March 31, 2019

Financial letter, Winter 2018, 46^th edition

It’s time to turn the page!

What a year it has been! Investors will remember 2018 as a year marked by the return of volatility and its impact on portfolio returns, which were far below the 10-year average. This year, none of the asset classes stood out with positive returns, except cash.

Interest rate hikes and signals by the Federal Reserve had repercussions on global financial markets over the course of the year. In emerging markets, the U.S. dollar’s appreciation and the tariff battle between the United States and China caused a domino effect and sent the stock markets into a nosedive. In Europe, the political situation in Italy and Brexit also dragged down European stock markets.

What’s in store for 2019?

Despite numerous concerns, the U.S. economy remains robust, which is good news for the global economy. The most likely scenario seems to still be one involving a stock market rebound in the coming months. There is little chance of a recession in 2019, but growth is expected to slow somewhat. However, the markets anticipated this, which is one of the reasons for their recent decline. According to Desjardins Group, the global economy should grow 3.7% in 2019. Historically speaking, it’s very rare to see negative returns on the U.S. and Canadian indexes two years in a row. In our view, the recent stock market downturn in the third quarter of 2018 was exaggerated, and we anticipate an upward adjustment in 2019. The price-earnings ratios (share prices divided by earnings) on the S&P500 are currently 14x, compared with 18x at the start of 2018. This is a sign that stock prices are currently very attractive and that there will be a correction.

Fixed income

We expect interest rates to continue to normalize in 2019. However, the Federal Reserve may adopt a slower pace than anticipated, given the stock market’s recent downturn and signs of a slowdown for the U.S. economy. North of the border, commodity prices, household debt and inflation will dictate the actions taken by the Bank of Canada.

We forecast key rates of 3.25% in the United States and 2.25% in Canada. Meanwhile, 10-year bond yields should reach 3.60% in the United States and 2.90% in Canada.

As for our fixed income strategy, when we near the end of the expansion period of the economic cycle and the normalization of rate hikes, we will increase the term of our portfolio and reduce the proportion of corporate securities to government securities at the appropriate time. For now, we have opted for a short-term strategy, given the prospects of rate increases in the near future.

Currencies

The U.S. dollar has been trending upwards for the past several months. Markets are still very volatile, which continues to buoy the U.S. currency somewhat due to its safe-haven status. The pace of monetary tightening in the United States was a major source of concern on the markets in the fall. The Federal Reserve finally ordered another interest rate hike in December, the year’s fourth, but is signalling slower tightening for 2019.

The Canadian dollar is continuing on its downward trend that began in early October and is currently trading below the US$0.75 mark. Fresh concerns have surfaced lately about Canada’s economy. Domestic demand was lower than expected in the third quarter and the short-term outlook is still clouded by the recent drop in oil prices. The Bank of Canada’s rhetoric has also changed drastically since October. It is now less eager to normalize its monetary policy as a result of the new risks that have emerged in the Canadian economy. Rising oil prices and the narrowing gap between Canadian and U.S. oil prices, due to measures taken by the Alberta government, could boost the value of the loonie in 2019. Desjardins Group forecasts that the CAD/USD exchange rate will fluctuate between $0.75 and $0.77 in 2019.

Investment strategy

We adopted a cautious investment strategy in 2018, which we will maintain in early 2019, given the volatility of the markets. Discretionary portfolio management enables us to act quickly for all our portfolios, which is a key advantage in the current climate.

Here are a few of our accomplishments with regard to managing volatility in our portfolios in 2018. First, we have maintained an overweight position in cash (liquidity) and an underweight position in stocks since September. Second, our cash balance in U.S. dollars proved to be a wise choice due to the increase in the greenback’s value during the recent period of market turbulence. Third, during interest rate hikes, long-term bonds generate negative returns, which is why the average duration of bonds in our portfolios is two years.

As we kick off 2019, we are remaining cautious by maintaining an underweight position in stocks and an overweight position in cash. We will wait for a clearer signal by the markets before freeing up liquidity.

Geographic diversification

We are favouring U.S. stocks, as we anticipate that the pace of U.S. economic activity will remain higher, as it is supported by fiscal and budgetary expansion. U.S. households will continue to spend, as the United States has achieved full employment, wages are up and the price of energy is extremely low. Recent fears felt on the stock markets have pushed down rate hike forecasts, which could be beneficial for the stock markets.

We are maintaining our strategy regarding exposure to Canadian companies. The labour shortage and improved working conditions will continue to benefit consumers, but they will be overshadowed by high debt levels and low savings rates. Higher oil prices due to controlled supply and the implementation of railway lines to export surplus oil will bolster the Canadian economy. The elimination of uncertainty over trade with the United States should spur investments and exports. Furthermore, we are nearing the end of an economic cycle, which usually pushes up energy and commodity prices. This could benefit the Canadian economy, whose performance has been less than stellar in recent years. All of these factors could help push the Canadian dollar up to $0.77.

We are maintaining an underweight position in Europe. Since the start of 2018, we have seen a deterioration in several economic indicators for the euro zone. The global economic slowdown is being felt in Germany. The outcome of Brexit remains unclear and is hurting the British economy, which is going through a period of weak growth.

Conclusion

Volatility is a reality that investors must come to terms with and get used to. One of the most crucial parts of our job is ensuring that every investor has a portfolio that reflects their age, investment horizon and risk tolerance. For example, as an investor ages, their portfolio will contain fewer stocks, as their investment horizon is shorter in order to recover losses in the event of downturns.

We believe that actively managing your investments will help you mitigate the effect of declines, such as the one we are currently experiencing, and maximize long-term returns.

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.