Second Quarter Commentary

Stocks had their best quarter in over 20 years as the rebound from the March lows was almost as swift as the decline. This in an economic environment resembling the worst periods of the great depression. The unprecedented $1.6 trillion stimulus package from the Fed and Congress (and similar programs from other developed countries central banks and governments) lifted most stocks. The government support amounts to over 10% of developed economies GDP. The Fed has indicated that interest rates are likely to be near zero for at least the next two years. Chairman Powell not only stated that the Fed is not thinking of raising rates, but that they “are not even thinking about thinking about raising rates”. Investors are clearly looking through the dire economic situation with expectations of a sharp recovery. With interest rates almost near zero, only equities have potential for positive returns that are greater than low single digits.

The Fed and the US Treasury department being “all in” in addressing the recession also led to a rally in bonds. The Fed recommitted to its monthly pace of buying treasury bonds and agency backed securities. The current yield on the 10-year treasuries is below 0.7%, and the corresponding yield on 10 -year government of Canada bonds fell below 0.6%. The average yield on US and Canadian stocks is around 2% and 3%. While stocks are not cheap by most metrics, they are cheap relative to bonds.

The economic picture remains bleak. Nearly 20 million people have lost their jobs, and the unemployment rate is above 10%. Retail sales remain far below year ago levels and manufacturing activity has also contracted. The congressional budget office predicts that the US economy will contract over 35% in Q2. The hope is that with the governments support, the recession will be short.

This quarter also saw protests and rioting related to racial inequality and police violence. Riots, while tragic, do not directly impact earnings or markets. People are impacted. Small private businesses incur significant losses, but it does not materially affect large publicly traded companies. Looting is bad but will probably not change the American political system or bring about the demise of democracy. Hopefully, it will change the political discussion around racial inequality, but the only concern of the market (and stock prices) is money and not human liberties.

One potential impact of the unrest is that it may boost the probability of Joe Biden winning the presidency in November. While it is still early in the campaign, we have already seen a marked increase in support for Biden in the polls. The odds of a blue wave (Biden wins presidency, and Democrats retake senate) with Democrats controlling all 3 branches of government is increasing. This would imply higher personal taxes (including capital gains) and more spending (beyond the COVID extravaganza spend) on social programs. Analysts say a Democratic-controlled government would also likely roll back the tax cuts Congress enacted in 2017, constraining corporate profit margins. While having a more rational albeit more geriatric president, a significant move to the left is not constructive for rising stock prices. It is uncertain whether Biden will campaign on his traditional left of center platform, or whether he will be pulled further to the left by progressives in the Democratic party.

Western relations with China continue to deteriorate. Heightened fears of a shooting war or a world that is split into two economic zones have increased tensions between the two largest economies. In the short term these problems are not as consequential for stocks if the Fed is providing support and western governments continuing to subsidize their economies. In the long term, a continued strain in relations has the potential for supply chain disruptions, inefficiencies and higher costs which would impact margins and profits.

Investors have been looking past the current bad economy and dismal corporate news anticipating a vaccine some time in the next nine months with everything then returning to normal. While optimistic relative to the typical vaccine development cycle, it is not unrealistic. Accelerated timelines has multiple drug companies starting phase 3 trials this summer. The US government is expediting reviews and approvals and funding a portion of these trials. It is also committing billions towards manufacturing for the delivery of hundreds of millions of doses.

Unfortunately, even with aggressive vaccine timelines, the US budget agency has said that the US economy is not expected to recover from the pandemic and related shutdowns for the better part of a decade. This implies that not all companies will safely make it to the other side. This impacts smaller companies more than larger companies, but it will have a dampening effect on the overall economy. Some states that contained COVID early in the pandemic are currently seeing an explosion in COVID cases. This is not necessarily a second wave, but part of the initial surge. This has resulted in delays in reopening the economy or in some cases a re-closing of previously opened states. The recovery will be bumpier and take longer than the best-case scenarios.

Even with a vaccine, social distancing will still be prevalent as it will take time for entire populations to be inoculated. We remain cautious, even with stocks being cheaper than bonds, as they are not cheap relative to historical levels. While the pandemic will be controlled, it might take longer than investors are anticipating. The road to recovery will be choppy, as evidenced by the failed reopening in some states following a surge of new cases. Stock have priced in a lot of good news. A lot needs to go right to justify these valuations. We do not foresee another significant decline as central banks and government support will prevent the economy from falling into a depression. Client portfolios are conservatively constructed with an emphasis on capital preservation.

As always, we welcome your thoughts and comments.

First Quarter 2020

It was an ugly quarter for stocks as COVID-19 progressed from a regional virus to a global pandemic. Equity markets experienced the fastest fall into bear market (defined as a fall of 20%) in history, taking 22 days vs an average of 86 days (Chart 1). The COVID-19 pandemic is a classic exogenous demand shock, tipping the global economy into recession. In response to the developing healthcare crisis and to slow the spread of the virus, countries have instituted social distancing and stay at home policies. This led to the first ever stoppage of non-critical economic activity. Initial jobless claims have exploded with over 10 million claims over the last two weeks vs. an average of 225,00 per week. Compounding the blow from the healthcare crisis was a cratering in the price of oil (See Box 1). The US and Canadian stock markets declined 35% (aided by margin calls and forced selling) from their highs and then bounced over 20% in a very quick time frame. While the volatility in the markets has been anything but pleasant, we must remember that at some point there will be a historic buying opportunity as crises always end. 

Stock volatility is typically a result of the fear of the unknown. Equity investors hate uncertainty and fear of a financial or liquidity crisis led to the sudden drop in stock prices. From Feb 27 till the end of the quarter, 19 of the 23 days saw moves of greater than 2%. This includes the biggest percentage gain in over 80 years, and the second biggest percentage loss since 1940. We expect a cessation of extreme volatility when we have a better idea of the shape and duration of the crisis. 

Bonds have a place in a diversified portfolio due their ability to provide stability during times of stress. They did exactly what they were designed for delivering a small positive return despite their low yields. During the final month of the quarter bond prices declined as corporate bond spreads widened. Elevated refinancing and repayment concerns drove the decline until the Fed stepped in to calm the markets. 

The current COVID-19 shock is akin to a natural disaster which generates a sharp but short-lived disruption. The hope is that we see a normal and rapid economic recovery. However, the global scale of the disruption is both unique and historic. Synchronized global downturns typically take longer to heal and production losses are rarely made up in full. 

We continue to grapple with the severity of the downturn and how long the economy will be closed for business. Investors are cognitively still trying to get their arms around these issues and the shape of the recovery. This time really is different, and not in a positive way. We are not overly optimistic of a quick return to the old ways. Countless individuals and companies will see their balance sheets take a hit as there will be little money coming in the door for two to three months. When life returns to “normal”, we will not see an immediate economic recovery to prior levels. It will take a while to rebuild consumer confidence and for individuals to return to their regular routines. Social distancing will remain in place for longer than is currently contemplated which will prohibit certain activities where many people congregate in tight confines. Individuals who saw a reduction in cash flows will also be hesitant to spend at pre-crisis levels until they rebuild a portion of their savings. The market has correctly priced in a recession, but we suspect the market has also priced in a swift recovery, which is not a foregone conclusion. 

On the positive side, stocks typically bottom four months before the end of a recessions. Recessions normally do not end with the end of bad data, but with a sequentially positive inflection of the bad data (i.e. data is less bad on a sequential basis or second derivative turns positive). Again, we are back to looking at the duration and depth of pain of the recession. 

Governments are pumping liquidity into the financial system by providing financing for businesses and wage supplements for individuals. The US alone is planning on over $2 trillion in support to soften the severity of the recession and prevent it from turning into a devastating liquidity or financial crisis. While providing a backstop for both individuals and businesses is positive, it will not make the recession any shallower or shorter. This recession is the result of a virus, and all the money in the world will not change that. Governments are ordering their populations to cease all economic activity and stay home for an indeterminate amount of time. Unfortunately, the pandemic needs to run its course. 

The Federal Reserve has also stepped in with bazooka. They have stated that they will do whatever it takes to help the American economy. For the most part, central banks have dusted off the playbook from the 2008/2009 crisis and further augmented what they did during that time period. This includes, but is not limited to, extending loans to businesses, purchasing unlimited amounts of corporate debt and introducing a new lending facility for the commercial paper market. These actions are designed to prevent a corporate liquidity crunch turning into a solvency crisis. They have been very quick to respond as the credit markets briefly froze in March. The Fed and most central banks have also significantly decreased their lending rates. Typically, the Fed using its unlimited balance sheet and “doing whatever it takes” to backstop the economy has been a buy signal for stocks. Government and central bank interventions are designed to ensure that individuals, small businesses and companies do not drown before they see the other end of the enforced shut down. 

While we are optimistic that we have seen the bottom, we are not as confident that we will not revisit the lows. Companies have yet to confess how bad it is and the impact on their finances. The current consensus is that this will last another two to six weeks, but we think that this is optimistic. While we believe the “lock down” will be lifted at some point this quarter, social distancing will be in place for the foreseeable future as there is currently no way to treat the virus.

Current predictions are that new COVID-19 cases will peak in most countries sometime in April. Social distancing is working. Unfortunately, we cannot simply declare victory and return to our normal lives. There is still no cure, vaccine or widespread tests. We do not know what proportion of people are infected without symptoms due the lack of extensive testing. As can be seen from countries that are past the peak of new cases (i.e. Singapore, Japan), lessening of restrictions might allow the virus to flare up again. 

We believe the best course of action is risk mitigation. Having said that, some companies stock prices were pricing in a severe recession and their stocks were buyable. To reiterate, we need to be selective about which companies we buy and at what price. Client portfolios have cash, but we will be very discriminating on how we invest the money. 

We adhere to the adage “that the better that we can define the problem, the closer we are to the bottom”. We know that COVID-19 is an insidious disease, that is easily spreadable, and has lower mortality rates than other viruses. We know that the economy has shut down, and central banks and governments are throwing money at the economy to ensure that the current recession does not morph into something larger. What we do not know, is how long we will purposely impair the economy to contain the virus, what the recovery looks like, and when it will begin in earnest. We also do not know when there will be a vaccine or universal testing. Companies will report OK March quarters, and guide to ugly June quarters (if they provide guidance at all), but everything beyond that is unknown. Based on being able to quantify the present and the next three months, but nothing after that, we remain cautious and would look to put money into stocks on a pull back as the unknowns either are better defined or become a concern for investors. 

As always, we welcome your thoughts and comments.

Fourth Quarter Review

Global equity markets hit record highs capping a strong year for stocks. Easier monetary policy and re-accelerating economic growth fuelled the gains. The strengthening economy and the completion of the Fed’s easing cycle in the fourth quarter drove a bump in interest rates and a decline in bond prices.

At the end of October, to almost no one’s surprise, the Fed cut interest rates. This was the third time since August that they reduced the Fed’s fund rate. They stated that they would pause to assess incoming data before lowering rates further. The rational for the rate cut was to provide insurance from ongoing risks. The Fed’s chair, Jerome Powell stated, “there’s plenty of risk left” but some of the challenges are subsiding. The recent easing should buoy confidence and aide the economy.

The US consumer is in pretty good shape. The US economy remains resilient to most of the headwinds impacting other countries growth profiles. Data from recent jobs reports is strong despite Boeing’s issues and its impact on its supply chain. Rising average hourly earnings continues to induce more workers to enter the workforce leading to an expanding labour pool.

Corporate earnings reports were better than feared, which tends to be supportive of a continued upward movement in stock prices. Companies have been maintaining future guidance, which is positive considering the trade rhetoric and tariff fears. Industrial companies have communicated that the mid-year inventory destocking is nearing an end. This is most evident by the bottoming of the Purchasing Managers Indexes (PMI’s).

Green shoots from Europe signify a pick-up from near recession levels. Autos, housing and manufacturing PMI’s all have been positive recently. The Chinese economy appears to be rebounding based on accelerating industrial production data. After lengthy on-again / off-again negotiations, China and the US have reached a tentative mini trade deal. While positive, it is not the all-encompassing deal that the market hoped for.

The presidential impeachment trial and the upcoming 2020 election are both risks that should not be ignored. As the Republicans control the senate, it is unlikely that President Trump will be convicted for impeachment. Based on publicly available evidence, it is improbable that enough republicans senators will be persuaded to change their stance and vote against the president.

The election risk is related to the uncertainty of who will be the next president. How will investors respond if it is likely that Trump remains in office for another four years? How would confidence be impacted if Elizabeth Warren was the president elect? Her expansion of government and the big tax increases required to pay for these programs could put a chill on the economy. On the other hand, the markets would probably respond positively if Michael Bloomberg was the president elect as he is viewed more of a centrist.

The Stock market remains near record highs, and valuations remain full. Corporate earnings are expected to grow 8% this year. Low interest rates and no impending recession continues to support an extension of the bull market. The only caveat is that gains in 2020 will not be as robust as in 2019 and we should expect elevated volatility. While volatility is typically not perceived as a positive, it should not impact long term investors.

Bonds had a poor fourth quarter but a remarkably good year considering the low yields at the start of the year. It surprised us that interest rates declined as much as they did in the second half of the year. The slower economy led central banks to reverse course and begin easing. Central banks have again reversed course signalling that the easing cycle is complete implying interest rates are unlikely to decline further.

We continue to prefer equities over bonds. Although bonds had a great year (+6.9%), they still underperformed equities. Going forward, stocks should benefit from an improvement in US business activity, trade deals between Canada, Mexico and the US and a US – China trade deal. A deal to keep the US government operating for another year, avoiding a repeat of this year’s shutdown is also positive. The results of the UK election also eased some uncertainty about the how and when the UK will leave the European Union. We expect moderate economic growth in 2020, with the downside risk being less severe than three months ago.

As always, we welcome your thoughts and comments.

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.

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.

Third Quarter Review

Global equity markets saw strong gains during the third quarter as global economic growth strengthened. All 45 countries as tracked by the OECD (Organization for Economic Cooperation and Development) are set to grow this year. This is very rare as there are usually a few countries or regions experiencing economic contraction. The Canadian bond market posted negative returns as the Bank of Canada twice raised it policy interest rate.

The two interest rate increases lifted short term rates from 0.5% to 1.0% and shifted the entire yield curve upward. As an example, the ten year government of Canada bond yield moved from 1.75% to 2.1% during the quarter. As bond prices are inversely correlated with bond yields, the rise in interest rates led to a decline in bond prices and negative bond returns.

This move was not a surprise to us at Condor and client's holdings were positioned accordingly. Client’s fixed income holdings positively contributed to overall returns during the quarter as portfolios were constructed using shorter duration bonds. Shorter term bonds were less impacted from the rate increases than longer term bonds.

While we remain cautious on bonds due to their low yields, it is unlikely that Canadian interest rates will rise in the near term. The Bank of Canada is moving to a more data dependent stance relative to inflation and has signaled that they are more guarded about future rate increases.

The US stock market gained 4.0% during the third quarter. The rally was characterized by small incremental daily gains resulting in multiple record highs with no big declines. We were a little surprised by the lack of volatility. It was the economically sensitive sectors (financials, industrials and energy) that powered the market move. Somewhat coincidentally these are among the cheapest sectors in the market. The staples and utilities sectors which are historically expensive and not economically sensitive, lagged.

Canadians investing in the United States also need to factor exchange rates when determining their US equity returns. With the recent weakness of the US dollar (-3.6%), Canadian dollar returns from US stocks were virtually zero during the quarter. We believe this year's Canadian dollar rally has run its course. The Canadian dollar has retreated from its recent highs as the Bank of Canada will proceed more cautiously with respect to future rate increases.

The Canadian stock market gained on the strength of financial, energy and commodity stocks. Financials benefited from rising interest rates while higher oil prices were the primary driver for energy stocks. A less aggressive interest rate stance from the Bank of Canada and a short term peak in oil prices will hinder future Canadian stock gains.

Our outlook remains unchanged. Bonds should at best provide coupon like returns in a world where interest rates are projected to be flat to up. Rising rates will pressure longer duration bond prices. Stocks should provide returns that are in excess of bonds, although with a higher degree of volatility. While stocks are not cheap, the global economy is experiencing synchronized growth. This bodes well for continued corporate earnings growth, which is the primary driver of stock prices.

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.

Second Quarter Commentary

Accelerating US corporate earnings growth lifted US stock prices while the Canadian stock market declined. Stock gains should continue in the US and resume in Canada. The corporate profit outlook remains encouraging and there are no signs of a recession.

The yield curve (a graph of bond yields plotted against their time till maturity) is typically relied upon to provide signals of an impending recession. A normal yield curve (where short-term interest rates are lower than long term interest rates) is a sign that the economy is still growing. An inverted yield curve (short term rates higher than long term rates) typically signals the onset of a recession. Short term interest rates are currently lower than long term rates (albeit a little flatter than normal) signalling that we are not on the cusp of a recession.

Excesses in the economy (i.e. inventories) can also lead an economy into a recession but there are no obvious economic excesses. The fed dot plots (a prediction of future interest rates by the open Market committee members) are showing a steady, yet measured pace of interest rate hikes. If members of the Open Market Committee have recession concerns, they would not be forecasting a gradual increase in interest rates.

Global PMI's (Purchasing manager Indexes) are currently in the low 50's. Anything above 50% indicates an expanding manufacturing sector. Global economic data suggests that the global economy is experiencing synchronized GDP growth. The International Monetary Fund (IMF) recently raised its forecast for global growth from 3.3% to 3.5% for 2017. They also see a slight acceleration in growth in 2018 to 3.6%. While these growth rates are less than they were before the financial crisis, most regions are contributing to this growth. As 40% of S&P 500 revenues and revenues and profits are linked to overseas economies, global growth will provide a boast to US corporate earnings. This will be most pronounced in the technology, healthcare, and industrial sectors, as they are most exposed to non-US markets. An expanding global economy is typically positive for stocks. US stock gains have benefited from both earnings growth and an expanding price / earnings multiple. Valuations can be justified based on accelerating earnings growth and future earnings projections but they are not cheap based on current earnings. Although there is no indication that the market has peaked, it will likely be more difficult to make large gains from these levels by investing in stocks. We are not predicting a market decline, but we believe it is prudent to be more cautious.

The Canadian stock market dynamics are vastly different from the US stock market. While technology, Healthcare and industrial sectors should benefit from their large foreign exposure, the Canadian market has limited exposure to these sectors. The financial sector, the largest sector in the Canadian stock market, lagged due to a moderation in interest rate expectations. With the Bank of Canada hinting at rate increases through the end of the year, the bank stocks are poised to rebound. Declining energy prices has depressed the energy sector, which is the second largest sector in Canada. Any stabilization or rebound in oil prices would provide a lift to investor sentiment and stock prices.

Although bonds ended the quarter on a sour note, they still managed to post gains for the quarter. The Bank of Canada is moving to a less accommodative stance. Rate increases will be gradual, but the direction of rates is clearly up. Rising interest rates will pressure bond prices in the near term. Longer term we believe bonds will provide investors with low single digit returns that are consistent with their coupons. We view bonds as a stable repository for portfolio assets, whilst acknowledging their potential to reducing overall portfolio returns as interest rates rise. Our client’s portfolios are positioned in shorter duration bonds, mitigating the impact of rising rates.

We continue to prefer equities over bonds but plan to trim equity positions as stocks continue their push to new heights. This is a tactical decision to boost client cash positions to opportunistically take advantage of any stock price weakness. As the Fed is beginning a tightening cycle, greater volatility is to be expected.

By providing strategic personalized portfolio diversification, over the past five years, Condor's clients have enjoyed returns that significantly outperformed the Canadian stock market. Please refer us to your colleagues or friends who may be looking for a personalized investment service. As always, we welcome your thoughts and comments.

First Quarter Commentary

The post election stock market rally extended its gains into the first quarter. The US economy continued to gain steam as corporations reported accelerating revenue and earnings growth. Canadian stock market gains lagged US stock market gains related to weakening oil prices and tepid economic growth.

The Federal Reserve Board hiked short term rates twice in three months, unusual in this cycle. Despite this, the Federal Reserve Board intimated that there would be additional rate hikes during 2017. The Consumer Confidence Report and the ISM US Manufacturing report have both sent out positive signals with respect to economic growth. The latter report provides an indication of future growth rates for industrial production. Thus, both economic and corporate fundamentals appear to be in good shape.

The Trump agenda continues to dominate the daily news. For the Trump team, winning an election is starting to appear relatively easy compared with governing. President Trump’s hastily conceived healthcare bill, intended to replace Obamacare, did not even achieve a floor vote in the House of Representatives despite a Republican House majority. There is no guarantee that the Trump team will be able to pass legislation and advance their agenda within their original planned timeframe. President Obama required a full year to pass his landmark healthcare bill, even with a filibuster proof Democrat majority in both the House and Senate. Under optimal conditions, governing and getting laws passed can be a messy process.

It is anticipated that President Trump will now shift his focus to implementing his priority policies such as tax reform, deregulation, and infrastructure spending. These initiatives have been the primary catalysts for positive stock gains since the election. Like President Obama before him, President Trump has begun to use executive order to enact laws and ensure his agenda is being carried out. He has used executive order privilege to reverse some of President Obama's environmental regulations. We would not be surprised if he signs more executive orders to move his agenda along.

The President has been talking a good game, but now that he has been in office for over two months, he needs some legislative wins. After losing the healthcare battle, we should expect him to tackle issues where he can successfully move legislation along. Infrastructure spending is an area where there is bi-partisan support. Tax reform can also happen, but the scope of the reformation will be more limited than what was originally envisioned by the President and the Speaker of the House.

Stocks have had an excellent run since the election. It has been a while since stocks corrected and we would not be surprised if this were to occur in the near term. Stocks are not cheap based on earnings but they are fairly valued based on based on book values and dividend yields. Stock market investors have responded positively to the Trump agenda, nonetheless uncertainty related to their ability to pass legislation may trigger market volatility. Corrections are a normal, albeit unpleasant, part of an investment cycle. We continue to prefer equities over bonds but we plan to trim equity positions as stocks push to new heights. This is a tactical decision to boost client cash positions to take advantage of any weakness in stock prices.

Canadian Bonds have provided investors with low single digits returns over the last couple of years. With no upcoming change in interest rates, bond returns will remain anemic. Accelerating growth in the US economy may lead to an increase in interest rates with a potential for further dampening of bond returns. The clients of Condor Asset Management are largely invested in shorter term bonds, limiting their exposure to interest rate fluctuations. We currently view bonds as a stable repository for portfolio assets, whilst acknowledging their potential for reducing overall portfolio returns.

By providing strategic personalized portfolio diversification, over the past five years, Condor's clients have enjoyed returns that significantly outperformed the Canadian stock market. We look forward to welcoming new clients. Please refer us to your colleagues or friends who may be looking for a personalized investment service.

Donald Trump Wins!

There is an old saying on wall street “that nobody rings a bell at the top or the bottom of a market”. With the surprise Trump victory it's almost like the bell has rung as we are witnessing one of the most significant market pivots in history. Irrespective of your personal thoughts of President-elect Trumps environmental policies, his attitudes to women and minorities and his behaving like a bully, the recent election is positive for the US stocks.

President-elect Trump promises to lower taxes and reduce the regulatory burden on companies. The hope is that these actions will boast economic growth and unleash pent up consumer demand. Trump has reinforced his commitment to reducing regulations with his initial cabinet choices. Selecting Rex Tillerson as Secretary of State, former Texas governor Rick Perry as Energy Secretary and Oklahoma attorney general Scott Pruitt as head of the EPA signal a friendlier regulatory environment. Strategas Research estimates that there is $48 billion in energy projects languishing due to environmental concerns. These projects should now move more quickly through the approval process.

The banking industry has also faced a progressively onerous regulatory burden as it has been sued for both real and imagined misdeeds. With the US government continuing to levy fines on the banks, banks are effectively being treated as the governments piggy bank. This has become an expensive cost in the financial sector. The government has sued J.P. Morgan for the errors of Bear Stearns, after J.P. Morgan rescued Bear Stearns at the behest of the government and immunized (from lawsuits like this) J.P. Morgan for the violations of Bear Stearns that preceded the rescue. Regulatory over reach has resulted in banks reducing their balance sheet risk by not making loans thereby limiting their typical role of financing economic growth.

The Dodd frank bill of 2010 as originally envisioned was supposed to be a six-page document. It was passed as a 2,000 plus page law with few people having read it prior to its passage. This law has fuelled growth in non-productive (from an earnings perspective) compliance departments. The newCommerce and Treasury secretaries are more pro-business and less ideological than their predecessors. Even if the new government does not reverse President Obama's executive orders, the psychology has shifted as banks will be less fearful of doing the wrong things.

Blackrock’s CEO Schwartzman says that the Trump administration will usher in the most profound regulatory and tax changes that he's seen in 45 years. He says “the changes as a result (of the election) are going to be very substantial in many areas, but particularly in the business community and the financial area. You’re going to have a very substantial reversal in regulations of all types… if you look at the architecture of the financial world, it’s going to change substantially…this is as big a change happening all at once. I’ve been in finance for, I don’t know, 45 years? This will be the biggest. When you have changes like this that are so profound, it’s going to drive higher GDP. It’s going to make the US a friendlier place for foreign capital. And it’s going to have significantly accelerated growth not just for the financial institutions but for the country as a whole. So, this is like very important. It’s very important. And it’s not just about some stocks for financial companies, although that would be a nice thing. It’s much bigger and more impactful over a much longer period of time.”

The US election provided more surprises than just Trump winning the presidency. As expected, the Republicans (GOP) retained their majority in the house but the big surprise was their maintaining
more than half of the seats in the Senate. The GOP senate majority is not filibuster proof, meaning the GOP will need to get some Democratic votes to enact legislation. This should not be arduous if the GOP understands that the key to constructive government and passing sustainable legislation is negotiation and compromise.

One of the meaningful changes that is rarely discussed is the transition in the senate leadership. Harry Reid, the outgoing senate minority leader was an obstructionist, “my way or the highway” type of guy. He was replaced by Chuck Schumer, who is more open to negotiations and getting things done when the two parties are generally in agreement (like tax reform).

During the recent election, the Republicans had the most at risk senators up for re-election. In two years’ time, it will be the democrats who will be most vulnerable to losing seats. (As senators terms are six years, they only run every six years, meaning that only 1/3 of sitting senators are running to retain their seat during an election cycle). The Democrats cannot afford to be obstructionist as the Republican's might pick up enough seats to have a 60 seat, filibuster proof majority. One of the big issues Democrats had in the last election was that Harry Reid brought so few bills to the senate floor for a vote. Democratic senators in swing states were not able to vote on important local issues and demonstrate to voters how their views were differentiated from the leadership of the party.

President-elect Trump will be a president like no other. While President Obama had his blackberry, Trump has his twitter account. This allows him to berate company managements (United Technologies, Ford) or negotiate in public (Boing or Lockheed Martin). We have also seen that the President-elects’s policies can be fluid. This will increase volatility as stock market movements can now be triggered by presidential tweets and increased policy uncertainty.

GDP growth has averaged only 2% during the Obama presidency. The economy is in year eight of a tepid expansion and there is currently no obvious reason to expect an expansion ending recession. The economic cycle has not been overly robust, but it is enduring. Growth should accelerate in 2017, due to lower taxes and a pro-growth environment.

President-elect Trump has discussed corporate tax reform as a primary goal for 2017. There is a high probability this will happen as both parties have agreed it’s a priority. Trump has discussed a 15% rate, while the house GOP plan is closer to a 20% rate. Assuming the new rate is closer to the house version, this would translate into an almost 10% boost to corporate earnings. Repatriation of foreign earnings, increased defense spending and deregulation (especially in banking, energy and healthcare) would all be additive to earnings.

Equity upside will be linked to improving earnings. Current policy neutral earnings (meaning we do not consider potential economic, taxation or regulatory policy changes due to Trump’s victory) growth for 2017 is forecasted to be 6 – 8%. This assumes accelerating revenue growth, neutral margins, and continued stock buy backs. Stocks are not cheap, especially with the move since the election. If the Republicans are successful in making a fraction of their proposed changes, we would expect acceleration in economic growth and corporate earnings. On this basis, the stock market will appear cheap fuelling another increase in stock prices.

The caveat to this rosy scenario is if President-elect Trump is not successful in passing his pro-growth agenda. Growth would then continue along at its recent tepid pace and the stock market would languish at current levels. While both parties have incentives to move proposed legislation forward, passage of these changes is not guaranteed.

While pro-growth policies are positive for US equity markets, they are bearish for bonds. Since the election, there have been record outflows out of bonds into equities. The interest rate on the ten Year US Government bond has risen almost 1.0%. The Federal Reserve Board is discussing two to four interest rate increases in 2017. For the first time since the great recession, investors believe that there is a high probability that this will occur.

Here in Canada, economists continue to forecast an anemic expansion (sub 2%). There are few expectations that the Bank of Canada will raise short term interest rates during 2017. Rates for five and ten-year Canadian government bonds have recently increased, but that is in response to the rate increases seen for similar maturities in US bonds. As US rates increase, Canadian mid to long term bond rates (which are set by the market and not by the Bank of Canada) should also continue to rise. This does not auger well for bond returns in 2017. We have already seen the negative effects rising rates have on bonds, with Canadian bond returns being negative for the latter half of 2016. Bond coupons were not high enough to offset the decline in bond prices due to the rise in rates.

With US economic growth accelerating, and the expected increase in both earnings and interest
rates, we continue to prefer equities over bonds. Those bonds that clients hold are short term in nature and not materially impacted by the recent rise in rates. US equities overall should perform better than Canadian stocks due to better growth dynamics. We expect a heightened level of volatility due to elevated valuations, the uncertainty related to the passage of the new administrations pro-growth agenda and the President-elect being more unpredictable than any preceding president.

Contact us to discuss how to navigate the opportunities and pitfalls.

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.

Third Quarter Review

Third quarter equity market returns were ugly. The S&P 500 declined 6.9% while the S&P / TSX 300 declined 8.6%. Concerns related to global growth was the primary reason for the selloff. China and emerging market economies slowed resulting in a decline in commodity prices. Corporate earnings estimates were trimmed mostly due to the strong US dollar. Uncertainty related to timing of the Federal Open Market Committee's (The Fed) first rate hike in over eight years did not help matters. While the increased volatility of stock markets is never a pleasant experience, we do not believe that we are on the cusp of a recession. Pullbacks, such as we are currently experiencing is considered normal in a bull market, with unpredictable timing.

The US economy appears solid in the face of a dull global economy. While US export are being hurt by a strong US dollar in the face of weak economies in their trading partners, domestic demand remains strong and demonstrates ongoing growth. The US consumer remains confident and healthy. US personal spending rose 0.4% in August compared to the prior month. This was after 0.4% and 0.3 % increases in July and June. Consumer spending strength is aided by the combination of consistent growth in hiring rates, falling unemployment rates and rising wages. We are also finally starting to see consumers spend some of their savings from lower energy prices. Consumer spending is important as it comprises two thirds of Gross Domestic Product, which is a broad measure of the overall economy.

After a tepid first half, the global economy appears to be gaining momentum due to better growth advanced first world countries. Nonetheless, China and emerging market economies will continue to be a drag on global growth. Emerging markets are experiencing a liquidity squeeze related to the stronger US dollar as it is increasingly more expensive for them to refinance their debt as it comes due.

The Fed did not raise interest rates in September as we expected. Fed Officials decided to wait and observe the impact on the US economy from financial and economic turmoil abroad. More specifically, Fed officials are watching for evidence that the US economy is resilient in the face of headwinds of a stronger dollar, a slowdown in China and volatility in financial markets. Nonetheless, Chairwoman Yellin and Fed Governors Dudley and Williams have recently stated that they still expect the central bank to raise interest rates by the end of 2015. Global monetary policies are diverging as Europe and Japan will continue with their quantitative easing programs, whereas the US is expected to embark on a rate tightening cycle.

The US Stock market appears to be fairly valued, with the forward price earnings ratio being close to its long term average. Earnings estimates for 2015 have declined over the last 6 months, primarily due to the strong US dollar and its impact on foreign earnings of US multinationals. The US dollar has recently stabilized relative to most foreign currencies. As forward estimates already account for the strong US dollar, a stable US dollar would result in earnings estimates being realistic and achievable. 2016 earnings estimates are currently forecasted to rise mid – high single digits, which is a good indication of what can be expect in the way of stock gains over the next twelve months.

The US Stock market appears to be fairly valued, with the forward price earnings ratio being close to its long term average. Earnings estimates for 2015 have declined over the last 6 months, primarily due to the strong US dollar and its impact on foreign earnings of US multinationals. The US dollar has recently stabilized relative to most foreign currencies. As forward estimates already account for the strong US dollar, a stable US dollar would result in earnings estimates being realistic and achievable. 2016 earnings estimates are currently forecasted to rise mid – high single digits, which is a good indication of what can be expect in the way of stock gains over the next twelve months.

The US business cycle is maturing, in part due to its longevity but also due to many cyclical indicators being near or above past peaks. US profit margins are near peak levels and have been soft recently due to rising wages and a stronger US dollar. While these negatives need to be monitored for further signs of deterioration they do not sufficiently concern us to modify our positions. This recovery has been more muted than prior cycles, permitting it to continue longer than has been the historical norm. Recent flattening of the US dollar would allow margins to at least stabilize at current levels.

We do not believe that stocks are entering a bear market. With stocks being extremely oversold, the market is set to bounce off the lows resulting in a strong quarter for stocks. The fourth quarter has historically been the strongest quarter for equities. Summer sell offs tend to reverse, and we see no reason why this would not be the case this time. We will revisit stock positions towards the end of the quarter with an eye to paring overweight equity positions.

During the first half of 2015, Canada experienced a short, shallow recession, mostly due to lower energy prices. The economies of the provinces outside of the energy patch were not impacted by this recession. Canada exited the recession with the GDP rising in both June and July. After two interest rate cuts, it is unlikely that the Bank of Canada will continue cutting rates due to the firming of the economy. US GDP growth is forecasted to be a full percentage point higher than Canadian GDP growth for both 2015 and 2016. The Canadian dollar experienced a significant decline relative to the US dollar due to the weak Canadian economy and the decline in the Bank of Canada benchmark rate. The depreciated dollar makes Canadian goods and services more competitive and provides a lift to Canadian exporters. This is good for the manufacturing sector and counter balances some of the weakness in the energy and commodity sectors.

The possibility of oil prices bottoming and the Bank of Canada keeping interest rates steady should limit the future decline of the Canadian dollar. If oil prices increase in 2016, this would be considered a major positive for the Canadian dollar and stock market.

The Canadian stock market has significantly underperformed the US market over the last year due to both weak commodity prices and a weak economy. While it is not surprising that anything related to the energy sector suffered significant losses, it is somewhat surprising that the financial sector has also taken a hit. This selling pressure is based on fears of deteriorating credit quality in both energy and real estate related loans. Both the Canadian currency and stock market are correlated to the price of oil and the health of emerging markets. Weak commodity prices are largely reflected in current stock prices and currency exchange rates. A sign of stock bottoms occurs when the bear case can be well articulated, as is the case now. With the majority of negative news priced into financial market and oil prices trying to find a bottom, we believe are nearing an inflection point with respect to a bottom in Canadian stocks and a top in the US dollar. In the portfolios we manage, we are evaluating when would be the appropriate time to lift Canadian stock weights.

The Canadian bond market was flat for the last three months. The Bank of Canada did not lower rates in September as widely anticipated due to stabilization in the Canadian economy. While growth is not forecast to rise above 2% over the next year, it is still forecasted to grow. We expect the Bank of Canada rate to remain at current levels, but do envision a rise in longer term (5 - 10 years) rates. This increase in longer term rates will continue to pressure the bond market. Investors should expect low single digit bond returns for the foreseeable future.

We continue to prefer equities over bonds and US over Canadian stocks. Canadian stock market results from the past year were discouraging (down 11% over last twelve months). Our clients were not significantly impacted as we mostly avoided these markets. We are warming up to the idea of increasing our Canadian stock weights in the coming year. We feel that some Canadian stocks were unfairly “punished” and that we are nearing an inflection point for the Canadian dollar relative to the US dollar. We continue to believe that US stocks will perform better than Canadian stocks over the long term while also providing diversification opportunities that are not available in the Canadian market. We see bonds as an asset class that will provide stability to portfolios despite their somewhat mediocre returns. With the Fed on the cusp of raising interest rates, we expect the stock market to be increasingly volatile with more frequent corrections. Typically, we have not been aggressive in paring positions that have grown significantly as a percentage of the overall portfolio. Given the increasing volatility in stock prices, we intend to pro-actively take profits and keep positions within their targeted range.

This has been one of our more lengthy quarterly news reports, a reflection of the increasing complexity of global market interactions. When beginning a tightening cycle, it becomes even more important to trust your financial advisor to be in tune with your individual client risk profile. We, at Condor Assess Management, pride ourselves in being available for consultation and advice at any time.