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Montreal, October 13, 2021 THE LATEST ON INFLATION The U.S. Bureau of Labor Statistics recently reported that the U.S. Consumer Price Index (“CPI”) had risen 5.3% in August from August of last year. The increase was smaller than the 5.4% increase reported year-on-year for July. Similarly, the Core CPI, which excludes more volatile energy and food items, had risen 4.0% in August from August 2020. The increase was also smaller than the 4.3% year-on-year increase reported last month. In Canada, the CPI accelerated to 4.1% in August year-on-year relative to a 3.7% increase in July. When excluding gasoline, prices increased 3.2% year-on-year, up from 2.8% in July, the highest level in 13 years. Similar observations can be made for other parts of the world with Eurozone and Japan inflation hitting levels not seen in a decade. OF USED CARS AND CHIPS When we examine the price increases at the component level, we note that the principal contribution to core inflation increase comes from the used cars and trucks component, which is up over 30% from August 2020. Used cars and trucks are more expensive due to the reduction in new car inventory, which caused surging demand in the used passenger vehicle channels. The reduction in new car inventory was largely attributable to a shortage of key components, including computer chips. To meet the needs of an increased percentage of the global population that started to work from home at the onset of the pandemic, the semi-conductor manufacturers were forced to reroute their foundry capacity away from automotive chips to cloud, home computer and peripheral chips. Things were slowly returning to normal earlier this spring when a fire broke out at Renesas Electronics’ Naka factory in Japan, where chip production did not return to full capacity until three months later. Elsewhere, the worst drought experienced in Taiwan during the last 50 years forced producers on the island to make production adjustments at their processing facilities which require large amounts of water. Interestingly, while the world has gotten used to the threat of inflation at the raw material level caused by the shutdown of an oil field in Saudi Arabia or elsewhere in the Middle East, by a strike at a copper mine in Chile or at a platinum mine in South Africa, it is the first time that shortage of a manufactured product has had such an impact. Given the fact that chips represent as much as 40% of the cost of an automobile, in a sense, computer chips are to 2021 what oil was a generation ago in terms of its strategic importance. Understandably, this risk is being addressed already. For instance, Intel announced that it would build two plants in Chandler, Arizona at the cost of 20 billion while Mudabala’s Global Foundries subsidiary announced that it would establish a plant in Singapore. We believe there will be other announcements as President Biden’s Infrastructure Plan has earmarked 500 billion for this sector. As such, we believe that the risk of lingering inflation rise from this component of the index will abate before the end of spring 2022. PERMISSION TO DOCK DENIED Going back to the sources of contributions to core inflation increases, beyond used cars, trucks and parts, we note significant year-over-year increases in the price of household furnishings and supplies, which includes furniture, home appliances and apparel. As the vast majority of these goods are imported goods, their prices have been directly impacted by container shipping costs, which have been booming. To this point, the Drewry World Container Index, which tracks the cost of shipping a 40-foot container over various routes globally is up 600% from January 2020 through late August 2021. Similarly, the Baltic Dry Index, which tracks the cost of shipping bulk commodities (like coal, iron ore and grains) is up 1000% over the same period. Shipping costs are extremely volatile and the sector is famous for its boom and bust episodes. In fact, despite the spectacular run-up in prices that we have witnessed in the past 18 months, container and dry bulk shipping costs have not even reached half of the levels reached in the months leading to China’s Beijing Olympics Games in 2008 when enormous volumes of raw materials needed to be imported for all the infrastructure projects that were being developed in parallel to the Olympics. While the shipping market imploded shortly after the Beijing Olympics with the rest of the economy, the current price surge could be more lasting than it was 13 years ago. While global trade volume is not as effervescent as it was back in 2008 relative to the number of vessels, port congestion is causing long delays and constraining supply. A COVID-19 outbreak at a Ningbo-Zhoushan Port terminal which forced a partial shutdown of the port earlier this summer did nothing to alleviate price inflation. That being said, given the history of this sector, we believe that price pressures will likely be resolved through a combination of increased port capacity and a larger fleet. That could, however, take a while as the current dry bulk orderbook, measured in terms of deadweight ton on order as a percentage of the current fleet was recently observed at the lowest levels since 2003. The prospect of shipping crew shortage also risks complicating the situation. In fact, UN-Secretary General Antonio Guterres, during an address on World Maritime Day, recognized the humanitarian crisis that hundreds of thousands of seafarers face as many became effectively stranded at sea, unable to disembark due to voyage delays caused by the pandemic. 139 MILLION HOUSES FOR RENT So far, we have looked at the two principal components of Core CPI increases from August 2020 to August 2021 and have concluded that those increases will probably subside. Given that certain Core CPI components have seen muted price increases, could we witness a material impact in inflation should they start moving up? An obvious item to scrutinize, if only because it represents nearly one-third of the entire Core CPI measure, is shelter. Shelter, however, is misleading, to say the least. In effect, apart from minor items such as the cost of lodging away from home and household insurance, the Bureau of Labor Statistics considers houses as capital, not as consumption items. As such, instead of using actual home price variation as an indicator, the cost of shelter is the implicit rent that owner-occupants would have to pay if they were renting their own homes. It is referred to as owner equivalent rent or OER. To quantify it, the Consumer Expectations Survey simply asks consumers who own their primary residence the following question: “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” Surveyors then compile responses collected from their sample which is designed to be representative of nationwide housing dynamics. It is easy to see how this method for estimating variations in housing costs can be misleading. In fact, the Federal Reserve Bank of Cleveland itself, in a research conducted in 2014, suggested that OER did not appear to be influenced by vacancy rates, unemployment rates or the real interest rate. Furthermore, only lagged house price appreciation appears to have a statistically significant relationship with the Bureau of Labor Statistics’ OER. Actually, historical data shows that from 2005 to 2007, OER increases were trailing substantially the increase in the house price index and OER puzzlingly continued to increase from 2007 to 2009 when house prices were comparatively falling at near double-digit rates nationwide. In other words, it appears that the Bureau of Labor Statistics measure of shelter cost appears quite disconnected from actual changes in homeownership costs. From our perspective, this is rather important as OER represents more than two-thirds of the shelter CPI component, and one-third of the index. To the extent that it is implicitly a lagging indicator, as more surveyed homeowners realize what has been happening to home prices nationwide, they may adjust their response accordingly. And as such, even if the price of other items starts to decline, as lumber and iron ore have recently, it may take a while for the index to decline if the OER component starts to tick up. WHAT IF EVERYONE IS WRONG AND INFLATION IS STRUCTURAL At the moment, after having reconsidered the numbers, we continue to believe that the recent above-trend increases in inflation are transitory, rather than structural, and that by the second quarter of 2022, year-on-year inflation increases will have subsided to levels that are within the Federal Reserve’s comfort band. Our view is aligned with the current consensus. In fact, the U.S. 5-year expected inflation derived from the difference in yields between 5-Year Treasury Constant Maturity Securities and 5-Year Treasury Inflation-Indexed Constant Maturity Securities has stabilized around 2,5%. Leaving aside questions about Central Banks‘ willingness and ability to raise the discount rate and end their bond purchase programs, we asked ourselves if assets owners’ portfolios are constructed to withstand unexpected increases in inflation and if not, what should be added or removed to improve resiliency? ASSET CLASS PERFORMANCE IN RISING INFLATION ENVIRONMENT: PERCEPTIONS AND REALITY In the following section, we will discuss the performance of broader asset classes during rising inflation periods historically and whether such performance is likely to be repeated. We will then summarize which asset classes an investor should consider to reposition his portfolio in order to make it more resilient should inflation unexpectedly increased further. EQUITIES The current narrative is that equities would do well if inflation was a little higher. The rationale is that corporations would be able to pass on higher costs to end consumers while a portion of their costs, such as labor-related costs, would not increase immediately. Additionally, higher inflation would tend to increase the replacement cost of existing assets and make those relatively more valuable. While these are reasonable assumptions, we believe that the ability to pass on higher costs to end consumers will vary greatly from one company to another. Our view is that companies with a relatively high proportion of their cost structure consisting of fixed costs will tend to do better. All else equals, value stocks should be favored relative to growth stocks. That being said, it is important to consider what is happening to growth and productivity at the same time. Unfortunately, inflation has been in a downward trend in the past 40 years. In fact, before 2021, there have been only three instances where the Core CPI increased by more than 1% relative to the prior year in the U.S., 1987, 2000 and 2008. We would highlight that these were not good years for this asset class even though there were clearly other factors at work. With that in mind, we accept that equities would probably do well with minor increases in inflation but that beyond a certain level, market participants will assume that inflation could persist and reflect those views by adjusting the equity risk premium higher and lowering price targets. FIXED INCOME The relationship between nominal bond yields and the rate of change in the CPI has been quite strong going as far back as the end of World War II. They have tended to increase in tandem from the early 1960s to the late 1970s before declining together since 1980. Given the inverse relationship between nominal bond yields and bond prices, the empirical evidence is quite strong: rising inflation is detrimental to fixed income. That being said, not all fixed income instruments have similar characteristics. To this point, instruments with more distant maturities exhibit more sensitivity to changes in inflation expectations. Conversely, instruments like Canadian preferred shares and bank loans, whose distributions increase when short or intermediate government bond yields increase, may benefit in a rising inflation scenario. The condition for that to happen, however, is that higher inflation needs to trigger a monetary policy response, as distribution rates are linked to short or intermediate-term government bond rates, not to inflation specifically. In fact, these instruments have been negatively impacted by the various rounds of quantitative easing that have suppressed interest rates. As such, while these instruments would likely do better than government bonds and investment-grade corporate bonds in an inflationary scenario, we believe these instruments remain more responsive to changes in monetary policy than to changes in inflation. Furthermore, it is important to note that while these instruments might be effective for small increases in inflation that would drive small increases in rates, beyond a certain level, the relationship could break because default risk jumps . More direct exposure to inflation increases is possible via Treasury Inflation-Protected Securities (“TIPS”) in the U.S. which have been auctioned since 1997. In Canada, Real Return Bonds play an equivalent role. With TIPS, for instance, the principal value is adjusted for inflation. As such, if held to maturity, TIPS will have provided full indemnification for inflation increases. Before maturity, though, TIPS are impacted by future inflation expectations, which may cause them to appreciate or depreciate and potentially negate, at least temporarily, their inflation hedging properties. Another fixed income market segment to consider is emerging market bonds, and in particular, those denominated in local currencies. The logic is that the value of coupons and principal payments could be worth more in U.S. terms should the United States experience an extended period of elevated inflation relative to other countries, which could depreciate the U.S. dollar. The inflation hedging properties of emerging markets local currency bonds could become particularly interesting if inflation increases are driven by a surge in commodity prices, from which numerous emerging-market countries still derive a significant portion of their international trade revenues. Lastly, income generated from emerging markets fixed income tends to exceed the income generated from their counterpart in developed markets over time. However, the segment is not without risk. To this point, default risks and political risks tend to be elevated as compared to developed markets and we are doubtful that on aggregate, emerging markets fixed income would perform well in a stagflation scenario, characterized by higher inflation but comparatively low economic and productivity growth. COMMODITIES Commodities are generally thought to be decent inflation hedges. The principal reason is that demand for commodities tends to be relatively price inelastic. This is true for agricultural, energy and industrial metals. Commodities could be really effective hedges if supply and demand dynamics for a particular commodity are the cause of a broader increase in inflation, as was the case in 1973 when the Organization of Arab Petroleum Exporting Countries declared an oil embargo against nations that were perceived to support Israel during the Yom Kippur War. This embargo impacted the global economy for many years. However, one of the challenges with commodities is that the asset class is quite volatile and that, unfortunately, changes in inflation expectations explain only fractions of that volatility. In fact, one could argue that while the introduction of commodities in a portfolio might contribute to hedge against unexpected inflation increases, it could introduce a number of undesirable risks or compound existing risks. Some argue that gold and other precious metals are better inflation hedges than other commodities. Unfortunately, data going back to the days when Richard Nixon rendered the Bretton Woods regime inoperative in 1971, suggest only a weak relationship between quarterly spot gold prices and U.S. Core CPI. While the relationship appears stronger for increases in inflation that exceed 5% per annum, this would indicate that like other commodities, the price of gold is largely driven by factors other than inflation, at least over the short term. In fact, a good portion of those arguing that gold can serve as a great inflation hedge also thinks that gold is a good deflation hedge. We believe that perhaps it is more a hedge against heightened uncertainty in general, not necessarily specific to inflation considerations. Another theory suggests that gold prices are inversely related to the real expected return on other financial assets. In other words, the best environment to hold gold is one where negative real rates of return (that is nominal rates of return after inflation) are expected to be low. We think this theory makes intuitive sense as gold, an asset that produces no income, becomes an attractive alternative to assets whose income is not expected to cover the cost of inflation. This theory, however, has not proven very effective. Actually, in spite of the deeply negative real expected rates of return prevailing for most of the fixed income universe, gold has not meaningfully appreciated and has in fact lagged most other commodities. To be clear, gold’s behavior puzzles us. Admittedly, there seem to be more unknown than known factors at work. We even wonder if large-cap technology stocks have taken over gold’s role as a hedge against declining real rates of returns. INFRASTRUCTURE, COMMERCIAL REAL ESTATE, FARMLAND AND TIMBERLAND Real assets are often presented as natural hedges against rising inflation since the income generated from the underlying assets through rents, tolls and other sources tend to increase over time. As most investors approach the real asset sector principally through private markets funds that report net asset values infrequently, it is difficult to empirically validate this claim. Some researchers use publicly-traded market proxies, such as Real Estate Investment Trusts (“REITS”) or Infrastructure Equities to estimate real assets sensitivities to various risk factors and then generalize finding to private markets. For us, this is a delicate exercise as the nature of publicly listed companies can be quite different from that of private companies or assets in the space. For instance, the public REITS side is largely comprised of core, stabilized properties while there is typically a larger content of development projects on the private side. In fact, public REITS are often buyers of assets developed in the private space. With regards to listed infrastructure, publicly listed indices include companies involved in engineering and construction, which may be quite a bit more cyclical than the infrastructure assets themselves. Ultimately, there are indeed assets that present superior ability to pass through cost inflation, like regulated power utilities, but it is not true for all assets. Real asset values change in response to several factors and we suspect that inflation is responsible for only a modest proportion of real assets price variations, not unlike the situation that we described for commodities. Moreover, changes in value related to local markets, supply/demand dynamics and the debt structure underlying real assets seem of capital significance. For instance, in a rising inflation scenario, real assets financed with fixed-rate long-term debt should appreciate more than comparable assets financed with floating rate short-term debt. The reason is that income matters more than revenues and having a fixed debt charge will be more beneficial than a floating debt charge as the latter will increase with inflation. With that in mind, we think that interest rates, specifically long-term interest rates, have a greater influence on real assets values than inflation itself. After all, real assets have been amongst the best-performing assets in the last decade, a relatively benign period from an inflation standpoint but one that saw long-term interest rates decline consistently. LONG/SHORT AND RELATIVE VALUE STRATEGIES As we have seen so far, the vast majority of assets which potentially have interesting inflation hedging characteristics are also sensitive to many other factors. As such, when introducing those assets in a portfolio, investors must weigh the other risks that are being introduced and in what proportion relative to the assets already held. Alternatively, investors could consider the introduction of long/short or relative value strategies in which the instrument that is sold short is designed to offset one or more of the undesirable characteristics of the instrument that is being held long. An example would be the introduction of inflation break-even strategies, which consist of a long position in an inflation-linked bond, usually a TIPS, and a short position in a duration equivalent nominal government bond. The intent of such strategies is to remove the impact of changes in inflation expectations during the holding period. This is important because, as we have discussed before, changes in future inflation expectations will cause fluctuations in the value of TIPS that are unrelated to the current level of inflation. In contrast, a long TIPS position hedged with a duration equivalent government bond will eliminate this risk and result in a purer, inflation hedging strategy. Another strategy could consist in establishing long positions in a basket of stocks with desirable inflation hedging characteristics like infrastructure or commodity-related equities, with a beta matched short position in the broader market of sector indices, thereby emphasizing the inflation hedging characteristics and removing the broader equity market risk. These are the type of strategies that are tactically implemented by global macro managers, often with significant leverage in order to compound potential benefits. The main challenge is to identify managers whose fund’s exposure to a rising inflation thematic would be large enough relative to other exposures to warrant an allocation on that basis. Unfortunately, such managers are scarce as the business of selling inflation protection has not been very lucrative in the past twenty years. Most of them turned to something else or diversified their portfolio to the point where the inflation hedging properties had been severely diluted. CONCLUSION We have discussed in detail the causes underpinning the increase in inflation and have concluded that the phenomenon is temporary. We also debated the idea that the shelter component of the Core CPI calculation may in itself be a lagged indicator of future inflation and that this component could cause inflation to persist. We then examined each asset class from the point of view of their respective inflation hedging characteristics and conclude that making an investment portfolio more resilient in the face of unexpected increases in inflation is challenging. For one, the reality is that the traditional fixed income and equity allocation do not tend to do well when inflation expectations accelerate too quickly. Secondly, the vast majority of assets or strategies that exhibit inflation hedging features also happen to bear other risks which are sometimes greater than the risks they are designed to reduce. The key is to find the appropriate balance in the choice of assets and their corresponding allocation, such that a portfolio does relatively well should inflation expectations increase while not doing too badly should inflation expectations remain stable. We believe that the solutions that we have deployed and the robust portfolio construction framework that accompanies it does improve expected outcomes in a rising inflationary scenario without compromising expected outcomes in other scenarios. Dimitri Douaire, M. Sc., CFA Chief Investment Officer  Bureau of Labor Statistics  Statistics Canada  We focus on Core Inflation rather than broad inflation measures as the latter do not influence monetary policy.  Source : Alix Partners  Source : Drewry  Source : Bloomberg  Source: BIMCO  September 30  U.S. Census estimate of the number of houses in the U.S.  Federal Reserve Bank of Cleveland, Recent Owners’ Equivalent Rent Inflation Is Probably Not a Blip, August 11, 2014  Source : World Gold Council  Robert Barsky & Lawrence Summers, Gibson’s Paradox and the Gold standard, 1985  Companies that own or that operate infrastructure assets. Photo credit
Montreal, September 23, 2020 FROM LAGADO PROJECTORS TO MODERN-DAY SPAC SPONSORS In Jonathan Swift’s Gulliver’s Travels, Gulliver visits Lagado, the metropolis of the fictional island of Balnibarbi where he is given the privilege to examine the works of the Grand Academy’s scholars called Projectors. There, he is acquainted with Projectors that dedicate their life to futile studies such as the extraction sunrays from cucumbers, the transformation of ice into gunpowder or the softening of marbles to make pillows more comfortable. Swift was one of the most famous political satirists and pamphleteers of his time and this passage can be interpreted as a parody of the speculative excesses that were prevalent in the late 17th and early 18th century. It is worth noting that Gulliver’s Travels was published shortly after Swift’s generation had witnessed the collapse of two of the most notorious stock market bubbles in history. The first one took place in the mid-1690s. It involved a flurry of companies that had become public a few years earlier. Almost all of these companies were engaged in the manufacturing or distribution of diving apparatus and pumps, industries that had suddenly become ebullient after Sir William Phips and his associates, on a private expedition, were able to recover nearly 3,000 gold coins and three silver bars from the wreck of the Spanish armada ship Nuestra Señora de la Concepción. The view was that anyone with the right equipment could ‘strike gold’. Ultimately, most expeditions were ruinous and the companies supplying equipment for those ventures ended up worthless. The second one has a dedicated chapter in almost every financial market history book: the South Sea Bubble, which almost bankrupted England in 1720. This speculation mania centered of the South Sea Company which was founded in 1711 and enjoyed a British government monopoly to trade slaves with Spain controlled Central and South America. For many years, the South Sea Company’s stock languished, in spite of its guaranteed 6% interest, as the terms of the Utrecht Treaty with Spain in 1713 were less favorable than had been anticipated. In effect, an annual tax and a strict quota were imposed on slaves imported to the Americas. Confidence was restored in 1718 when King George I himself was nominated to the Board of Governors of the South Sea Company but it is only in 1720 that the South Sea Company’s stock took flight after the British Parliament accepted its offer to take over the National debt in exchange for an upfront loan. The company expected that the expansion of its trading activities would enable it to pay the government debt. Soon after the announcement, the South Sea Company stock went up eightfold. Business was lucrative for shylocks who were granting loans to Londoners who couldn’t get enough of the stock, and for swindlers and fraudsters who were promoting the stocks of other trading companies engaged in similar activities. One adventurer even set up a company whose prospectus stated “…an undertaking of great advantage, but nobody to know what it is.” Eventually, the stock market collapsed, dragging down the entire country with it, including notable members of the aristocracy. The collapse of the South Sea Company led Sir Isaac Newton – who reportedly lost a fortune in the debacle – to declare: “I can calculate the movement of the stars, but not the madness of men.” To be clear, we do not think that the global stock market as a whole is in bubble territory from a valuation standpoint. In fact, relatively speaking, developed markets government bonds, with maturities ranging between 5 and 20 years and with their yield to maturity standing at levels well below the expected inflation rate over the same maturity, appear to us in a far more precarious state. This is particularly true now that the Federal Reserve acknowledged that it will let inflation to overshoot above its long-term target of 2% before raising interest rates. Nonetheless, there are symptoms that bubbles may be forming in certain parts of the stock market, some of which would certainly draw Swift’s attention as a fertile source of inspiration were he alive today. For example, there are situations when dilutive stock offerings or stock split announcements are perceived positively on the grounds that more marginal buyers will now be able to participate. Other examples include the recent record high transaction volume on short-term single stock call options and, last but not least, the exuberance around Special Purpose Acquisition Companies, or “SPACs.” By way of background, a SPAC is a publicly listed company established with the sole purpose of acquiring another company, within a given time frame, typically 2 years. On its formation date, the SPAC does not own any assets and the money it raises from investors through its own initial public offering (IPO) is kept in a trust until the SPAC sponsor successfully consummate a merger with an operating company. Following the merger, the operating company becomes a publicly traded stock. Typically, SPAC sponsors receive a combination of shares in the SPAC (typically 20% of the outstanding shares), and warrants with an exercise price marginally above the SPAC’s IPO price, in exchange for small consideration. Importantly, the sponsor is compensated in shares once a merger is completed, not as a function of the company’s performance following the merger. In other words, SPACs sponsors tend to be incentivized more by the strict completion of a merger transaction itself than by the financial success of the operating company. If a SPAC fails to complete a merger within the time frame, it is contractually obligated to return capital to its shareholders. In 2020, more SPACs are raising IPOs than ever before. Separately, the amount of money raised by SPACs and the number of deals completed are also on record track. Our estimate suggests that SPACs are collectively sitting on more than 40 billion in cash raised from their respective IPOs. Once a tiny and obscure stock market niche attracting a number of unsavory characters, SPACs have gained notoriety as more sophisticated investors such as Bill Ackman are getting involved. Celebrities and political figures are also surfing the wave. For instance, Billy Beane, of Moneyball fame, is behind Red Ball Acquisition Corp. while Paul Ryan, the former Republican party house speaker, is the Chairman of Executive Network Partnering Corp. Some argue there are legitimate reasons that underpin the decision for an operating company to become public through a merger with a SPAC, as opposed to the more traditional IPO route. Rapidity of execution and certainty of proceeds probably rank amongst the most important reasons in comparison with the IPO process which is tedious and for which the value of the proceeds is usually not known until 24-48 hours prior to the IPO. From the vantage point of the SPAC shareholder, however, we do not see many good reasons, quite the contrary. First, as described above, there is an inherent misalignment between the interests of the SPAC promoter and the interests the shareholder. In effect, the SPAC promoter generally gets compensated simply for completing a transaction while the shareholder compensation is tied to the longer-term success of the company. Basically, unless the SPAC promoter manages to acquire a company that is undervalued by a greater percentage than the percentage of the company that he obtains for completing a transaction, SPAC shareholders tend to get a smaller fractional share of the post-merger entity than what they paid for. While some argue that IPOs are notoriously undervalued, given the lackluster performance of a large number of stocks post-IPO in recent years, we think the argument is debatable. Second, a SPAC shareholder does not have the same degree of regulatory scrutiny and transparency into the books and records of the operating company targeted by the SPAC as they would during the normal IPO vetting process. After all, investors that were contemplating the acquisition of WeWork shares were rewarded when the company’s IPO filing documents revealed its weak governance and aggressive accounting practices, ultimately forcing the company to shelve its IPO plans. Unfortunately, if history is a guide, in a world awash with liquidity and zero interest rates, while many SPAC sponsors are undoubtedly well intended, it is almost certain that many dramatically overvalued companies and potentially fraudulent ones will get the attention of SPACs. In many aspects, the SPAC promoters’ financial engineering approach to value creation may not be that different from the pseudo-science techniques employed by the Lagado Projectors which were dubious. Thankfully, signs of speculative excesses seem to transpire from relatively concentrated segments of the growth equity space. As such, the idea is not to eliminate growth stock exposure altogether. In fact, we find that certain growth stocks remain undervalued relative to value stocks. Therefore, from a portfolio construction standpoint, the key is to maintain a good balance between different types of stocks and between asset classes. Dimitri Douaire, M. Sc., CFA Co-Chief Investment Officer  Jonathan Swift, Gulliver’s Travels. Original title: Travels into Several Remote Nations of the World. In Four Parts. By Lemuel Gulliver, First a Surgeon, and then a Captain of Several Ships, Benjamin Molte, 1726.  Charles Mackay, Memoirs of Extraordinary Popular Delusions, Richard Bentley, London, 1841.  In July, Bill Ackman raised 4 billion for the IPO of Pershing Square Tontine Holdings Ltd., the largest SPAC IPO to date.  Billy Beane is the former General Manager of the Oakland Athletics professional baseball team from 1997 to 2015 whose attempt to assemble a competitive team is depicted in the movie Moneyball (2011, directed by Bennett Miller) based on Michael Lewis’s book Moneyball: The Art of Winning an Unfair Game (W.W. Norton & Company, 2003). Photo credit
Montreal, July 30, 2020 ENTERS PLUTUS, THE GREEK GOD OF WEALTH Johann Wolfgang von Goethe was not a particularly prolific writer. The genesis of his magnum opus took over 30 years. Nowadays, Goethe might even be considered a mere “one hit wonder”. But what a hit it was! Written against the backdrop of the Age of Enlightenment and the Romantic period, Faust is regarded by some as the greatest work of German literature. Faust marks the origin of the pact with the devil mythos, from which so many derivatives took their inspiration afterwards. Yet aside from the play’s main theme and its central character’s deal with Mephistopheles, there is a side story in Faust Part II which is particularly interesting in light of recent policy decisions. The story revolves around an emperor whose realm is afflicted by economic problems. In an early scene, at a reception at the court, the emperor is acquainted with an unlikely duo consisting of Faust, disguised as Plutus, the Greek god of wealth, and Mephistopheles, disguised as the emperor’s fool. Later in the evening, Plutus tricks the intoxicated emperor into signing a paper note. Unbeknownst to the sovereign, Plutus and the fool promptly print unlimited copies of the paper note which are then circulated throughout the empire, thereby eliminating economic problems. Later on, the emperor realizes that the shortsightedness of Plutus’ solution has created a false sense of prosperity in the realm, which in turn enabled greed and corruption, ultimately leading to a compounding of the economic problems that prevailed and bringing the realm on the verge of rebellion. We think there are striking parallels to be drawn between the money printing metaphor in the play with what happened in the last few months. In effect, by resorting to an unprecedented monetary expansion effort in order to avert an economic crisis that would rival the Great Depression, central bankers have turned into a modern version of Plutus. While we understand that there may have been no other choice, in their attempts to reduce short-term damage, central bankers, whose recent policy actions included massive intervention in the investment grade credit sector, have now socialized large swaths of the financial sector, the consequence of which has been the extreme distortion of the value of a broad range of financial assets. In doing so, they have made a remarkable entrance disguised as Plutus and consummated their own Faustian bargain. Even if the long-term outcome of this bargain may not be as tragic as in Goethe’s play, we prefer to be invested conservatively and to be diversified across a broad range of risk factors rather than chase the financial assets whose value may have been the most artificially inflated. ONE COUNTRY TWO SYSTEMS NO MORE Hong Kong’s current crisis can be traced to the implementation of the 1990 Basic Law, a constitutional law whose purpose was to give effect to the 1984 Joint Declaration between China and the United Kingdom that guaranteed the continuation of Hong Kong’s capitalistic and social freedom system for 50 years following its return to China in 1997. Article 23 of the Basic Law stipulates that Hong Kong is responsible for enacting laws to prohibit treason, secession, sedition and subversion against the Chinese government and bar foreign organizations to conduct political activities in the region. Indirectly, it meant that Hong Kong’s retained its independence but that China would ultimately dictate policy around security and foreign relations. Unfortunately, since its return into China’s lap, Hong Kong has tried and failed repeatedly to implement Article 23 due to public outcry. Its latest attempt, in June of last year, was met with daily widespread protests and demonstrations lasting through late fall. In retrospect, the COVID-19 pandemic provided the distraction that China needed to force the implementation of the missing legislation. To this point, diplomatic attempts to dissuade China from asserting more direct authority over Hong Kong have fallen into deaf ears. Similarly, since China has waited over two decades for this moment, we don’t think that calls for sanctions from countries with assets in the region will have an impact. In fact, a series of recent events suggest that China is less preoccupied by the image that it projects on the international scene than it was 30 years ago, in the aftermath of the Tienanmen Square events. Notably, China is particularly emboldened when it comes to pushing the limits of public international law in the South China Sea. This is an adverse development which few had foreseen. The widely held view was that Deng Xiaoping’s thoughtful “one country, two systems” formula was beneficial for China as it could draw inspiration from Hong Kong’s British heritage in the transformation of its state-controlled economy to a market economy. Evidently, China viewed the situation differently, which raises questions about what comes next. Firstly, what will China’s tighter grip mean for foreign companies operating in Hong Kong? Secondly, are Trump’s United States willing to militarily guarantee the Taiwan’s independence if China’s policy towards Hong Kong sparks the nationalist fervor on the island? Thirdly, how will China react should foreign countries offer fast track visas to the highly skilled citizens of Hong Kong who see China as a menace and choose to emigrate? Answers to these questions could have potentially serious geopolitical consequences. For this reason, our strategy is to approach China and the broader Asian region without taking too much directional risk. As such, we think that this in an area where hedge funds, whether they focus on equity or credit markets, interest rates or currencies, are worth considering. This is a key research focus of ours as a result. DEAD SHOPPING MALLS RISE LIKE MOUNTAINS BEYOND MOUNTAINS The title of this section is a line that we stole from a song by the internationally acclaimed Canadian indie-rock band Arcade Fire . While the decline of the suburban shopping malls had already been chronicled, as COVID-19 rampaged through the world, forcing business closures, their problems only worsened. In retrospect, Arcade Fire was prescient. The reason we mention the shopping mall situation is because the broader commercial real estate sector – publicly listed Real Estate Investment Trusts (REIT) aside – typically comprises a core portion of ultra-high net worth (UHNW) investors allocation to alternative investments and that many UHNW are attempting to assess whether the recent carnage witnessed in the space as an opportunity to increase their exposure. After all, they argue, from a Canadian investor’s vantage point, the commercial real estate sector, has been largely immune to recessionary shocks in the past three decades and until the pandemic hit, it had generally outperformed both equity and fixed income over relatively long periods. While these arguments are undebatable, they are backward looking. To this point, we believe that there are fundamental reasons that underpin the weakness experienced by commercial real estate since March. Firstly, in many sectors, rent collections are at risk. In effect, while such risk appears contained in the traditionally more defensive multi-family residential sector as well as the industrial and storage sector, it is particularly acute in the hospitality, office and retail sectors. We further suspect that even the student housing sector could face problems if college and university campuses do not re-open this fall and that foreign students are frozen at the border. To date, real estate owners and operators have engaged in proactive discussions with their tenants, which have led to the implementation of various rent relief measures. Nevertheless, these measures are temporary and since the commercial real estate sector has not directly been targeted by government and central bank measures to date, we wonder how long can these voluntary measures last and what happens when they expire. Secondly, we note that a many nonbank real estate debt providers such as mortgage REITs, specialty finance companies and hedge funds have significantly curtailed their activities or effectively exited the space. As such, capital for development and repositioning projects has become scarce and more expensive. Ultimately, we think it will cause many commercial real estate owners, operators and developers to prioritize debt reduction over distribution payments and that major expansion projects will be postponed. To summarize, while the opportunity to uncover unique assets which will generate superior outcomes given the depressed valuations may very well be real, the level of uncertainty is unprecedented and the risks of making a costly mistake by increasing exposure too early is high. With that in mind, until we overcome the COVID-19 pandemic, we consider it prudent to focus on the most defensive sectors, use only conservative amounts of borrowing and more importantly, borrow on conditions that cannot be unilaterally amended by the lender. Reassuringly, while we did not deploy capital in the space anticipating a global pandemic, our recently completed investments appear well positioned to withstand the negative influence of the pandemic. To this point, to date, there has been little deterioration in vacancy and rent collection metrics and developers indicate that construction projects remain on time and on budget. Dimitri Douaire, M. Sc., CFA Co-Chief Investment Officer  Johann Wolfgang von Goethe, Faust Part I, published in 1808, and Part II, published posthumously in 1832.  Sprawl II, the Suburbs, released by Merge Records in North America in 2011.  We do not consider publicly listed REITs as alternative investments. We view REITS as equity market investments. 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