March 27, 2018

2017 Fourth quarter update

The year 2017 can be broken down into three periods. The beginning of the year (January to June) was noteworthy, with rising stock markets and low volatility. At the end of June, the Bank of Canada changed its tone about the vigour of the Canadian economy. That was good news in itself, but the two interest rate increases that followed (in July and September) triggered a pullback in the bond sector and drove the Canadian dollar up. Then in October, November and December, Canadian rates declined, the U.S. dollar rose, the stock markets rebounded and the much-touted U.S tax reform became law. That’s ending the year on a good note!

In other words, 2017 had its fair share of major financial and economic events. Here are some of them:

• Despite the slow start to the year, the S&P/TSX still rose 922 points (9.08%). While a decent performance in absolute terms, it nevertheless lagged behind most foreign stock exchanges. Ten of the 11 Canadian sectors contributed positively to this growth. The only negative sector was Energy, which trimmed 340 points from the index. Of the 15 worse TSX performances, only one was not related to energy or raw materials.
• The setback-plagued energy stocks were puzzling considering that WTI oil prices advanced by 12.5% in 2017 and by 42.1% since their June low, and even reached a high of $60 on December 29. While oil progressed in the short term, futures contracts maturing in 2025 declined by $4.60 to $52. This inversion of the oil futures curve nevertheless accelerated the drawdown of excess inventories. The price of an ounce of gold remained relatively stable, fluctuating by more or less $100 between January 1 and December 31, 2017.
• Even if the strengthening of the loonie in summer 2017 negatively impacted foreign gains, the S&P 500, the most representative index on the U.S. side, progressed by 13.5%.
• Despite the fact that the Government of Canada’s two-year bond yield rose by 94 basis points and the country’s 10-year bond yield added 33 points, investor appetite for yield did not abate. Corporations took advantage of this windfall to issue a record volume of corporate bonds. At over $115.4 billion, this issue easily surpassed the previous high of $107.4 billion (2013), another sign that supports our scenario of higher yields in 2018.
• In the U.S. bond market, two-year and ten-year rates were going in the opposite direction. While short-term yields rose 69 basis points, ten-year yields fell three points. This flattening of the yield curve caused some bond market experts to wonder if a recession might be near at hand. While the history of the bond market commands the greatest respect, this evolution is likely more attributable to foreign capital inflows than a deterioration of economic conditions in the United States.

 

A solid start to the year

It’s already been 18 years since we celebrated the turn of the new millennium and, along with it, the historic high of the U.S. stock markets at the time, which was driven in large part by the tech boom/bubble. However, it was a rather rude awakening for a number of investors who believed the upward trend would last indefinitely. This “irrational exuberance” (a term popularized by Alan Greenspan, the then-Federal Reserve Board Chairman) affected many investors who, like thrill-seeking teenagers, were compelled to take ever-greater risks and seek returns “at any price”. This year, children born in the year 2000 will reach the age of majority, an age not necessarily synonymous with maturity, which is defined in some dictionaries as the ability to reason and make sound judgments (associated with age).

After a few years of seeing portfolios generate returns beyond all reasonable expectations, will investors be inclined to go against nature and become bolder? Or will excessive caution rule their decisions?

What we do know is that 2018 is starting off on a relatively solid footing from an economic standpoint and that we’re in the middle of the second phase of the longest expansion in modern history. Growth is broadening worldwide and there are no signs, at least for the time being, that an economic downturn will occur. What’s been particularly positive since the crisis is the continued robustness of the economic data. Fortunately, valuations are still far from the multiples achieved at the beginning of 2000, when the longest phase of economic expansion in modern times ended.

Because our role consists, now and always, in preserving capital over the long term, we sometimes need to temper our clients’ expectations and, more importantly, avoid being complacent in our investment choices. This involves clearly identifying, as we did last year, the various themes that we will be focussing on over the next quarters.

Below is a summary of these themes:

1. Normalization of interest rates, currency and inflation

   After seeing the Bank of Canada follow in the footsteps of the US Federal Reserve by implementing two successive interest rate hikes, it will be interesting to see how our big banks will respond. Chances are they will adopt more of a wait-and-see attitude and keep an eye on what our American neighbours do over the coming months. The rise of the Canadian dollar, following the hikes implemented in Q3 2017, has tempered the eagerness of the Canadian authorities somewhat. If oil, supported by solid economic data, continues its rise of the last few weeks, it could exert upward pressure on our currency. The increase expected at the beginning of 2018 (the third since July 2017) seems to have already been taken into account by the market. However, we believe that in the coming quarters, the Bank of Canada will exercise caution in its rate normalization policy by keeping close watch on what the US Federal Reserve does.

   Increasing rates again before our neighbours to the South would put added pressure on our currency, a bold strategy given the uncertain context of NAFTA.

   We need to keep in mind that in a context of rising rates, the bond portion (fixed income) of portfolios undergoes certain adjustments. Because of this situation, return expectations for this asset class are much more modest. The bond component of portfolios limits expected returns due to interest rates, which are already extremely low. The current weakness of interest rates poses an imminent risk for portfolios with a strong bond component. It remains to be seen by how much and how frequently central banks will increase rates. The answer to these key questions may lie in how quickly inflationary pressures manifest themselves.

2. Tax reform and corporate profit growth

   The highly-touted U.S. tax reform may be a double-edged sword for stocks markets. The tax relief offered to businesses should help grow their profits. As the growth posted in the last quarters is due largely to higher price to earnings ratios (supported by the drop in interest rates, weak inflation or the absence of volatility on the markets), it is essential that corporate profit growth take centre stage in the near future. With P/E ratios currently surpassing their historical long-term average in some regions, it is highly unlikely that higher market valuations will be enough on their own to support a stock market rally.

   Currently, the changing outlook for the domestic economies of several regions around the world favours profit growth (higher public spending, more flexible regulations, rising inflation, repatriation by U.S. corporations of liquid assets held abroad, etc.). Given current valuations, we remain conscious of the fact that markets could undergo a correction if profits were to fall short of expectations. The risk is significant enough for us to mention it in this newsletter early in the year.

3. Canadian challenges

   NAFTA
   Many Canadian observers welcomed the approval of the tax reform proposed by the U.S. president. For the Trump administration, it couldn’t come at a better time, not because the U.S. economy really needed it, but because the new tenant at the White House could finally claim credit for something resembling an accomplishment. In this context, can we expect greater flexibility during the NAFTA renegotiations? It’s hard to say. This file deserves our full attention and we will be watching it closely. NAFTA discussions could cast a bit of a pall over the Canadian economy.

   Real estate and household debt in Canada
   In its mid-year quarterly report, the Canada Mortgage and Housing Corporation (CHMC) reported that the Canadian real estate market was still showing “strong evidence of overall problematic conditions”. There is a gap between supply and demand in both the rental and new home markets. That situation is all it takes to drive prices up, create overvaluations and cause this major sector to overheat. Gradual rate increases may be what we need to put an end to this period of “irrational exuberance”. Caution is advised.

   What can we say about Canadian household debt? In an interview conducted last September, Laura Cooper, a Royal Bank economist said: “A decline in household net worth, albeit modest, alongside a sharp increase in consumer credit growth are notable as together they suggest that the ability of households to absorb higher interest rates continued to deteriorate.”

   When the Bank of Canada increased key rates in July 2017, the major Canadian banks responded by hiking their prime rates, which are used to set rates for variable mortgages and other types of loans. Fortunately, we have a healthy labour market, which means households can still count on a source of income and job security. Provided that Canada’s unemployment rate remains low, that the Central Bank gradually normalizes rates and that the real estate market bubble doesn’t burst, we should be able to avoid a scenario similar to the one in the U.S. As for the rest, only time will tell.

   Geopolitical tensions
   “What more can we say on this subject? Hoping that tensions between key economic and political players worldwide will abate at this stage is wishful thinking. Perhaps the first step towards improving the climate might be to ban all elected presidents from using “Twitter” to vent their feelings.”

   These last lines from our January 2017 financial newsletter still apply. It will be interesting to see what reconciliations might be possible as we get closer to the 2018 Olympic Games in South Korea. However, it would be surprising if tensions between Trump and his counterpart in North Korea were to end. After all, they’ve taught us to expect erratic behaviour. We are not building our portfolios on a bet that war will break out. If that was our prediction, all positions would be liquidated and the only asset left in our portfolios would be cash. Nonetheless, we do need to acknowledge and accept the fact that volatility might return if a diplomatic mishap were to occur. The saga continues.

   In the 18 years since the turn of the new millennium, we’ve lived through a number of rebounds and witnessed some dramatic events. This type of context doesn’t make the investor’s job easy but it does provide a great learning opportunity for those just out of university who are being courted by the world of finance. My colleague Frédéric Gingras and I cut our teeth and grew up in this environment. Over the years, some highly skilled and passionate people have joined our team to make it what it is today: Gingras-Barrette Group. Our team is very proud to participate in the management of your financial assets and looks forward to being of service for many more years to come. We acknowledge, appreciate and thank you for your trust.

As this new year begins, we would like to wish you and your loved ones a year that lives up to all your expectations!