Third Quarter Review

Third quarter equity market returns were ugly. The S&P 500 declined 6.9% while the S&P / TSX 300 declined 8.6%. Concerns related to global growth was the primary reason for the selloff. China and emerging market economies slowed resulting in a decline in commodity prices. Corporate earnings estimates were trimmed mostly due to the strong US dollar. Uncertainty related to timing of the Federal Open Market Committee's (The Fed) first rate hike in over eight years did not help matters. While the increased volatility of stock markets is never a pleasant experience, we do not believe that we are on the cusp of a recession. Pullbacks, such as we are currently experiencing is considered normal in a bull market, with unpredictable timing.

The US economy appears solid in the face of a dull global economy. While US export are being hurt by a strong US dollar in the face of weak economies in their trading partners, domestic demand remains strong and demonstrates ongoing growth. The US consumer remains confident and healthy. US personal spending rose 0.4% in August compared to the prior month. This was after 0.4% and 0.3 % increases in July and June. Consumer spending strength is aided by the combination of consistent growth in hiring rates, falling unemployment rates and rising wages. We are also finally starting to see consumers spend some of their savings from lower energy prices. Consumer spending is important as it comprises two thirds of Gross Domestic Product, which is a broad measure of the overall economy.

After a tepid first half, the global economy appears to be gaining momentum due to better growth advanced first world countries. Nonetheless, China and emerging market economies will continue to be a drag on global growth. Emerging markets are experiencing a liquidity squeeze related to the stronger US dollar as it is increasingly more expensive for them to refinance their debt as it comes due.

The Fed did not raise interest rates in September as we expected. Fed Officials decided to wait and observe the impact on the US economy from financial and economic turmoil abroad. More specifically, Fed officials are watching for evidence that the US economy is resilient in the face of headwinds of a stronger dollar, a slowdown in China and volatility in financial markets. Nonetheless, Chairwoman Yellin and Fed Governors Dudley and Williams have recently stated that they still expect the central bank to raise interest rates by the end of 2015. Global monetary policies are diverging as Europe and Japan will continue with their quantitative easing programs, whereas the US is expected to embark on a rate tightening cycle.

The US Stock market appears to be fairly valued, with the forward price earnings ratio being close to its long term average. Earnings estimates for 2015 have declined over the last 6 months, primarily due to the strong US dollar and its impact on foreign earnings of US multinationals. The US dollar has recently stabilized relative to most foreign currencies. As forward estimates already account for the strong US dollar, a stable US dollar would result in earnings estimates being realistic and achievable. 2016 earnings estimates are currently forecasted to rise mid – high single digits, which is a good indication of what can be expect in the way of stock gains over the next twelve months.

The US Stock market appears to be fairly valued, with the forward price earnings ratio being close to its long term average. Earnings estimates for 2015 have declined over the last 6 months, primarily due to the strong US dollar and its impact on foreign earnings of US multinationals. The US dollar has recently stabilized relative to most foreign currencies. As forward estimates already account for the strong US dollar, a stable US dollar would result in earnings estimates being realistic and achievable. 2016 earnings estimates are currently forecasted to rise mid – high single digits, which is a good indication of what can be expect in the way of stock gains over the next twelve months.

The US business cycle is maturing, in part due to its longevity but also due to many cyclical indicators being near or above past peaks. US profit margins are near peak levels and have been soft recently due to rising wages and a stronger US dollar. While these negatives need to be monitored for further signs of deterioration they do not sufficiently concern us to modify our positions. This recovery has been more muted than prior cycles, permitting it to continue longer than has been the historical norm. Recent flattening of the US dollar would allow margins to at least stabilize at current levels.

We do not believe that stocks are entering a bear market. With stocks being extremely oversold, the market is set to bounce off the lows resulting in a strong quarter for stocks. The fourth quarter has historically been the strongest quarter for equities. Summer sell offs tend to reverse, and we see no reason why this would not be the case this time. We will revisit stock positions towards the end of the quarter with an eye to paring overweight equity positions.

During the first half of 2015, Canada experienced a short, shallow recession, mostly due to lower energy prices. The economies of the provinces outside of the energy patch were not impacted by this recession. Canada exited the recession with the GDP rising in both June and July. After two interest rate cuts, it is unlikely that the Bank of Canada will continue cutting rates due to the firming of the economy. US GDP growth is forecasted to be a full percentage point higher than Canadian GDP growth for both 2015 and 2016. The Canadian dollar experienced a significant decline relative to the US dollar due to the weak Canadian economy and the decline in the Bank of Canada benchmark rate. The depreciated dollar makes Canadian goods and services more competitive and provides a lift to Canadian exporters. This is good for the manufacturing sector and counter balances some of the weakness in the energy and commodity sectors.

The possibility of oil prices bottoming and the Bank of Canada keeping interest rates steady should limit the future decline of the Canadian dollar. If oil prices increase in 2016, this would be considered a major positive for the Canadian dollar and stock market.

The Canadian stock market has significantly underperformed the US market over the last year due to both weak commodity prices and a weak economy. While it is not surprising that anything related to the energy sector suffered significant losses, it is somewhat surprising that the financial sector has also taken a hit. This selling pressure is based on fears of deteriorating credit quality in both energy and real estate related loans. Both the Canadian currency and stock market are correlated to the price of oil and the health of emerging markets. Weak commodity prices are largely reflected in current stock prices and currency exchange rates. A sign of stock bottoms occurs when the bear case can be well articulated, as is the case now. With the majority of negative news priced into financial market and oil prices trying to find a bottom, we believe are nearing an inflection point with respect to a bottom in Canadian stocks and a top in the US dollar. In the portfolios we manage, we are evaluating when would be the appropriate time to lift Canadian stock weights.

The Canadian bond market was flat for the last three months. The Bank of Canada did not lower rates in September as widely anticipated due to stabilization in the Canadian economy. While growth is not forecast to rise above 2% over the next year, it is still forecasted to grow. We expect the Bank of Canada rate to remain at current levels, but do envision a rise in longer term (5 - 10 years) rates. This increase in longer term rates will continue to pressure the bond market. Investors should expect low single digit bond returns for the foreseeable future.

We continue to prefer equities over bonds and US over Canadian stocks. Canadian stock market results from the past year were discouraging (down 11% over last twelve months). Our clients were not significantly impacted as we mostly avoided these markets. We are warming up to the idea of increasing our Canadian stock weights in the coming year. We feel that some Canadian stocks were unfairly “punished” and that we are nearing an inflection point for the Canadian dollar relative to the US dollar. We continue to believe that US stocks will perform better than Canadian stocks over the long term while also providing diversification opportunities that are not available in the Canadian market. We see bonds as an asset class that will provide stability to portfolios despite their somewhat mediocre returns. With the Fed on the cusp of raising interest rates, we expect the stock market to be increasingly volatile with more frequent corrections. Typically, we have not been aggressive in paring positions that have grown significantly as a percentage of the overall portfolio. Given the increasing volatility in stock prices, we intend to pro-actively take profits and keep positions within their targeted range.

This has been one of our more lengthy quarterly news reports, a reflection of the increasing complexity of global market interactions. When beginning a tightening cycle, it becomes even more important to trust your financial advisor to be in tune with your individual client risk profile. We, at Condor Assess Management, pride ourselves in being available for consultation and advice at any time.