Second Quarter 2018 – Quarterly Commentary
WHAT’S THE NAME OF THAT ELEPHANT IN THE ROOM?
We have finally arrived at the halfway point of 2018. It’s been a bumpy ride in the capital markets so far and very unlike the experience of 2017 in which, it seemed anyway, that the equity markets only went up. The reality is that we have returned to a much more normalized state of capital market choppiness – both in equities and fixed income.
Year-to-date the “new” reality provides the following observations: Equities in Canada and the U.S. are essentially flat excluding dividends. Fixed income, if measured by the common metric of the U.S. ten-year bond, is down on a capital basis and this is principally because, as we have cautioned before, interest rates are on their way up. Surprisingly, the Canadian 10-year bond has reversed course in recent weeks, ending the quarter almost exactly where it started the year, as concerns over the potential of a trade war leave investors questioning the ability of the Bank of Canada to further raise interest rates. Gold is down some five percent (in U.S. dollars) and the big loser was that which was the most hyped “asset class” coming into 2018, Bitcoin, which is down over 60% and has been by far the most volatile “commodity” (if we can use that term for the cryptocurrencies).
However, stepping back from the daily smoke of battle, and assessing where we might be in the economic and market cycles, it is by no means clear that this is the end. Despite many concerns being (legitimately) raised, the good news is that corporate earnings have not just held up well of late but have continued to power ahead. Capital spending has remained strong and the addition of fiscal stimulus suggest economic growth will remain sound for the near term.
WHAT IS THE NAME OF THAT ELEPHANT IN THE ROOM? (1)
We are now going to attend three cocktail parties, in three different salons, in three different cities, in three different countries.
First, we go to Brussels where a distinguished group of European financiers are busy celebrating the successful end to the ten-year-old saga of the Greek bailout. “Whew”, one of them exclaims as he raises his glass to toast the new deal with Athens – “There was no Grexit! We’ve succeeded in maintaining the Euro intact [we should note here that there is no legal exit mechanism from the Euro] and we look forward to celebrating its twentieth birthday next year in 2019”. As this has major ramifications for the Germans, they toast “Ein prosit” to there being no Greek exit. Not really meaning to be either a jester or a party-killer, someone then calls out loudly: “What is the name of that elephant in the room?” Suddenly, all faces turn ashen in colour as someone replies, “Oh….its name is Italy.” Everyone in the room knows Italy is too big to bail out! However, the questioner continues; “The new Italian government wants to increase spending and borrow to do so even though Italy’s debt is already the highest as a percentage of GDP anywhere in the world, except Japan. Worse, Italy has had zero growth since it joined the Euro back in ’99”. Now, there is dead silence in the room. The questioner continues with a real party-killer query: “Just who among us, is going to bail out Italy?”. There is silence… Then, a Frenchman pipes up and says; “We have worked with the Italians through numerous governments and we have always managed to resolve critical issues – we are confident that we can work matters out before things get out of hand as they did with Greece”.
Italian Debt-to-GDP Ratio
We will leave our readers with these two statistics: The Greek economy constitutes two percent of the overall Eurozone economy. Italy’s economy is ten times the size of Greece’s. If anyone at this party needed any reminding that the “Italian challenge” to the Euro’s stability is real, just have them look at a chart of Italian ten-year bond yields of late, relative to the other major Eurozone economies. Having learned from the Greek experience (and, to a certain degree, the British experience with Brexit) the power-brokers in Brussels know that they have their work cut out for them in these next several years to help make the Euro and the Eurozone, work for their large southern member.
This elephant’s name is: Italy
Italian 10 Year Bond Yields in Comparison to Germany
WHAT IS THE NAME OF THAT ELEPHANT IN THE ROOM? (2)
Now, let us head over to Washington D.C., to listen in on a cocktail party in progress at the Canadian Embassy. The mood is tense. Everyone knows there’s an elephant in the room but nobody wants to mention its name. Finally, a Canadian steel company executive blurts out: “He can’t be serious, can he?” “Who?” says the Canadian aluminum company executive? “Trump!” says the first. “You’ve got to be kidding!” says the Canadian dairy producer. “The PM says they’re not going to push us around!” says the softwood lumber producer (with a wry smile upon his face). And throughout the room, the conversation swirls around the break up or, break down of NAFTA and its consequences for Canada’s various industries. There is an unsettled air in the room as the various executives endeavor to determine just how bad it could get as Canada prepares to impose its retaliatory tariffs on imports from the U.S. Everyone knows this is only ’round one’ in a boxing match in which nobody knows how many rounds there might be. They also know that the bottom line is Canada imports 40% of its goods from the U.S. and sends 75% of its exports to the U.S. While there is and can be no doubt that many American states would feel the pain of Canadian tariffs, the truth is that as between the proverbial elephant and the mouse, the U.S. might catch some form of an economic ‘chill’ from a trade spat with Canada, while with trade flows like these, Canada would catch economic pneumonia. In other words, Canada could not ‘win’ a trade war with the U.S. The recent weakness of the Canadian dollar relative to the U.S. greenback is reflecting this reality as well as one more we will address below. “I would note”, the Canadian Ambassador says, “that our discussions with the American representatives at the NAFTA negotiating table have a very different context and tone to them than certain ‘tweets’ emanating from Washington on the subject. We still very much believe – as do the Mexicans – that there is a deal to be reached”.
“Amen”, say the company executives in unison.
This elephant’s name is: Trade.
Canadian Exports by Industry
WHAT IS THE NAME OF THE ELEPHANT IN THE ROOM (3)
We now head north to Ottawa, where we have yet another cocktail party to attend. This time the room is filled with policy-makers from the Bank of Canada (BoC). The buzz in the room relates to many factors – “trade” issues being one of them – but, being policy-makers from the BoC, they are focused on any resultant economic impact and, of course….interest rates.
Here our crowd perceives itself to be faced with a true Hobbesian Choice. The Canadian economy faces serious headwinds for many reasons such as; poor productivity, a huge dependence on trade with the U.S. (see above elephant’s name) renewed pressure from the American corporate tax cuts (taking away a key, long-standing advantage Canada held) and a weakening dollar which is or, will be potentially be inflationary. “What is the right response?” asks one attendee. “No question, we should raise rates to attract capital and head-off inflation” says another. “No way, we should keep rates low, let the dollar sink and boost exports as best we can”, declares a third, “We’re in the early stages of a trade war”, he continues. “The Americans look like they are going increase rates with their unemployment rate now down below four percent and hitting the top end of their economic capacity, so we have to match them or the Loonie could crater!” says the bartender. “Yes, but we don’t want to damage the domestic economy” responds Governor Poloz of the BoC “so, perhaps a ‘steady-as-she-goes’ response is best for us right now” he opines.
As with many cocktail parties, a degree of confusion reigns however, there is a consensus in the room that interest rates are highly unlikely to go down in the foreseeable future. The Canadian economy is recovering nicely from the oil price collapse of a few years ago, following the concerning surge in housing prices. The market appears to have stabilized and Canadian rates can still ‘tag along’ with a rise in U.S. rates so long as it is not too fast or, too aggressive on the upside.
This elephant’s name is: Interest Rates
Trend in Canadian and U.S. Interest Rates
So, dear Reader, things are “OK” for the moment with strong corporate profits which continue to exceed expectations for the time being. However, the outlook is not without its challenges – both here at home and abroad. A possible disintegration of the Euro (which, we don’t see as “likely” but cannot be ruled out IF there is an Italian debt crisis) could swiftly become a global currency crisis. The outbreak of a full-blown trade war (have we learned nothing from history?) would simply be catastrophic for everyone involved and we cannot think of any country which would ultimately not be involved. Finally, interest rates are clearly heading up after a lengthy period close to rock bottom. Rising rates can be a sign of economic strength and that is a good thing. How high rates can go will be a function of two things: 1) continuing economic strength and 2) the need to contain inflationary pressures at the (roughly) two percent target levels set by the U.S. Federal Reserve and the Bank of Canada. None of these issues are unresolvable, but each is real and like potentially explosive material needs to be ‘handled with care’.
We considered titling this piece, “2020 or, bust”, as looking out to the second half of 2018 and into 2019, the question remains; Will it be a “correction-to-rebound” story or, some form of “muddling through”? There are some significant bullets to be dodged (with arguably little room for error) and at least one “bull in a Washington china shop”. Cool heads must prevail and the centre must hold for us to get through this without an economic or financial accident. As your portfolio managers, we wrestle every day to find the right balance by seeking out the best opportunities available with the right trade-off between risk and return.
Logan Wealth Management Inc.