July 24, 2017

Financial letter, Summer 2017, 40^th edition

The loonie takes flight

Without fanfare, the Canadian dollar rose from US$0.7375 in early June to more than US$0.78, an increase of 6.6% against the greenback. The Bank of Canada's change of tone in June and the announcement of the first increase in its benchmark rate since September 8, 2010 are the main reason for this surge. This brings to the forefront the exchange rate's effect on an investment strategy. For example, the year-to-date return of 9.1% on the S&P 500 falls to 3.26% when converted to Canadian dollars.

The impact of the 0.25% rate hike announced on July 12 on the payments on a $200,000 mortgage – whose rate increases from 2.89% to 3.15% – is $25.68 per month. In other words, the equivalent of a coffee at McDonalds from Monday to Friday!

For the governor of the Bank of Canada, this increase is a vote of confidence in households and their capacity to pay. Travellers preparing to leave on vacation will benefit from this exchange rate, which offers a good opportunity to convert Canadian dollars into U.S. dollars or euros!

Interest rates

Unless the stock market undergoes a correction or economic activity slows, the Fed will raise its benchmark rate to 1.5% by December 2017. In Canada, the Bank of Canada (BoC) raised its benchmark rate by 0.25% on July 12, from 0.50% to 0.75%. And the stage is set for a second rate hike by year end.

In reality, the BoC influences rates of less than two years; the rest of the yield curve is subject to U.S. bond yields. With the situation south of the border and improved economic conditions in Canada, we expect a steepening of the yield curve.

Desjardins' forecasts for year end 2017 call for yields of 2.50% to 3% on 10-year U.S. Treasuries and 1.65% to 2% on 10-year Canada bonds.

In light of this gradual increase in interest rates, we are opting for three fixed-income strategies. First, it's important to have a short duration for the bond portion. Second, we are opting for a 35% fixed-income weighting invested in short-term corporate issues. And third, we are investing in floating-rate securities that benefit from rate increases, such as certain preferred shares.

Currencies

According to the economists of many large banks, the Canadian dollar will trade in a range of 74 to 80 cents U.S. between now and year end. It will be influenced by the frequency of rate hikes in the U.S. relative to those made in Canada. Also, the price of natural resources, particularly oil –whose target is US$45 to US$60 a barrel –, dictates the direction of the Canadian dollar. Strong job creation in the country recently boosted the loonie.

The currency market bears continued close watching, since the appreciation of the Canadian dollar hurts the return of investments in the U.S. As for international investments, we are opting for a currency hedging strategy that protects investors against currency risk.

Our portfolio strategy

Over a three to six month horizon, our strategy is marked by cautious optimism. Although valuation ratios are historically high, this does not mean that the U.S. stock market could not become even more expensive. A correction (decline of 5% to 10%) is possible, but the economic and financial outlook favours a continuation of the investment cycle. The S&P 500 Index has not suffered a decline of at least 5% since June 2016 and a drop of 10% since February 2016. Another sign of complacency: the S&P 500 has had only one daily decline of more than 1.5% in 2017. Among a long list of imponderables that could trigger a stock market correction and create investment opportunities are investor complacency, the unpredictability of the U.S. president, U.S. monetary policy, the situation in North Korea, China, Russia and Italy, international terrorism, and a cybershock. Such a pullback would represent an opportunity to invest our cash reserves in the stock market. If a correction occurs on the stock market, buying opportunities would arise and result in a decrease in our cash position and an increase in our equity holdings. Here is the game plan:

• A decline of 3% to 5% on the S&P 500 would result in a first cash reduction of 5%.
• A decline of 7% to 10% would trigger another cash reduction to 5%.

Sector allocation

In terms of sector allocation, we favour interest-sensitive sectors. We prefer financial services and technology, which usually perform well in a rising rate environment. We continue to underweight resources and energy, particularly oil. At present, supply far outstrips demand, largely because of the emphasis on shale oil development in the U.S.

Geographic allocation

Canada

In our portfolio, we are currently underweight Canadian equities. The Canadian stock market's poor performance in 2017 follows a pattern marked by a miserable 2015 followed by an impressive rebound in 2016. Canadian stocks could therefore present a buying opportunity in the coming months. The high volatility affecting the Toronto Stock Exchange once again illustrates the importance of geographic diversification for Canadian investors.

Apart from the uncertainty surrounding the outlook for energy stocks, the main risks facing the TSX are probably the threat of U.S. tariff barriers, the housing market – where prices continue to set new records, particularly in Toronto and Vancouver – and the household debt rate, which is higher than that of our neighbours to the South.

Our significant underweighting of the energy and resources sectors has worked in our favour year to date.

United States

With the high valuation of the U.S. stock market and its outperformance of other global markets in recent years, it is tempting to reduce the weighting of U.S. equities and increase exposure to other regions. Valuation multiples are definitely high, but there is nothing to prevent their becoming even higher. The stock market rally under way since November 2016 is essentially based on the prospect of tax cuts and infrastructure investment in the U.S. If they end up passing, the budget and tax measures proposed by the White House could propel the stock market to new highs. The opposite is also true if the measures announced during the electoral campaign and confirmed by the White House do not garner enough votes in the House of Representatives and the Senate. Generally speaking, the economy, job creation and consumer confidence are robust, which is why we favour an overweight position in U.S. equities.

Europe

In our portfolios, we are currently overweight European equities and we increased our position in the past quarter. Our conclusions are based on the outlook of the European Central Bank (ECB) and the International Monetary Fund (IMF). The economic data confirm that the recovery is gaining strength. Supported by a very flexible monetary policy, domestic demand is fuelling growth in the euro zone.

In 2017, the European market is posting the highest returns, except for emerging markets. Europe has thus shrugged off the concerns that were widespread early in the year, stimulated by promising economic growth and an encouraging French election. Despite their recent performance, European stock markets continue to trade at a discount relative to the U.S. and Canadian markets.

Conclusion

Over the past three and five years, most investors have obtained results that exceed reasonable expectations. However, these returns will be difficult to reproduce over the next three to five years, since the bond component of the portfolios will limit the expected returns because of interest rates that are already excessively low. Note as well that the strong returns of the past 12 months reflect the lows hit in the first quarter of 2016.

Volatility is a reality that investors have to live with and have to overcome. In 2017, producing a return of 5% for an investor with a balanced profile will not be easy. By recommending a tactical allocation and adopting a cautiously optimistic approach, we are reducing the impact of volatility and risk on our investment portfolio.

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.