January 10, 2020

Financial letter, Winter 2019, 50^th edition

Several factors point toward optimism for 2020.

Overall, 2019 was a great year for investors. The year started off with concerns following the sharp decline in the final quarter of 2018. In view of the reduced expectations, the market was surprizing. For the first time ever, the U.S. economy went a full decade without a recession.

In North America, the economy has reached full employment and inflation is approaching its target of "2%". Overall, the economic climate is being buoyed by domestic demand due to consumer spending (consumer confidence supported by job opportunities, rising wages, low interest rates) and residential investment (demographics and low financing rates), while the contribution of businesses is being hamstringed by political, geopolitical and commercial uncertainty. The phase one trade deal with China will boost industrial production and exports within North America and elsewhere in the world. With the impeachment process passing from the House of Representatives to the Senate, President Trump will certainly want to chalk up some more victories before the election, which the markets would love.

Overall, the ground is ripe for economic growth of around 1.5% to 2.0% in the U.S. and Canada in 2020. Monetary policy will remain accommodative. It’s possible that the Fed (Federal Reserve) and the BoC (Bank of Canada) will further increase monetary stimulus, if necessary, with further cuts in interest rates.

PORTFOLIO STRATEGIES

The economic and financial outlook is favorable for an overweight in equities and cash, an underweight in bonds and a neutral position in alternative investments compared to the target. Increased corporate profits, economic growth and TINA (There Is No Alternative) could lead investors to give a higher valuation multiple to equities, which means they’re willing to pay more than usual.

Strategically, it’s still too early to adopt a defensive position in view of an end in the cycle. A rebound in international trade (due to a China-U.S. trade agreement, a stabilized Chinese economy and harmonious relations between the U.S. and the rest of the world) and industrial output (namely in the auto sector), along with positive public action (including budget and tax policies) could give an additional boost to the global economy in 2020 and exceed expectations. Barring any unforeseen shocks, a global recession remains unlikely.

INTEREST RATES AND FOREIGN EXCHANGE

After U.S. rate cuts in 2019, the markets expect central banks to continue with the status quo for the next year. Expectations for economic growth and inflation are positive in developed countries. However, fear of recessions and geopolitical tensions seem likely to remain for the following reasons. The central banks will focus more on easing than on a return to tightening, which will keep rates low. As the Canadian economy is sensitive to global growth, it could take accommodative measures to avoid a higher loonie and decide to cut rates. Overall, the impact of fixed income securities on the investment strategy and the return will be low, but now boils down to the role of the insurance policy.

Unless there’s a significant increase in inflation above 2%, interest rates are unlikely to retest their 2018 high in the next 12 months. If there are any signs of trade tension, the U.S. dollar will fare well, as it acts as a safe haven. The value of the Canadian dollar will depend on the easing measures the Bank of Canada wants to take. Rate cuts would bring the Canadian dollar down.

GEOGRAPHIC ALLOCATION

U.S.

Politically, the impeachment process will be in the forefront in the first quarter. Will Democrats succeed in convincing voters that the president's actions are so egregious that he should be removed from office? The Republican-run Senate will have to adjudicate the charges laid out by the House. If public opinion stagnates at around 50%, the Senate will acquit the president. There’s the possibility of a new budgetary or fiscal plan in 2020, but the Senate will still have to go along. Since the economic cycle continues to be supported by flexible financial conditions, domestic demand will be supported by full employment, wage growth, stabilization of the manufacturing sector, business investment and business leader and consumer confidence. Our scenario consists of an overweight in U.S. equities at 38% versus our benchmark.

Canada

Skeptics will continue to be confused by the dynamic nature of the economy and domestic demand. Monetary policy will remain flexible against the backdrop of the status quo until the BoC can properly assess the combined effect on the economy of full employment, low interest rates and a flexible fiscal policy on household balance sheets, inflation and consumer spending, as well as the international situation. Finding defensive securities is difficult in Canada, as the valuations are very generous. There’s little appetite for the energy sector given the surge in popularity of environmentally responsible investments around the world as well as the political stalemate over pipeline projects. The scenario consists of an underweight of 40% of Canadian equities versus our benchmark.

Europe

In Europe, the expected rebound of international trade and the automotive sector will confirm the positive signal sent by stock markets in 2019. It remains to be seen whether this will be enough to further stimulate economic activity in 2020. Supported by a buoyant job market and a relatively high savings rate of 11%, consumers suddenly helped propel the economy beyond the expectations of forecasters in 2019.

Europe is positioned to benefit from increased world trade and stabilization of the Chinese economy. Not to mention the additional momentum that the recovery in the automotive sector will bring. Newly elected Boris Johnson now has the legitimacy to withdraw the United Kingdom from the European Union. An orderly and negotiated exit seems plausible, but let's not forget how unpredictable British politics can be. We are overweight in European equities (10%) versus our benchmark.

Emerging markets

Emerging markets are also positioned to take advantage of a positive economic and trade backdrop. However, the disparities between countries and stock markets and the rise of the super cycle of debt leaves us unsure about this region of the world. Not to mention the impact of currency movements on the investment strategy. In theory, Asia’s emerging markets have low valuation multiples. While true, in practice, a long list of uncertainties could limit their short-term potential. To be monitored…

China is stabilizing its economy and ratifying a partial trade deal with the U.S. The easing of trade tensions is boosting international trade and exports from emerging markets. The Belt and Road initiative is benefiting signatory countries as investments boost economic growth. We have a neutral weighting (4%) in equities of emerging Asia markets versus our benchmark.

CONCLUSION

Bouts of anxiety and volatility should continue to be ignored focusing rather on the economic and financial backdrop and the leading indicators of recession to take full advantage of investment opportunities. Historically, the S&P 500 index has gone up by 7% on average 3 months before the end of the cycle and by 5% in the last month. And investors have an average of six months after the end of the stock market cycle to change their investment strategy. Selling too early also has a cost, which could very well be negative.

Negative years are rare in the U.S. market outside of recessions or financial bubbles. The backdrop for the next 12 months thereby promises to be beneficial for equities, but there’s little chance of producing results as high as 2019. Best be realistic. As asset allocation is behind 95% of the variability of returns, management is more important than ever. For a balanced investor, a total return of more than 5% is possible in 2020. It will mainly come from equities and, to a lesser extent, bonds. Alternative investments could be options for maximizing a portfolio’s risk-adjusted total return, as could cash holdings. We also believe that the focus on responsible investments is set to grow and we can confirm that it’s becoming increasingly pivotal in our investment decisions.

We hope that this information helps you better understand the markets. Please don’t hesitate to contact us if you’d like to discuss our investment strategies in more detail. We’d like to reiterate our commitment to keep working hard to help you meet your long-term financial goals by seizing the best opportunities offered on the markets.