Third Quarter Commentary

After a challenging summer, equities rallied into September resulting in mild gains for the Canadian and US equity markets.  In response to a continued slowdown in economic growth, US and European central banks lowered interest rates.  The lower rates led to a solid quarter for Canadian bonds.

An inverted yield curve, negative interest rates and fears of a recession contributed to stock volatility.  The US yield curve briefly inverted (short term rates are higher than long term rates) during the third quarter.  Inverted yield curves typically precede recessions by six to nine months. One can argue that this indicator is not as relevant today as over $15 trillion of sovereign bonds currently trade with negative interest rates. While we do not typically subscribe to the “this time is different” camp, we acknowledge that the yield curve barely inverted for a few days so maybe we should focus on other indicators.

The ISM Manufacturing Index dipped below 50 indicating that the Manufacturing economy is weak.  Although this is not positive, manufacturing accounts for a small percentage of the US economy.  The US – China trade war is also generating business uncertainty contributing to lower investment in the US and slower economic growth in China.

On the positive side, the US consumer remains healthy.  Consumer confidence declined slightly from elevated levels and consumer spending has remained robust. The tightening cycle of the last few years is over as most central banks are easing. Employers are continuing to hire, especially when they can find people who have the skills to fill open vacancies.

When considering the future direction of equity markets, investors are looking at a muddled picture.  There appears to be a tug of war between slowing growth, a short-lived inverted yield curve and recession fears on one side with fair valuations and central banks easing on the other side.  We currently do not envision a recession, but we will continue to monitor the data to evaluate if a change in strategy is warranted. 

These mixed signals point to muted stock returns with increased volatility. There are still opportunities to make money but making significant returns will be challenging.  To be clear, we do not envision a recession or a significant drop in the market, but also can make a case where stock market returns will be more subdued than they have been over the last 10 years.

The stock market remains near record levels which is partly related to historically low interest rates. We are still positive on the outlook for stocks, even though valuations can best be described as full, being neither cheap nor hideously expensive.  We continue to believe that stocks are more attractive than bonds even if our equities outlook is increasingly subdued. 

Due to slowing earnings growth and the run up in prices since the beginning of the year, stocks are vulnerable to a pull back. We are getting increasingly conservative with respect to the stocks we hold for clients and are gravitating to companies that are not particularly economically sensitive.  If anything, we prefer stocks where performance will be a function of something other than the economy.  We prefer catalysts that involve a turnaround, a restructuring or being dependent on a cycle that is independent from the economy. We have also trimmed positions that have performed particularly well leading to cash being at more elevated levels.  We will redeploy cash into stocks if better opportunities are presented.

As always, we welcome your thoughts and comments.

Second Quarter Commentary

Stocks finished the quarter near record highs despite a slowing global economy. There was little change in the economic data or the outlook from the prior quarter. The on again, off again Chinese – American trade negotiations achieved little progress. Interest rates extended their decline, as central banks became increasingly accommodative. US treasury prices increased as investors anticipate multiple rate cuts through year end.

As the quarter progressed, volatility in equities increased. Stocks initially rallied on an accommodative fed, upbeat growth prospects and decent earnings reports. As global economic forecasts moderated in May, stocks declined. Stocks rallied into the end of the quarter once equity investors realized that the probability of a Fed rate cut was increasing.

Escalating global trade tensions is the primary explanation for the global slowdown. The US threatened to impose punitive tariffs on Mexico unless it was more serious about stemming the flow of illegal immigration. While this spat was eventually settled, the trade dispute with China has endured. This trade conflict could become problematic as it involves the two largest economies in the world. The US also threatened to impose tariffs on European manufacturers. Trade uncertainty led to diminished business investments and curtailed consumer consumption.

Central banks have been quick to react to the economic slowdown by tilting towards a more accommodative stance. There were strong hints at the last Fed meeting that a rate cut was likely at their next meeting (late July) if there is no acceleration in GDP growth. Slow downs are not atypical during expansions, especially at this late stage of the business cycle. With the Fed willing to cut rates, it is likely that growth will re-accelerate in the second half of the year.

With lower interest rates, Canadian bond prices rose and provided a robust 2.5% return during the quarter. As we currently do not anticipate a recession, interest rates have probably bottomed. Future bond returns should reflect the prevailing bond yield, which is in the low single digits.

The stock market remains near record levels which is partly related to historically low interest rates. Valuations can best be described as full, being neither cheap nor hideously expensive and modestly above their long-term average. We are still positive on the outlook for stocks, but have difficulty making a case for significant upside. Although we still believe that stocks are more attractive than bonds, we are beginning to temper our bullishness. Stocks are vulnerable to a correction due to slowing earnings growth and their run since the beginning of the year. We are getting increasingly conservative with respect to the stocks we hold for clients and are gravitating to companies that are not particularly economically sensitive. If anything, we prefer stocks where performance will be a function of something other than the economy. We prefer catalysts that involve a turnaround, a restructuring or being dependent on a cycle that is independent from the economy. We have also trimmed positions that have performed particularly well leading to cash being at more elevated levels. We will redeploy cash into stocks if better opportunities are present.

As always, we welcome your thoughts and comments.

MARKET REBOUND

Stock are off to their best start in over 20 years. A more benign Fed with respect to future interest rate increases and solid earnings reports drove the sharp reversal from Q4. The bond market also performed well reflecting declining interest rates. While the US economy has lost some momentum, it remains on sold footings.

Most issues weighing on stock prices during the fourth quarter were resolved in a positive fashion. US recessionary concerns proved to be overblown. Reported economic data revealed a slowing US economy albeit one that is still growing. Worries that the Fed would make a policy mistake by raising interest rates too far or too fast were assuaged when the Fed said that it would pause hiking interest rates to gauge the state of the economy. Fears of a trade war with China leading to a global recession dissipated as productive talks increased the likelihood of a resolution. Jitters that a long-term government shutdown would impact the economy disappeared once a budget deal was reached. Finally, the Mueller investigation concluded with a report that there was no collusion between Russia and President Trump. While none of these add to US or global growth, eliminating these potential negatives relieves the stock market of uncertainty. This led to expanding stock valuations as investors were increasingly confident in the outlook.

Although several potential negatives and uncertainties are “off the table”, risks remain. There is no guarantee that the China – US trade dispute will be successfully resolved. China and particularly Europe are exhibiting slower growth, which could still impact global growth.

The stock market is at a crossroads. As stock prices near their all-time highs, decreases in corporate earnings estimates have stock valuations close to their historical average. At this late stage of the business cycle, it is unlikely that valuations will expand materially. Upside for stocks will have to come from earnings growth.

Earnings growth is typically a function of corporate revenue growth and margins. Revenue growth should be additive as we currently do not forecast a recession. Expanding margins have been an important component of the current bull market. Declining labour costs, increasing international sales and lower taxes have all contributed to margin expansion. Unfortunately, most of these tailwinds are peaking or are at risk of being unwound.

Labour as a percentage of Gross Domestic Income has been falling since 1980. This was partly due to declining union membership, less bargaining power on the part of workers and the rise of China (with significantly cheaper wages) as a global manufacturing hub.

The US – China trade dispute (and punitive tariffs) has led US corporations to seek other manufacturing sources besides China. The rise in labour costs in China has also made that country less attractive for low-cost production. Unfortunately, few other countries have the scale or infrastructure to be a global manufacturing powerhouse to replace China as a source of low-cost goods. This means that corporations will have to absorb higher wage costs and tariffs (impacting margins) or pass them along to customers.

Worries about income inequality is also on the rise. The democrats have made this a central plank of their platform which could result in a higher national minimum wage. This would impact corporate margins in labour intensive sectors of the economy.

Companies have used havens and other avoidance schemes to lower taxes over the last few decades. The 2018 tax cuts capped a multi-decade decline in corporate rates with tax rates likely bottoming. Left leaning candidates are campaigning on everyone paying their fair share, including corporations. If the Democrats win in 2020, we should assume they will be aggressive in raising corporate tax rates.

With the recent slowdown in economic growth, bond prices increased as yields decreased. This resulted in bonds returning a robust 3.9% during the quarter. With the decline in yields, bonds are less attractive than they were three months ago. We expect bond returns will track bond yields which are currently in the low single digits.

This cycle is one of the longest on record, but that does not necessarily presage its impending doom. The economy continues to grow and there has not been a substantial change to corporate earnings prospects. Although we expect stocks to provide positive returns, they are less attractive than they were at the beginning of the year due to their big upward move. We have become increasingly defensive with respect to stock selection. We have sold some companies that are more cyclical in nature and added stocks where the business model is more durable. With bonds providing low single digit returns, we continue to prefer stocks over bonds.

Market Correction

2018 ended on an ugly note as December was one of the worst months ever for stocks. The final quarter saw a marked increase in volatility as investors demanded a higher risk premium in the face of tighter monetary policy (rising interest rates). Trade tensions between China and the United States provided an additional overhang for stocks. Overall, it was an awful quarter for stocks as the S&P 500 declined by 14.0% and the S&P / TSX fell by 10.9%. Many stocks fell more than 20%, putting them in bear market territory. Since reaching their lows in late December, stocks have rebounded. The bond market provided a measure of stability returning 1.8%.

While earning reports this quarter were solid, they were not as robust as in prior quarters. Investor fears related to a peak in economic growth and earnings weighed on stocks. We currently do not envision a recession this year but acknowledge that growth will not match the level of 2018. A deceleration in earnings growth warrants a reduction in stock prices but corporate America is still healthy notwithstanding the slower earnings growth. With the recent pull back, stocks are currently trading below 15 times 2019 earnings, which is close to its long-term average. Lower equity prices, no material change in earnings prospects and no impending recession puts equities at more attractive levels than three months ago.

As expected, the Fed increased short term interest rates in December. They also signaled that they would be less aggressive with respect to raising rates in 2019. Inflation is a more serious threat than at any time in the last ten years due to low unemployment and a shortage of skilled workers. This threat is offset by slower economic growth. The net result is a Fed that will take a wait and see stance that is more data dependent. Chairman Powell has also stated that interest rates are currently near a neutral level (neither too restrictive or accommodative) which is beneficial for economic growth.

The US yield curve briefly inverted during the quarter. This means that longer dated bonds were yielding less than shorter term bonds. Investors were spooked as this is typically looked on as a recessionary indicator. We are not overly concerned as this indicator gives plenty of false signals and the inversion was ever so slight (5 basis points) between the one- and five-year bonds. Typically, investors who follow this indicator tend to monitor the spread between the two and the ten-year bonds and this segment of the yield curve never inverted.

The Bank of Canada held its benchmark interest rate steady at 1.75% during their December meeting. Lower oil prices and slower economic momentum were the primary reasons for officials striking a more cautious tone and casting doubts about future rate increases. This dovish tone from the Bank of Canada resulted in a meaningful decline in the Canadian Dollar vs the US Dollar.

We can’t write about the quarter without mentioning the US Political situation. The midterm elections resulted in the Republicans adding to their slim majority in the Senate, and the Democrats convincingly taking control of the house. A divided government is typically positive for markets as gridlock and a do-nothing government allows businesses to thrive. Unfortunately, we are not in a normal environment. The political environment is divisive, with little civility between the two parties. Democrats winning a majority in congress results in their chairing house committees. They will probably use this new power to search for proof of Trump’s malfeasance. Whether they are serious about impeaching President Trump or just making noise to embarrass the president is moot. The investigations will create additional political uncertainty which is never positive for the markets.

The economic outlook remains bright but not without risk. This cycle is one of the longest on record, but that does not necessarily presage its impending doom. Political, trade and potential monetary mistakes are all risks that could derail this cycle or the bull market. We do not expect these risks to materialize this year, but we will remain vigilant for any changes to the outlook. From a “glass is half full” positive perspective, the recent swoon in stocks has resulted in more attractive valuations with no change in the fundamental outlook. The economy continues to chug along and there has not been a material change to corporate earnings prospect. Consequently, we continue to prefer stocks over bonds and will maintain this stance until a change is warranted. As always, we welcome your thoughts and comments.