Half Empty or Half Full?

January 17, 2019

“Is the glass half empty or half full?” is a common question. The answer depends on whether a situation is viewed positively (half full) or negatively (half empty). The point of the question is to demonstrate that a situation can be viewed differently, depending on a person’s point of view.

The equity market is like a glass of water – in reviewing the past year you can arrive at one of two conclusions, depending on your disposition. The glass half empty side would say that the negative equity returns of 2018 make complete sense given trade war concerns and other events. The glass half full side would say that 2018 was a year marked by fundamentally solid economic growth that was strong enough to require interest rate increases to temper inflationary risks, yet was not rewarded by equity markets’ returns. In light of these market dynamics, do we need to adapt from a portfolio management perspective?

Returns (as of December 31, 2018) Fourth Quarter 2018
Canadian equities
(S&P/TSX Index) CAD$
-10.1% -8.9%
U.S. equities
(S&P 500 Index) USD$
-13.5% -4.4%
International equities
-12.5% -13.8%
Canadian fixed income
(FTSE TMX Canada Bond Universe Index)
1.8% 1.4%

Glass Half Empty

2018 was a roller coaster ride to many with the most significant equity market downturn happening during the latter part of the fourth quarter. There were several key events that drove market volatility in 2018:

  • The renegotiation of the North American Free Trade Agreement kept the Canadian equity market in a state of confusion for most of last year as the renegotiated agreement (USMCA) was not reached until the final hours of September 30, 2018. As of today, the agreement has yet to be ratified.
  • U.S. driven tariffs and trade war concerns plagued most of 2018. The escalation of tariffs and tensions between the U.S. and China dominated many news headlines during the past year and continue to do so today.
  • Brexit dominated headlines in European markets with ongoing talks between British and European Union (“EU”) negotiators, turmoil within the U.K. parliament and prime minister Theresa May’s difficulties in trying to win parliamentary backing for her deal to leave the EU. This resulted in her pulling the plug on the scheduled parliamentary vote in December to approve the deal she negotiated.
  • Interest rate expectation changes – in December, market participants reacted strongly to the Bank of Canada’s monetary policy announcement or, more specifically, the tone of the policy statement which noted that “there may be additional room for non-inflationary growth”. This was interpreted by some as an indication that expected interest rate increases may not be forthcoming in 2019 due to concerns regarding a slowdown in the economy, which led to a late fourth quarter sell-off in equities and a rally in fixed income.
  • Economic growth estimates for 2019 were reduced from 2.1% to 1.7% in Canada and from 2.5% to 2.3% in the U.S., based on Gross Domestic Product (GDP) growth forecast revisions from the Bank of Canada and the U.S. Federal Reserve.
  • Declining oil prices also weighed heavily on Canadian equity markets, given concerns for the resulting impact on the resource dependent Canadian economy.
  • The Trump effect – enough said.

Glass Half Full

During 2018, the noise of the events noted above overshadowed solid economic fundamentals. The U.S. and Canadian economies continued to experience solid growth in terms of economic and payroll job growth amid a tightening labour market.

U.S. Economy

  • In the U.S., 2018 inflation, as measured by the Consumer Price Index, hovered fairly close to 2% (partly in thanks to the 1.0% of interest rate increases implemented by the U.S. Federal Reserve during 2018), with expectations of an average inflationary rate of 2.3% for 2019.
  • The labour market was extremely strong in the U.S. given 2018 payroll increases of 2.6 million jobs which marks the third strongest annual reported figure in the current market cycle.
  • As noted by Federal Reserve Chair Powell, “inflation remains under control” and “we’re in a place where we can be patient” with respect to interest rate increases.
  • Despite the volatility, the U.S. economy is expected to remain strong. Expectations are for positive GDP growth of 2.3% in 2019.
  • The majority of current economic forecasts are calling for two more 0.25% interest rate increases later this year.

Canadian Economy

  • The Canadian economic picture also appears quite positive. As noted by the Bank of Canada in their Monetary Policy Report released at the beginning of this month, “The economy has been operating essentially at its full capacity for about 18 months now” and “unemployment is as low as we have ever seen it”. Not quite the story of gloom portrayed by Canadian equity market performance.
  • The Bank of Canada also noted they are remaining mindful of oil price impacts, trade war concerns, and the stabilization of the housing sector.
  • However, the Bank of Canada did not infer that they have stopped raising interest rates (which is what the markets priced in during the last month of 2018). Rather, “the Governing Council continues to judge that the policy interest rate will need to rise over time”. Interest rates may be increasing at a slower pace and we may have experienced the majority of the interest rate increases for this tightening cycle, but there is still some tightening left to come barring any unexpected changes.
  • Expectations are for positive GDP growth of 1.7% in 2019. The Bank of Canada also increased their forecast GDP growth expectation in 2020 from 1.9% to 2.1%.
  • The majority of current economist forecasts in Canada are also calling for two more 0.25% interest rate increases in the second half of this year.

Is the Glass Half Empty or Half Full?

In short, the answer is yes.

How do we reconcile the two viewpoints? Based on economic data and forecasts, the rate of growth may have slowed for most economies but growth, in absolute terms, is positive and remains close to capacity. An examination of Canadian and U.S. economists’ interest rate forecasts shows that the majority are still calling for one to two more interest rate increases, albeit later in the second half of 2019. The market, however, is not buying it. As an example, based on the trading activity of Canadian interest rate forward contracts, the market is not pricing in any further increases and potentially expects interest rate decreases in 2019. This separation of fundamentals versus market momentum is concerning…or is it?

Let’s suppose that interest rates increase given positive economic growth:

  • From a fundamental perspective, increasing interest rates implies decreasing bond prices which would be negative for fixed income returns.
  • Should the global uncertainties / events continue (trade wars, Brexit, etc.) leading to equity market volatility and further declines, fixed income markets may benefit (the money has to go somewhere) which may lead to positive fixed income returns.
  • Or, these two dynamics may balance each other out and interest rates may remain rangebound for the time being.

As can be seen, even if expectations turn out to be different there is a myriad of potential outcomes.

Quadrant’s Glass

At Quadrant, we are mindful not to conclude whether the glass is half empty or half full although we remain watchful of market influences and respond when warranted. Our goal in designing a portfolio is in alignment with the following quote by noted pioneer of investing, Benjamin Graham:

“The essence of portfolio management is the management of risks not the management of returns. Well-managed portfolios start with this precept.”

We believe many asset classes aren’t trading based on fundamentals today but rather more on speculation and uncertainty. Also, in recent years, computer driven trades based on algorithms have magnified the swiftness and severity of trade volume responses to market headline events. It is currently estimated that about 60% of stock trades in the U.S. are computer driven based on algorithms according to a report published by the Washington Post in February, 2018. As these computer-generated trades are automatically triggered based on a set of “rules” (i.e. the algorithm), thousands of trades per second can be completed. This can quickly spiral into an avalanche of trade activity that can move markets up or down dramatically in a matter of minutes.

So how do we design a long term portfolio and address short term volatility that is not fundamentally based but is rather headline/sentiment/trading momentum driven? The answer lies in a simple and well-known concept – diversification and how we take diversification to the next level given the current financial market landscape. In examining the diversification of an already “good” portfolio, this is not about a complete overhaul but rather a fine tuning. Below are a couple of thoughts.

  • In looking at a portfolio’s equity exposure in the small capitalization area, is the geographic diversification sufficient or is it limited to markets with a home country bias (Canada and/or the U.S.)? Expanding small capitalization equity exposure to an international perspective may be beneficial.
  • If the majority of holdings within a portfolio are based on publicly traded investment products, consideration could be given to private investment products which are not priced daily and do not trade frequently. These investments are typically real estate, equity, fixed income, or alternative product based. These strategies reduce the effects of short-term volatility on the market value of a portfolio, as private investments’ values are largely based on pure fundamental information. As these products are typically less liquid, consideration should also be given to portfolios’ liquidity needs.

These are two options to reduce portfolio volatility. Depending on the asset allocation of an existing portfolio, there may also be other opportunities. However, any asset allocation changes made need to be within the context of the portfolio’s investment objectives, risk tolerances, income requirements and time horizon.

A diversified, balanced portfolio will serve you well over time no matter how you view the glass.



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