US Presidential Election

Both the S&P 500 and the S&P TSX traded in a dead zone for the majority of the third quarter. With little change in the economic data reports and a seasonal decline in trading activity, volatility was nonexistent over the summer. Most of the third quarter increase in stock prices (S&P 500 +3.3%, S&P TSX +4.8%) occurred in the first ten days of the quarter.

Stock markets became increasingly volatile in the latter stages of September due to seasonality, an increased frequency of central bank meetings and a heightened focus on the impending US election. We expect this market uncertainty to persist as we await the outcome of the election. The incoming president (along with who controls the senate and the house) will define the US economic policies for the next four years.

Hilary Clinton is advocating increasing taxes on both income and capital. Donald Trump is proposing a larger fiscal stimulus, with lower taxes on capital, wages and corporate income. He also proposes a reduction in federal regulations. Clinton proposes financing the increased spending with more taxes on the rich. Trump’s budget assumes incremental growth from lower tax rates will drive an increase in tax revenues. Unfortunately, both candidates' plans would probably result in increased deficits. The Clinton plan would not raise sufficient revenues from increasing tax rates on the rich while Trumps’ plan is unlikely to see the necessary growth to offset his budgets incremental spending.

Presidential candidate platforms are nothing more than promises that may or may not be enacted. Proposed legislation and budgets still need to pass the House of Representatives. As we do not know which party will control the house and the senate it is impossible to say definitely what impact a Trump or Clinton victory would have on the markets and the economy. From a very short term perspective (think one to two weeks max), markets would behave better with a Clinton victory. She is perceived to be a more stable presidential candidate due to her being more of a "known" entity from her years in public service. Trump on the other hand is more of a wild card, as he has never served in public office and his policies are vague and constantly changing. The only thing we can state with a high degree of confidence is that a Trump victory should be positive for the stock market through year end while a Clinton victory would be bearish through year end.

Canadian economic growth has been quite subdued this year while the Canadian equity market has been one of the better performers in the developed market. This is due to the rebound in oil prices and the Canadian economy stabilizing and not entering a recession as originally feared.

Bonds continue to provide safety with respect to a return of capital, but with expectations for a minimal return on capital. Bonds (as measured by the Dex Bond Universe) returned 0.2% during the quarter. Abnormally low bond yields will continue to result in low returns assuming no material change in interest rates. Stocks will continue to provide returns that are greater than bond returns, although with a higher degree of volatility.

The current “recovery” is now in its eight year. Since the end of the Second World War, expansions have typically lasted between two and ten years. This expansion has been the most anemic since the end of the Second World War. While we currently see few signs that the current expansion is nearing an end, there is also no reason why the current sclerotic growth could not continue beyond ten years.

Low interest rates (monetary policy) have been the driving force behind the global expansion. Countries in the developed world have piled on debts even as government spending (fiscal policy) has subtracted from economic growth. For the first time since the recession, fiscal policy across the developed world is turning more stimulative. Political populism has pushed fiscal deficits down the list of political priorities. Tax cuts and working class benefits have become politically more important. This is evident from the platforms of both US presidential candidates and from the policies of the Federal Liberals during the last Canadian election.

While the scale of the fiscal stimulus is modest in dollar terms, it does signal a profound shift in government policies with respect to stimulating growth. This change is positive as central bank tools for inciting growth are reaching their limits. A portion of the growth in fiscal spending (and debts) is being supported by the low interest rates policies of central banks reducing the cost of servicing the growing government debt.

With tepid economic growth and valuations being pricey we expect increased volatility to be the norm. During the fourth quarter, this will likely be compounded by the US election. We continue to believe that economic growth and earnings are poised to accelerate, providing the framework for a positive stock market. Stocks should continue to out perform bonds. It also goes without saying that any deviation from these expectations would result in significant fluctuations in both stock and bond prices.

Second Quarter Review

Stocks had a strong quarter as interest rates continued to move lower. With the recent rebound of both the Canadian dollar and commodity prices, Canadian stocks returned 4.2%, but are still in negative territory when compared to a year ago. In the last quarter the US stock market gained an encouraging 1.9% as compared to only 1.9% for the entire prior year. The US dollar has recaptured some of the previous year’s gains.

With stocks near record highs, the margin of safety from cheap valuations has been reduced, thus we are tempering our bullishness towards global equity markets. We are in an environment where valuations are full, global economic growth remains somewhat tepid and there is increased political risks related to Brexit  and the upcoming US presidential election.

Valuations are still reasonable based on 2017 S&P 500 earnings estimates. The US stock market has largely gone sideways as 2016 earnings are forecasted to be flat relative to 2015 earnings. If anything, valuations are stretched based on current profits leaving little margin for error. US corporate earnings stagnation is due to slower economic growth (particularly outside North America) and last year's US dollar strength depressing foreign earnings.

As both the bull market and economic cycle age, we are highly focused on the potential risks of reduced global growth expectations. Let's be clear, we do not see an impending recession. The upside in stocks continues to outweigh the downside, an environment where the risks are also increasing. We believe this is a time when an experienced portfolio manager can add value.

The good news is that the current earnings growth recession is poised to end. As the US dollar partially regains lost territory, this translates into a relatively improved profit outlook. This improvement in the US dollar exchange rate comparables should help the S&P 500 profits begin growing by late summer. US earnings revisions have turned positive for the first time since 2014. This environment of favourable earnings momentum is typically positive for equity performance. The two biggest drivers for the upward earnings revisions is the weaker US dollar and the recent recovery in commodity (and specifically oil) prices.

Oil production is mostly in balance with demand resulting in oil prices rising significantly from the bottom, yet still off their highs. The rise in oil prices has probably peaked in the short term with the current price becoming the new normal. Oil prices benefited from unscheduled supply disruptions in both Canada and Nigeria. Oil at $50 allows some capital expenditures to return to the sector, but not the unconstrained spending on shale fracking that we saw a few years ago. Energy prices remain low enough that consumers will not be materially impacted by the recent rise, but high enough that most production companies with reasonable costs will be profitable. The marginal high cost producers will not be incentivized to drill, limiting the likelihood of a return to an oversupplied market.

The economic cycle is aging. Investors are nervous and are selling stocks based on any indication (no matter how minor) that economic growth might be slowing. The risk is not so much that we will enter a severe recession as we did seven years ago, but that this “muddle along” economy with 2% growth turns into a no growth scenario. Central banks around the world have been highly accommodative trying to stimulate the global economy with the provision of zero to negative interest rates. The Bank of Japan is ramping up their easing program while the European Central Bank has started their bond buying program. The Fed began their tightening program in December, yet they have not raised rates since. It is highly likely that if they do raise rates again this year, they will only do so once. While it has been almost 7 years since the end of the recession, US GDP growth has only averaged 2% / year during that timeframe. This is the most tepid economic recovery we have experienced over the last 100 years. Although 2% is nothing to write home about, it remains stronger than comparative European and Japanese growth rates.

Bonds continue to provide safety vis-vis a return of capital. From a return on capital perspective, bonds are less attractive. Super low bond yields results in miniscule bond returns, assuming there is no material change in interest rates. We continue to believe that stocks, judiciously chosen, will provide higher returns than bonds. The dividend yield on equities is higher than 10 year government bond yields for the first time in 35 years. This typically results in stocks outperforming bonds.

With relatively pricey stock valuations, we are cognizant that if the forecast for growth prove overly optimistic there may be a reactive increase in market volatility. If this should transpire, we advise our investors to remain confident in their investment plan. After six sluggish months, economic growth remains poised to accelerate. This should provide a background for the equity markets to advance higher.

First Quarter Commentary

After a very rocky start to the quarter, stock indexes rebounded and posted positive returns. An oil price recovery, receding recession fears and easy monetary policy from central banks keyed a powerful recovery in global stock markets. The Canadian Stock Market (as measured by the S&P / TSX) gained 3.7%. Coincident with the January bottom in oil prices, the Canadian dollar (relative to the US dollar) began a torrid rally. While US stock indexes were up modestly (0.8%) for the quarter, Canadians experienced declines from their US investments due to the depreciating US Dollar. The bond market was an oasis of stability, returning 1.4% with positive returns in all three months.

With the market declines of January and August, investors have now experienced a double dip correction . Although we expect volatility to remain elevated, we do not anticipate another significant correction in 2016. The US economy continues to grow implying a low probability of recession. The Canadian economy is also poised to expand as we have seen the trough in commodity prices. Oil Prices are up over 45% from their January lows, and while they are unlikely to revisit the January bottom, the rally is running out of steam. The recent federal budget with its emphasis on increased spending will also provide a boost to the economy.

The structural underpinnings are in place for stocks to continue moving higher. While the North American economy continues to grow at a tepid pace, stock valuations based on corporate earnings remain reasonable. Over the last couple of years, corporate earnings growth has been muted by the strong US dollar. The recent strengthening of the Yen and Euro will reverse some of last year’s currency pressure providing a tailwind for both revenue and earnings growth. The headwind for earnings will not completely disappear as most commodity based currencies (such as the Canadian Dollar) are still down relative to year ago levels. The lower dollar will also make the goods and services of US based companies more competitive. The positive currency effects will result in US and Canadian earnings growth re-accelerating which will be beneficial for stocks.

The Federal Reserve Board Open Market Committee (The Fed) remains committed to further rate increases, albeit at a slower pace than communicated in December. Chairwoman Yellen recently stated that The Feds current intention is to be less aggressive than their original plan from three months ago. This was positively received by investors as they perceive that the Fed is going to be lower for longer with respect to interest rates.

In Canada, the Liberal government's recent expansionary budget should provide additional stimulus to the economy. This reduces the likelihood of another reduction in the Bank of Canada rate. Low and stable interest rates implies that expected bond returns should be close to the current yield of 2 - 3%. The risk of widening spreads with an increase in rates for 5 and 10 year Canadian bonds is also a distinct possibility. This would put additional pressure on bond returns.

A wrinkle for stocks this year is that we are entering a presidential election cycle that looks to be one of the wackiest ever. Despite a spirited challenge by Bernie Sanders, it is likely that the Democrats will anoint Hillary Clinton as their candidate. While Donald Trump has a significant lead amongst Republican candidates, there is still a great deal of uncertainty as to who will win the Republican nomination. Assuming the presidential candidates are the current leaders (and this is a big assumption on the Republican side), we should expect a heightened level of financial market turbulence. Both candidates are polarizing figures with neither being particularly well liked, respected or trusted.

We continue to believe that we remain in a low return, highly volatile environment. Stocks should do better than bonds. Assuming the oil rally that drove the Canadian stock market has exhausted itself, the US market should perform better than the Canadian market. We are in the late stages of an economic expansion and a bull market. Stock markets can still advance from current levels, but progress is likely to be choppy. Cautious investment strategies with a tight handle on market conditions will be invaluable over this coming year.

Contact us to discuss if your investments are properly positioned in an increasingly turbulent world.

Low Return, Volatile Environment

Condor’s clients saw returns that ranged from modest gains to +10% during a year most other investors would like to forget. A year like this separates the astute investor from those who mirror the market swings. The majority of investors and their clients either lost money or saw very modest gains. The S&P / TSX declined significantly, while the S&P 500 declined slightly. As expected, the Canadian Bond market saw modest returns. Our clients benefited from our strategy of being more heavily invested in the US stock market versus the Canadian market. They profited from both a stronger US dollar and better relative US stock market performance.

 In this newsletter we will begin with a focus on the Canadian stock markets. The Canadian stock market dropped 11.1% for the year. Much of the weakness was fueled by a significant contraction in commodity and energy prices. This impacted corporate profits resulting in significant declines in the energy, materials and mining stocks. See post below for more on the oil market. These sectors comprise almost half of the S&P / TSX Composite index. Our clients were significantly underweighted these sectors, thus their Canadian equity holdings performed better than the Canadian market. Going forward, any tightening in the supply of commodities with a corresponding increase in prices will provide a sharp boost to stocks within these sectors. We currently do not envision this upswing scenario to occur during 2016.

While Canadian household debt levels remains perilously elevated, there is currently no catalyst to push the Canadian housing market into a downturn. Typically this happens when either interest rates or a recession pressures consumer's ability to service their mortgages. Alberta and other regions that are dependent on energy related jobs are at risk due to the high number of layoff and the effect on local economies. The economy in the remainder of the country continues to grow as export oriented manufacturing regions benefit from a weak Canadian dollar. Canadian GDP growth was around 1.2% in 2015. It is very possible, if not highly likely, that the economic growth profile for Canada in 2016 will remain tepid.

The US economy is in better shape than the Canadian economy. American automotive sales and production remain at record levels. Housing continues to be strong and consumer balance sheets are in their best position since before the recession. Wages are rising and employment levels continue to grow. The Fed recently instituted their first rate hike in years as they now consider the economy to being closer to “full“ employment.

The Fed's computer model for economic projections assumes low unemployment will result in unacceptably high inflation. Their current model projects full employment by early 2016. In turn, this will result in an upward pressure on wages and prices. The first evidence of this is third quarter inflation adjusted hourly compensation rising 3.4% versus the year ago quarter. Over the last nine years, the adjusted hourly compensation annual growth rate has been averaging less than 0.5%.

A more volatile environment linked to central bank policies (the speed and level of rate rises) is typically the norm. The US Central bank is moving from low interest rates and market intervention to raising rates. The current annual iteration of the “dot plot” (representing Federal Open Market Committee member Fed Funds annual rate forecasts) projects rates rising 1.0%. The market is currently expecting rates will only rise 0.5% over the coming year. It is not unreasonable for analysts to expect rates to rise slower than the Fed forecasts as it did take longer for the Fed to initiate lift off versus initial expectations. A deviation from current market rate forecasts (i.e. moving closer to the Feds 1.0% increase) would result in volatility for both stocks and bonds. Current forecasts are unlikely to remain static for the next twelve months. As rate assumptions change based on newly released economic data, we should expect heightened volatility even if the current rate forecasts are ultimately correct by the end of 2016.

We are forecasting continued US economic growth. We currently do not foresee a recession for either Canada or the US, although Canadian economic growth will be less robust than that of the US. The US economy is projected to grow around 2.5% and fuel further gains in the US stock market even though corporate earnings growth has slowed. Current S&P 500 earnings growth projections for 2016 are in the 4 - 6% range. Assuming companies continue buying back 2% of their outstanding stock as they did in 2015, earning per share growth will be in the 6 - 8% range. Assuming Price to Earnings multiples do not change, we can expect US stocks to gain 6 - 8%.

There are a lot of assumptions made to arrive at the 6 - 8% stock appreciation forecast. A lot can change over the next year resulting in US stock returns being materially different (either higher or lower) from these projections. While the projected Price to Earnings ratio is reasonable, it will increase if investors feel more bullish about US economic growth prospects. It can also decline if investors become more risk adverse or there is a perception that there is an increased likelihood of a recession. A change in corporate profit expectations would also contribute to stock market variability.

Although we forecast the US bull market will remain intact, we acknowledge that we are in a low return environment for both stocks and bonds with a heightened level of volatility. We anticipate more dips and rises in the market, similar to the experience of the late summer when stocks dropped 10% with a subsequent full recovery by the fall. These dips and rises may take several months to balance out, thus investors will need to hold steady through some tough times.

The rationale for potential muted stock performance is multifaceted including factors such as weak global economic growth, fairly priced stock valuations, potential future rate hikes by the Fed and ongoing uncertainty regarding the upcoming US Presidential election. Despite our concerns about increased volatility, US stocks have typically performed well in the months following a Fed rate hike initiation. On average, the S&P 500 is roughly 6% higher one year after the first rate hike. More importantly, the index has returned about 14% on average for the duration of tightening cycles since 1982. Negative return probability significantly decreases as time passes. In fact,  there have been no periods where the S&P 500 return was negative one year following the first rate hike, and similarly no tightening cycle has produced a loss for the S&P 500.

We expect that 2016 will look a lot like 2015, with low returns and elevated volatility. We continue to prefer stocks over bonds (See post below for more). Investors should focus on quality investments which have the characteristics of consistent and dependable earnings growth. Stock picking will be increasingly important. While we prefer a buy and hold strategy and investing in positions for the long term, we acknowledge that it will be increasingly important in 2016 to consider tactical trades. Cautious investment strategies and a tight handle on market conditions will be invaluable over this coming year. Contact us to discuss if your investments are properly positioned in an increasingly volatile world.

Canadian Interest Rates

The Bank of Canada has a neutral interest rate policy although they are on record that they would consider a further decrease in rates to support the weak Canadian economy. This, combined with the Fed raising interest rates has resulted in a weakening of the Canadian dollar. As the Bank of Canada rate is 0.5%, there is not a lot of room to cut interest rates before Canada is in a sub-zero rate environment. Absent another exogenous shock to the economy, we currently do not envision the Bank of Canada raising rates over the next six months. We are more likely to hear the Bank of Canada discuss lower for longer, even in the face of the US raising rates.

As we are not forecasting a rise in Canadian interest rates, bond returns in 2016 will be similar to 2015 in the low single digit range. Upside could come from further easing by the Bank of Canada and downside would result from Canadian rates moving in tandem with rising US rates. Studies have shown that there is an 85% correlation between American and Canadian interst rates. Notwithstanding, it is unlikely that we will see the typically tight correlation between US and Canadian rates over the next year as we project differing growth characteristics of the two countries.

Low Oil Prices Is The Solution For Low Oil Prices

A portion of the Canadian stock market decline can be attributed to the bursting of the commodities bubble and subsequent decline in commodity prices. The price for the oil benchmark West Texas Intermediate (WTI) declined by over 35% in 2015 to $35. Since Canadian oil typically trades at a discount to WTI, investments are being pared as newly drilled oil is not profitable at current prices. Employment in the energy sector is also affected. While any improvement in global GDP would aid the demand outlook, the real issue is oversupply. OPEC continues to pump at capacity and the North American shale revolution has resulted in a significant amount of new oil coming to market over the last few years. The lifting of the Iranian oil embargo in 2016 will further exacerbate the glut. It is unlikely that there will be a meaningful decline in the supply of oil through the end of 2016, even though the current environment lays the foundation for its recovery.

There is an old saying in the oil business that the solution to low oil prices is low oil prices. Low oil prices forces the oil supplied from high cost wells to be taken off the market. Evidence of this is showing up in the North American supply data as new drilling projects are being shelved as they are not profitable at current prices. This trend should continue through 2016 as hedges previously put in place to sell oil at higher prices roll off and producers are forced to sell at market prices. While the current depressed oil prices creates an environment that will ultimately lead to higher prices, this will take multiple quarters to play out and we are unlikely to see higher oil prices over the next six months.