December 29, 2017

Financial letter, Winter 2017, 42^th edition

2017 was a good year!

At the outset of 2017, market outlook and investor judgment were clouded by economic and political uncertainty. The new occupant of the Oval Office—with his unconventional, unfiltered and unremitting communication style—fuelled concern and anxiety. Twelve months later, global economic growth is strengthening and the U.S. economy continues to beat expectations. The financial markets had such a good year that we're now seeing signs of investor complacency.

As we begin the new year, investors are once again worried about the market cycle. More and more analysts are predicting a tactical retreat. And yet, economic and financial conditions are the most positive and inclusive they've been since the start of the cycle. According to the International Monetary Fund, the current economic recovery is more broad-based than any we've seen in the past decade. Like last year, global economic growth could exceed expectations, while industrialized countries continue to benefit from near record-low interest rates and more flexible budget and tax policies in 2018.

The economy continues to grow well beyond the uptick that followed Donald Trump's election. Investors are confident that the policies announced by the new president will lead to further growth. Only time will tell how the new administration's economic policy and protectionist rhetoric will impact the trajectory of the economy.

Currencies

The currency market had another volatile year. The U.S. dollar hit the ground running on Mr. Trump's promises of economic stimulus, but it quickly lost steam. The Canadian dollar rallied on higher oil prices and two consecutive interest rate hikes over the summer. But there could be serious repercussions for Canada if NAFTA is shelved. As Canada's largest trading partner, the U.S. has a ripple effect on our economy. If Washington were to scrap NAFTA, we could see a period of volatility that would dim prospects for the loonie and Canada's economy. The Bank of Canada would have to exercise extra caution and possibly even reverse last year's interest rate hikes if the economy were to become unstable. All eyes will be on the NAFTA talks early this year. Desjardins's economic forecasters expect the Canadian dollar to hover between US$0.75 and $0.80.

Fixed Income

Over time, households, businesses and investors have gotten used to low inflation and interest rates. Canadian 10-year bond yields stand at 2%, which means investors expect inflation to remain below 2% over the next 10 years.

According to Desjardins analysts, the Bank of Canada will increase its key interest rate three times in 2018, bringing it to 1.75% by December. Meanwhile we'll be at full employment with inflation around 2%. However, there are a number of economic and political factors that could influence interest rate decisions. If U.S. inflation were to exceed 2% for an extended period, the U.S. Federal Reserve (Fed) could lose control. To avoid unrest in the bond market and a spike in interest rates, the Fed will have to raise its key rate to 2.25% by the end of the year.

We'll be adopting three main strategies to address gradually rising interest rates and ensure that fixed income securities generate acceptable yields. Firstly, our bonds have an average maturity of 2.5 years, which protects capital in the event of an interest rate hike. Secondly, nearly 40% of our portfolios are in investment-grade corporate bonds and preferred shares. Thirdly, we invest in floating-rate securities such as preferred shares that perform well when interest rates rise.

Portfolio Strategies

We take an active allocation management approach that takes into account asset classes, countries (including the exchange rate strategy), sectors, styles, company size, currencies, maturities and issuers. Maturities are of strategic importance in today's climate.

Volatility is here to stay and must be managed. We recommend a tactical allocation and cautious optimism to reduce the impact of volatility and risk on the investment portfolio.

The length of the economic cycle alone won't trigger a recession. Until the U.S. economy shows recession warning signs, the market will continue to surprise investors as it soars to new heights. However, there may still be occasional downturns, in which case cash will be king.

Given current conditions, we expect the economic and market cycle to continue but recommend a cautious approach to bonds. We predict 2018 will be a good time to overweight equities and cash, and underweight fixed income. Geographically, we recommend overweighting the U.S. and Europe, and taking a neutral position regarding emerging countries and Canada.

We favour interest-sensitive sectors.

Monetary normalization will benefit financial companies that account for over 55% of TSX gains.

In the consumer sector, Amazon poses a direct threat to fewer publicly traded companies in Canada than in the U.S. Since execution is still a differentiator in this niche, it's imperative to limit investments to the top performers.

Surprise moves are common in this sector and you have to be ready to capitalize on them. Last fall we invested in Alimentation Couche-Tard, just the type of solid security you want in the event of a market correction.

We also favour industrials. After years of government austerity, the purse strings seem to be loosening for major projects. This new movement comes as business investment is on the rise. For several years now, large companies have been extremely cautious, buying back shares and paying dividends instead of investing in growth. The tide now seems to be turning. In 2017 WSP and CNR posted returns of over 30% and 15% respectively.

Conclusion

2018 should be another good year, though perhaps not quite as strong as 2017. Investors will face three main risks: a rapid rise in inflation and interest rates, the growing spectre of the end of the cycle, and political and geopolitical uncertainty. Low volatility isn't necessarily synonymous with low risk. Though we don't expect the start of a bear market (downturn of more than 20%), corrections are possible over the next six to twelve months, and higher valuations will leave less room to absorb the losses.

In early 2017, we said that a 5% return wouldn't be easy for investors with a balanced profile. Last year, this profile generated a return of more than 9% (before fees). According to the Institut québécois de planification financière and a number of pension funds, the expected return for clients with a balanced profile is around 5% in today's climate. Hopefully we're proven wrong again this year.

We hope this provides you with additional market insight. We're always available to discuss our investment strategies with you at greater length. We remain committed to working even harder to identify promising market opportunities to help you achieve your long-term goals.