July 25, 2018

Financial letter, Summer 2018, 44^th edition

The wind shifted in the second quarter...

The volatility that was absent last year has been shaking the financial markets since the end of January. The surge in volatility has given investors more insight into their real tolerance for risk, which is essential in the investment world.

This volatility is being generated by several factors: the bunker mentality (protectionist measures) that is hurting international trade, U.S. and European policy, geopolitical tensions, oil prices and the direction of interest rates.

Despite the background noise, financial and economic conditions remain favourable. Given the general dynamic, and expectations of fiscal expansion in the U.S. this year and next, the IMF is now forecasting global growth of 3.9% in 2018–2019. Tactically, this landscape is good for equity. Progressive monetary policy adjustments in the major industrialized nations will lead to interest rate normalization (gradual increase) from now until the end of the cycle, which creates a context that plays against bonds.

Interest rates

The bond market continues to normalize (gradual increase) in both Canada and the United States. After bottoming out at 1.37%, Canadian 10-year bonds hit a high of 2.53% on May 17, while 10-year Treasuries (U.S. bonds) went from 2.04% to 3.22%. One more increase to Canada's policy rate is anticipated in 2018, with two more to come in 2019.

Currencies

The U.S. dollar will continue to shine due to the economic and monetary misalignment between the industrialized nations; it is up almost 4% against the Canadian dollar since the start of the year. According to Desjardins Group forecasters, the loonie will end the year at around 75 cents U.S. NAFTA talks could alter this scenario. If a dialogue of the deaf causes the trade negotiations to skid, Canada's economy could lose its momentum, while the loonie could fall to 70 cents U.S. The United States represents approximately 80% of Canada's total exports, which has a big influence over the negotiations.

Our portfolio strategy

Our reading of the broad economic and financial landscape is positive in 2018–2019, and even into 2020. As a result, it is characterized by some optimism while remaining selective over a 12- to 18-month horizon. In fact, the tactical asset allocation is overweight in equity, particularly U.S. equity, but underweight in fixed-income securities. Volatility will be an integral part of the equation until this cycle winds up.

Caution is in order on the fixed-income side. One way to limit the impact of rate increases on the portfolio involves altering the allocation of maturities. Our average maturity is 2.25 years at this time. In other words, this means we could sell off some bonds with no capital loss, and replace them at a better rate, at any time. Moreover, in June, we lowered our weight in preferred shares due to the uncertain economic climate in Canada being generated by the NAFTA negotiations and the negative impact they could have on this asset class. We could, however, increase the weighting if the uncertainty dissipates. One premise continues to be that fixed income is the secure portion of the portfolio, which acts to protect the portfolio in the event of a market downturn. We still prefer risk taking with equity rather than fixed-income securities.

Sector allocation

In equity, we are maintaining a positive position in the financial sector, and neutral position in industrials. We are still underweighting the consumer sector. However, Alimentation Couche-Tard's recent pullback gives us an opportunity to acquire shares. We are also underweighted in the natural resources sector due to the difficult-to-sustain surge by Canadian energy securities.

Although the rise in interest rates is negative for utilities and real estate trusts, it is otherwise for the remainder of the rate-sensitive securities niche. Insurers and banks are usually the big winners in such circumstances.

Geographic allocation

Canada (underweighted)
Like many industrialized nations, Canada's economy slowed in the first quarter. According to the Bank of Canada, "elevated household debts make the Canadian economy more vulnerable to events that could affect growth and financial stability." Households' vulnerability to interest rate changes will moderate consumption and the economy. For now, full employment and the rise by wages seem to be offsetting the impact of interest rate increases on household balance sheets. We are currently underweighted in Canadian equity.

United States (overweighted)
Given the economic and financial environment, we can anticipate economic growth (GDP) of 2.8% in 2018 and 2.5% in 2019. The adoption of expansive fiscal policy (tax cuts) will add about 0.5% per year of stimulus to economic activity until the end of 2020. This measure will help prolong the cycle, but make the Federal Reserve's (Fed's) job harder. An economy that is almost at full capacity, a job market with full employment (in April, 6.7 million jobs were vacant, while 6.4 million workers were available) and a high consumer confidence index mean we are overweighted in U.S. equity.

Europe (underweighted)
Europe is facing a variety of challenges, with Brexit and the Spanish and Italian political situations in the lead. Brexit could cause the United Kingdom to implode if Northern Ireland, Wales or Scotland decided to jump the U.K. ship and head for the European Union. Spain and Italy are an umpteenth challenge for the euro zone. For one thing, the Spanish political landscape was marked by a change of prime ministers in May; for another, populism is surging in Italy. Italians could go back to the polls for what could be a referendum on the euro.

The Italian drama is packed with plot twists! The problems plaguing the country are structural, affecting demographics, productivity and public finances. The population is ageing and would benefit from some rejuvenation. Productivity has been on the decline for some 30 years. For these reasons, we are currently underweighted in European equity.

Conclusion

Since 1950, recessions have materialized 28 months after the real economy exceeded capacity. According to Credit Suisse, the U.S. economy and job market are already above capacity, pointing to a recession starting in the second half of 2020. It is thus too soon to adopt a prudent strategy in equity, but we must keep in mind that we're in the eighth inning of a baseball game that started on March 9, 2009. Day after day, we continue to pinpoint and listen for any signals that could augur the onset of a recession and therefore a bear market.

Volatility will remain an integral part of the cycle until it ends. In the last three and five years, most investors have reaped results that outstrip all reasonable expectation. The pendulum is now swinging back toward normal. The second half of the year promises to be packed with opportunities and investment options, as well as uncertainty and anxious moments. Standing pat is not a viable option for investors who want to hit their long-term return targets, especially with bond markets on the way to normalizing.

We hope this information will help give you a better understanding of the markets. Feel free to contact us for a more in-depth discussion of our investment strategies. We are committed to working ever harder to find solid opportunities in the financial markets, so as to help you reach your long-term goals.