Third Quarter 2017 – Quarterly Commentary
What was Stephen Poloz thinking?
Last quarter we titled our report “A Tale of Two Markets”. It seems we may have used our title a quarter too early. Although in the last quarter we were focused on the equity markets, in this quarter it is the bond markets between Canada and the United States that have diverged.
10 Year Bond Yields: Canada vs. U.S.
The blame can be laid at the door of the Bank of Canada. As late as April, commentary from the Bank continued to tease markets with the idea that a further cut in interest rates might be required to shore up a Canadian economy still looking to find its feet. Market watchers were therefore caught flat-footed when the Bank of Canada increased interest rates by 0.25% in July, followed by a second hike in September!
So how did we move from a potential rate cut earlier in the spring to two increases by the end of September with the hints of a third before the end of the year? What was motivating the Bank of Canada?
There has been much debate and little indication from the central bank. Growth certainly showed recovery in the second quarter and early parts of the third, led by a strengthening energy sector. So, it could be argued that the increases were merely a reversal of the two cuts made in 2015 when the energy sector collapsed. It may also have been a desire to stabilize the Canadian dollar, as speculators mused that the currency would slide below 70 cents U.S. Or, it could have been a sense of urgency to move rates higher so they can be cut should the economy start sliding towards recession. The fact is, we may never know what motivated the quick change in policy direction.
Meanwhile, in the United States, the Federal Reserve seems to be backing away from its implied bias towards increasing interest rates as wage inflation – and in fact any form of inflation – remain difficult to sniff out.
The reasons behind these diverging policies may be less important than the impact. U.S. interest rates drifted lower through most of the quarter, while at home Canadian bond yields and the Canadian dollar both spiked, a move magnified by the element of surprise. It was truly an unwelcome surprise to Canadian investors, who experienced the resulting drag on their portfolio returns.
But with every turn, a new opportunity opens. In this case, we now have more flexibility to explore U.S. securities as well as the ability to make shifts in some areas of the fixed income portion of the portfolios to add yield.
Flashing back once more to last quarter’s commentary, where we highlighted the movement in opposite directions of the Canadian and U.S. equity markets, we can now report that by the end of this quarter that gap had essentially closed. In Canadian dollar terms, the year to date gain in the U.S. market is now on par with the S&P/TSX Composite Index. How a quarter can change things, indeed!
Donald Trump & Kim Jong Un: Two Peas in a Pod?
Although political dramas dominate the news cycle these days, in general, geo-political events tend not to have lasting impacts on financial markets. However, we can often count on these events to create short term volatility – ergo opportunities.
But could the drama playing out in North Korea be different? Possibly, for two reasons. First is the real potential for this conflict to turn nuclear. A terrifying prospect that the world has never dealt with – at least not since the Cuban Missile Crisis, which was a short-lived issue. Second is the artillery built up along the demilitarized zone and aimed directly at Seoul, a globally important industrial city whose destruction would disrupt global supply chains – not to mention the risk to millions of civilians.
The United States and North Korea seem to have a classic prisoners’ dilemma, where no action is everyone’s best choice, but if someone is going to take military action – it is best to go first.
The possibility of North Korea having a nuclear weapon capable of reaching the United States is an untenable idea for any American President, and possibly even more so for the current President, who tends to be more reactive than diplomatic. But what about North Korea? Undoubtedly Kim Jong Un has contemplated the outcomes of other dictators that have given up their weapons of mass destruction (e.g. Saddam Hussein and Muammar Gaddafi) and finds their fate equally untenable.
Of course, the Chinese have something to say within this discourse as well. If war breaks out they can expect a stream of refugees crossing their borders. Also unbearable to the Chinese is the possibility of Japan steadily increasing its military power or, even worse, feeling compelled to become a nuclear power on its own. Equally disturbing is the idea of a unified Korea under U.S. influence.
The best outcome is for a Chinese brokered resolution. The worst-case scenario is nuclear war. The likely outcome is somewhere in between these two points, but saying where on that spectrum the future lies is a fool’s guess at this point and is not likely to be any more accurate than a monkey throwing a dart.
So, will any of this matter to the financial markets? Maybe, but it will depend on how it plays out. What is likely to be more important in the near term is the trajectory of corporate earnings. As can be seen in the chart below, corporate earnings and equity market performance are very highly correlated.
S&P500 Earnings (red) vs. S&P500 Index (white)
We are now eight years into the current business cycle, with the last recession ending in 2009. This is a long cycle by historic standards, but it continues to show momentum. In fact, we are now in a relatively rare period where virtually all major economies are experiencing an acceleration in growth at the same time. It hardly seems likely that we are about to tumble into recession.
On the “heat map” below, countries indicated in green are experiencing growth in manufacturing, while those in orange and red are seeing conditions deteriorate. Countries in gray are those without data.
Valuation levels, however, remain somewhat of a concern. Depending on the metric you choose to apply (Price to Earnings, Cyclically Adjusted P/E, Price to Cash Flow, Price to Sales) equity markets range from slightly above normal valuations to significantly above average levels. A reversion back towards normal levels could reduce the upside potential even while earnings continue to grow.
There are times it makes sense to be cautious as an investor and times it makes sense to become aggressive. These times (particularly an aggressive stance) are, in fact, quite rare. Most times, portfolios are best managed near their target asset mix.
Eight years into a business cycle with equity valuations high is hardly the time to add risk. Yet, with global growth accelerating and recession unlikely in the near term, it does not appear to be the time to become more conservative. In general, we continue to take a neutral stance, maintaining an asset mix close to the target level in each client’s portfolio. We continue to watch the economic and earnings data, as well as closely monitoring earnings trends, in order to identify the next broad shift.
Important Housekeeping Notice!
As of November 1st 2017, National Bank Correspondent Network will CHANGE ITS NAME to:
“NATIONAL BANK INDEPENDENT NETWORK”
This matters as, from this date on, ALL cheques or transfers payable to your custodian must reflect their new name. We will do our best to remind you of this on every occasion it may matter. However, we urge you to make a note of this for now. You should also be receiving an announcement to this effect from National Bank directly and you may note the new name on your statements and other documentation received directly from the custodian.
Welcome aboard Derry!
Logan Wealth Management is very pleased to welcome to our team Mr. Derry Burns in the capacity of Portfolio Administrator. Derry comes to us from the United Kingdom, where he commenced his career in the financial services industry in 2010. Since arriving in Canada Derry has taken and completed, the Canadian Securities Course and now plans to start the CFA accreditation. Outside of work Derry enjoys playing football for a couple of local teams and reading history.
For those who may follow it, his favorite team in the English Football Association is neither Manchester United nor, Arsenal but…Tottenham Hotspur FC!
Logan Wealth Management
October 5, 2017