the last fifty years. The Trump trade wars, if allowed to continue, give more cause for concern.

“Expansions don’t die of old age.1” “They get murdered instead.2” The “murder” is usually perpetrated by the central bank raising interest rates to counter excesses in the economy, usually signaled by rising inflation.  The inflation rate is hovering well below the target today, and the Federal Reserve appears to be more inclined at the moment to cut interest rates rather than raise them. 

There are reasonable arguments on both sides of these forecasts. Which is right? Time will tell. Recessions are hard to predict; that is what makes them so disruptive.

At Kingwest, we do not rely on forecasts of the economy or the market in making our investment decisions.

Why? For something to be valuable it must be important and it must be knowable. What will happen in the economy in the future is clearly important. But, the future is unpredictable — it is unknowable. It is not that macro factors do not matter, but rather that they are too hard to predict with any accuracy, and therefore they are of little help in achieving investing success.

What we do know is that the economy will grow over the next few years. Notwithstanding the bumps, the North American economy continually expands over time. We just do not know the pattern — when a recession may or may not hit. We base our investment decisions on what we know for sure, the economy will be bigger three years from now. So we ignore the noise of talking heads, of pundits, and of oracles who purport to see into the future.

Think longer term, in years and decades, not months or quarters, and you will be much better off.

We prepare for the inevitable volatility of the market by investing in and supporting companies we believe can best withstand — and perhaps thrive — during a slowdown, and come out more valuable than when they went in.

We are unwavering in our commitment to seek and identify long-term winners through intensive, fundamental research. Within the context of today’s macroeconomic uncertainty, we find ourselves particularly grateful for the constructive partnerships with the teams across our companies and we are pleased by their collective solid growth. Not only have many of our businesses achieved strong operating performance, but several augmented their business by completing strategic acquisitions, while others expanded teams and implemented improved systems. 

Experience has taught us time and again to remain focused on our key investment principles: backing healthy companies with strong management teams, differentiated business models, and opportunities to invest their capital to earn compelling returns. We reviewed hundreds of opportunities in the past year  — many fell short of our criteria, while others would have been attractive at a lower price. We remain disciplined in our approach, and we remember that patience has been beneficial over the years.

While interest rates jumped in the fourth quarter of last year, they are returning to the low levels extant for most of last year. Central banks seem again to be pushing interest rates back towards zero. This is taking the bond market to a strange place.

Austria just issued a new Euro 1 billion tranche of its century bond, which matures in 2117, with a yield of 1.17%. Shockingly, there was demand for five times that amount.

Does it make sense to own a bond with these low yields? And for such a long period of time? We have pointed out many times there is nothing innately safe in owning bonds with yields at, or below, the rate of inflation. For example, your $100 investment with that Austrian bond will only buy you $12 of goods if inflation continues the way it has at 1.9 % per year. What good is that?  You did get the 1.17% interest every year but that does not account for much income after you pay the tax. These bonds assure you only that when the bond matures, you will have less purchasing power than you had when you bought the bond. This is capital destruction, not capital preservation.

That is why people are searching for different assets with better yields. These government issued bonds do not provide an adequate return relative to inflation and taxes.

We had very little activity in the last quarter. We capitalized on favourable market conditions to sell our position in Rogers Communications at a profit of about 75%. We originally purchased Rogers around $40 because we believed that the sports franchises they owned were worth about $5 billion and this value was not recognized in the share price at that time. Now that the Raptors won, everyone is talking about how valuable sports teams are, and the stock price rose to $71 reflecting that value; that made it our time to sell.

We identified an interesting development in the portfolio. Over the past 25 years, Canadian oligopolies have delivered strong returns to the portfolios. We have been very successful investing in the Canadian telecom companies. Our initial investments were made when the market failed to recognize the long term potential of their investments into the wireless infrastructure.

Similarly, Canadian banks have done well as their solid, protected domestic businesses generate very high returns. We have put our investments into those banks which are reinvesting their returns wisely. 

We now find ourselves as owners of the newest Canadian oligopoly: the airlines. Our Air Canada investment has tripled since inception and the company keeps getting stronger. In May, the purchase of AirTransat was announced. ONEX Corporation, which we own, announced its purchase of Westjet on May 13th. The airline industry has harnessed the power of technology to keep planes full, and the bottom line positive and improving. This wave of consolidation in Canada is positive for the industry environment and should improve the results of both airlines. 

Drawing parallels between teams in sports and business is a familiar practice. We would be remiss if we did not give a nod to the Raptors who secured the NBA title. We could not resist linking our world of investing to the leadership and teamwork that led to the exciting Toronto championship. Even fundamentally good businesses can face real challenges without strong teams that are united around a clear, common set of goals. In reflecting on the lineup across our portfolio, we feel incredibly fortunate to work alongside so many exceptional leaders and committed teams.

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  1. Janet Yellen, past Chair of the Board if Governors of the Federal Reserve System, the central bank of the United States, from 2014 to 2018, and as Vice Chair from 2010 to 2014
  2. Ben Bernanke, Chairman of the Board if Governors of the Federal Reserve System from 2006 to 2014