Author: Transcend

Rising Short Rate Doesn’t Mean Bond Disaster

Interest rates have been on the rise in Canada since June 2017 and the general consensus is that they will continue to go up. What will this mean to the average client’s portfolio? Of course, everyone knows that rising interest rates are bad for bonds, right? In reality, history shows a different conclusion concerning the impact of rising interest rates on a broadly diversified bond portfolio.

When analyzing the past experience of bond investors under different interest rate scenarios it is clear that a bear market in bonds is quite different from a bear market in stocks. Unlike stocks, where the common definition of a bear market is a 20% decline in prices, to most investors a bear market in bonds is simply a period of negative returns. The past 49 years of return data shows that these periods are few and far between with only 5 calendar years of negative performance.

The chart below shows that increases in interest rates at the short end of the yield curve have not necessarily hurt most bond portfolios. Since 1970 there have been 22 years (including 2018 year-to-date; where bonds still managed to achieve a gain) when short-term or 91 day T-Bill yields have increased over the previous year. The chart shows the calendar year performance for the FTSE Universe Bond Index, the broadest and most widely used measure of government and corporate bonds in Canada, for the years when short-term rates increased. The first point of note is that there are only 2 years with negative results; 1974 and 1979, and the -4.5% return in 1974 was the worst annual bond performance of the last 40 years. The average annual performance over the 22 years was 7.0% which is only slightly less than the 8.7% average annual return over the last 5 decades.

Even when rates are rising across the maturity spectrum, it is unusual to suffer large losses in bonds. When both short-term and longer-term rates increase together it is more likely that bonds will see low or slightly negative performance.  As the data to the left illustrates, periods in which short-term rates increased between 1 and 3%  had a positive impact on bond results. Even during periods when short rates were rising at a rate of greater than 3% (which only occurred 3 times), bond investors still managed to realize positive returns on average.

Since the Bank of Canada’s priority is to keep inflation low, the likelihood of the Bank triggering a surge in interest rates is not very high. Most diversified, long term investors should not view weakness in the bond market with the same apprehension as an equity bear market. In general, investors should look to bonds for stable income and to protect against disaster, something which they did well during the financial crisis. Bonds are an asset class capable of storing value, providing liquidity and most importantly, providing positive returns in most economic environments.

Interest rates hikes don’t automatically spell disaster for bonds. Most investors own bonds in order to preserve capital and mitigate the volatility inherent in stocks or other risky assets. In a world where equities are becoming more expensive, maintaining exposure to bonds is a wise move. Ultimately, most bond investors are likely to be best served by sustaining their strategic allocation to fixed income. While short-term bond returns may not be overly impressive at the moment investors will be more than satisfied during the next equity bear market. Disaster? Unlikely.

MARKET DATA

This report may contain forward looking statements. Forward looking statements are not guarantees of future performance as actual events and results could differ materially from those expressed or implied. The information in this publication does not constitute investment advice by Provisus Wealth Management Limited and is provided for informational purposes only and therefore is not an offer to buy or sell securities. Past performance may not be indicative of future results. While every effort has been made to ensure the correctness of the numbers and data presented, Provisus Wealth Management does not warrant the accuracy of the data in this publication. This publication is for informational purposes only.

Q2 2018

MARKET COMMENT

Across the financial landscape all anyone is talking about is Trump, tantrums and tariffs. Tensions are not going to disappear, but they are going to ebb and flow. However, looking below the surface, things are a little more placid. Certainly, investors’ nerves have been rattled. While there have been several days of large declines in the financial markets, for the most part investors are better off than they were at the start of the year. Investors just need to push aside the political distractions and recognize the world’s economies are only now normalizing and previously growth has been quite slow, disjointed and restrained.

Despite this period of turmoil and uncertainty, the Canadian stock market has hit a record high. Obvi-Equities this is impressive considering the recent economic news, ongoing trade woes, soft housing market conditions and weaker Canadian dollar. Clearly, investors are looking past the escalating tensions and are repositioning themselves in part due to the very attractive Canadian equity valuations relative to U.S. equities. This is something that normally happens during the late stages of an economic cycle, which could be very rewarding for investors over the coming years.

The U.S. market navigated, virtually unscathed, through a gauntlet of central bank meetings, a historic summit between the U.S. and North Korea, and flaring trade tensions. This is even more impressive considering that the Federal Reserve lifted interest rates for a second time in 2018, amid rising inflation and the lowest jobless rate in nearly two decades. Volatility has been trending decisively lower since it surged in February. Still, the road ahead looks fraught with potential landmines especially if the tariffs result in lasting damage and escalating tensions.

The European economy has been a puzzle lately as some indicators are pointing up, some down and some sideways. It is hard to know whether it is the beginning of a decline or simply a normalization following a period of strong growth. Amid so much uncertainty the European Central Bank is closing one chapter by shutting down its bond buying program; but it has also promised to continue other stimulus efforts for now. This can be justified by robust underlying growth, unemployment falling to its lowest level in a decade, and a rebound in inflation and wages.

For the rest of the world, last year’s financial market boom seems to have been completely forgotten as we’ve seen the worst start to a year for emerging market stocks since 2010. They began the year as a market darling only to be toppled by a surge in the dollar, a 16% leap in oil prices and rising political risks. While only a few small markets are at any material risk of crisis, it has truly been a test of investors’ patience. China, in particular, long seen as the world’s growth engine, slipped into a bear market falling more than 20% below its high earlier in the year. the end of the day, the results have been positive. Canadian stocks were up 6.8% in the quarter (1.9% for the year-to-date) and U.S. stocks climbed 5.5% over the last 3 months (7.2% YTD, all figures in Canadian dollar terms). International stocks as a whole gained 1.1% in the quarter (2.2% YTD); while emerging market stocks lost 6.6% (-3.1% YTD). Bonds continued to lag only climbing 0.5% in the quarter and 0.6% for the year-to-date.

Investors breezed into 2018 expecting to pick up easy returns. Instead, euphoria was replaced with volatility and uncertainty. This sea of change stemmed from the snap stock selloff in early February. Since then, markets have become more vulnerable to growing political uncertainty and investors are becoming risk averse. The extreme swing in market psychology from a time when all risks were being ignored to one that is hyper-sensitive is cloaking the bright spots which are still plentiful.

Christopher Ambridge, CFA


CANADIAN EQUITIES

The second quarter saw a sudden change of narrative on global economies. At the start of the year there were fears over trade tensions and some optimism on a possible deal, but in the second quarter that optimism quickly faded as talk of a trade war erupted between the U.S. and the rest of the major economies. Also, heightened political risk with populist governments in Europe, and nuclear programs in North Korea and Iran added to global concerns. Yet for most of the quarter these tensions turned out to be noise. The overall macro backdrop remained supportive amid rate normalization in North America and prospects of decent global growth for 2018.

The Canadian economy particularly has shown much resilience with expectations of moderate expansion in the second quarter despite recently imposed tariffs, especially with steel and aluminum. The job market has been tight with about 23,000 new jobs per month over the last twelve months. Although trade concerns weighed more on many global markets, the S&P/TSX index went into rally mode to reach record highs and posted its best quarterly performance since 2013 with 6.8% gain on a total return basis.

At the start of the year investors were wary that geopolitics would have a more pronounced impact on the global economy and markets rather than business fundamentals and that has proven true. Over the last six months with the U.S. trade war against the rest of the world, renewed populism in parts of Europe and the North Korea nuclear issue, volatility has returned with a vengeance. However, Canada seems to be dodging these global threats so far with a resilient economy and an unemployment rate at a record 5.8%. The strong job market is causing inflationary pressures as the latest Consumer Price Index measures showed inflation levels above the Bank of Canada’s benchmark rate of 2%. On the other hand, the threats are not preventing the S&P/TSX from making new highs as it did on June 22 when it closed at 16,450 points.

After years of negative news regarding household debt, there seems to be a turning point as the debt load got a bit lighter according to June data from Statistics Canada. Also Canadian banks, though not stellar in the second quarter, have improved a lot thanks to their strong balance sheets and profitability. Thus their exposure to housing is not a major concern to some investors. Years of underperformance have made the S&P/TSX a bargain compared to other global markets and with improving energy prices the index can rise to within striking distance of its long term average return.

Ari Abokou, MBA, CIM, FCSI


FIXED INCOME

During the second quarter of 2018 the Canadian FTSE TMX Universe Bond Index gained 0.5% and has risen 0.6% so far this year. The Bank of Canada raised its key lending rate in July and September of 2017 and again in January by a quarter point to 1.25%. Interest rates are recovering from the once record lows of last summer in response to signs of an improving economy. The central bank has taken a cautious stance on rate adjustments but investors are pricing in at least two more hikes by the end of this year. The recent increases overwhelm the two rate cuts introduced in 2015 which were to help cushion and stimulate the economy from the collapse in oil prices. In the U.S. the Federal Reserve has raised interest rates eight times since the financial crisis with the two most recent rate hikes coming in March and June 2018. The U.S. central bank has increased its benchmark interest rate target range each time by 0.25% to a new band of 1.75% to 2.0%.

The most recent version of the Bank of Canada’s biannual Financial System Review (FSR) was released in early June. The FSR is the central bank’s main vehicle for communicating developments related to stability of the financial system. At the FSR release press conference Governor Stephen S. Poloz confirmed that the main vulnerabilities they see today are the same as those in the last FSR in November. They are elevated household debt, imbalances in some housing markets and cyberattacks.

Governor Poloz noted that, “there are several factors helping to lessen the vulnerability related to household indebtedness. There have been a series of changes to mortgage lending guidelines, a slowdown in credit growth along with higher interest rates. As well, a solid expansion in the Canadian economy is leading to strong growth in employment and income and, over time, this will support Canadians’ ability to manage their debt, even at a time of rising interest rates”.

In the U.S., long term bond yields briefly broke above 3% earlier this year for the first time since 2014. It didn’t take very long for the yield to fall back below that level but many investors say a bear market is near as rates inevitably rise and deficits grow but they are missing one key point: The 30 year bull run pretty much ended years ago as U.S. government bond returns have failed to keep up with even the recent weak inflation.

In their June 13 press release, the U.S. Federal Reserve observed that the labour market continued to strengthen and that economic activity has been rising at a solid rate. Job gains have been strong, on average, in recent months and the unemployment rate has declined. Recent data suggests that growth of household spending has picked up, while business fixed investment has continued to grow strongly. The stance of monetary policy remains accommodative, thereby supporting strong labour market conditions and a sustained return to 2% inflation.

Peter Webster, CFA


U.S. EQUITIES

The Standard & Poor’s 500 index climbed 3.4% in U.S. dollar terms over the second quarter of 2018 and year to date the index is up 2.6%. In Canadian dollar terms the respective change was 5.6% for the quarter and 7.6% year to date as the loonie lost 2.1% during the second quarter and has weakened by 5.0% so far this year. The long bull market in the U.S. has now passed its ninth birthday and, while it has been a long run, the longest post war bull market lasted for nearly 10 years until March 2000.

The books are now closed on a tumultuous first half of 2018 that saw volatility surge amid trade war fears and a faster moving central bank. While the going got rough, including twin routs in February and March, U.S. stocks avoided disaster as earnings showed no sign of unraveling. By at least one measure, corporate earnings are the best in nearly a quarter century. According to Thomson Reuters I/B/E/S, 499 companies out of the S&P 500 index have reported Q1 earnings as of June 29 and 78.2% have reported earnings per share that were above analysts’ expectations, putting the season on track for the highest earnings beat rate on record, going back to 1994. The first quarter growth rate for earnings is 26.5% above the same period last year. The recent quarterly results have seen outperformance of about 3 to 4% better than analysts’ consensus estimates on average. What’s really impressive is that expectations were already lofty and the quarter represented the first in which expectations were raised to factor in fiscal stimulus measures such as the corporate tax cuts which took effect in late 2017.

Given the strong earnings numbers, the advance of the S&P 500 index was surprisingly paltry. It isn’t easy to pinpoint exactly what’s troubling investors. There are signs that harmonized global growth is starting to unwind and that has hurt investor confidence. Concerns about global trade tensions between China and the U.S. and the fear that the stellar earnings could be as good as it gets for stocks are all combining to undermine the sort of confidence that was in abundance during last year’s run of repeated records for equity benchmarks. Investors may also be concerned that the U.S. economy is in its ninth year of expansion and the Federal Reserve is moving to normalize monetary policy from crisis era levels. Another headwind is the strengthening dollar and rising interest rates. Recently the dollar put in its best monthly rise since President Donald Trump’s election and the yield on the 10 year Treasury note touched its highest level in more than four years, briefly rising above 3% in the quarter.

The U.S. equity market continues to show signs of late cycle angst. While political uncertainty, threats of a trade war, hostile rhetoric and bullying of U.S. manufacturers are not helpful, the strength in the economy and a healthy earnings outlook should be supportive of U.S. equities.

Peter Webster, CFA


INTERNATIONAL EQUITIES

The uncertainty surrounding the global outlook has increased as stock markets around the world slumped in recent weeks amid mounting trade tensions between the U.S. and everyone else. It is undeniable that investors had recently been quite enamored with the return prospects for international stocks, but these days they are dumping riskier stocks and seeking safe harbours for their money. They are reacting to signals of more rapid policy tightening, although full policy normalization will take years.

Economic growth across the European Union (EU) looks like it will remain robust this year and next, particularly when compared with Britain. The debt crisis that had ravaged the Eurozone and many of its members, notably Greece, is now past. Europe has finally turned the page of the crisis. Unemployment in the 19 countries that use the euro fell to its lowest level in a decade as the region’s economy kept benefitting from waning worries over debt. The EU statistics office, Eurostat, said the rate dropped to 8.5% in February from 8.6% in the previous month marking the lowest level since December 2008. While unemployment was down, annual inflation in the Eurozone jumped to 1.4% in March, ending several months of decline but failing to come near the European Central Bank’s (ECB) own target of close to 2%. Britain will continue to lag the Eurozone over the coming years, with the economy hobbled by Brexit uncertainty. As the country prepares to leave the EU on March 29, 2019, its future relationship with the Eurozone remains unclear.

The euro sold off after the ECB announced that it would look to finish its bond buying program by yearend but also pledged to leave interest rates unchanged until mid-2019. The ECB announced it would taper its asset purchases further in October to €15 billion a month from €30 billion before the quantitative easing program likely concludes in December.

Japan’s tightest labour market in decades just got tighter driving companies to hire more workers in full-time, permanent positions. That’s positive news for the Bank of Japan as it struggles to generate 2% inflation. Consumer prices in Tokyo, a leading indicator for the nation, rose more than expected. The unemployment rate in May fell to 2.2%, the lowest since 1992. As companies struggle to find workers they’re hiring more staff on permanent, full-time contracts, which generally means higher pay and benefits. Still, challenges to the economy abound. The export dependent nation faces fallout from global trade tensions and the slowing of growth in China. Japan’s factory output fell slightly in May after rising for three consecutive months.

The world’s second biggest economy cooled slightly in March as China faces an escalating U.S. trade spat which could have damaging economic consequences hitting exporters of both nations and shattering global growth. Economists are penciling China’s growth to slow to 6.5% this year, from a solid 6.9% in 2017, also due to a cooling property market and rising borrowing costs.

For the most part the second quarter was weak for international stocks as the overall market fell 1.0% (all figures are in U.S. dollar terms). Overall, European stocks were down 2.7% last quarter, which was better than Asian stock markets which lost 5.0%. Emerging markets tumbled in the second quarter after a stronger dollar and higher U.S. interest rates led many investors to flee from riskier developing markets. The MSCI Emerging Markets stock index fell 8.7% over the past three months, the index’s worst quarterly performance since the third quarter of 2015.

Some investors’ patience with stocks is waning, particularly in Europe where this was supposed to be the moment when European equities would finally catch up with the U.S., lifted by a revival in economic growth and corporate earnings. Instead, investors are once again preparing to start de-emphasising international stocks in light of the simmering trade war and the dithering on the interest rate outlook.

Christopher Ambridge, CFA

Reversing the Performance Difference

The performance difference between Canadian and U.S. stocks has been very pronounced over the past few years, but that could be about to change. Of course, the U.S. is a growth stock market and Canada is deep value, which as most investors know do very well during the late stages of an economic cycle. Since, Canada is relatively commodity price sensitive, which means the Canadian market is a much more effective hedge against inflationary pressures, which leads to Canada almost always outperforms the U.S. late in the investment cycle. Throw in the discrepancy in stock market valuations and equity risk premiums the case for choosing Canadian stocks is become quite compelling.

In fact, Canadian stocks frequently rise as the U.S. market declines or heads into recession as happened from August 2007 to August 2008 when the S&P/TSX index rose 3.5% while the S&P 500 sagged -10.7% (all figures in Canadian dollar terms). The reason for this can be summed up in one word: oil. Oil prices surged 56% which allowed the Canadian energy sector to advance 16%. The same thing happened in 2005, when the S&P 500 was only up 1.6% for the year, while the S&P/TSX rose more than 24.1%. Again, because of oil prices surged 37.7% and the Canadian energy space jumped 45%.

These are not isolated instances, but in fact highly correlated recurring events. Oil prices increase and Canadian stock markets out performance U.S. stocks; oil prices decline and Canadian stock markets lag behind U.S. stocks. This is not the case in most other stock markets, but none of them have currently have over 20% of there stock weighting in the energy sector and 30% in 2008 when oil prices reached its peak, like Canada does. For most of the rest of the worlds major stock markets the Energy sectors peaked out at 12% weighting versus a relatively meager 6% today.

The relationship between stocks markets and oil is volatile, with the correlation between the returns for stocks and oil prices swinging between positive and negative values depending upon the time period used. However, the correlation is very positive for Canadian stocks versus U.S. stocks over longer time periods.

The chart the right and the data to the left, clearly show that on an annual basis, when oil prices increase the Canadian stock market does better that the U.S. market, in fact this outperforming correlation occurs 83% of the time. Over the past 18 years this relationship has only broken down 3 times: 2011, 2013 and last year, 2017. And other than, 2011 Canadian stocks gained on average 11.0% during the other two years, which are better than long term stock market performance. The problem has not been Canada, it has been the U.S. stock market producing abnormally large returns during 2013 and 2017, 27.9% on average.

When it comes to the relationship between oil and stock pricing, normally a moderate correlation does exist. However, when it comes to different markets and their underlying core components the price change in oil can have a highly cyclical and major impact on results. It is crucial to keep this relationship in perspective during this period of late cycle U.S. market conditions since traditionally the best place to hide is the Canadian energy sector and Canadian stocks in general.

Market Data

 

This report may contain forward looking statements. Forward looking statements are not guarantees of future performance as actual events and results could differ materially from those expressed or implied. The information in this publication does not constitute investment advice by Provisus Wealth Management Limited and is provided for informational purposes only and therefore is not an offer to buy or sell securities. Past performance may not be indicative of future results.

While every effort has been made to ensure the correctness of the numbers and data presented, Provisus Wealth Management does not warrant the accuracy of the data in this publication. This publication is for informational purposes only

Uniquely Canadian

Around the world, particularly since the bottom of the stock market crash of 2008 (which occurred in February 2009), growth stocks have lead the recovery – but not in Canada. Global value stocks have traditionally produced greater gains during good quarters and bigger declines through bad quarters but Canada is different in this regard than the rest of the world. In this we are uniquely Canadian.

Growth indices include stocks with higher price-to-book ratios and faster than expected earnings growth rates. The value index includes stocks with lower price-to-book ratios and slower earnings growth rates. A quick glance at the three main sectors for Canada versus the U.S. and EAFE markets show exactly why our market marches to a different beat:

Canada – Financial Services (36.5%), Energy (19.4%) and Materials (11.7%)
U.S. – Information Technology (24.7%) Financial Services (17.4%) and Health Care (13.8%)
EAFE – Financial Services (23.6%), Industrials (14.6%) and Consumer Discretionary (12.6%)
Not only does Canada have one of the most concentrated stock markets in the world, it is also highly value stock orientated. Unfortunately for the past 10 years that has been a very bad combination.

By looking at the cumulative total return chart to the right (all values in U.S. dollar terms) investors might conclude that for the past 20 years Canadian value stocks (especially) and growth stocks would have been the place to be. And they would be absolutely correct except this timeframe can be divided into two distinct periods; before the 2008 market crash and after. As the data to the left shows, over the last 20 years we were world-beaters; after February 2009 (the market bottom of the crash) not so much. The U.S. stock market has absolutely dominated the rest of the world and growth stocks (everywhere but Canada) have ruled the roost.

Growth has normally been the better strategy in this bull market which could be coming to an end in the not too distant future. Bull markets have been greatly supported by the stimulative policies of the world’s central banks, which increased the money supply and kept interest rates at historically low levels for nearly a decade.

Value stocks do their job for the most part (everywhere but Canada) as a defensive play during the last cycle of rising interest rates. This time around, inflationary pressure, brought about by rising rates as demand for workers increases could force the central banks to be more aggressive. In Canada, we simply do not have many growth stocks so value stocks lead the way over most market cycles and distort the Canadian stock market relative to most other countries.

Despite the runaway success of growth stocks globally over recent years the reality of rising interest rates could mean a comeback for value stocks beginning this year as investors flock to defensive investments. During the last period of sustained interest rate increases Canadian value stocks have reeled off 10 straight quarters of outperformance. And for a country like Canada where value stocks are king and historically outperform the rest of the world, we might just be able to break the back of the sustained period of weak relative performance and once again become the world-beaters we used to be. In that way being uniquely Canadian may work in our favour once again.

Market Data

This report may contain forward looking statements. Forward looking statements are not guarantees of future performance as actual events and results could differ materially from those expressed or implied. The information in this publication does not constitute investment advice by Provisus Wealth Management Limited and is provided for informational purposes only and therefore is not an offer to buy or sell securities. Past performance may not be indicative of future results.

While every effort has been made to ensure the correctness of the numbers and data presented, Provisus Wealth Management does not warrant the accuracy of the data in this publication. This publication is for informational purposes only

The Downside of Market Timing – Missing Out?

Trying to avoid a bear market can come at a very steep price: missing out on further gains if you get it wrong. Market timing can be a costly mistake since correctly timing the market is virtually impossible. The potential mistakes are just as severe whether you are trying to time the market to sell high or buy low. Because of this, investors who are troubled by the current state of the stock market may want to take a long term view and hold tight.

A bear market is typically defined as a 20% drop from a market peak, or twice as severe as the threshold for a correction which is just a 10% decline. The last year of a rally is sometimes referred to as a “melt-up” or a move higher that is driven by investors being fearful of missing out on past gains. The final years of a bull market are usually the best years of the economic cycle and staging an early exit from stocks to avoid a coming downturn can be a damaging long term mistake. In particular, equities tend to see steep gains in the 12 months before the start of a bear market. Double digit gains have historically been seen in the year leading up to a bear market, as the gains in the last year of a bull market make for a much more pronounced rally than is seen earlier in the cycle. There have been nine significant market corrections since 1970 (using the Canadian stock market as the reference, see the dates of the market peak on the left). The chart to the right shows the asset class returns late in a bull market for various periods prior to the various security types reaching their apex.

The penultimate year of a bull market has seen a 31.3% gain for Canadian stocks on average, which on its own would more than compensate for the pending market correction. More importantly this level of return confirms the fact that typically Canadian stocks are very much late cycle stocks and their performance dwarfs what is achieved elsewhere. For example, U.S. stocks “only” averaged 16.1% in the year before the stock market correction occurred, while bonds eked out 7.3% over the same time span. Comparatively, in the year before that and the two years before the peaks (meaning the period that is between 24 and 36 months before the start of the bear market), U.S. stocks were clearly the better overall investment. This sounds very familiar to what has been occurring over the much of this economic cycle. Should this 40-plus year pattern continue and if the current market uptrend is winding itself closer to a market correction or a bear market, it is possible that Canadian stocks could make up much of their relative underperformance versus U.S. stocks over the past few years.

Certainly, the concerns that stock markets could be looking at weak future results, if not necessarily a bear market, have been growing. However, stocks are not seen as overly expensive right now and the first quarter earnings season has been strong, although the market’s reaction to them suggests investors have not been impressed. The final stages of a bull market can be lucrative for investors and an early exit can be detrimental to an investor’s long term results. Current economic data supports the case for continued economic recovery and further stock market gains. Despite what could happen in the coming years, the best course for most investors is to stay put, getting the benefit of compound growth and not making short term trading decisions.

MARKET DATA

 

This report may contain forward looking statements. Forward looking statements are not guarantees of future performance as actual events and results could differ materially from those expressed or implied. The information in this publication does not constitute investment advice by Provisus Wealth Management Limited and is provided for informational purposes only and therefore is not an offer to buy or sell securities. Past performance may not be indicative of future results. While every effort has been made to ensure the correctness of the numbers and data presented, Provisus Wealth Management does not warrant the accuracy of the data in this publication. This publication is for informational purposes only.

Q1 2018

MARKET COMMENT

The turbulent start for financial markets so far in 2018 has left few places to hide. Investors have had a lot thrown at them; escalating tensions over global trade, major tech sector wobbles, increasing turmoil at the White House and an onslaught of stock volatility. Certainly, the markets were overly greedy and downturns are normal but what has investors in a tizzy is the abrupt and perhaps savageness of the swings. However, while the ride was bumpy the final outcome was not overly hideous or cataclysmic.

Last year the Canadian economy expanded at a much stronger pace in comparison to the previous year and the outlook for 2018 remains positive. However, it is likely to march along at a slower pace due to increasingly uncertainty. As there are ominous signs ahead due to U.S. trade and tax policy as well as weakening investment fears related to the unknowns of U.S. corporate tax cuts and NAFTA’s renegotiation. None of which is expected to overcome the steadily rising employment, cool inflation and manufacturing and service industries expansion at their highest pace of growth since 2011. What is particularly positive is the fact that the biggest contribution to growth in 2017 came from the natural resources extraction sector, which has been in the doldrums for years.

The U.S. economy has been like a tortoise; slow but steady. Last year was the ninth year of this expansion, the third longest since 1900. Near term risks to the economic outlook appear roughly balanced. Corporate earnings have been quietly spectacular and the future impact of corporate tax cuts will only boost them further. Inflation has picked up slightly last year while interest rates remain low and stable despite the sixth hike since the credit tightening cycle began in December 2015. The Fed is trying to keep a tight labour market from overheating without raising borrowing costs so fast that it would stifle the economy. While the tax cuts could lead to rising budget deficits and ultimately even higher interest rates, growth is expected to remain on an upward trajectory in the coming years.

As central banks around the world slowly withdraw policy support and raise interest rates, economic growth should accelerate and stabilize. Europe is growing particularly fast thanks to a still undervalued currency, rising confidence and considerable pent up demand. The U.K. appears to be weathering the impact of Brexit better than many had feared. Rebounding demand for commodities continues to be positive for Latin America and Australia, while Chinese growth has ebbed slightly as authorities try to restrain financial speculation. Japan’s economy expanded for the eighth straight quarter, its longest consecutive period of expansion in 28 years. All-in-all, the global economy is growing everywhere but booming nowhere adding a welcomed level of stability.

Clearly, the markets have been more volatile this year versus last year, which were all calm seas and blue skies. But markets run on fundamentals and the fundamentals look very, very solid. After a surge in stock markets in January, most of the returns were given back in the latter half of the quarter, such that without the appreciation of the Canadian dollar (up 2.5% for the quarter) most foreign markets would have been negative. Emerging markets were the best performers, climbing 3.6% (all returns in Canadian dollar terms); while other International stocks were up 1.1%; and U.S. stocks rose 1.7%. The worst market was Canada where stocks declined 4.5%. Surprisingly, Canadian bonds managed to eke out a small gain on the quarter at 0.1%.

With Europe coming off a stellar year, Japan maintaining its longest expansion in years, the U.S. growth still on solid footing and the emerging economies in good shape, the synchronized global growth acceleration appears to be shifting into another gear. Of course, this business cycle is relatively mature but global monetary conditions should remain accommodating enough to leave plenty of room for future gains.

CANADIAN EQUITIES

Global economies and markets started the year with plenty of optimism that the synchronized momentum exhibited in 2017 should continue in 2018. Though optimistic, there were concerns over rising protectionism from the U.S. along with its disruption to global free trade. There was also some concern for the upward trajectory of interest rates. Some of these fears materialized as cracks erupted in February and March with the VIX (an index that measures market volatility) more than doubling from its level in 2017. The double digit returns that markets around the world posted in 2017 quickly evaporated in the first quarter as almost all major global indices ended with negative returns despite the fact that most economies are still growing.

Canada, in particular, saw its economy expanding for most of 2017 with 3% GDP growth (highest of the G7 countries), but it unexpectedly shrank in January coinciding with the biggest job decline since 2009. Though the outlook remained positive as the economy entered the “sweet spot of the business cycle” according to Bank of Canada, the cumulative effect of these interim shifts may continue to pull the Canadian market down. The S&P/TSX composite index had no reprieve in any of the months during the quarter as each one ended in negative territory. Overall the index returned -4.5% in the first quarter on a total return basis, making it one of the worst performing major global indices.

Although the Canadian economy started slowly for the year, it is still slated to record decent GDP growth in 2018. The relatively good shape of the economy has even pushed up the inflation rate a little over Bank of Canada’s target 2% rate; the highest since 2012. Additionally, the 5.8% unemployment rate is close to a 40 year low. Despite some 88,000 job losses in January, the job market added an impressive 283,000 positions over a twelve month period. Nevertheless the Canadian equity market and corporations are still exhibiting price/earnings (P/E) compression.

The lower ratio is not because of business fundamentals but rather due to NAFTA uncertainties as well as household indebtedness. Current pessimism appears overdone and the TSX should rebound to its fundamental value once these concerns abate.

The succession of impactful events was very swift in the first quarter. Although a correction was expected and overdue since the beginning of the bull market in 2009, especially in the U.S., investors’ reactions appear to be overdone. For instance, February, the most tumultuous month of the quarter, contributed to the biggest loss for the TSX amid a volatility surge that pushed the VIX past 35. This is a situation that has occurred only ten times since 1988. Yet 60% of the TSX companies’ results were positive on their top and bottom lines with upbeat outlooks for earnings revisions. This evidence seems to infer that continued underperformance of the Canadian stock market is not consistent with the true valuation of the underlying stocks.

FIXED INCOME

During the first quarter of 2018 the Canadian FTSE TMX Universe Bond Index gained 0.1%. The Bank of Canada raised its key lending rate in July and September of 2017 and again in January by a quarter point to 1.25%. Interest rates are recovering from the once record lows of last summer in response to signs of an improving economy. The central bank has taken a cautious stance on rate adjustments but investors are pricing in at least two more hikes by the end of this year. The recent increases overwhelm the two rate cuts introduced in 2015 which were to help cushion and stimulate the economy from the collapse in oil prices. In the U.S. the Federal Reserve raised interest rates in March for the sixth time since the financial crisis and signaled that at least two additional rate hikes are coming in 2018. The U.S. central bank increased its benchmark interest rate target range by 0.25% to a new band of 1.5% to 1.75%.

At a speech in early March, the Bank of Canada’s Deputy Governor Timothy Lane made a number of comments as to why the central bank decided earlier that month to put any rate changes on hold for the time being. The decision was grounded on their assessment of developments in the Canadian economy and what that meant for the outlook for inflation which is key to their decision. In that regard, global and Canadian economic data had been coming in as expected which gave them greater confidence that inflation will remain sustainability near their 2% target.

US EQUITIES

The Standard & Poor’s 500 index fell 0.8% in U.S. dollars but rose 2.0% in Canadian dollar terms over the first quarter of 2018. The loonie finished the first quarter with a 2.8% loss after gaining almost 6.6% in 2017. The first quarter of the year injected a spike of volatility into the nine year bull market as fears regarding protectionist trade policies from the White House, tightening monetary policy and heightened regulation on the tech sector, including President Donald Trump’s desire to take on Amazon and its founder Jeff Bezos, have dragged the market down.

The U.S. market correction began on January 26 with the selloff reaching 10% on February 8. It has since been followed by heightened volatility as equity markets again struggled at the end of the quarter with ongoing weakness in technology weighing on broader market sentiment. The wave of selling brought the U.S. indices down near their 200 day moving averages, levels that held during the early February selloff. The setback seemed to be particularly unsettling, largely because it was sudden, deep and followed a long period of low volatility.

Stocks have been pulled down by a number of factors, including growing fears of a global trade war following weeks of heated rhetoric and threats between the world’s two biggest economies, the U.S. and China. Beijing imposed tariffs of up to 25% on 128 U.S. imports worth $3 billion a year, including fruits and pork, in retaliation to U.S. duties on steel and aluminium. President Trump has repeatedly railed against China’s massive trade surplus over the United States, promising during the U.S. election campaign to slash the U.S. deficit.

Republicans are pouring government stimulus into a steadily strengthening economy, adding economic fuel at a moment when unemployment is at a 17 year low and wages are beginning to rise. The $1.5 trillion tax cut that President Trump signed into law late last year is likely to lift growth in 2018, though the Fed and most analysts see little long-term boost, if any, to the economy.

Nevertheless the agreement to increase federal spending by hundreds of billions of dollars should deliver a large short term fiscal boost. There are many reasons why the U.S. equity market underwent a setback lately but the health of the U.S. economy isn’t one of them. Despite a five year running tradition of consumers pulling back on their spending in the first quarter, the U.S. economy looks to be doing just fine and should strengthen this year thanks to the brisk fiscal tailwind. The concern for investors is not that the U.S. economy will slow this year but that it will grow too fast thanks to the fiscal expansion. At this stage it appears that this correction may well turn out to be just another dip in the long running bull market.

INTERNATIONAL EQUITIES

The global economic expansion looks to be on track for some pretty impressive gains going forward as the world becomes more synchronized despite escalating trade tensions. Trade wars are aimed more at punishing other countries than protecting domestic producers and they will inevitably cause pain for domestic consumers and import consuming industries. While collateral damage could be widespread, likely in the form of more volatility being unleased on stock markets around the world; eventually saner heads should prevail and co-operation will likely unfold. We can only hope, anyway.

Europe finished off last year with robust economic growth while confidence among businesses and households suggests there is no slowdown in sight. After years of suffering from the consequences of a sovereign debt crisis, unprecedented stimulus by the European Central Bank has turned Europe into a pillar of the global economy, recording its fastest rate of growth since 2008. Yet, despite this economic upswing, inflation remains muted. Employment is expanding at a vibrant pace. The Euro has recently climbed to a 3 year high against the U.S. dollar. However this is threatening to throw a spanner in the works and will likely force the Central Bank to wait until the year end before ending its asset purchase program or meaningfully contemplating raising interest rates.

Japan, the world’s third largest economy, saw manufacturing activity expand at its fastest pace in almost 4 years. Stock prices are at their highest in 26 years and corporate profits are near an all time high. Japan is seeing strong export growth, which could be impaired by a strengthening currency and simmering fears of a trade war. Add in the fact that labour shortages and a dwindling working age population have pushed the jobless rate to a near 25 year low, concerns remain about the future of the country’s economic turnaround. Still, with domestic demand accelerating and inflation remaining low there is little sign that any sort of correction will happen in the short term.

China has been experiencing unexpectedly robust growth in the first part of the year. The trade situation with the U.S. is obviously a rising risk and a relatively new challenge. While the risk of increasing trade tensions exist, the overall economic damage is likely to stay contained. Still, China’s growth will be moderate this year weighed down by a cooling property market and the government’s clampdown on riskier lending practices. While infrastructure remains a main engine behind China’s investment growth, high tech manufacturing has also expanded rapidly and now accounts for 43% of the total exports to the U.S., so it could be vulnerable to punitive U.S. trade measures.

In many cases the world stock markets reached new highs in January. Unfortunately, volatility swept over the global stock markets and they have since retreated 6.1% (all returns in U.S. dollar terms), at least temporarily from their highs. Collectively, all international stock markets declined 1.4% in the first quarter. Outside of Emerging Markets which gained 1.1%, all other regions generated negative returns; European stocks fell 2.6% and Asian stocks dropped 1.4%.

Concerns over a potential trade war are beginning to weigh on confidence around the world and could potentially slow the economic dynamic during the coming year. However, this increasing uncertainty will likely strengthen central bank resolve to hold the line in future interest rate hikes and take a more cautious approach to exiting most of the extraordinary fiscal measures that are still in place. This should be enough to allow the world’s economies to withstand most of the tit-for-tat gamesmanship that appears to be unfolding.

The Downside of Market Timing – Missing Out!

Trying to avoid a bear market can come at a very steep price: missing out on further gains if you get it wrong. Market timing can be a costly mistake since correctly timing the market is virtually impossible. The potential mistakes are just as severe whether you are trying to time the market to sell high or buy low. Because of this, investors who are troubled by the current state of the stock market may want to take a long term view and hold tight.

A bear market is typically defined as a 20% drop from a market peak, or twice as severe as the threshold for a correction which is just a 10% decline. The last year of a rally is sometimes referred to as a “melt-up” or a move higher that is driven by investors being fearful of missing out on past gains. The final years of a bull market are usually the best years of the economic cycle and staging an early exit from stocks to avoid a coming downturn can be a damaging long term mistake. In particular, equities tend to see steep gains in the 12 months before the start of a bear market. Double digit gains have historically been seen in the year leading up to a bear market, as the gains in the last year of a bull market make for a much more pronounced rally than is seen earlier in the cycle. There have been nine significant market corrections since 1970 (using the Canadian stock market as the reference, see the dates of the market peak on the left). The chart to the right shows the asset class returns late in a bull market for various periods prior to the various security types reaching their apex.

The penultimate year of a bull market has seen a 31.3% gain for Canadian stocks on average, which on its own would more than compensate for the pending market correction. More importantly this level of return confirms the fact that typically Canadian stocks are very much late cycle stocks and their performance dwarfs what is achieved elsewhere. For example, U.S. stocks “only” averaged 16.1% in the year before the stock market correction occurred, while bonds eked out 7.3% over the same time span. Comparatively, in the year before that and the two years before the peaks (meaning the period that is between 24 and 36 months before the start of the bear market), U.S. stocks were clearly the better overall investment. This sounds very familiar to what has been occurring over the much of this economic cycle. Should this 40-plus year pattern continue and if the current market uptrend is winding itself closer to a market correction or a bear market, it is possible that Canadian stocks could make up much of their relative underperformance versus U.S. stocks over the past few years.

Certainly, the concerns that stock markets could be looking at weak future results, if not necessarily a bear market, have been growing. However, stocks are not seen as overly expensive right now and the first quarter earnings season has been strong, although the market’s reaction to them suggests investors have not been impressed. The final stages of a bull market can be lucrative for investors and an early exit can be detrimental to an investor’s long term results. Current economic data supports the case for continued economic recovery and further stock market gains. Despite what could happen in the coming years, the best course for most investors is to stay put, getting the benefit of compound growth and not making short term trading decisions.

MARKET DATA

market data imageThis report may contain forward looking statements. Forward looking statements are not guarantees of future performance as actual events and results could differ materially from those expressed or implied. The information in this publication does not constitute investment advice by Provisus Wealth Management Limited and is provided for informational purposes only and therefore is not an offer to buy or sell securities. Past performance may not be indicative of future results. While every effort has been made to ensure the correctness of the numbers and data presented, Provisus Wealth Management does not warrant the accuracy of the data in this publication. This publication is for informational purposes only.

There is more to risk than meets the eye

The  term  risk  often  gets  thrown  around  in  the  investment  world.  But this  term  goes  far  beyond  market  volatility.  Here  are  five  types  of  risk  to  consider  and  you  put  together  a  portfolio:    

Interest  rate  sensitivity  risk   
As  bond  yields  have  been  on  the  decline,  this  has  become  an especially important type  of  risks  for  investors.  It  is  a  measure  of  how  much  the  price  of  a  fixed-income  asset  will  fluctuate  in  response  to  interest  rate  changes.  Securities  sensitive  to  this  risk  tend  to  have  larger  price  fluctuations  than  other  securities.    

Political  risk 
A  hot  topic  lately,  especially  with  new  trade  directions  out  of  the  US,  but  overall  it’s  the  risk  associated  with  government  or  social  action  that  could  result  in  loss  of  value.  Political  risk  can  impact  an  investor  both  nationally  and  internationally.

Credit  risk 
Since  bond  yields  have  fallen  they  have  decreased  in  popularity  which  means  the  credit  curve  is  affected  as  well.  The  lower  the  credit  curve,  the  more  a  portfolio  risk  increases. 

Purchasing  power  risk 
Using  bonds  as  an  example,  if  inflation  rises  and  an  investor  has  invested  in  shorter  duration  bonds  with  a  lower  return,  it  is  likely  they  are  trading  equity  market  risk  for  inflation  and  overall, losing  purchasing  power.    

Sector  risk 
A  portfolio  that  is  based  on  an  investment  style  that  includes  a  focus  on  one  sector  can  be  extremely  vulnerable.  If  this  sector  experiences  any  kind  of  downturn,  a  portfolio  could  be  significantly  negatively  impacted.    In  conclusion,  while  investing  is  not  a  game  of  certainty,  understanding  the  fuller  spectrum  of  risk  helps  ads  some  important  safeguards.   

Closing The Gap

Dividend paying stocks have been very popular with investors in recent years due to weak returns in the bond market. That picture appears to be shifting in Canada for the first time in almost a decade. As the Bank of Canada has slowly tightened monetary policy, bond yields have naturally risen, yet still remain well below the levels seen before the financial crisis.  As bond yields rise, investors may cut their exposure to equities. Historically bull markets tend to end once interest rates have risen too much, too fast. The current long-lasting uptrend is beginning to show signs of entering the euphoria stage. If dividend yields drop below bond yields it could be another indication that the high-flying stock market is headed for a correction.

The ‘Yield Gap’ is the difference between the S&P / TSX Stock Index dividend yield and the 10 year Government of Canada bond yield. The yield differential between stocks and bonds has historically been one of the more attractive signals for many investors. It has signaled when equities were good value relative to bonds. However in the last few months that spread is becoming less favorable to equities and is giving many investors pause for thought. Higher bond yields could make stocks look more expensive. Additionally, higher borrowing costs could have an impact on corporate earnings as it becomes more expensive for companies to finance projects. Lower profits could result which would boost the price-to-earnings ratio and raise equity valuation concerns.

Before the 2008 financial crisis the yield on 10 year bonds was markedly higher than equities, before abruptly changing course during the depths of the crisis. In fact, for most of history, dividend yields have stayed below 10 year bond yields. During the 2008 financial crisis bond yields started oscillating around dividend yields for several years but have spent significant time below dividend yields since June 2011, as economic growth recovered and inflation concerns faded. As the chart above and data to the left illustrates, the dividend yield of the S&P / TSX has remained steady at around the 3% mark throughout the post-2008 crisis recovery period as companies have grown their dividends to keep up with increasing share prices.

For the past decade, investors have flocked to the stock market for higher yields as government bond yields have hovered at historic lows. The increase in asset prices can be partly attributed to low yielding debt instruments. Still dividend paying stocks tend to be a poor defense when rates are rising and stocks could be facing yield competition from bonds for the first time since the financial crisis. If and when the S&P / TSX yield falls below bonds it will not necessarily be bad news as most equity investors generally buy stocks for capital appreciation and not for steady income.

At this juncture, the case for stocks still appears to be favourable compared to owning bonds so yield seekers currently invested in stocks do not necessarily need to jump ship yet. As with all market measures, the consequences of the narrowing yield gap are hard to predict. While some risk averse investors might switch to bonds, for most investors dividend yield is simply one factor contributing to the total performance of owning stocks.

MARKET DATA

This report may contain forward looking statements. Forward looking statements are not guarantees of future performance as actual events and results could differ materially from those expressed or implied. The information in this publication does not constitute investment advice by Provisus Wealth Management Limited and is provided for informational purposes only and therefore is not an offer to buy or sell securities. Past performance may not be indicative of future results. While every effort has been made to ensure the correctness of the numbers and data presented, Provisus Wealth Management does not warrant the accuracy of the data in this publication. This publication is for informational purposes only.

Closing The Gap

Dividend paying stocks have been very popular with investors in recent years due to weak returns in the bond market. That picture appears to be shifting in Canada for the first time in almost a decade. As the Bank of Canada has slowly tightened monetary policy, bond yields have naturally risen, yet still remain well below the levels seen before the financial crisis. As bond yields rise, investors may cut their exposure to equities. Historically bull markets tend to end once interest rates have risen too much, too fast. The current long-lasting uptrend is beginning to show signs of entering the euphoria stage. If dividend yields drop below bond yields it could be another indication that the high-flying stock market is headed for a correction.

article table

The ‘Yield Gap’ is the difference between the S&P / TSX Stock Index dividend yield and the 10 year Government of Canada bond yield. The yield differential between stocks and bonds has historically been one of the more attractive signals for many investors. It has signaled when equities were good value relative to bonds. However in the last few months that spread is becoming less favorable to equities and is giving many investors pause for thought. Higher bond yields could make stocks look more expensive. Additionally, higher borrowing costs could have an impact on corporate earnings as it becomes more expensive for companies to finance projects. Lower profits could result which would boost the price-to-earnings ratio and raise equity valuation concerns.

Before the 2008 financial crisis the yield on 10 year bonds was markedly higher than equities, before abruptly changing course during the depths of the crisis. In fact, for most of history, dividend yields have stayed below 10 year bond yields. During the 2008 financial crisis bond yields started oscillating around dividend yields for several years but have spent significant time below dividend yields since June 2011, as economic growth recovered and inflation concerns faded. As the chart above and data to the left illustrates, the dividend yield of the S&P / TSX has remained steady at around the 3% mark throughout the post-2008 crisis recovery period as companies have grown their dividends to keep up with increasing share prices.

For the past decade, investors have flocked to the stock market for higher yields as government bond yields have hovered at historic lows. The increase in asset prices can be partly attributed to low yielding debt instruments. Still dividend paying stocks tend to be a poor defense when rates are rising and stocks could be facing yield competition from bonds for the first time since the financial crisis. If and when the S&P / TSX yield falls below bonds it will not necessarily be bad news as most equity investors generally buy stocks for capital appreciation and not for steady income.

At this juncture, the case for stocks still appears to be favourable compared to owning bonds so yield seekers currently invested in stocks do not necessarily need to jump ship yet. As with all market measures, the consequences of the narrowing yield gap are hard to predict. While some risk averse investors might switch to bonds, for most investors dividend yield is simply one factor contributing to the total performance of owning stocks.

MARKET DATA

market data image

This report may contain forward looking statements. Forward looking statements are not guarantees of future performance as actual events and results could differ materially from those expressed or implied. The information in this publication does not constitute investment advice by Provisus Wealth Management Limited and is provided for informational purposes only and therefore is not an offer to buy or sell securities. Past performance may not be indicative of future results. While every effort has been made to ensure the correctness of the numbers and data presented, Provisus Wealth Management does not warrant the accuracy of the data in this publication. This publication is for informational purposes only.