Third Quarter 2016 – Quarterly Commentary

Not too Hot… Not too Cold… But Definitely not just Right
Market performance

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Brexit? What Brexit??? The third quarter was remarkably stable, marked by some volatility in the oil market and a shifting bet on the risk of Federal Reserve tightening which failed to materialise. For Canadians continued uncertainty in the direction of oil prices is somewhat alarming as it appears that despite many forecasts to the contrary, the amount of oil being produced globally continues to exceed demand and the much vaunted “balancing” of the market may not come about for at least another year despite the possible intervention of OPEC, who have agreed to cut production. At this point it is uncertain whether the proposed cuts by OPEC – if they materialize at all – will balance the market sooner than had previously been anticipated. Iran was not part of the agreement and will continue to increase production, partly offsetting the committed reductions by others.

Importantly, the equity markets continued to rally to the upside. During the quarter the S&P 500 broke through a strong resistance level at 2125. The Canadian market followed its US counterpart and also rallied as stability in oil prices allowed the S&P/TSX Composite to continue to outperform the U.S. market.

Interest rates declined as the Federal Reserve held short term rates stable and long term bond rates moved lower. The Bank of Canada made some noises of easing, as our economy appears to be slowing, however once again did not actually do anything – a recurring pattern of North American central banks of late!

What do we expect?

The month of October traditionally strikes fear in the hearts of equity investors, however it is September that has historically been the worst month. That having been said, no prudent manager bets the farm in October. This year is particularly interesting as the S&P 500 has finally broken out of an upward wedge formation that has been 4 years in the making. This move typically is followed by a test of the old resistance level and if that holds it signals a new bull run. As the chart shows we broke through resistance in August and bounced off the same line in September. Should we still be above 2125 at the end of October we believe that the market will experience a Christmas rally that should extend into next year and possibly beyond. This could be triggered by an expanding US housing market as discussed in last quarter’s report.

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However, our longer-term optimism is tempered by multiple events that could lead to uncertainty in financial markets in the near term. First, Deutsche Bank, one of the largest financial institutions globally, is facing intense financial pressure triggered by a combination of bad debt, negative interest rates squeezing profitability and the threat of a large financial penalty imposed by the U.S. justice department. Uncertainty regarding such a large institution could trigger a “flight to safety” in financial markets.

The Federal Reserve continues to threaten a series of interest rate hikes and while we believe they will eventually move in this direction they will strive not to destabilize global markets. Rate hikes will be nuanced with an eye to keeping the economy on a sustainable growth path.

Amongst other concerns, corporate earnings growth remains elusive.

Finally, in the coming quarter, we shall also learn the identity of the next US President and can then determine what effect if any that might have on the marketplace. We can expect increased volatility leading up to the election, as investors are currently shrugging off the potential for a Trump presidency. As they say: “A day in politics is an eternity”. Amen to that.
Thus, a sudden shift in the polls could trigger heightened concern.

Musings from the Capital Markets:
Goldilocks and the three bears

Much is written about the actions of the Federal Reserve in the USA. The “Fed” as it is affectionately known, is the Central Bank of the USA. It controls the three tools of monetary policy: open market operations (Papa Bear), the discount rate (Momma Bear) and reserve requirements (Baby Bear). The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, and the Federal Open Market Committee (FOMC) is responsible for open market operations. The three Bears sit down to dine at regular, pre-determined intervals to set interest rate policy with the aim of creating a stable economy operating at peak performance without (theoretically at least) creating excessive inflation. This is done by ‘targeting’ the Federal Funds rate or overnight lending rate amongst major banks. After every meeting the Minutes of the meeting are released and analysts pour over the discussion points to try to determine when, or by how much, the Fed will next adjust rates. For market watchers and the real economy (Goldilocks) this is very important as, an easy monetary policy (low rates) will leave too many bowls of porridge (cash) on the table which swirls around the system looking for investments, frequently creating bubbles. If there are insufficient bowls of porridge around, bubbles burst and markets fall dramatically. Thus, signs of Fed tightening (rate hikes) are responded to in the markets by selling investments. Stock markets together with bond markets tend to fall, at least initially, under this scenario. In other words, as you can sense, the Fed tries to get it “just right” so Goldilocks will continue to be happy at the dining room table!

We are currently in a long term experiment with ultra cheap money (low interest rates) as well as very expansive monetary policy. This has been brought about by the central banks of the world trying to avert a depression (economic starvation). The Financial Crisis of 2008 was the trigger for the Fed to lower interest rates to record lows and flood the market with porridge − rather cash, in the hope that banks would lend the money to businesses which would create goods and to consumers, who would consume these goods. Gradually the economy has been rebuilt to pre-2008 levels and the focus of the Fed now is to lead a continuation of the expanding economy on a sustainable path without boosting inflation. Inflation however is at the moment not a problem. Rather the success of automation combined with globalization and the aging of the Baby Boom has created a strong deflationary environment to contend with. Deflation is extremely dangerous in that it discourages Goldilocks from eating (spending) and can lead to a depression. To counter-act this, the Fed has set a minimum inflation target of 2% and at the same time is looking to create sustainable job growth to ensure that Goldilocks will have wages with which to eat (consume).

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As one can see from the chart the US Unemployment Rate has fallen steadily and appears to be sustainable at levels around 5%. Unemployment rates below 5% risk a return to inflation which the Fed would welcome but Goldilocks might not. However, the Fed needs to raise its Fed Funds rate from its current very low levels as with rates near zero, the Fed has no ammunition to lower rates should the economy falter.

Thus it is that for most of the year the professional market watchers have closely watched all actions and speeches from Fed Governors to identify key signs that the Fed is about to raise rates. All this to no avail. The Fed has waffled (leaving a lot of porridge on the table) and although more Governors (3) voted in September to raise rates than in June (1) their vote of 9-3 is remains overwhelmingly dovish.

The Fed tries not to run political interference

The three bears (the Fed) wishes to be seen as apolitical, generally trying to be absent from markets during election time. Fortunately, at the moment the economy is aiding and abetting the Fed’s inaction and with the next FOMC meeting scheduled for the week before the Presidential election we expect no action from the Fed until its December meeting.

Goldilocks continues to muse about the effects of a Trump victory in the election. For the majority of classical economists his anti-free-trade stance is of major concern and his tax cuts will further exacerbate the already bloated US debt position.

All-in-all a Trump win is likely negative for Goldilocks. As with all events that will affect markets the trading fraternity looks for a way to ‘bet’ on a given outcome. In the case of this election the markets are using the Mexican Peso as a proxy for their Trump bet. If Trump wins it will likely be negative for Mexico as he will attempt to impose tariffs on Mexican goods, stop American companies from relocating there, re-negotiate NAFTA and build his “Wall”. Thus if traders feel Trump is moving towards victory they will sell the Peso. The attached chart was taken the day after the first debate.

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Clearly the market felt Trump lost that debate as the Peso gained in value immediately after its conclusion. (Note: the chart is inverted as it shows the US Dollar versus the Peso thus, as the Peso rises it costs fewer pesos to buy 1 Dollar and the line falls).

From this Goldilocks’s perspective, a Democrat victory will have little impact on the markets, while a Republican victory will create volatility and might signal weaker markets for a time in which case, our three bears will most likely be kept busy well into 2017.