Tricia Leadbeater’s Market Updates
Third Quarter Review
The stock market rout of January and February already seems a distant memory, as stock and bond markets followed that with a steady march upwards through to early September. Canadian markets have rallied 13% this year, but are still down from their 2015 peak by 4.5% (as a reminder, the TSX was The sharp rally in Canadian and global markets has been fuelled in large part by the sharp rebound in commodity prices that occurred in February. There was some brief spluttering of momentum of the trajectory in the first weeks of September, over concern that the Federal Reserve may take the improving economy and stabilized US dollar as opportunity to hike interest rates. This would be perceived as a potential negative for both equity and bond markets, and even threaten a “taper tantrum” like we saw in early January. But the outcome of the September Fed meeting was a relief for markets, for now, as the Fed indicated no rate hikes were likely before December. Many analysts (about 50% by interest rate futures indications) think rate rises won’t happen until well into 2017, after a new president is established. Even then, they will be very gradually increased over the next several years.
2 year S&P/TSX INDEX (blue) vs S&P 500 (red), in local currencies
The S&P 500 is up 10% over a 2 year holding period, while the TSX is negative -0.54%.
The European Central Bank also signaled in September that it plans to continue its market-supportive bond buying program, therefore driving more of European sovereign bonds into negative yields. Right now, about $11 trillion in sovereign bonds globally are trading at negative interest rates, an unprecedented figure. The scheduled end of the European QE program was intended to be March 2017. Markets will be watching closely for signals on whether the program will continue, as the market hopes it will. The first negative yield corporate bonds were issued in Europe last month: Henkel issued a €500 million 2 year bond with a minus 0.05 percent yield and Sanofi with a €1 billion three-and-a-half year bond also with a yield of minus 0.05 percent.
Other quantitative easing trends include Britain. Following the “Brexit” vote in June, the Bank of England cut interest rates and started its own aggressive monetary easing program in August, anticipating that economic weakness would flow from the Brexit vote. The rapid fall in the British pound in the last week may cause pause to the need for easy monetary policy. The UK, like Canada, can benefit from a cheap domestic currency. Like Canada, it also plans to borrow heavily at cheap rates to fund infrastructure spending in a bid ward off recession. Canada’s spring budget approved $11 billion for infrastructure spending over the next two years.
For now, the theme continues that global central bank interest policies are generally supportive for stock market investors and for borrowers, but punitive for savers and institutions needing cash investments and low risk sources of return. Money market investments provide negative returns, once tax and inflation are considered, and so investors continue to hunt for alternative sources of yield. We expect there to be support for yield generating investments for years to come as large investing classes – ageing retirees and pension plans- require cash flow to meet current and future obligations.
The benefits of diversity in a challenging investment environment
The charts below track performance of some of factors that most heavily influence our portfolios: the US dollar and Canada’s energy sector. These charts also demonstrate the long term benefits of diversity to a portfolio. The goal of diversity is to not be overly exposed to any single major factor of returns, as that can cause disproportionate losses should that factor turn negative. Investing capital is a dynamic endeavor that balances the goals of capital growth, protection of the purchasing power of savings, and income generation, while minimizing the risk of capital losses and giving investors and portfolios resilience (emotionally and financially) through the market volatility that we know is an increasingly common, if unpredictable feature of the markets.
By example, while the TSX has been one of the best performing markets in 2016, it had extreme volatility in the early part of the year, plunging 11% in 2 weeks. Over a two year holding period, the TSX has annualized a negative return of -0.8%, and only 2.3% annualized rate of growth over 10 years. This volatility and sensitivity to a small number of factors is why we don’t invest to track the TSX: it is far too sector/factor concentrated for most investors to bear the exposure to the returns of this single index. As previously mentioned, much of the rally in Canada this year has been driven by one sector - commodity producers. Note that while Canadian energy stocks have rallied impressively since January, up 21% if we use the exchange traded fund XEG as our proxy, the energy index is still down 40% from its peak of summer 2014.
The better diversified S&P 500 has underperformed Canada’s index year to date, but provided superior returns over the last 2, 5 and 10 years as compared to Canada’s index. We also look for the US (and other) currency diversification for long term benefits to the Canadian investor portfolio. The CAD troughed at 68 cents earlier this year to stage a huge rally back to 75 cents versus the USD (over 10% in 2 months!); however our dollar is down 15% over the last two years, making US investments even more valuable in the hands of the Canadian investor over a longer stretch.
2 year return on CAD vs USD: Down 14.8%
2 year return on XEG/Canada’s energy sector: Down 30%
Canada: Economic growth does not correlate with stock market returns
Annual GDP growth in Canada is in one of its weakest periods ever, at 1%, but you’d never guess that from the performance of our market in 2016. Sitting at 23X earnings, Canadian stocks haven’t traded at these valuations since September 2002 (Bloomberg). It may seem contradictory that our economy is generally struggling yet our stock market surges upwards but this is in fact not uncommon – GDP growth and market returns don’t have tight correlations – just look at the rise in the US markets over the last four years in a tepid GDP growth environment.
Stock valuations price in future expectations about growth, currency, and interest rate expectations. They’ve also in the last several years more highly valued dividend payers over non-dividend payers (see chart below). The following key factors have come into play to drive Canada’s market returns of this year: the low Canadian dollar (so, in a global pricing environment, with our currency down 15% over two years, to have the market move up 11% year to date reflects perceived benefits of a depreciated currency), low interest rates which allowed companies to sell $26 billion of bonds this year, making balance sheets much more attractive for stock market investors; low interest rates are also supporting bustling M&A activity (a record $123 billion so far this year in deals in Canada announced as of June 30, 2016, Bloomberg) as companies seek to grow through acquisition, like the multi-billion dollar foreign takeovers made by TransCanada, Enbridge and Alimentation Couche-Tard; dividend payers like banks and Telco’s enjoyed multiple expansion (market paying more for the same earnings), as the hunt for yield became even more focused. The appeal of dividends plus the possibility of capital growth in stocks keeps becoming more appealing over time as bond yields continue to be pressured downwards. Rallies of 25% or more in USD terms in gold and crude prices propelled the resource sector to be the most winning sector. Resource exporters, selling their products into a USD priced market, make the USD receipts more valuable to a company’s bottom line, especially if labour costs are also concentrated in Canadian dollars.
Source: Richardson GMP
It’s not only corporate Canada that is taking advantage of low interest rates – municipalities, provinces and agencies are also on track for record debt issuance this year to finance deficit spending. Sub- sovereign Canadian borrowers sold $96 billion of bonds to date this year which the most since 2005 when Bloomberg started compiling data (Bloomberg).
Oil price: Driver of stock market and high yield bond market volatility, and of global social stability
Investors are tracking oil supply and price developments more closely than ever, as broad earnings growth and balance sheets are highly sensitive to even small changes in the oil price at these current levels. Many corporate projects, lender decisions, and government budgets were built around assumptions of long term oil prices at $80 floors several years ago. At $40 - $50 oil prices, even a few dollars can mean the difference of sustainability versus bankruptcy.
Oil and gas producers and service companies took advantage of low interest rates and demand for yield to borrow heavily in high yield debt markets over the last 5 years, to finance large scale resource development and equipment acquisitions. Through 2015 and early 2016, high yield bond markets suffered with major losses as some companies defaulted on interest payments and many more looked vulnerable if oil price stayed sub-$30. Energy failures pushed US high yield defaults to a 6-year high in June 2016, with US $50 billion in defaults so far this year, back at levels of the 2009 crisis. Fitch, the bond rating agency, predicted that the energy default rate to be at around 18% by year end (July 12, 2016, Bloomberg). High-yield energy bonds make up about 16% of the broad high-yield index in the US, making ETF investors sensitive as well as their funds holdings likely have exposure (Bloomberg). Volatility in bond markets caused spin-off volatility in stock markets.
Bond investors and bank lenders breathed a sigh of relief with oil moving back to hover between $40 $50 WTI over the 2nd and 3rd quarters. Earnings on the S&P 500 are expected to stabilize going forward, with oil producer earnings not continuing to plunge. As we saw this past quarter in Canada, Canadian banks were optimistic enough about the future oil price, that they reduced their rate of loan loss provisions against bad oil industry debt. Scotiabank CEO Brian Porter said about the third quarter: “(energy sector) losses will be manageable and we are confident that losses in this sector have peaked.” (August 31, CBC). Bank stock investors cheered and ran bank stocks to multi-year highs. As a side note, bank loans to the energy sector, which Bloomberg says account for two percent of banks’ total loan portfolio, are dwarfed by the amount of loans outstanding in mortgages. This latter topic has become a dominant conversation in the 4th quarter and expected to continue into 2017. Mortgage and consumer lending remain a point of vulnerability for our banks.
Many emerging markets, such as: Brazil, Russia, Venezuela, Nigeria, Mexico, depend on strong oil prices to support their debt payments to international lenders, and to keep their local currencies and economies strong. Some, like Saudi Arabia, also depend on strong oil prices to maintain social order via every expensive social welfare programs. Oil price stability brought stability and confidence to emerging market stocks and bonds as well this past quarter.
Based on their stated intentions to limit production for the year going forward, OPEC appears for now to have backed away from their 2014 intention to wage war and crush the US shale oil industry; or, they feel the battle has been successful enough (see chart below). Energy consultant Wood Mackenzie estimates that $380 billion in major projects have been delayed or cancelled since 2014. Until now, OPEC has shied away from cutting production as they feared US shale oil would rush in to fill any supply gap an OPEC cut would create. It remains to be seen if OPEC follows through on the promised cuts in production, but for now the market is a believer: WTI crude oil price jumped up 6% on the news. It is likely that US shale production will rise somewhat to the stimulus of higher prices: in the Permian Basin of Texas by example, some fields only need $40 per barrel to be profitable (Wood Mackenzie). Chevron has said that at $40 oil it can drill 1,300 profitable wells in the Permian, and at $50 it could drill 4,000 wells (Financial Times, September 29, 2016). Still, investors and producers hope production cuts, in addition to the slowdown in large project investment over the last two years will bring oil markets into balance and perhaps to a WTI $60 per barrel price at some point in 2017. Oil stocks in Canada are already pricing in $60 - $70 oil, and reflect little concern over pipeline/market access issues and upcoming fossil fuel taxes.
Source: Energy Information Administration
Positioning portfolios for the 4th quarter and beyond
Markets have been supported by the lower Canadian dollar encouraging foreign investment; commodity prices rose significantly from February lows, helping to bring back investor confidence in banking and resource sectors, further gains from here though may be limited.
At today’s valuations both the banking and commodity sectors seem fully valued. Banks will likely provide dividends but no growth in near term. Energy stocks need to see $60 oil and higher to justify current valuations.
Utilities, Pipelines, Telecommunications may be vulnerable to interest rate increases. However, pipelines have a very high barrier to entry and moats around their businesses, making certain companies attractive for investment dollars. Renewable energy will continue to be a theme for investment dollars with carbon taxation an ongoing trend.
To date, non-energy exports have not compensated for the drop in oil and gas prices: the delays on getting export and transportation projects approved for oil and gas means continued headwinds for exports and economic benefits from the oil and gas sector. This will have a trickle-down effect to slow down other related sectors.
US Markets: Uncertainty is increasing, for now.
Federal rate hike: at writing, the Federal Funds futures are evenly divided on hiking by 0.25% or staying still at the December meeting.
Presidential elections in November: it is far from certain who will win. There is evidence that corporations are delaying investment until uncertainty on the election is over – this causes uncertainty for investors as well.
Corporate earnings season in the US in November: the markets have priced in high expectations of corporate earnings growth. Disappointment on earnings growth could lead to some stock market volatility before the end of the year. Right now, the consumer looks to be slowing down in the US, and domestic consumption drives around 60% of US GDP. Rising labour costs may help consumption down the road; but will also weaken corporate profit margins. The weaker USD compared to last year, however, is a help for many large cap US companies that operate globally. Rising oil and gas prices help the financial sector, which act as lenders, as well as the earnings of oil and gas producers. Much of the decline in corporate earnings overall over the last two years was driven by the energy sector, as the oil price fell 50% in the second half of 2014, and then another 50% from Q42015 to Q12016.
Valuations are not excessive at 16.7X earnings on the S&P 500 (10 year average is 14.3X P/E); but not cheap. Disappointment in the upcoming earnings season could lead to some repricing of stocks, but on balance we don’t see extreme vulnerability at these earnings multiples (Factset).
Sectors that are expected to have earnings growth compared to 2015: Information Technology, including Intel, Facebook, Google (Alphabet); Utilities; Health Care; Consumer Discretionary. We are looking to be positioned in this space for growth and in many cases attractive dividends.
Global risks are present:
Potential for hard landing out of the Brexit vote in the New Year.
European bank instability and whether there is the potential for contagion if any require bail-outs.
War against ISIS escalating further as a proxy war between the US and Russia, among other risks.
Rising populism means lots of room for temporary market volatility in the upcoming year. Immigration and unemployment are increasing stresses in the western world. Sense of growing distance between rich and middle classes; impacts of free trade/ globalization on labour. With major votes coming up, public policy driven by populism could be a theme in the next year in the US and across Europe.
PIMCO has provided this Political Risks calendar:
US presidential election
Italian constitutional referendum
Austrian presidential election re-run
UK expected to invoke “Article 50” to start exit process
Netherlands general election
French presidential election
German general election. Debate on whether Merkel will run for 4th term
China’s 19th National Party Congress (political, economic, military future)
In short, the risks to the investing outlook is pretty typical at this moment as it has been for several years!
We can count on there being geopolitical tensions, that if triggered could cause extreme volatility, or pass quickly without much notice. We can’t accurately predict when geopolitical events will hit, so we build portfolio to balance growth investing with the ability to be resilient in times of choppy seas.
Resilience is built through:
Equities: Owning companies that have strong “moats” around their business model or pricing power and/or companies that pay sustainable dividends that grow, as the cash flow coming into the account can offset interim volatility. Diversity among sectors – we limit sector exposure to reduce overall portfolio volatility – the swings of the TSX are highly dramatic, and we are constructing portfolios to lower drama while achieving long term growth targets.
Corporate bonds: While we have low yield expectations going forward in a depressed interest rate environment, shorter maturities with quality issuers can provide some portfolio insurance and modest income. In today’s environment where yields in Canada are extremely low, we are using top tier bond managers to get exposure to US and global bonds. These managers have track records of superior long term performance, adding value through active management; they create capital gains through expert trading; they command better prices for being large buyers as compared to what retail investors can get; and they have the ability to access markets with higher yields while also adding some benefit through alternative currency exposures. Managers include RP Investment Advisors, Manulife, PIMCO.
Alternative investments: For accredited investors, we are focusing on market neutral strategies and some long/short hedge fund strategies where appropriate for a client’s risk tolerance. These specialist fund managers employ options strategies; pair trading; arbitrage strategies, long/short strategies and more to achieve returns that are not correlated with stock market movement, and aim to take advantage of periods of volatility.
Cash/Gold: Large amounts of cash can’t be held for long terms – it is a certain if slow destruction of purchasing power. But short term, it allows investors to act opportunistically. Gold has had a resurgence of interest, as interest rates look to stay low or negative, and the opportunity cost of holding a non-interest bearing asset has disappeared. We also expect continued buying to come from China, as the government continues to weaken the Yuan and wealthy individuals seek to diversify their wealth out of government reaches. A modest position in gold and/or gold equities as a strategic hedge is warranted.
Please feel free to contact me with your comments.
Director, Wealth Management
The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Limited or its affiliates. Assumptions, opinions and estimates constitute the author's judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. The comments contained herein are general in nature and are not intended to be, nor should be construed to be, legal or tax advice to any particular individual. Accordingly, individuals should consult their own legal or tax advisors for advice with respect to the tax consequences to them, having regard to their own particular circumstances..Richardson GMP Limited is a member of Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.