Financial Letter Second Quarter of 2018

Market review

By Louis Lizotte, CFA, FRM, Vice President, Investments, FERIQUE Fund Management

PRINTER FRIENDLY VERSION

Source: MSCI

Sources: Bank of Canada, St.Louis Fed, U.S. Energy Information Administration

 

 

SUMMARY

It was a disparate quarter in terms of performance: returns were appealing for Canadian and U.S. equities, positive but low for Canadian bonds and shaky for emerging markets.

Quite simply, we have a tug-of-war going on: 

  • On the one hand, the global economy is still being supported by accommodative central banks, expansionary fiscal measures and record corporate earnings (an average increase of 25% in the first quarter for the S&P 500 Index).
  • On the other hand, the protectionist political rhetoric is taking on an increasingly worrisome tone.

We have frequently referred to the Goldilocks scenario that prevailed in 2017. 

In the first quarter of 2018, the renewed volatility on the markets was to great extent caused by expectations that overheating would bring the idyllic situation to an end. In brief, economic growth was expected to cause inflation, prompting the central banks to restrict monetary conditions by raising interest rates, which would cause price adjustments for the various asset classes.

In the second quarter, it was the opposite that gradually occurred on the markets, as various events led to a cooling of expectations.

We must bear in mind that the 2017 results were driven by such factors as the peak of accommodative monetary policies and an oil price that had been low since 2015. 
The higher oil price and the rising U.S. dollar, the political situation in Italy and, of course, the uncertainty caused by the threat of tariffs imposed by the United States have begun to weigh heavily on the markets.

 

Source: FERIQUE Fund Management
Note: Conservative and Aggressive Growth Portfolios don’t have a year of historical data.

RESULTS AND EXPLANATIONS

Canadian and U.S. interest rates were up slightly in the second quarter of the year although they were down in Europe. This reflects the struggle between overheating and cooling referred to above. As the U.S. Federal Reserve (Fed) continued the “beginning of the end” of its accommodative monetary policy, the Bank of Canada played it safe in the second quarter.

The Fed raised its rate for the second time in June but the Bank of Canada opted for the status quo. As for the European Central Bank, it set a schedule for the completion of its asset purchases. 

In this context, the FÉRIQUE Bond Fund returned 0.4% on the quarter. As for the Diversified Income Fund, it returned 0.2%.

OUTLOOK AND ISSUES

The Bank of Canada is demonstrating patience and, above all, determination not to cause any disturbance. Risks remain in the level of household debt and real estate, especially in the large cities. The uncertainty over NAFTA is also a reason to be extra cautious. Even so, the Canadian dollar continues to be slightly undervalued and the economy is faring very well. The Bank of Canada confirmed this scenario by raising its key rate on July 11. 

RESULTS AND EXPLANATIONS

The Canadian stock market, as measured by the MSCI Canada Index, returned 6.8% in the second quarter. As we said in our previous newsletter, the Canadian market was due for a rally. Despite the difficult NAFTA renegotiations, the strong oil price buoyed our market, which was among the best performing during the quarter. 

OUTLOOK AND ISSUES

All sectors of the Canadian stock market recorded positive returns in the quarter. The sector that contributed the most to these solid results is Energy, as the Canadian oil price was subject to the usual differential of about $15 a barrel in relation to the American barrel price (WTI).  Even though the big names (Suncor and Canadian Natural Resources) led the way, the returns within the sector were generally positive.  

That being said, the oil price will most likely be volatile in the months to come. The current price is high enough for U.S. shale producers to again become a factor, given that their floor price is $50 to $55 a barrel, and OPEC would like to increase its output. As well, production is down in Venezuela and Iran. Above all, the United States is openly encouraging its major partners to boycott Iranian oil. In response President Hassan Rouhani hinted at the possibility of blocking the Strait of Hormuz, which about 20% of the world’s oil output passes through. 

As an asset class, Canadian equities still have potential. On the basis of the average stock market valuation, our market is not considered expensive. As well, in a context of sustained economic growth, our Energy and Materials sectors could generate attractive returns. If the scenario of an economic slowdown becomes more concrete, the solidity of Canadian banks, which have made massive investments in the United States in recent years, as well as the country’s economic stability, will offer Canadian equities a degree of protection.

RESULTS AND EXPLANATIONS

South of the border, the Information Technology sector again led the way, followed by the Energy sector and the Consumer Discretionary sector.  

Why Consumer Discretionary? Amazon, of course! With a 45% return (in U.S. currency) since the start of the year and a weight of about 2.6% in the MSCI United States Index, it is the company that contributed most to the advance of the U.S. benchmark index. Amazon’s strength brought its price-earnings ratio for the past 12 months to a “modest” multiple of more than 210x. It is clear that whether or not a portfolio holds this security has a major impact on its results.

In United States, the U.S. stock market returned 5.6% (MSCI United States Index in Canadian currency). The loonie’s weakness against the greenback increased the return by more than 2.0%. 

US Market (MSCI USA (USD))

Source: MSCI

OUTLOOK AND ISSUES

The U.S. economy is thriving and inflation is persisting at a slow pace. 

The U.S. Federal Reserve is now calling for a total of four increases in its key rate in 2018, in line with consensus expectations.  

Fundamentally, tariffs are inflationary and the risk is that their escalade will affect global output. Global supply chains are highly integrated, so even though the tariffs imposed by the United States are aimed at China, they will affect businesses around the world, including U.S. companies. The result will be a clear weakening of global growth and additional inflationary pressures.

Ultimately, the Federal Reserve could be confronted with the need to continue raising its key rate to contain inflation in the context of an economic slowdown. It would be anything but a winning combination.

Another important factor is that the favourable economic situation in the United States, combined with the spectre of tariffs, has finally pushed the U.S. dollar up, a consequence that had been expected for some time. 

 

Currencies vs USD

Source : MSCI

The consensus about the U.S. market is that it has reached the end of the cycle. This is not necessarily the best time to take on additional risk, but it is historically a good period for stock market returns. The unemployment rate is at its lowest level in 18 years. Critics will say that this indicator excludes people who have stopped looking for work, but the demographic situation has played a role. Moreover, recent figures show that former workers are returning to the job market, confirming the strong demand for labour.

This environment is highly positive for confidence and will enable the U.S. economy to stay on its growth trajectory for some time. As for the U.S. dollar, its recent strength is normal in the circumstances and it should remain at its current level.

In conclusion, BCA Research has pointed out that the tax and tariff measures put in place by President Trump contradict his political rhetoric. Stimulating an economy that is already in good health will put upward pressure on consumer demand, which will increase imports, which will cost more as a result of the tariffs. An overheating economy and rising inflation will prompt the Fed to raise rates more quickly, thereby pushing up the greenback – all of which will produce a higher trade deficit! It will be interesting to hear the explanations during the 2020 election campaign.

RESULTS AND EXPLANATIONS

 During the quarter, the strength of the Canadian dollar, in particular against the yen (1.9%) and the euro (3.3%), reduced the returns generated by these regions.  

 

The MSCI Europe Index, the MSCI All Country Asia Pacific Index and the MSCI Emerging Markets Index returned 1.0%, -1.3% and -6.0% respectively.

OUTLOOK AND ISSUES

In May, another political crisis arose in Europe, when it appeared that Italy’s coalition government would collapse, sending Italians back to the ballot boxes. Gains by Eurosceptic parties were a source of concern. This situation caused global investors to adopt a defensive stance and long-term interest rates to fall in most of the European countries. The other worrisome development in Europe is the strong appreciation of the euro in 2017. The quarterly data seem to indicate a slowing of economic activity, which was detrimental for the financial sector in particular.  

The following graph shows the various purchasing managers’ indexes. It is not necessarily cause for concern, because the indexes are still above 50, but just the same it shows a reversal of the generally upward trend that had prevailed since mid-2016.

Global Manufacturing PMIs

Source: BCA Research

Emerging markets were shaken during the quarter.

U.S.-China trade hostilities officially began. An initial series of tariffs on some Chinese imports took effect in the United States on July 6. The Chinese retaliated with similar measures.

Even so, the Chinese will not be able to pursue this game of escalation because the Americans import $500 billion of goods from China, which imports only $130 billion of goods from the United States. The Chinese leaders will have to opt for other measures if they want to maintain a reciprocal strategy; they could reduce the level of imports by means of quotas or administrative roadblocks or depreciate the yuan to offset the tariffs.

Surveys show that President Trump’s approval rating has increased since he took a hard line on tariffs, especially among his voter base, so it would be surprising if he changed his tone before the mid-term elections in November.

Apart from China, which is being targeted directly, emerging markets as a group had a trying quarter. Generally speaking, they are very sensitive to international trade. Moreover, they still have a significant amount of debt denominated in U.S. dollars. Thus the combination of the start of decelerating global exports and an increase in the greenback is negative for them. 

Obviously, this asset class is not homogeneous and the U.S.-dollar-denominated debt is less worrisome than it was in the past because many countries have accumulated significant foreign currency reserves.  

It is essential to be selective with this asset category, which offers good opportunities for long-term investors. 

Approval Rating Among Republican Voters

Source: Gallup and the American Presidency Project, University of California
*Includes: Bush Jr., Bush Sr., Reagan, Nixon, and Eisenhower. President Ford is excluded because he was not inaugurated.
**Includes: Obama, Bush, Clinton, Bush Sr., reagan, carter, Nixon, Kennedy, and Eisenhower. Presidents Ford and Johnson are excluded because they were not inaugurated.

 

Conclusion


As always, it’s not easy to make sense of the situation. 

The end of the Goldilocks scenario as a result of overheating assumes continuing economic growth supported by expansionary U.S. tax measures. It would also involve a change of tone concerning tariffs. In this context, the asset classes that are most sensitive to growth (European, Asian and emerging markets equities) should continue to perform well.  

In contrast, if the Goldilocks scenario ends because global growth and corporate earnings level off, combined with a rate increase by the Federal Reserve and higher tariffs, the more defensive asset classes (money market, high-quality bonds and U.S. equities) will outperform. Hence the importance of a diversified portfolio!

In conclusion, as Michael Cembalest of JP Morgan Asset Management has pointed out, trade deals are like Chinese handcuffs; they look easy to get out of until you start pulling on them.  

Cheers!

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