April 20, 2018

Financial letter, Spring 2018, 43^th edition

Volatility unseen in 2017 is part of the equation in 2018

2017 closed with excellent returns and low volatility. 2018 began in the same vein, with most North American indexes reaching new highs in January. February and March however marked a break in the cycle and saw a return to volatility. The first signs were seen in early February, with the release of employment statistics showing hourly wages rising by about 3%. A few sessions later, the market experienced its first 10% decline since early 2016. True to form, it quickly rebounded. A second volley followed on the heels of the U.S. President’s protectionist statements, and was exacerbated by revelations about Facebook collecting user data. Markets turned upside down again and have been struggling to recover.

While fluctuations of this kind are not uncommon, they have been more tempered in recent years. That said, since 1950, markets have experienced more than 20 corrections of 10% to 20% in a bull market, resulting in average drops of 13% lasting about four months, i.e., time it took for the market to recover.

The real question is whether this is the beginning of a full-blown bear market or just a transitory downturn. In the first case, we would minimize our equity exposure and accumulate long-term government bonds. In the second case, we would take advantage of opportunities to redeploy some of our accumulated cash.

Current low unemployment figures and a relatively strong economy are usually associated with an uptick in inflation and a more restrictive monetary policy. However, inflation remains low and monetary policy is still largely accommodative.

Millions of U.S. households will see their 2018 incomes boosted by bonuses and wage increases announced at the beginning of the year, following tax cuts and tax holidays on repatriated foreign earnings. The windfall is expected to sustain household confidence and spending. In 2019, the economy is expected to benefit from infrastructure investment and accelerated business investment. Therefore, the odds of a recession in the next 18 to 24 months are low.

That’s why we believe we are witnessing a short-lived correction in a bull market. The main underlying risks are the rate of wage and inflation growth, the bond market’s response to the Fed’s intervention plan, White House decisions, protectionism and geopolitics.

Protectionist measures over intellectual property rights being considered against China are a source of concern. However, our experts believe China will favour de-escalation and negotiation over aggressive reaction and a potential trade war.

Interest rates

The Bank of Canada (BoC) has raised its key rate three times since last July, bringing it to 1.25%. Additional rate increases will be needed if the economy continues to improve and inflation exceeds 2%. However, the BoC is showing restraint and patience considering the economy’s sensitivity to interest rates (namely with respect to household debt and the housing sector) and uncertainty surrounding trade negotiations with the United States.

We anticipate a gradual rise in interest rates in 2018. The two-year and ten-year U.S. bond rates will be in the 2.50-2.75% and the 3-3.25% range, respectively. Canadian two-year and ten-year bonds will vary between 2.25 and 2.40% and 2.50 and 2.75%, respectively.

Currencies

The White House's trade policy will set the tone for the U.S. dollar. With protectionism and tariffs being inflationary, the Fed may be forced to tighten monetary conditions more quickly, which would favour the rise of the dollar.

The Canadian dollar will remain dependent on the BoC, the spread with the Fed, oil prices and trade negotiations with the United States. NAFTA is a major concern. According to the Conference Board, the end of the North American Free Trade Agreement would result in a 0.5% drop in GDP and 85,000 job losses the following year. Desjardins Group economists estimate the Canadian dollar could then slip to around 70 cents U.S. At the moment, we estimate the likelihood of NAFTA being revoked at 30%. The Canadian dollar is expected to move within a range of 75 to 80 cents U.S. by the end of the year.

Portfolio strategies

Since we deem the disruption to be a temporary correction in a bull market, our strategy is to deploy cash at the right time. In February, we invested in the Canadian market, which had fallen sharply since the beginning of the year and lags behind other G7 countries in terms of 2017 returns. We still have cash available to take advantage of these erratic market movements.

We will maintain an overweight position for interest-rate sensitive securities and pursue a short-term bond management strategy for fixed income (on average two years in our portfolios). Preferred shares are the right investment for generating returns during periods of rate increases.

Geographic allocation

Our interpretation of the economic and financial situation worldwide remains positive. According to Desjardins Group, the world economy will grow by 3.8% in 2018 and 3.9% in 2019.

We continue to overweight U.S. equities. Tax reform, corporate earnings and near-full employment are driving the U.S. economy. The current correction improves valuation multiples. In other words, lower prices make stock purchases more attractive.

In Canada, domestic demand will continue to be the engine of the economy. Household debt and the housing market need to be monitored, but as long as job creation is dynamic, borrowers will be well positioned to meet their financial obligations. NAFTA will be front and centre in the short term. Also, low oil prices are unfavourable to the western provinces and therefore detrimental to overall Canadian growth. Two more key rate hikes are expected in 2018, and three more in 2019. Economic growth of 2.1% and 1.9% respectively is forecast for 2018 and 2019. This is why we are underweight in Canadian equities.

Sector allocation

We still favour tech and finance overall. While securities in the technology sector have jumped 88% since 2014, compared to 26% for the rest of the market, tech stocks are trading at a ratio of only 2.8 points higher than the S&P 500 (20.6 versus 17.8). By December 1999, the gap was 20.2 percentage points. Yet the technology sector is far more profitable than the overall S&P 500 and has been growing steadily since the late 1990s. Financials stand to benefit most from a robust economic cycle, improved credit securities and anticipated interest rate increases. We remain cautious with respect to natural resources and the consumer sector.

Conclusion

While current conditions don’t signal an end to the bull market, future returns are expected to pale compared to recent years and higher volatility can be expected. Generating a 5% return on a balanced portfolio will be a challenge with the bond market generating low return given the rising interest rates.

Behavioural finance teaches us that emotions can lead to impulsive and irrational decisions. But managing emotions and impulsiveness is not easy. A sound investment strategy that is aligned with an investor’s individual profile and focuses on long-term investment objectives and targets is more important than ever.

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.