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.
Thursday, April 14, 2016
Wednesday, January 20, 2016
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.
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.
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.
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.
Thursday, October 15, 2015
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.
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.
Wednesday, July 22, 2015
The Pause That Refreshes
With second quarter US economic data validating our thesis that first quarter weakness was largely
transitory, it appears increasingly likely that the Fed will raise interest rates sometime in 2015. While
the resumption of economic growth is positive for stocks, it will not necessarily bode well for the bond
market. The Canadian bond market returned over 4% in the first quarter as investors questioned the
sustainability and pace of economic growth. With more recent data demonstrating economic growth,
rising interest rates resulted in the bond market giving back almost half of the first quarter's gains
resulting in a -1.7% return for the bond market.
For a change of pace, most of the action was in the bond market during the second quarter as government yields increased sharply. Ten year German Bund Yields rose from a low of 0.1% to over 1.0% before settling in around 0.76%. The sharp movement in German bonds was related to unsettling remarks from the chair of the European Central Bank, Mario Draghi in combination with bond yields being unusually low due to deflationary concerns. With Europe leaning more to an economic recovery, deflationary fears eventually dissipated resulting in a rise in interest rates. This rise in German bond yields was the primary catalyst for an upswing in global government bond yields.
The Greek debt crisis pushed stock markets into the red at the end of the second quarter, despite trading flat for the majority of the quarter. Notwithstanding fears of a Greek default and exit from the European Economic Union, the quarter was relatively quiet with most stocks trading within a narrow band. The S&P 500 (US $) was flattish (-0.2%) while declining 1.9% in CDN dollars. The Canadian markets (as measured by the S&P / TSX composite) declined by 2.3%.
The end of the brutally cold winter season contributed to a more positive GDP in Q2. Retail sales accelerated and consumer spending growth is tracking to increase 2.3% in Q2 (final numbers have not yet reported). We are also seeing rising auto sales and the continued growth in housing starts. Consumer balance sheets are also in great shape. Household liabilities / assets are at fifteen year lows of around 21% which compares to greater than 30% in 2007. Recent employment data is also coming in strong with employment growth of 2.2% and year over year payroll income growth of 4.3%. This has resulted in the savings rate increasing by 1% over the last eight months. Also contributing to the higher savings rate is lower oil prices putting more money in consumers' wallets.
Investors have taken more of a wait and see attitude with respect to putting cash to work in the stock markets. To use a poker analogy, they are "checking" for more information before making large bets on the stock market. There are a number of wild cards and investors are searching for clues as to how they settle out. A number of geo-political situations (Russia and the Ukraine, ISIS) are periodically diverting investor's attention away from corporate earnings, which is the primary long term driver of stock prices. Greece's perennial debt restructuring drama remains a concern, with fears of a Greek debt default and its impact on the Euro. Company valuations are also a little higher than historical averages, reducing the margin of safety. Global growth remains tepid. The strong US dollar is also acting as a headwind for US company revenue and earnings growth. We continue to believe that these issues are unlikely to derail the economic expansion or the bull market for stocks.
The US stock market has had some big gains over the last few years, and it would be prudent to expect some sort of pause before resuming its upward trajectory. Absent an imminent recession (which we do not envision), we don't foresee a large market correction. For the stock market to begin its next upward swing, there will need to be growth in corporate revenue and earnings. Although earnings continue to grow, they do so at a slower pace than we originally forecasted six months ago. Stocks moving sideways coupled with a little more earnings growth will result in valuations trending down to something that is closer to the long term average. We feel that we are currently experiencing nothing more than a pause in a bull market. Longer term we continue to prefer stocks over bonds. With a stronger US economy, and the Fed poised to increase interest rates, the recent rise in US interest rates is unlikely to reverse. We expect US interest rates to continue to creep up resulting in low single digit bond returns. Canadian rates are likely to stay flat, as the Canadian economy is not as robust as the US economy.
Contact us to ensure that you are properly positioned to navigate these potentially murky markets.
For a change of pace, most of the action was in the bond market during the second quarter as government yields increased sharply. Ten year German Bund Yields rose from a low of 0.1% to over 1.0% before settling in around 0.76%. The sharp movement in German bonds was related to unsettling remarks from the chair of the European Central Bank, Mario Draghi in combination with bond yields being unusually low due to deflationary concerns. With Europe leaning more to an economic recovery, deflationary fears eventually dissipated resulting in a rise in interest rates. This rise in German bond yields was the primary catalyst for an upswing in global government bond yields.
The Greek debt crisis pushed stock markets into the red at the end of the second quarter, despite trading flat for the majority of the quarter. Notwithstanding fears of a Greek default and exit from the European Economic Union, the quarter was relatively quiet with most stocks trading within a narrow band. The S&P 500 (US $) was flattish (-0.2%) while declining 1.9% in CDN dollars. The Canadian markets (as measured by the S&P / TSX composite) declined by 2.3%.
The end of the brutally cold winter season contributed to a more positive GDP in Q2. Retail sales accelerated and consumer spending growth is tracking to increase 2.3% in Q2 (final numbers have not yet reported). We are also seeing rising auto sales and the continued growth in housing starts. Consumer balance sheets are also in great shape. Household liabilities / assets are at fifteen year lows of around 21% which compares to greater than 30% in 2007. Recent employment data is also coming in strong with employment growth of 2.2% and year over year payroll income growth of 4.3%. This has resulted in the savings rate increasing by 1% over the last eight months. Also contributing to the higher savings rate is lower oil prices putting more money in consumers' wallets.
Investors have taken more of a wait and see attitude with respect to putting cash to work in the stock markets. To use a poker analogy, they are "checking" for more information before making large bets on the stock market. There are a number of wild cards and investors are searching for clues as to how they settle out. A number of geo-political situations (Russia and the Ukraine, ISIS) are periodically diverting investor's attention away from corporate earnings, which is the primary long term driver of stock prices. Greece's perennial debt restructuring drama remains a concern, with fears of a Greek debt default and its impact on the Euro. Company valuations are also a little higher than historical averages, reducing the margin of safety. Global growth remains tepid. The strong US dollar is also acting as a headwind for US company revenue and earnings growth. We continue to believe that these issues are unlikely to derail the economic expansion or the bull market for stocks.
The US stock market has had some big gains over the last few years, and it would be prudent to expect some sort of pause before resuming its upward trajectory. Absent an imminent recession (which we do not envision), we don't foresee a large market correction. For the stock market to begin its next upward swing, there will need to be growth in corporate revenue and earnings. Although earnings continue to grow, they do so at a slower pace than we originally forecasted six months ago. Stocks moving sideways coupled with a little more earnings growth will result in valuations trending down to something that is closer to the long term average. We feel that we are currently experiencing nothing more than a pause in a bull market. Longer term we continue to prefer stocks over bonds. With a stronger US economy, and the Fed poised to increase interest rates, the recent rise in US interest rates is unlikely to reverse. We expect US interest rates to continue to creep up resulting in low single digit bond returns. Canadian rates are likely to stay flat, as the Canadian economy is not as robust as the US economy.
Contact us to ensure that you are properly positioned to navigate these potentially murky markets.
Thursday, April 23, 2015
First Quarter Review and Outlook
Our clients have done well this quarter. The ongoing strength of the US dollar was the main story of the first quarter. The US Dollar gained 9.3% versus the Canadian Dollar and 12.7% against the Euro. Condor's clients benefited from the stronger US Dollar as the majority of equities held by our clients are in US stocks. Diverging policies from central bankers with respect to interest rates was the primary reason for the rising US dollar. The US Fed Reserve Bank is signaling that they are poised to begin an interest rate tightening cycle due to better economic data. Europe is entering a period of lower rates as the European Central Bank is starting a quantitative easing program. Here in Canada, The Bank of Canada cut interest rates due to slackening economic growth. All things being equal, higher interest rates and a stronger economy tend to attract investments resulting in higher exchange rates.
Although our clients saw their portfolio values increase, stocks were relatively flat for the quarter, not withstanding their trading with increasing volatility. The S&P 500 increased fractionally (+0.4%), while the Canadian market (S&P / TSX) was up 1.8% reversing some of the decline from the previous six months. The Canadian bond market returned 4.2% as it benefited from the surprise interest rate cut by the Bank of Canada.
US economic growth was positive during the first quarter, but was not as robust as the prior three quarters. Economic activity was impacted by the West Coast port strike and unusually cold weather. This will translate into earnings growth being a little slower than previously forecast. Companies with big international exposure will also see earnings impacted by a stronger dollar which will hurt both sales and margins.
Lower energy prices detracted from the aggregate S&P 500 earnings number, as energy companies realized lower revenues and profits. On the other hand, companies with significant energy input costs have yet to see the benefit of lower commodity prices. Companies that are net energy users, typically hedge oil and gas costs six to twelve months out. These companies will benefit from lower energy prices in the second half of the year as the hedges roll off. We recently saw the first example of this when Carnival Cruise Lines reported better than expected earnings, primarily related to lower energy costs. For 2015, this will result in the S&P 500 earnings recovering some of the earnings lost from the energy producing companies.
Equity markets remain fairly valued, being neither cheap nor expensive. Markets that are fairly valued, with average economic growth (2.0% - 3.5%) should see stock prices increase close to the long term average of 7 - 8%. S&P 500 returns were flat during the quarter, but this follows positive returns in every quarter of 2014. The S&P 500 appears to be consolidating last year's gain resulting in a churning type of market. The volatility in the first quarter is probably a good indication of what to expect for the remainder of the year.
With the Fed on the cusp of its first interest rate hike in many years, we would expect that stock volatility will increase. While there has been significant analysis of when the Fed will institute the first rate hike, there has been little discussion as to the type or timeline for subsequent rate hikes. We believe that interest rate hikes will be at a measured pace (0.25% per rate hike) and continue at a slow and gradual pace. We anticipate the Fed's future action will be data dependent. If the economy continues to experience strong growth, rates will continue to increase. If growth lags, rate increases will be put on hold. We do not believe that rate hikes will cause major problems for the economy or the financial markets as interest rates are currently near zero. A cumulative rate increase of 1.0% will still leave interest rates below what is considered to be neutral and will remain economically stimulative.
The Bank of Canada lowered the overnight lending rate in January by 0.25% due to a sluggish economic outlook related to lower oil prices. The rate cut took everyone (including us) by surprise, resulting in strong bond returns in the first quarter. Our current thoughts are that the Bank of Canada is unlikely to change interest rates in the short-term. With the current low level of interest rates, bond returns will remain in the low single digit range.
US dollar strength should persist, albeit not to the same degree as the last four months. US GDP growth is stronger than Canadian GDP growth and this situation should continue through the remainder of 2015. The US economy is benefiting from accelerating job growth, stronger US auto production and increased housing activity. Canada on the other hand is facing economic challenges from a combination of layoffs associated with lower oil prices and a peaking housing market. This potentially leads to higher interest rates in the US with the Bank of Canada having more of a neutral bias on rates.
Depressed oil prices are also impacting the Canadian dollar US dollar exchange rate. Lower oil prices result in less (US $) revenues for energy companies. As Canadian energy producers convert less US dollar revenues into Canadian dollars (to cover their costs), there is less demand for Canadian dollars. The Canadian dollar has been viewed by some financial investors, as a “petro currency” resulting in the dollar moving in tandem with oil prices. Persistent oil price weakness has translated into persistent Canadian dollar weakness. If the price of oil rebounds significantly, there would be a reversal of the recent Canadian dollar weakness. Our ability to predict oil production is limited due to the uncertainly of global conflicts and of OPEC oil quotas.
We continue to believe that stocks are the most attractive asset class, although we expect stock volatility to be higher and stock returns to be lower as compared to the last few years. While stock price variability will increase, we currently do not envision a stock market decline of greater than 10% as economic growth is still positive and stock valuations are not expensive. Bonds will continue to yield positive returns, but in a low interest rate environment, returns are unlikely to be as robust as equities.
Although our clients saw their portfolio values increase, stocks were relatively flat for the quarter, not withstanding their trading with increasing volatility. The S&P 500 increased fractionally (+0.4%), while the Canadian market (S&P / TSX) was up 1.8% reversing some of the decline from the previous six months. The Canadian bond market returned 4.2% as it benefited from the surprise interest rate cut by the Bank of Canada.
US economic growth was positive during the first quarter, but was not as robust as the prior three quarters. Economic activity was impacted by the West Coast port strike and unusually cold weather. This will translate into earnings growth being a little slower than previously forecast. Companies with big international exposure will also see earnings impacted by a stronger dollar which will hurt both sales and margins.
Lower energy prices detracted from the aggregate S&P 500 earnings number, as energy companies realized lower revenues and profits. On the other hand, companies with significant energy input costs have yet to see the benefit of lower commodity prices. Companies that are net energy users, typically hedge oil and gas costs six to twelve months out. These companies will benefit from lower energy prices in the second half of the year as the hedges roll off. We recently saw the first example of this when Carnival Cruise Lines reported better than expected earnings, primarily related to lower energy costs. For 2015, this will result in the S&P 500 earnings recovering some of the earnings lost from the energy producing companies.
Equity markets remain fairly valued, being neither cheap nor expensive. Markets that are fairly valued, with average economic growth (2.0% - 3.5%) should see stock prices increase close to the long term average of 7 - 8%. S&P 500 returns were flat during the quarter, but this follows positive returns in every quarter of 2014. The S&P 500 appears to be consolidating last year's gain resulting in a churning type of market. The volatility in the first quarter is probably a good indication of what to expect for the remainder of the year.
With the Fed on the cusp of its first interest rate hike in many years, we would expect that stock volatility will increase. While there has been significant analysis of when the Fed will institute the first rate hike, there has been little discussion as to the type or timeline for subsequent rate hikes. We believe that interest rate hikes will be at a measured pace (0.25% per rate hike) and continue at a slow and gradual pace. We anticipate the Fed's future action will be data dependent. If the economy continues to experience strong growth, rates will continue to increase. If growth lags, rate increases will be put on hold. We do not believe that rate hikes will cause major problems for the economy or the financial markets as interest rates are currently near zero. A cumulative rate increase of 1.0% will still leave interest rates below what is considered to be neutral and will remain economically stimulative.
The Bank of Canada lowered the overnight lending rate in January by 0.25% due to a sluggish economic outlook related to lower oil prices. The rate cut took everyone (including us) by surprise, resulting in strong bond returns in the first quarter. Our current thoughts are that the Bank of Canada is unlikely to change interest rates in the short-term. With the current low level of interest rates, bond returns will remain in the low single digit range.
US dollar strength should persist, albeit not to the same degree as the last four months. US GDP growth is stronger than Canadian GDP growth and this situation should continue through the remainder of 2015. The US economy is benefiting from accelerating job growth, stronger US auto production and increased housing activity. Canada on the other hand is facing economic challenges from a combination of layoffs associated with lower oil prices and a peaking housing market. This potentially leads to higher interest rates in the US with the Bank of Canada having more of a neutral bias on rates.
Depressed oil prices are also impacting the Canadian dollar US dollar exchange rate. Lower oil prices result in less (US $) revenues for energy companies. As Canadian energy producers convert less US dollar revenues into Canadian dollars (to cover their costs), there is less demand for Canadian dollars. The Canadian dollar has been viewed by some financial investors, as a “petro currency” resulting in the dollar moving in tandem with oil prices. Persistent oil price weakness has translated into persistent Canadian dollar weakness. If the price of oil rebounds significantly, there would be a reversal of the recent Canadian dollar weakness. Our ability to predict oil production is limited due to the uncertainly of global conflicts and of OPEC oil quotas.
We continue to believe that stocks are the most attractive asset class, although we expect stock volatility to be higher and stock returns to be lower as compared to the last few years. While stock price variability will increase, we currently do not envision a stock market decline of greater than 10% as economic growth is still positive and stock valuations are not expensive. Bonds will continue to yield positive returns, but in a low interest rate environment, returns are unlikely to be as robust as equities.
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