Executive Summary – Stock Market Corrections have a Silver Lining
Well, that wasn’t a fun quarter for anyone. We do believe that much of the damage is now behind us, and in most cases, clients remain in positive territory for the past year during a time when the Toronto stock market has dropped 11%. In this report, we will explain what happened and why we are generally positive at this point.
Periodically, markets experience corrections of 10% or more. We believe these corrections are necessary to cool off an overheated stock or bond market. Despite these sell-offs, the equity markets have enjoyed historical returns of over 8% per year for long-term investors. Presently, even with the recent declines, equity markets are substantially higher today than in 2007 (pre-financial crisis) and 2011 (last major decline).
In fact, these market corrections create buying opportunities when stocks, bonds or the overall markets have reached lower price levels.
Our Perspective on Market Volatility
The third quarter witnessed a sharp drop in the price of global equities and commodities. This high market volatility is not unusual from a historical perspective. In fact, some of the best market returns come after turbulent times (e.g., after the 2000-2002 Technology-Media-Telecommunication bust and after the 2007-2009 global financial crisis).
Why are markets so volatile recently? We believe the following are key contributing factors:
- Concerns over China’s weakening economic growth and surprising devaluation of its currency on August 11th, resulting in downward pressure on global inflation. China’s action also negatively influenced emerging market currencies and bonds;
- The fall in commodity prices, including oil prices; and,
- Investor discomfort with the rising likelihood that the U.S. Federal Reserve will move to gradually raise rates this year due to signs of strength in the U.S. economy.
Concerns about China’s weak growth and currency devaluation
China and the other emerging market economies rose markedly over the past 30 years, currently representing 57% of the global economy (30 years ago it stood at 35%) and over 80% of global growth in recent years; therefore, its influence on the global economy and the markets generally, is substantial. So, when the Chinese economy is slowing as it is presently, investors are concerned. Fortunately, China has put in place a number of reforms, in recent years, to transform its economy for sustainability and higher economic development.
Falling commodity prices
Prices of most commodities fell sharply this year. Prices fell because of rising supply, as well as commodities being priced in U.S. dollars, and the U.S. dollar continues to appreciate. The supply of commodities increased owing to rising production and stockpiling over the past number of years in anticipation of strong demand, which did not materialize. We expect commodity prices to continue to fall until these excess supplies start falling.
Expected Rise in the Fed Funds Rate
The argument in favour of a rate hike in the near future in the U.S. is based on reasonably solid economic growth and a falling unemployment rate. In contrast, the argument against a rate hike is based on slower global GDP growth, falling commodity prices and currency devaluations, which reduce the rate of inflation (a key metric for the U.S. Federal Reserve). Regardless of where you stand on this argument, it is important to realize that when rates start rising, which they will at some point, it will likely be gradual and slow. This likely slow and gradual pace of rate rises should not hinder the global economy.
Even with this high volatility, the prudent approach to investing does not change:
- Suitable investment plan/strategy: In times of uncertainty, you may be tempted to change your investment strategy, but often change is not necessary and may be detrimental to your long-term return. We take great care to ensure that your portfolio’s asset allocation and strategy is consistent with your risk tolerance, goals, financial situation and time horizon. Unless your goals and/or financial situation change, you should not make major adjustments to your portfolio based solely on market volatility.
- Diversification: Spreading your investable funds across a portfolio of multiple asset classes – equities, bonds, as well as alternative investments such as real estate, infrastructure, and the like – and within each asset class will dampen volatility in your portfolio. Why is it the case? Different securities within and across asset classes do not all move in the same direction and/or with the same magnitude over time; therefore, a well diversified portfolio will fluctuate less than a portfolio with very few securities over time.
- Stay invested: Trying to time the market can be very costly to investors because a significant portion of the market’s gains historically occur in very short periods of time. If you are not invested during these small windows of opportunity, you may miss most of the up market. Furthermore, many of these short periods of time occur during very unpleasant market environments when you may feel compelled to sell.
Equity Market Commentary
The third quarter of 2015 was a rough one for equity investors around the world as fears of a global slowdown, emanating potentially from weakness in the Chinese economy, hit the markets. Other factors came into the fray as the energy market continued to weaken and politicians in the U.S. stirred the pot by raising concerns about pharmaceutical pricing, which hit all stocks in the health care sector.
In local currency, the Chinese market was the worst of the major indices down more than 19%; whereas, the Swiss and Italian markets were some of the best performing, down just over 3% and 5%, respectively. Closer to home, the TSX Composite was down 8.6%, and the S&P 500 was down 6.9% in local currency. The U.S. currency was a positive factor for our portfolios, as measured in Canadian dollars, as the U.S dollar strengthened 6.8% relative to the Canadian dollar, severely curtailing most of the loss in the U.S. equity market.
For the TSX Composite, it was a volatile three months, since all months had decent declines and rallies, but in the end all three months were negative. From a sector level, the three worst performing sectors in the quarter were Materials, Energy and Health Care, which were all down between 17% and 20%. In contrast, the top performing sectors were Consumer Staples, up around 6%, followed by Technology, Telecommunications and Utilities, which were up marginally.
The S&P 500 was a slightly different story. July posted a marginal gain; whereas, August had a big decline, down more than 11% at one point, before rallying at the end of the month to stem the decline to only 6.4%. All sectors but Utilities, up about 2%, were negative for the quarter. Similar to the TSX Composite, the major decliners were Materials, Energy and Health Care. Consumer Staples was the least negative performing sector, down 2%.
Core Equity Model – For higher growth-oriented clients
The Core equity model was down 4.2% for the quarter, outperforming the TSX index by 4.4%. During the last three months, Core accounts were very active. Early in July, we reduced our equity exposure by around 5% for most clients, selling the S&P Mid Cap ETF; and later in the quarter, we also had two other sales that went to cash as we did not find attractive purchases that met our criteria for ownership.
We did two trades in the Energy sector: the first trade was to sell our S&P TSX Energy ETF position, which was one of our bigger negative contributors for the period; and, we purchased Suncor, which we were able to eke out a small gain plus a dividend before it failed our criteria for ownership and was sold due to negative earnings revisions.
Some of our higher growth companies detracted from performance in our Core model as Concordia Healthcare and Valeant were hit by the broad decline in pharmaceutical stocks.
On the positive side, a number of our consumer staple stocks, including Weston and Alimentation Couche Tard, had strong performance. Moreover, O’Reilly Automotive, in the Consumer Discretionary sector, continues to execute on its strategy and had a solid quarter. Three companies in the Core equity model – Altria, Verizon and Royal Bank – raised their dividends during the quarter.
Pension Equity Model – For clients requiring higher income and lower volatility
The Pension equity model was down by 2.5% during the quarter, as our more conservative strategy outperformed the TSX index by 6.1%. Based on its Pension mandate, less trading occurred in the third quarter relative to the Core model: we reduced our equity exposure in the model at the beginning of July by selling the S&P 500 ETF, and late in August we sold our Energy ETF and purchased Potash, which was eventually sold with the proceeds going to cash. For the past 12 months or so, the model has been underweight the Energy and Materials sector, which has reduced the impact of the broader market declines. That being said, Enbridge, Potash and the TSX Energy ETF were the worst performing names in the model along with Home Capital Group. Home Capital declined over the quarter because of concerns over the economy and repayment of mortgages. The company’s stock was further hampered by U.S. short sellers that were taking large short positions in July. We continue to hold the position, since we believe management at Home Capital will continue to grow earnings and dividends and it is trading at less than 8X projected earnings. A number of our stocks had good quarters, including Transcontinental, General Mills and BCE. Five companies in the Pension model increased their dividends during the quarter: Emera, Bank of Nova Scotia, CIBC, Verizon and Royal Bank.
The Quarter Ahead for Equities
It is our view that the majority of the decline in the equity markets is over, and we are looking for opportunities to be fully invested again in the coming months as each model currently has cash available to purchase two equity positons. Overall, the equity markets appear to be fairly valued with a number of undervalued sectors, the cheapest being Financials. For this reason, along with a number of other factors, we added Sunlife to the Core model at the end of September. Potential catalysts to higher equity prices include positive third quarter earnings announcements, and a possible U.S. interest rate hike in December based on the more moderate tone by the U.S. Federal Reserve. Historically, equity markets tend to have above average performance for about six months after the first rate hike.
Fixed Income Commentary
The third quarter was again rife with extreme volatility in the bond market. The cause of such volatility was threefold. First, bond market investors were getting mixed signals from central banks: the high expectation of the U.S. Federal Open Market Committee (FOMC) to start raising overnight rates paired with the softer tone coming from the Bank of Canada (BOC), where the latter lowered rates on July 15th for the second time this year (taking overnight interest rates to 0.50% down 0.25% from the last ease on January 21st). Second, the lack of liquidity in the fixed income markets; and third, the sharp moves in global equity markets.
The source of the economic weakness in Canada continues to emanate from the energy fields as oil prices (WTI) ended the quarter down 25.4%. Surprisingly, with such a sizable and sustained move, the BOC did not allow the effects of a 6.6% decline in the Canada-U.S. exchange rate to work its way through the economy, and lowered overnight rates for the second time this year. Perhaps the BOC was also concerned about the economic deterioration abroad, especially in China, and decided that the Canadian economy needed the extra support/stimulus.
The FOMC wrapped up one of their most divided regularly scheduled meetings on September 17th (economists placed the odds of a hike at 80%, while Fed Funds futures contracts placed the odds at about 40%), highlighting global economic concerns as the source of their hesitation to follow through with their first interest rate hike in over 9 years.
Core and Pension Fixed Income Models
The fixed income models have slightly shorter average bond maturities than the DEX Bond Universe Index heading into the third quarter as the global economic situation still warrants a defensive posture since both the FOMC and the Bank of England (BOE) are poised to hike overnight interest rates, and any economic fallout from Greece has already been eliminated.
Our present strategy is to remain overweight corporate bonds in near term maturities (as we view the BOC and FOMC as incapable of delivering any tightening of monetary policy) and opportunistically adding to longer term maturities because we believe that the weak economic landscape will cause the yield curve to flatten. This strategy should prove beneficial for our models over the next couple of quarters, as we believe any rate hikes by the FOMC would cause long interest rates to fall and short interest rates to rise with credit spreads narrowing, and thus bond prices rising. This forecast is premised on the notion that raising rates may trigger a higher probability of an economic slowdown.
In contrast, should the FOMC not follow through with their many hints of a rate hike as soon as October 28th, bonds will benefit on the premise that the FOMC’s mandate of price stability (i.e., 2.0% headline inflation – currently at 0.2% year-over-year) has not been achieved, and again, global economic headwinds will continue to play a role in their decision process; thus, validating lower interest rates.
The Quarter Ahead for Fixed Income
As we head into the final stretch of 2015, it appears that monetary policy globally will remain quite accommodative, meaning rates will stay low. As mentioned earlier, China’s economy is slowing and it has devalued its currency; moreover, the FOMC just balked at the much anticipated rate hike, and Japan is planning to restart “Abenomics”.
Prime Minister Shinzo Abe recently unveiled new growth initiatives, including targeting GDP at 600 trillion Yen (i.e., expanding by roughly US$10 billion), and social programs to assist families to care for the elderly. In conjunction with the Bank of Japan (BOJ), the Labour Democratic Party (LDP) will do its “utmost” to lift wages and consumption. As Japan endeavours to roll this program out as soon as possible, the Europe Central Bank (ECB) is under pressure to expand its Quantitative Easing (QE) program by extending it beyond September 2016, and by increasing asset purchases above 60 billion EUR per month. The end of easy money may not be as close as previously thought.
We believe high volatility in the bond market will continue until the end of the year; and, we are prepared to extend/lengthen the maturities of our bonds in the models further as yields approach our target.
Preferred Share Commentary
Preferred shares experienced the following problems in the quarter:
- Reluctance by the BOC to raise the overnight interest rate (a cut actually materialized) has caused the Government of Canada 5-year bond yield to remain stubbornly low. In fact, the yield is now roughly 0.55% below where it was at the end of 2014.
- Equity volatility, credit concerns and ultimately, risk aversion by investors caused a widening of market spreads for all five-year fixed reset preferred shares. As a result, the price of preferred shares fell.
- The persistently heavy preferred share issuance from financial institutions exacerbated the already fragile preferred share market (because banks and insurance companies are being subjected to punitive tier 1 and 2 capital requirements, thereby forcing them to raise more capital).
- Energy and resource based issuers (e.g., TA.PR.D & TRP.PR.B) were particularly harder hit because of the depressed level of oil prices and various other commodity prices.
The Quarter Ahead for Preferred Shares
The extraordinary capital gain offered in early 2009 (post financial crisis) on preferred shares may not be repeated this time around; however, the slow appreciation back to higher price levels will come about from the narrowing of credit spreads. In the meantime, the yields at current preferred share price levels are providing a very favourable after-tax income.
Although the markets have been tumultuous year-to-date, we believe that our clients’ portfolios are well positioned to weather the storm and take advantage of market weakness. That being said, it is often good to review, with your TriDelta Wealth Advisor, your investment plan/strategy during these periods of high volatility in the markets; however, staying the course is usually the best policy, assuming that your financial situation, goal(s), time horizon and risk tolerance have not changed.
As a final comment – Let’s Go Blue Jays!!
TriDelta Investment Management Committee
VP, Fixed Income
President and CEO
Exec VP and Portfolio Manager
Chief Operating Officer
VP, Portfolio Manager and