April 19, 2017

Financial letter, Spring 2017, 39^th edition

A good start

The year 2016 started poorly but ended well. The positive momentum of late 2016 carried over into the first quarter of 2017. Is the strong early-year performance entirely attributable to Donald Trump? That explanation might be a bit simplistic...

We are optimistic about 2017, although there are several risks on the horizon. Historically, an investment cycle ends for one or more of the following reasons: recession, monetary or budgetary shock, soaring commodity prices, a surge in inflation or excessive valuations. At present, none of these factors is in place. It is true that price-earnings ratios are high, but they are far from the levels seen before the crashes of 1929, 1987 and 2000.

While the U.S. Federal Reserve (Fed) will continue to normalize its monetary policy (increase in the benchmark rate and trimming of the balance sheet), and while it is likely that the budgetary and fiscal measures adopted will ultimately differ from the electoral promises, the stock market will inevitably be impacted by a moderation of investor expectations.

In 2017, the North American bond market will go from a period of falling rates to a period of rising rates. The return potential of bonds

Interest rates

The bond market's transition to a period of rising rates after 35 years of falling rates also bears watching. After its March rate hike, unless the outlook worsens, the Fed will raise its benchmark rate twice more by December, bringing it to 1.5%.

The Bank of Canada (BoC) will likely maintain the status quo, leaving its policy rate at 0.5% in 2017. We will keep an eye on the tone of its announcements if employment and inflation remain at levels of recent months. The bond market has been in transition since last July. After hitting a historical low of 1.36% on July 8, yields on 10-year U.S. Treasuries reached 2.39% at the end of the quarter. The rise in rates across the entire yield curve is due to an improved economic outlook and higher inflation. Our forecasts call for 10-year Treasury yields of 2.5% to 3% by year end.

Although the BoC's monetary policy will differ from the Fed's in 2017, our bond market will nevertheless by influenced by U.S. Treasuries. For 2017, we expect yields on 10-year Canada bonds of 1.75% to 2.05%. The contribution of government bonds to the total return of a suitably diversified investment portfolio could therefore be minimal.

While the BoC has some control over rates of less than two years, the rest of the yield curve remains under the influence of U.S. Treasuries. In light of the situation south of the border, we expect a steepening of the yield curve.

Bear in mind that a bond can lose value until maturity and that duration is a key aspect of portfolio management. In our portfolios, we are therefore opting for an average duration of 3.5 years.

Currencies

Currencies warrant close monitoring. As in 2015, the expected depreciation of the Canadian dollar could increase the return on U.S. investments. We also have exchange rate protection for our exposure in Europe and emerging markets.

According to Desjardins Group, the Canadian dollar will trade in a range of 72 cents to 75 cents US between now and year end. It will be influenced by the asymmetric monetary policies between Canada and the U.S., commodity prices, the evolving conflict in Syria and the situation in North Korea.

Portfolio strategies

In 2017, active management will be a must.

Producing a 5% return in 2017 will not be easy. First, a fair amount of caution will be required in the bond strategy. Then, the equity return will have to be optimized via active management of countries, sectors, styles and company size. Since about 90% of portfolio return variability depends on asset class allocation, sound management of this aspect will be essential.

The overweight cash position in the portfolios is temporary. A healthy stock market correction would offer a good opportunity to buy certain stocks at a discount. There are many possible triggers, but the ones most likely to impact the equity markets are President Trump, the Fed, the bond market, the rise of populism, the political environment, protectionism, Greece, Italian banks, Russia, China and North Korea.

While the outlook for stocks is favourable, the opposite is true for bonds, which will continue to adjust to monetary normalization and expansionary budget policies. Inflation will also be back. In a context of full employment in the United States, a sustained rise in inflation above its long-term target will accelerate the monetary normalization process.

Sector allocation

Considering the current economic cycle, we favour the technology sector and financial services. In the financial sector, we prefer insurers, asset managers and banks. We remain cautious on real estate investment trusts and utilities, which tend to underperform in a rising interest rate environment.

In our last quarterly letter, we wanted to add a position in renewable energies and, accordingly, we bought shares of Algonquin Power. Since then, the stock has risen by more than 10%, while paying an attractive 5% dividend. We remain cautious, though, and are maintaining a low weighting in the resource and oil sectors. The supply of shale oil and gas currently exceeds the demand, which is putting downward pressure on prices. However, everything can change if the military conflicts with Syria and North Korea persist.

Geographic allocation

According to Desjardins Group, the economy will grow by 2.2% in 2017 and 2% in 2018. The improvement of global economic conditions, and particularly the U.S. economy, favours exports, including exports in the resource sector.

If the set of budget and tax policies proposed by the White House is approved, infrastructure projects and tax cuts could propel the stock market to a new high. In the portfolio, we favour an overweight position in the United States, which is why we are maintaining our current U.S. equity weighting. The year 2016 will go down in history as a year marked by high emotion and mundaneness on the economic front, but 2017 looks promising. Consumption will be driven by a strong labour market thanks to the creation of an average of 200,000 jobs since June 2016 and an unemployment rate close to full employment, an increase in disposable income and asset values, and low borrowing costs.

Despite positive tailwinds, the rise of the protectionist discourse in the U.S. bears watching. At the top of the list: the renegotiation of NAFTA.

The economic recovery has taken hold in the euro zone. Fueled by a very accommodative monetary policy, domestic demand, including household spending, is picking up.

However, the rise of populism and Euroscepticism, combined with the difficulties experienced by polling firms in predicting the upcoming elections and deciphering a highly polarized electorate, will bear watching in 2017.

On the positive side, European and emerging economy stock markets are trading at very attractive valuations relative to North American equity markets. We will monitor the imminent elections in Europe very closely so as to be able to adjust, if necessary, the weighting of the portfolio, which is exposed to European companies.

Conclusion

Behavioural finance teaches us that emotions can lead to impulsive and irrational decisions. But managing emotions and impulsiveness is not easy. The virtues of a sound investment strategy that is aligned with an investor's individual profile are discipline, objectivity, caution and sticking to a long-term investment horizon. Monitoring and periodic rebalancing help bring a portfolio in line with its long-term investment objectives and targets.

We hope this information will help you to better understand the markets, and we're at your disposal to discuss our investment strategies at greater length. We remain committed to working even harder to identify good market opportunities in order to help you achieve your long-term goals.