Second Quarter 2017- Quarterly Commentary

A Tale of Two Markets                                                 

If all one read were the headlines one could be forgiven for thinking that every capital market everywhere, was hitting new highs. Keep in mind that those headlines came out of New York and focus on the U.S. equity markets. The problem is that for Canadian investors while those headlines are not wrong, they are misleading. Why? Two main reasons: 1) because while true – or at least mostly true – for major U.S. equity markets, it is not true for the Canadian market. 2) while most Canadian investors have some U.S. exposure, it tends to be a minority of their holdings. Thus, it is customarily Canadian equity and fixed income prices that determine Canadian investors’ overall portfolio results.

So, let’s look at the actual year-to-date results of the principal U.S. and Canadian equity market indices.

S&P/TSX Composite Index and S&P500

Source: Factset

Clearly, for Canadian-centric investors, the TSX has been a laggard vs. its U.S. counterpart. While the S&P 500 is hitting new all-time highs (plus 8.2% year-to-date) not only is the TSX not doing so, it is flat in absolute terms since the start of 2017. What explains this divergence? Firstly, while Canadian consumers are quick to cheer price drops at the pumps when filling their gas tanks, they must remember that these lower prices at the pumps are reflective of lower prices per barrel of oil refined to make the fuel being pumped into their vehicle. In fact, crude oil, as measured by West Texas Intermediate (WTI) pricing is down 14% year to date, dragging the shares of Canadian companies producing oil down 20% over the same period.

Second, due to the continued “growth slow-down” in China, coupled with previous inventory stockpiling there, the metals and minerals complex – also well represented in the TSX – is facing headwinds, ending the first six months of the year with a slight decline.

TSX Materials and Energy Sub-Indices

Source: Factset

But wait a minute you say! You forgot the banks! Aren’t they heavily weighted in the TSX and didn’t they just report record revenues and profits? Yes, they are and yes, they did. However, their stock prices are also more or less flat year-to-date. This may well have had something to do with jitters brought on by the “run on deposits” at Home Trust after the OSC charges were brought against that firm, or the fact that Moody’s (the credit rating agency) downgraded the big five banks – also in the second quarter – citing their significant exposure to Canadian consumer debts (mortgages, credit card, auto and student loans), which have now reached 170% of personal disposable income – a high measure by any standard.

 

 

Source: NBCN

Meanwhile, whether it’s the continuation of the “Trump effect” or simply recognition of the improvement in the economic growth that began last year, the U.S. markets continue for the most part, to just roll along – if you are lucky enough to be an American. For those of us in Canada, the 3.2% rise in the Canadian dollar so far this year reduced those gains. Those remaining gains were also highly concentrated, with approximately 40% of the return on the index being generated by five companies, known as the FAANG’s (Facebook, Apple, Amazon, Netflix and Google). Stripping out the impact of the FAANG’s and the impact of the strengthening Canadian dollar, the U.S. market starts to look only slightly better than the domestic market.

On a positive note, with global GDP growth improving, the outlook for corporate earnings remains upbeat. The return to earnings growth after a period of stagnation has been a support to U.S. and global equity markets. Add to this the promises of an easier regulatory environment and lower corporate taxes and optimism for continued earnings growth, at least in the U.S., remains.

 

Data: Thomson Reuters

 

In the world of Canadian fixed income, the pricing gains achieved in the first part of the year reversed later in the second quarter as the Bank of Canada had a sudden change of heart. No longer were we hearing whispers of another rate cut, but the central bank was openly discussing raising interest rates, triggering a rise in yields. This will likely leave fixed income returns relatively muted in the coming months.

Plus, as can be seen from the chart below, rising interest rates can, and have, produced unwanted side effects. The goal of raising rates is to slow down an overheated economy. If the central banks overshoot, economic growth is eventually stalled, leading to a recession and declining equity markets. It is a delicate balancing act for the Federal Reserve and now possibly the Bank of Canada.

Rising Interest Rates = Increased Risk

 

In all, with flat Canadian equity prices and modest returns from fixed income, the Canadian components’ return of an investor’s balanced portfolio is earning around 1.5% year-to-date. This is bolstered upwards only by the better absolute performance of U.S. equities.

Portfolio strategy in the shifting tides

We believe that we are entering the late stages of the equity bull market which commenced in March of 2009, now at some eight plus years of age and counting. Similar to the central banks, we are also trying to manage a delicate balancing act. The later stages of a bull market often generate strong equity returns, however valuations are becoming extended and protecting capital in the eventual downturn must also be a concern. Therefore, we are currently targeting a neutral asset mix for each client’s portfolio. That said, we are investing in Floating Rate Bonds, tied to U.S. interest rates, with the objective of insulating bond portfolios against the reversing trend in interest rates already underway in the U.S. If oil continues to sell off, or even just stays in the low forty dollars a barrel range, we are keeping an eye open for opportunities in the oil patch which is showing some early signs of being able to earn better profits, even if oil doesn’t go back to the $55 – $70 U.S. range, which many thought would have happened by now…but hasn’t. In other words, shares in that sector may well be coming to the end of their bear market which commenced in 2014 with the crash in oil prices.

Global uncertainty – the new normal?

From a broader economic perspective, China continues to “slow down”, however, at growth rates continuing (for now) north of 6%, it’s still in the forefront of the big-nation pack. That said, it’s no longer sucking up commodity imports (and supporting their prices) the way it was a few years back. India continues as a stand-out in terms of growth rates but, the base from which it is growing is still modest compared to China’s. While U.S. and Canadian growth is accelerating to a modest 2+% range, it is importantly Europe which is awakening (somewhat) from its torpor of these last five years, also posting growth in the 2% range. No, seriously, for Europe this takes it from being an outright drag on global growth to middle-of-the-pack.

It may seem unnecessarily repetitive, but just because these issues aren’t always on today’s front page, does not mean that they have gone away. North Korea will have to be dealt with by somebody, at some point. Military experts have prophesized           that within 18 – 24 months North Korea will have the ability to fire an ICBM and strike the west coast of the U.S. In the middle east, the “proxy war” (entangling the U.S., Russia, Iran and others) in Syria continues, more or less unabated. The risk of an “accident” turning a civil war into an international event remains unchecked. Lest we forget, there is still a war going on (involving Saudi Arabia) in Yemen, and Turkey is less-than-happy with the part being played by the Kurds in the war in Syria. Every day, Venezuela slides closer to collapse and possible civil war while Brazil is potentially going to impeach its second president in as many years.

While Canada’s markets may not have been bountiful of late, it sure does seem a comparatively safe and decent place to be viewing all the goings-on in the world around us. Happy 150th birthday to our home and native land.