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.