This article was first published in the National Post on August 5, 2023. It is being republished with permission.

by Tom Bradley

We’re in the depths of summer and the business news cycle is slow. It’s a good time to step back and assess the current investment landscape. As I camp out at our Crystal Lake office — a.k.a. the cottage — here are my observations about trends being overlooked, misunderstood, or in transition.

Last fall, I wrote that “finding pricing power today is like shooting fish in a barrel.” With inflation soaring, investors were focused on finding companies that could pass higher costs on to their customers while still maintaining sales volumes. Many companies were able to do that then.

It's a different story now. As companies report second-quarter earnings, it’s becoming apparent that volumes are being impacted by repeated price increases. Heineken, the world’s second-largest brewer, saw its beer volume drop 7.6% in the second quarter. Grocers and consumer goods companies have noted that customers are trading down to cheaper brands. It appears customers are hitting their limit, even beer drinkers.

Interest rate impacts

The U.S. Federal Reserve is so yesterday. Central bankers have facilitated a return to more normal interest rates and can now put their feet up on the desk, at least until the next recession. Their job is done.

What deserves more attention is the slow-moving but powerful impact that already higher rates are having on the economy. I say slow-moving because it’s taking time to play out. Mortgage renewals are spread over a few years. Higher financing costs for companies, particularly those with floating-rate debt, are currently being absorbed, but will become increasingly hard to manage.

Commercial real estate, which was a huge beneficiary of low rates and easy credit, will see cap rates (their valuation metric) move up (a bad thing) in line with higher financing costs. So far, this harsh reality has been delayed by rent increases (in some sectors) and a dearth of transactions.

Cheap debt and lots of leverage have also been a key part of private equity’s success. The cheap part is now gone. As for leverage, the financing tap is still open because fund managers haven’t stumbled yet but, like real estate, valuation multiples on existing holdings will need to come down to reflect the new rate reality. This is confirmed in the secondary market, where sellers of private funds are accepting larger than usual discounts for their units.

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In contrast, higher interest rates have been good for the banks for reasons we’ve all experienced. They’re quick to raise loan and mortgage rates and take their time increasing interest rates on chequing and savings accounts. This too will change, grudgingly. With better yields available, bank customers are incented to switch into high-interest accounts, GICs, money market funds and short-term investment products. Technology makes this move easier than ever. The percentage of bank assets that pay little or no interest will come down over time, and their funding costs will go up.

The missing recession

Many commentators are marvelling at how well the economy is holding up. The recession that seemed imminent is no longer a sure thing. Meanwhile, others are questioning deficit levels at the government and household level.

Both views are old hat now, but for some reason, few are putting the two together, which is curious given that the second observation partly explains the first.

Consumer spending is hanging in because we’re living beyond our means. Government revenue doesn’t come close to paying for the services it provides. My rough calculation suggests that an Ontario household is receiving $4,000-5,000 of services each year (based on their share of the federal and provincial deficits) that they’re not paying for — at least not yet. It’s being put on their tab. Buy now and a future generation will pay later.

China? What risk?

It continues to amaze me that the risk of China further isolating itself is not a bigger focus for investors. To me, previous economic disruptions that spooked markets, such as the European banking crisis (Greece), various U.S. budget standoffs, Brexit and the war in Ukraine, pale in comparison.

The likelihood of serious economic dislocation may not be high, but if it happened, the consequences would be off the charts, and devastating for many global companies. Suffice to say, Apple, Tesla, Volkswagen, and Starbucks desperately need China and the West to get along.

Urgent headlines may be missing, but it remains a fascinating time to watch the economy and businesses in transition. The most interesting developments are the ones not yet in the spotlight.