September 30, 2018

Financial letter, Fall 2018, 45^th edition

You never know what will happen from one year to the next

As portfolio managers, we need to be able to tell the difference between signal and noise. This helps us focus on what’s really important: economic and financial conditions, leading indicators, corporate profits, expected returns and risk factors.

We’ve been living in a two-speed world since the start of 2018. While the United States has been in overdrive, the rest of the world has been operating in low gear. The U.S. economy is fuelled by high-octane budgetary, tax and monetary policies designed to boost growth.

Meanwhile, held back by Brexit, U.S. protectionism and the euro’s appreciation between January 2017 and March 2018, Europe has stagnated, with its stock market recording negative performance since the start of the year.

As for China, social changes imposed to heighten domestic demand, structural changes and U.S. protectionism are slowing down the economy, while its stock market also posted highly negative returns.

Economic activity in Canada is robust, especially since the USMCA (formerly NAFTA) is not expected to slow the country’s momentum. However, the Canadian stock market’s year-to-date return is negative.

By structuring our investment process around economic and financial analysis, we have arrived at a positive investment outlook over a 12- to 15-month horizon. This investment cycle has lasted a long time, but it’s still got room to run. Ultimately, it will face the prospect of higher interest rates and a substantial risk premium. Until then, it will be fuelled by the probability of strong corporate earnings growth, especially in the United States. Leading indicators suggest that the U.S. will serve as the world’s economic powerhouse for several more quarters.

There aren’t many signs of impending recession, but it’s hard to believe there will be a major (20% or greater) downturn. However, temporary corrections similar to those experienced in January, February and October are becoming increasingly common. We must stick to our asset allocation and take advantage of these corrections by investing our cash and waiting for the storm to pass. Your asset allocation was designed to get you through good times and bad. Furthermore, it’s worth remembering that an investment’s return is measured over several years, not just a week, a month or even a year.

Currencies

The U.S. dollar will continue to shine until year-end due to monetary misalignment between advanced nations and the U.S. president’s tough trade talk. Meanwhile, the Canadian dollar will continue to be impacted by oil prices and the gap between key interest rates in Canada and the United States. At Desjardins, we believe the loonie will stay within a range of 78 to 80 U.S. cents until the end of the year.

Interest rates

The prospect of higher wages and inflation combined with the impact of protectionist trade policies will lead investors to align themselves with the Fed’s forecasts, causing an overall increase in interest rates by the end of the current cycle. We believe that by end-2019, U.S. 10-year Treasury yields will fluctuate between 3.75 % and 4 %, while Canada 10-year bonds will stay between 2.75 % and 3 %. The signing of the trade agreement could pave the way for Canadian interest rates to be raised at a slightly faster pace than previously expected. Against a backdrop of higher bond yields, we nevertheless expect the Bank of Canada to remain highly cautious and move slowly. We anticipate that, after an increase of 0.25 % on October 24, there will be two more rate hikes next year.

Although growth continues to outpace its potential and the labour market remains at full employment, U.S. monetary policy will be influenced by wages and inflation. The Fed will raise its key interest rate to 2.50 % in 2018 and could follow up with four more rate hikes in 2019, bringing it to 3.25 %.

Portfolio strategies

Overall, macroeconomic conditions are likely to extend the cycle, giving yet another boost to households and businesses. The global economy is expected to grow 3.8 % in 2018 and in 2019. However, we must keep a close eye on U.S. consumers, who will see the cost of imported goods rise. The S&P 500 will maintain its standout performance, but we wouldn’t be surprised if the Euro Stoxx 50 took the lead in 2019. We also expect the TSX to catch up.

We will keep following a conservative bond investment strategy. As the economic outlook improves, interest rate normalization will bring down bond values. This is why we’ve kept our portfolios’ average duration at two years: to minimize the risk of being penalized after a rate hike.

Investors close to retirement could enhance their returns by increasing their exposure to growth stocks and investing in high-quality preferred shares. Floating-rate bonds are another possibility, since they are pegged to interest rates.

Current conditions argue against overweighting Canadian natural resources, as China’s economic slowdown and its trade dispute with the United States do not bode well for the sector. In addition, the Canadian energy sector has been negatively impacted by substantial price differences, an inability to transport its output to market and a lack of confidence among foreign investors.

In short, the economic and financial outlook is still positive for equity, leading us to overweight tech stocks and interest-sensitive securities.

Geographic allocation

United States
The U.S. economy expanded at a rapid pace (4.2 %) in the second quarter. If this trend holds steady, the third quarter could also surprise to the upside. Another unexpected development in this cycle has been the tech sector’s remarkable climb in an environment of relatively weak growth. Although tech company earnings have risen substantially over the last 10 years, profits in other sectors are barely back to where they were before the financial crisis. Higher returns from the tech sector were also responsible for the U.S. stock market’s excellent performance against foreign markets.

Canada
After growing by barely 1.4 % in the first quarter, the Canadian economy climbed by 2.9 % in the second. The banking sector continued to perform well, but uncertainty over the real estate market and household debt remains. In the short term, conditions will remain positive as long as the labour market remains strong. As for energy, the inability to build the infrastructure needed to transport oil to market continues to chip away at investor confidence. In light of this, the Canadian market could post strong returns in some periods, but is likely to continue to lag over the long term. For this reason, we have adopted a neutral weighting for Canadian securities.

The signing of a free trade agreement for goods in North America has eliminated the biggest short-term risk for the Canadian market. Structural challenges remain, but the TSX could still enter a catch-up phase.

Europe
In the second quarter, eurozone economic growth stabilized at 0.4 %. Business investment was bolstered by favourable financing conditions. Residential real estate investment remained strong. Furthermore, the expansion of global activity is expected to continue, which will boost exports from this region. The focus will be on politics (United Kingdom - European Union and Italy - eurozone) and U.S. protectionism, fuelling uncertainty and volatility. The short-term outlook is mixed, but the Euro Stoxx could perform exceptionally well later in 2019. For the time being, we’re maintaining our underweight to European equity.

Conclusion

According to MRB Partners and the Institut Québécois de Planification Financière, a Canadian investor with a balanced profile can expect a 5 % nominal rate of return over a 10-year horizon. This is significantly lower than the 9.03 % and 6.91 % gains returned by a balanced portfolio over the last five and 10 years.

Investors will have to cope with rising interest rates and a decrease in the value of bonds held in the portfolio. However, economic and financial conditions seem ripe for a 5 % to 6 % advance on the major stock markets. The focus should be on optimizing allocation among countries, sectors and styles, as well as exchange rate strategy. Volatility is another factor that investors will need to reconcile themselves to, and even get comfortable with. Early October was a good example of this.

We hope this information will help give you a better understanding of the markets. Feel free to contact us to discuss our investment strategies at greater length. We remain committed to working even harder to identify promising market opportunities to help you achieve your long-term goals.