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.