We’ve Found Red October
November 5, 2018
From a financial markets perspective, October has turned out to be a sharp contrast to the first nine months of 2018. Headlines are beginning to use the words “bear market” with increasing frequency, leaving many feeling increasingly anxious about their portfolios. While many are more concerned with what has been going on with markets so far in the current quarter, let’s start with a look at the previous quarter and the factors that lead us to today. In other words, you need to understand where you came from, to grasp where you are today.
The Third Quarter
|Returns (in Canadian dollar terms) as of September 30, 2018||3-Month Returns||YTD|
(S&P 500 Index)
(MSCI EAFE Index)
|Canadian fixed income
(FTSE TMX Canada Bond Universe Index)
The theme of the third quarter of 2018 was similar to that of the last: global trade uncertainty dampening growth. Markets in both equities and fixed income moved very little, with one major exception: U.S. equities. The difference is not insignificant either – while Canadian equities (S&P/TSX Index) and international equities (MSCI EAFE Index) fell by 0.6% and 0.2% respectively, U.S. equities (S&P 500 Index) advanced by 6.0% (all returns in Canadian dollars). Exchange rates did not play a material role in investment performance. This marks the best quarter for U.S. equities in almost five years. It’s worth asking why this continuing divergence between the U.S. and other developed markets is taking place.
The most significant development from a North American perspective came in the very last hours of the quarter; a trade agreement in principle between the United States, Mexico and Canada, known as the United-States-Mexico-Canada Agreement, reached on September 30th. Given there were no major changes as compared to the previous NAFTA agreement, the greatest benefit to Canada is likely the simple effect of alleviating uncertainty going forward, allowing business confidence to improve and long-term investment to resume. In other words, what’s new in the agreement is of less importance than the fact that it is no longer a point of concern, which should be positive for the Canadian economy, and by association, Canadian equities.
In fixed income markets, the U.S. Federal Reserve raised the target range for the Federal Funds Rate by 0.25% in September up to 2.00-2.25%, with a further 0.25% hike expected in December, and three more expected in 2019. In Canada, the Bank of Canada raised its benchmark interest rate in July by 0.25% to 1.50%, and again in October by 0.25% to 1.75%. The Bank of Canada is still expected to maintain a lagging interest rate path compared to its southern neighbor, as structural challenges remain. Restrictive energy policy is driving a substantial discount on the price of Canadian oil – a key driver of the Canadian economy – while Canadian consumer debt sits very high relative to historical levels. Given these dynamics, we can continue to expect a gradual, controlled increase in interest rates and need to be mindful of the potential challenges and opportunities for fixed income investments.
The Great Decoupling
From a valuation perspective, the price-to-earnings ratio for both the Canadian market (S&P/TSX Index) and international markets (MSCI EAFE Index) have continued to decline moderately over the quarter, increasing their attractiveness. By contrast, in the U.S., the S&P 500 Index’s valuation multiple continued to rise, further accentuating its valuation differential with other developed markets. An ongoing source of U.S. equity outperformance is the U.S. tax cut legislation beginning in fiscal year 2018, which saw the corporate tax rate decline from 35% to 21%, translating to lower taxes – and therefore higher profit margins – for corporations. This change in tax policy, as well as the NAFTA uncertainty which troubled Canada throughout the third quarter, helps explain the valuation gap with Canada.
The more pronounced difference between U.S. and international markets can be partly explained by the ongoing complications of Brexit, economic troubles in Italy and Greece, as well as the struggles in emerging markets driven in part by rising interest rates in the U.S. It is important to note, however, that international equities are priced for modest growth, while U.S. equity markets are priced for very high growth. This means that there is very little room for error in U.S. equity prices, providing a much lower margin of safety and thus higher corresponding risk. It is also important to note that much of the growth in U.S. corporate profits has been driven by reduced tax rates, meaning that this degree of profitability is not necessarily reflective of a fundamental change in long-term economic prospects.
Rising Rate Impacts
Interest rates at the Federal Reserve have been kept low for several years following the 2008 recession, which has fueled a proliferating corporate debt market in the U.S. Some have criticized that much of this debt that companies are taking on has gone toward share buybacks, rather than investment in long-term capital investments, suggesting that the borrowed money is not being used to fund future growth. This distinction is important because share buybacks made when there are no better opportunities to deploy capital is a shareholder value-adding decision, whereas borrowing money simply to fund share buybacks only serves to temporarily support a company’s share price. Irrespective of where the borrowing is allocated, the bottom line is that corporate balance sheets are taking on more leverage, leaving firms with higher risk going forward.
There is nothing inherently wrong with firms taking advantage of cheap money – firms are expected to make capital allocation decisions according to the returns they expect can be achieved with the projects available to them. The problem is that when the cost of debt remains too low for too long, overleverage becomes a growing risk. As interest rates rise, it will be more expensive for companies to service debt and profit margins may be reduced. This is one potential risk for equity markets going forward, and especially for equity markets priced for higher growth expectations. It is in circumstances like these where an asset class manager can add value by scrutinizing a firm’s management, and its capital allocation decisions, limiting investments to those who demonstrate prudence in their deployment of capital.
Only when the tide goes out do you discover who’s been swimming naked.
Diversification: most important when you don’t think you need it.
For many investors, the relatively impressive growth experienced in U.S. equities in the last decade provides the temptation to over allocate more of their portfolio to today’s top performers. By the same token, they might also be inclined to shed their exposure to markets posting more stagnant performance, such as international equities. The problem is that nobody knows which market will be next year’s top performer, and similarly important, the concept of mean reversion would suggest that over time deviations from the mean (average) performance will reverse. Therein lies the value of diversification – it offers the discipline of accepting that you don’t know which sector or market will perform best, while also ensuring that you have exposure to each one so that you consistently share in the gains of the top performer. There will always be an underperformer that you are tempted to get rid of, but that same asset may well turn out to be the star performer next year.
It is understandable how current financial markets can deflect attention away from long term investment plans. So far, the last quarter of 2018 has been a clear return to volatility. Virtually all markets are down since the beginning of October, and as of October 26th, the S&P 500 Index is down 7.6% (in Canadian dollar terms). Technology stocks have been declining disproportionately, most notably the FAANG stocks (Facebook, Apple, Amazon, Netflix and Alphabet [G for Google]), some of which were at high relative valuations, and account for a disproportionate amount of the S&P 500 Index. During the week of October 26th, the S&P 500 Index touched a point 10% below its September peak (in U.S. dollar terms), meaning that U.S. markets briefly met the technical definition of a market correction.
Other developed markets were not much better off in October, with Canadian markets (S&P/TSX Index) down 7.2% and international markets (MSCI EAFE Index) down 8.8% as of October 26th (both in Canadian dollar terms). From a currency standpoint, the Canadian dollar has fallen about 1.7% relative to the U.S. dollar in October so far, meaning that Canadians holding U.S. stocks have seen the decline in U.S. stocks cushioned somewhat by the currency fluctuations. Canadian fixed income markets were affected too, but fared much better by comparison, remaining relatively flat. This speaks to the value of fixed income holdings in a diversified portfolio, as these instruments tend to vary in performance from equities, tempering the impact of equity market volatility. It is also noteworthy that while growth stocks have been significantly outperforming value stocks ever since the recession of 2008 (especially in 2018), October saw this trend reverse, as fundamentals began to be viewed as, well, fundamental. So where do markets go from here? Nobody knows, but one fact remains: maintaining diversification in your portfolio will limit your exposure to all markets, whether they rise the most or fall the most. And that’s a good thing.
Quadrant Private Wealth
As a private wealth management firm, Quadrant seeks a comprehensive and in-depth understanding of our clients and their financial goals and circumstances. In addition to managing investment portfolios, we provide advice and in-depth planning with respect to retirement, estate planning, risk management, taxation, and charitable giving. We believe that all of these important financial matters are intertwined and deserve to be viewed through a holistic wealth planning lens. As a firm that specializes in asset allocation, asset class selection and manager search and supervision, we are cognizant of the role that diversification plays in mitigating the risks of a heated market, and strive to ensure that client portfolios are defensively positioned accordingly.
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