Fourth Quarter 2017 – Quarterly Commentary
Around the World in Seven Pages
Let’s take a trip around the world to look at 2017 and see what could affect us in 2018. Starting here in North America, the view isn’t too bad. In fact, in terms of U.S. economic growth, it’s the best it’s been since the “Great Recession” of ’08 – ’09. U.S. unemployment is down to 4.1% and wage growth, now slightly over 2.0%, is trending back towards the average level experienced since the mid-1980’s. After a year of anticipation, the U.S. passed a tax package into legislation. The merits of the package can be debated, but it will almost certainly do two things. First, and most obviously, tax rates for corporations and some individuals are set to fall materially in 2018. Anticipation of the boost to corporate earnings has already helped drive U.S. equity markets to all-time highs. Secondly, deficits are expected to soar, with the current estimate being for an additional trillion dollars in debt over the next decade.
The U.S. Federal Reserve will remain a central character in 2018 as the current chair, Janet Yellen is replaced by Jerome Powell. Powell will have some rough waters to traverse in his new role as the spectre of rising inflation lurks in the background. Low levels of unemployment tend to bring increasing wage pressures, ergo rising inflation. Also, the increasing federal deficits must (eventually) unnerve the bond market. That said, these may be considered blessings to central bankers anxious to “normalize” interest rates as the U.S. commences the long effort to reverse Quantitative Easing. The theory here being that the higher interest rates move, the more room the central banks will have to “ease” should the economy slow as, inevitably, it will. Canadian and U.S. interest rate policies tend to be highly correlated, although the Bank of Canada is providing less clarity than its U.S. counterpart. Expect some surprises as central banks on both sides of the border stumble their way to the mythical objective of “normalization”. In other words, don’t expect the volatility that marked Canadian bond markets in 2017 to disappear in 2018. And, the general bias is toward higher rates across the spectrum.
As for the state of the economy, it is worth noting that we are now entering the ninth year of economic recovery/expansion. We have never had a full decade of economic growth during the last hundred years, caution is increasingly warranted. Valuation levels are also at above average levels. These two factors have historically led to below average returns over subsequent 5-year periods. Although, admittedly in the near term, these concerns are likely overridden by the strong global economy, which provides a backdrop for solid earnings growth as we enter 2018.
Nonetheless, we believe that this leg of the expansion is now in its later stages, with this view supported by rising interest rates, the length and duration of the expansion, low unemployment levels, the narrowing breadth of equity markets as evidenced by the outsized performance of the “FAANG” (Facebook, Apple, Amazon, Netflix, Google) stocks – see chart – and the increase in speculative activities – with cryptocurrencies (Bitcoin) and marijuana stocks as examples. As we manage the portfolios through this period, we strive to balance the ability to participate in the near-term upside, but also to remain focussed on the longer-term issues that may begin to bring pressure to equity markets as 2018 unfolds. We expect cash flow, through interest and dividends, to remain key to investment success over the next few years.
One final thought on North America, which is a question our “Snow Bird” clients often ask – what happens to the Canadian dollar? The loonie has three potential catalysts in 2018, although not all driving in the same direction. A failure of NAFTA would likely send the loonie spiralling lower, at least in the near term (although the decline would likely look modest in comparison to the skid likely to be suffered by the Mexican peso). Although interest rate policy in Canada is likely benign for the loonie over the next 12 months, should the Bank of Canada make the decision to raise interest rates faster than its U.S. counterpart, it could send the currency higher. In addition, a sustained higher oil price could be supportive for the loonie – a prospect we will discuss further below as we go globe-trotting.
On to the Middle–East…and oil
So, as we were just speaking of oil, let’s commence our world tour in the Middle-East. Oil seems to have found a level of stability in the $40 – $60 U.S. range – noting that at year-end, prices were hovering near the upper end of that range. If we assume that OPEC and its allies (primarily Russia) can hold to production cuts this will keep a floor of some sort under oil prices. For the first time since 2014 supply and demand are relatively balanced, but with oil prices trending higher, supply may shift higher as well, keeping cap on prices.
It is now more than clear that there has been a changing-of-the-guard in the Royal House of Saud in Riyadh, Saudi Arabia. The new Crown Prince and heir apparent, Mohammad bin Salman is moving aggressively on a number of fronts. He is engaged in an expensive “proxy-war” in Yemen with his chief rival Iran and is trying to diversify the almost entirely oil-dependent economy. To this end, he has announced that the Kingdom will commence the sale of the world’s largest oil company, Saudi-Aramco, with the first tranche (5%) estimated to sell for U.S. $100 billion. This suggests that, in addition to the $600 billion or so in reserves the country already has, there could be some $2 trillion more available to accomplish the repositioning of the kingdom’s economy. This may escalate tensions with Iran as the two bulls (or perhaps bullies) battle for dominance in the region.
Closer to home, the approval of the Keystone XL pipeline will help Canadian oil production (and hence exports) when it is eventually completed, but Canada desperately needs more export routes. The Trans Mountain pipeline has been approved, but construction remains hindered by ongoing permit delays from the NDP government in B.C. and obstacles raised by environmentalists opposed to the project. It appears likely to be a long battle to the sea! Without these outlets Canadian oil producers are forced to sell their oil at significant discounts to the quoted price.
Reverting to our earlier thesis that we are entering the later stages of this leg of the bull market, it is worth noting that higher commodity prices tend to occur once a business cycle has reached maturity. In recent weeks, not only has the price of oil drifted higher, but this is also a trend noted across the commodity complex. This was an area where we recently added exposure when appropriate for an individual client’s risk tolerance.
To the Indian Sub-Continent
Not too far away, to the east, is another significant emerging economic tiger – India. Under Prime Minister Narendra Modi, India is literally powering along on a number of important fronts, specifically, micro-finance and digitization. India is literally bringing a billion people into the digital and financial (banking) world through a massive programme to connect its still-large rural population to the net and by extension, banks. India’s economy is once again growing at 7 – 9% which makes it a world leader (of large economies) and a big contributor to overall global growth rates. This transition is worth monitoring.
Nor-East to Asia proper
North and east of India is the previous leader in economic growth – China. With the conclusion of the latest Party Congress, President Xi’s grip on power is at least as strong as was Deng Xiao Ping’s and possibly that of Mao himself. It’s become very much of a one-man show in Beijing. What seems to be “clear”, if that is a term one can use in Chinese politics, is that Xi is determined to clean-up the corruption mess and purge the party of non-believers, often confused with opposition. There will be no liberalization of the political status-quo in China. What is less clear is what actions Xi might take to clean up the debt overhang in the state-owned enterprises which is substantial enough to threaten the stability of the economy. Forcing the banks to recognize the dud loans on their books could provoke a financial crisis but ignoring them (the way Japan did for over two decades) has major credit implications as those banks cannot make fresh loans to spur growth. Chinese economic growth is still a very respectable 6% (or thereabouts because who knows if the numbers are credible) and this growth continues to have implications for both oil and the broader commodities complex and so, Canada. Of course, China has another, more immediate issue on its eastern border, namely North Korea.
Hello Pyongyang! Led by “Rocket Boy” as Mr. Trump has designated him (and to be fair, not without reason), China has belatedly begun to put pressure on its erstwhile ally Kim Jong Un, urging him to throttle back on his aggressive in-your-face testing of Inter-Continental Ballistic Missiles (ICBMs). The real issue here is that his firing missiles over Japan is providing its Prime Minister with the reasons he needs to continue with Japan’s rearmament campaign and this is something the Chinese DO NOT want to proceed. Japan (given its demographic challenges of an outright shrinking population) could now be described as having fewer people but more teeth. The risks of “something going wrong” in this situation are manifold and heightened by the increasingly widespread belief that North Korean missiles will be able to deliver nuclear payloads to any part of the U.S., as North Korea claims to already have the capability to reach American shores. It is not an exaggeration to say that this situation really is a ticking time bomb.
Asia & Europe = Russia
And to China’s “north” we have Vladimir Putin’s Russia. Is it really “midnight in Moscow” for the west’s relations with the new “Russian Czar” as The Economist magazine has dubbed Mr. Putin? Not really. Russia wants those sanctions lifted and the oil price higher – hence its effectively acting as the eighth member of OPEC (Russia is the largest producer of oil globally). It has also become considerably less aggressive in Syria and the Ukraine. In some respects, the good news is that the stabilization of the oil price has also helped to stabilize the Russian economy – albeit at lower levels. The west may not always care for Vladimir’s actions but a stable Russian economy is to be welcomed. We will refrain from commenting on Russian “involvement” in the U.S. elections, but will comment that cyber warfare is to be taken very seriously.
Heading west to the EU, there is good news economically and mixed news politically. Economically, the EU is at 2%+ growth rates of late, finally pulling out of the economic malaise induced by the financial crash of ten years ago. French growth has re-accelerated perhaps due to the election of Emanuel Macron as President (and not the far left, nor the far right). Spain too has commenced growing again but Italy remains a laggard. This will undoubtedly impact the forthcoming elections in which the 5 Star Movement is expected to emerge as the largest party with the traditional parties losing ground as they have elsewhere in Europe. The big challenge is now Germany since Angela Merkel’s government effectively “lost” the recent election which, unlike France, saw votes migrating to the left and the right. To date the markets have shrugged off the uncertainty as investors enjoy the improved economic conditions, partly fuelled by reductions in unit labour costs and supported by a weaker Euro. Equity markets in Europe are not as expensive as North American markets from a valuation perspective, although the dependency on “easy money” may be higher than in the U.S.
Staring down the barrel of the Brexit gun, Great Britain is in a bad way, both economically and, particularly, politically. In the recent budget brought down by the Chancellor of the Exchequer, growth forecasts were (literally) cut in half. This is after years of budgetary austerity which has left the electorate in a foul mood. The failed attempt by Teresa May to enhance the thin majority she inherited in 2016 from her predecessor was a disaster. Instead of adding over 100 seats as expected, the governing Conservatives lost their outright majority and are now dependent on the Ulster Unionists to keep the government afloat. The real issue is not just Brexit, and the credibility of the government in negotiating same, but the thought that the government might fall and the Labour Party under hard-left Jeremy Corbin and his acolytes might take over. Brexit might well bring on a recession in the UK, a Corbyn government could usher in a depression. This time, it is not impossible that Britain may not be able to “muddle through”.
Emerging markets remain caught in the spiral of political problems. In Brazil, the Petrobras scandal has destroyed two governments, Venezuela has completely collapsed economically, and South Africa appears determined to follow the populist road to destruction. On a positive note, Zimbabwe said farewell or, more appropriately, “good riddance” to its long-time despot Robert Mugabe who, since taking over in 1980, like Hugo Chavez in Venezuela, managed to single-handedly destroy one of the better economies in Africa. Argentina may be the brightest light as Maricio Macri’s government has been bolstered by recent local elections and the continuation of his policies will see Argentina re-emerge as a contributor to growth both in South America and the world. Political stability is paramount as is sticking with reformist policies – undoing the populist-oriented economic damage done by his predecessor – an important lesson that needs to be learned throughout the region.
2018 could thus prove to be a watershed year on many fronts and on many continents. Economic growth and corporate earnings growth appear likely to continue chugging higher over the next few quarters. However, a bias towards rising interest rates is likely to keep bond prices under pressure, and equities are at or, near all-time highs, with modestly inflated valuations. The downside risks are higher than they have been of late. This does not translate into a negative outlook but rather, a cautious one. We recognize we may well be premature in our caution, however, we believe preserving capital in a downturn is an important goal. Following a year in which the largest pullback in the S&P500 was a mere 3%, a more meaningful pullback is likely due. Select North American securities (both equities and bonds) remain on our watch list to acquire on a pull-back as well as some non-North American securities in areas/markets which are less expensive and offer the opportunity for success. We have and will continue to take profits on select securities which have rallied strongly and gotten ahead of themselves and the markets in the preceding year. As we enter 2018 we will continue to focus on the fundamentals that drive long-term success.
An optimist proclaims that we live in the best of all possible worlds….and a pessimist fears this is true.
Logan Wealth Management Inc.
January 5, 2018