THE RETURN OF VOLATILITY

Equity markets underwent a significant transformation during the first quarter. Volatility increased markedly after an extended period of calm as investors became increasingly concerned about rising interest rates and a potential trade war. This led to the cessation of the sustained market uptrend and a severe correction. A high level of complacency also contributed to the stock price vulnerability. The US stock market declined 1.2%, while the Canadian market declined 5.2%. Bond markets also fell as interest rates rose on inflation fears. Bond markets were responding to improving economic conditions and Central Banks removing previously injected monetary stimulus.

The recent rise in volatility and the stock market correction coincided with a changing of the guard at the Fed as Janet Yellen concluded her term as Fed chair. This should not be too surprising as the markets also experienced increased volatility when the previous Fed chair retired. The incoming fed chair, Jerome Powell, has signaled a continuation of the current policy of gradually raising interest rates. The economy is at a critical juncture due accelerating growth, near capacity employment and accommodative interest rates. Investors are fearful of a resurgence of inflation due to the government's tax cuts. Although it was Janet Yellen who began this tightening cycle, it will be Jerome Powell's Fed that does the heavy lifting with regards to monetary tightening. The trick will be to raise interest rates just enough to return interest rate policy to neutral (vs. the current accommodative stance) while at the same time not raising them too far or too fast and snuffing out the economic expansion. Federal Reserve tightening cycles always tend to be messy, and this one should be no different.

President Trump has been making a lot of noise of late about increasing tariffs on US trading partners and winning a trade war. Optimistically, his bluster is only a negotiating strategy to get US trade partners (and specifically China) to negotiate more balanced trade agreements. Unfortunately, the market has been focussing on the negative consequences of a potential trade war, and the theoretical impact on the economy. Investors are keying in on the tail risk that negotiations are unlikely to be successful which would lead to a full out trade war. This would obviously be negative for the global economy. Contrary to President Trump's recent statements, there are never any real winners in a trade war. While we believe a full blown trade war is unlikely, President Trump has created ambiguity as to the eventual outcome, and the market abhors uncertainty. Increased uncertainty implies lower valuations, which results in increased volatility.

As the market has recently been focused on issues that could derail the bull market and the economy (trade and interest rates), earnings estimates have continued to creep upwards. Positive estimate revisions are based on increased capital spending, benefits from the recently enacted tax cuts and better foreign earnings due to a weaker US dollar. This has translated into 2018 earnings estimates that are 16% higher than 2017, with a further 10% increase projected for 2019. Valuations towards the end of 2017 appeared expensive when in reality stock investors were anticipating the acceleration in earnings. With rising earnings estimates, we now have a market that is reasonably priced based on historical valuations.

We continue to prefer equities over bonds. Although bond yields have improved, bond yields are still only returning low single digits. US equities are trading at 15 times next year's earnings which is pretty close to the historical norm. While the Canadian market is a little cheaper than the US market, we continue to prefer the US market due to its diversity, higher growth profile and lower cyclicality. With the Fed tightening and with the current, uncertain political climate, we expect volatility to remain elevated.

By providing strategic portfolio diversification, Condor's client returns have significantly outperformed Canadian stock and bond markets over the last five years. As always we welcome your thoughts and comments.

2017 Review

Economic prospects look as favourable at any point during this expansion. Consumer confidence is at all time highs, global economic headwinds have turned into tailwinds and corporate earnings growth is accelerating. US fiscal austerity is reversing with the passing of the economically stimulative tax reform bill. Corporations are also operating in an increasingly benign regulatory environment. As a result, the US economy will experience above trend growth during 2018.

Fueled by better than expected corporate profits, US Equity markets had a great 2017 with the S&P 500 gaining 19.4%. Valuations are relatively unchanged from the beginning of the year as returns were mostly correlated with earnings growth. The US dollar weakened by 6.8% resulting in the S&P 500 gaining 11.3% in Canadian Dollars.

Our 2018 expectations for the US equity markets are positive, with a few caveats. Earnings growth will continue to be powered by a global economic expansion although headwinds to stocks include valuation, concerns about growth sustainability and increasing interest rates.

The Federal Reserve Board raised the benchmark interest rate three times in 2017 to 1.25%. The forecast calls for the Fed to raise interest rates another 3 – 4 times in 2018 bring rates to at least 2.0% by year end. Current low Interest rates provide support for equity market valuations, but with rates continuing to increase this argument will begin to dissipate. Monetary policy is finally normalizing, although it is unlikely to be restrictive in 2018. At some point, the absolute level of interest rates will begin to impact the outlook for economic growth but this is probably not a 2018 event. Towards the end of an economic cycle, EPS growth is typically offset somewhat by P/E contraction as investors begin to discount the next recession. This will eventually occur but not in the short term as we are nowhere near a recession.

The Canadian Stock market gained 6% during 2017, substantially underperforming the US market. Differences in Canadian and US sector weightings had the biggest influence on the performance discrepancy. Anemic returns from the energy and material sectors, which comprise 30% of the S&P / TSX index, held back the Canadian market. These sectors account for less than 10% of the US market.

Technology was the best performing US sector gaining 37%. Technology is almost one fourth of the US market but did not aide Canadian market returns as it comprises only 3% of the Index.

The Canadian bond market returned low single digits, mostly in line with its coupon yield. Recent Canadian economic data has been stronger than expected increasing the probability of a Bank of Canada rate hike. In a rising rate environment, coupon returns are as good as one should expect from bonds. We expect this to continue throughout 2018.

While we continue to believe that equities will provide superior returns than bonds, we are aware that we are closer to the peak of the economic cycle than to the beginning. The US economy is running at full potential for the first time in ten years. Auto sales peaked this year and US existing home sales might also have peaked. We are in what is typically termed a “late cycle” economy. US consumer confidence is at its highest level since the internet bubble. US employment rate is now at 4.1% which is near or close to full employment. The unemployment rate can go lower but risks increase of higher inflation and interest rates. Stocks still have upside as tax cuts and better economic growth are not fully priced into stocks. We remain focussed on any change in investor sentiment or economic outlook as we are mindful of current valuations and where we are in the economic cycle. As risks get magnified, we will be increasingly diligent as to our client's investments.

Although we are neither nervous nor getting cautious in the near term, we can envision a time during the next year when we do shift to a more defensive stance. This would involve an increase in our bond or cash exposure and focusing on higher quality stocks and companies (i.e. stronger balance sheets, market dominant positions, less cyclical industries). This bull market has proven to be more enduring than most people would have expected. While all bull markets must end, we do not see an imminent demise as we do not envision a recession in 2018.

Condor Asset Management has successfully positioned client portfolios to take advantage of stock market opportunities. Contact us to discuss how to navigate financial markets during the latter stages of an economic cycle. As always we welcome your thoughts and comments.