This article appears in the February edition of the Financial Post Magazine. Go to the iTunes store to download the iPad edition of this month’s issue.
Investors did not have an easy duration of it in 2015. From oil’s price slump despite rising and omnipresent tensions in the centre East and Russia’s invasion of Ukraine to the exit by Greece from the eurozone and technical recessions in Canada and Japan, stock and bond markets rode wave after wave of volatility and many investors wound up at a negative balance. How bad was it? Cash outperformed most asset classes for the first time because the 1990s.
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Unfortunately, 2016 didn’t begin much better. Within the first couple of trading times of January, contagion from China’s latest stock-market tumbles wiped out US$4 trillion in equity value worldwide. The S&P/TSX Composite Index, meanwhile, fell into a bear market, having dropped 20% since its September 2014 high. Further on the horizon loom as many as four rate hikes by the U.S. Federal Reserve, continuing its trend toward tighter monetary policy as the American economy recovers, even when few other economies are showing anything further than weak indications of life.
“Persistent weak global growth is intensifying,” says Bruce Cooper, TD Asset Management’s chief investment officer, chalking that as much as aging demographics in both the developed world and China in addition to high levels of debt, whether that’s government, corporate or consumer, in lots of areas of the world. Both factors lead to weaker aggregate demand, which results in slower economic growth and, ultimately, poorer investment returns – something investors are going to have to obtain accustomed to unless tips over to turn things around.
Much of a portfolio’s performance in the long term is driven more by macro-economic factors and less by stock-specific factors.
In the meantime, headlines scream that one event or any other will weigh down on portfolios. But that’s just a little simplistic. “The market doesn’t tell you why it did something,” says David Kaufman, president of Westcourt Capital Corp., a Toronto-based portfolio manager specializing in traditional and alternative investment. “One macro affects another, and the world keeps spinning so it causes it to be difficult to determine stuff that are affected by multiple factors.” Nevertheless, he says, more customers are asking him how events within the U.S., China along with other places affect their investments here at home.
“Much of the portfolio’s performance in the long run is driven more by macro-economic factors and less by stock-specific factors,” says Pramod Udiaver, co-founder and CEO of Invisor Investment Management Inc. in Oakville, Ont. “And why? Since the global economy is so well integrated nowadays, that your lot of people don’t really appreciate when they consider investments.”
That insufficient appreciation might be since the effects are not often direct ones, and sometimes it’s just the perception that they should change things. But that does not make sure they are less real, there a number of big macro-economic factors that have and will still play a role. “Investment securities are valued based on expected future performance, not on the way a clients are doing in a given time,” Udiaver adds. “And the future performance is largely determined by these larger macro factors.” Most of which, for the time being, appear to be headwinds instead of tailwinds.
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The red menace
China, for instance, once fuelled the worldwide economy and stock markets, especially in Canada. China economy for years has been investment-driven, which requires a lot of natural resources to build. Resources such as oil, wood, potash and lots of metals like nickel and copper that Canadian companies supply by the bucket load were needed. But a couple of things in China are occurring making it more of a continue global growth and, hence, investor portfolios here at home. The nation’s GDP growth is slowing from the 8-10% range to 7% or less – and, bear in mind, those are government numbers, which may overstate actual growth – which is attempting to transition its economy to 1 driven by consumption as opposed to investment. “Clearly, they can’t sustain the 10% growth number and markets need to comprehend might then adjust our valuations,” Udiaver says.
China is the world’s second-largest economy, accountable for about 20% of global GDP, and it’s Canada’s second-largest trading partner, so any slowdown will cause problems. “China is not causing this low-growth world, but with China slowing now, it’s exacerbating the low-growth world,” TD’s Cooper says. “It affects Canadians, of course, because China is a big consumer of commodities.” And, as everyone knows, commodities continue to be about 30% from the Toronto Stock Exchange, although that’s down quite a bit from just a couple short years ago. As China’s growth declines, they have less requirement for oil and other resources that Canada produces, which means the prices of these commodities drops. Consequently, there’s less demand for the Canadian dollar, that also depreciates. Live and eat the petro-currency, die through the petro-currency.
Another complication is that even China’s lower-growth profile assumes that its economic transition goes well, that isn’t confirmed even just in a government-led economy. State-owned enterprises are a big area of the economy and act in many cases like employment agencies, Cooper says. For example, it has many steel firms that should close down being that they are high-cost producers in a lower-demand environment. Closing them makes sense if China is really trying to be driven by consumer desires, but it can’t because it would throw thousands out of work and, therefore, hurt interest in goods and services.
Kaufman offers one caveat: if you feel China will grow, also it is still, purchasing Europe and Canada isn’t as crazy because it seems now given that they are two least-liked markets. “Even when they were to keep growth in-house and also have a massive trading deficit, they still need water, they still potash, they still oil, everything that the thriving urban economy requires that they don’t have within their massive geography,” he states.
It could be welcome news towards the oil industry if China does keep growing, even if more modestly. The original cause of oil’s price slump was excess supply brought on by the explosion in shale oil in the U.S. and the inclusion of about a million barrels each day from Iraq this past year. “Demand was pretty good, although not sufficiently good to overcome supply growth,” Cooper says.
Energy companies, especially in Canada and the U.S., responded by slashing their capital expenditure budgets and workforces, that will curtail production development in the coming years. That would normally stabilize prices and even turn back downward trend, especially since tensions continue to be simmering in the centre East. But Cooper wonders if the slump in oil prices that renewed in late December and continued through the first week of January was more details on slowing demand and fewer about excess supply. If true, that will prolong the energy industry’s agony and that of their investors.
Growth continues to be kind of crappy. One risk would be that the market loses confidence in central banks’ abilities to engineer a recovery.
The Canadian market, as mentioned, includes a high and direct correlation with energy prices and there is a domino impact on all the related businesses that service that sector, including banks, probably the last big bastion of strength on the TSX. “The banks are experiencing a knock-on effect although the direct affect is small,” says Beth Hamilton-Keen, chair from the board of governors at CFA Institute and director of investment counselling at Mawer Investment Management Ltd. in Toronto. “For example, TD has 1% contact with oil and gas lending – however the resulting job losses and defaults by men and women increase that secondary and tertiary effects,” She adds which means the loonie will remain weak, and so will the currencies of other countries that are heavily associated with oil.
As a result, Canadian investor portfolios will still be hit. The S&P/TSX 60 index, for instance, includes quite a few blue-chip companies and possess a lot of exposure to oil or other commodities. If the drop in oil impacted only energy companies as well as their investors, the 60 should fare better. And it has, to some extent. The Composite index has actually dropped in the last five years, while the 60 is slightly up. But that’s during what’s arguably been the greatest bull market ever. “If you believe this massive bull market was an indication of monetary strength inside a post-crisis world, then you’d need to believe Canada would have done well in that period of time,” Kaufman says. But, as has become very clear, it didn’t.
Rise from the Fed guardians
One economy that has strengthened throughout the post-financial-crisis world has been the U.S., somewhat aided, obviously, by three rounds of quantitative easing and interest rates that were slashed to near zero by the U.S. Fed. However the Fed, after dithering for several quarters, finally raised interest rates with a quarter point in December to 0.5%, signalling its faith the U.S. economy was on an even keel. Some key data points for example employment, housing and consumer spending all indicate a reasonably healthy U.S. “Any rate of interest increase is a a valuable thing,” Invisor CEO Udiaver says. “It’s a good thing for the economy, because minute rates are only increased if you find a longer-term expectation that the economy can do well.”
It’s no real surprise then the S&P 500 has been one of the stronger indexes in the last five years, but even that index struggled through 2015 and early 2016. That could be because investors believe growth rates will still be lower for extended, which should naturally translate into low interest rates for the foreseeable future. The Fed indicated that it expects to raise rates 4 times during 2016, while the market appears to be pricing in two. TD’s Cooper, however, is much more pessimistic. He believes the Fed will either not raise rates whatsoever or perhaps be quite happy with one hike. “We think growth will probably be disappointing, and if growth is disappointing, rates are not likely to go up,” he says. “And you see that at both short end, central bank administered rates, in addition to out the yield curve.” Cooper points out that 10-year Treasury yields actually declined following the Fed raised rates in December. Why? Since the U.S. economy is working at or near full capacity so there’s little extra growth available.
Again, that isn’t great for equities. The link between growth and equity is really through earnings. Earnings development in the U.S. has mostly been very good for the past six years, excluding 2015, but Cooper expects it will likely be pretty tepid came from here on. “Part from the reason is the fact that with low growth, information mill having problems growing revenue and they have already cut costs a lot and margins are near to all-time highs,” he states. “If your revenues aren’t growing and you’ve already done all the cost cutting you are able to, you would not expect earnings to grow much.”
If rates do keep rising within the U.S. – a rate cut is much more likely in Canada – Hamilton-Keen says certain sectors such as insurance should do much better than others, with respect to the number and size of those hikes. But, she adds, investors should have a balanced portfolio that has bets on sides of the rate equation as well as bonds for ballast.
The last hike through the Fed didn’t cause a stir, but that’s since it was well-signalled and considered. “The more important thing for investors in Canada will be the trend, the consistency and magnitude of rates in the future,” Hamilton-Keen says. Further hikes in the U.S. rate can lead to a strengthening greenback as well as an indication the U.S. is a safe place – a situation occupied by Canada throughout the fiscal crisis – so investors will flood into the country.
But hiking rates also hurts the income of U.S. companies that derive a big portion of their revenues from foreign countries, particularly if their costs are in dollars while their revenues are in weaker currencies. The price of capital also rises. Similarly, however, Canadian firms that get the bulk of their revenue from the U.S. while their cost is borne at home should do better. Manufacturing, for instance, should benefit, although it hasn’t to this point because other countries’ currencies are also depreciating from the U.S. dollar.
But in the portfolio level, Hamilton-Keen notes that any holdings investors have in U.S. or international equities probably have a different return profile than the usual home-biased portfolio since currency gains could account for as much as two-thirds of returns. “Those gains do not necessarily represent the underlying profitability from the company, however the spread differential, which can be a headwind if you have a portfolio heavily weighted in Canadian equities,” she says.
All which is the reason why investors pay so much attention to any hints of what the Fed and other central banks might do. The outcome of the actions on investor portfolios, as Hamilton-Keen suggests, may “well be blown out of proportion,” however the thought of macro-economic events might have just as strong effect on markets as reality can. Sooner or later, investors may realize that all of the zero rate of interest policies and trillions spent on quantitative easing haven’t done a whole lot to spur development in nevertheless. “Growth continues to be type of crappy,” Cooper highlights. “One risk is that the market loses confidence in central banks’ abilities to engineer a recovery.”
Unlike the U.S., Canada’s central bank has not taken more rate cuts off the table. The economy flirted with recession in 2015 and remains weak, as the dollar has dropped 15% over the past couple of years, which isn’t surprising considering the overhang from commodities and natural resources. “A slight increase in U.S. interest rates might weaken the Canadian dollar a bit, but exactly how a lot more is a huge question,” Udiaver says. “We think it’ll float round the current levels for any bit. We’ll probably not visit a major alternation in interest rates. We might actually visit a further reduction or negative rates because the Bank of Canada governor has indicated.”
Of course, the BoC’s official rates are only 0.5% after it cut rates twice last year, therefore it does not have much room left. It also indicated in January it’s content for that Canadian dollar to stay weak. Which may be good for some, but it doesn’t exactly establish confidence the economy includes a possibility of rebounding this season, plus some areas and sectors already are suffering.
Housing, for instance, is weakening in Alberta, but it’s strong in Toronto and Vancouver, where demand remains strong and there are space constraints. Any attempt to cool-down the latter two markets would almost certainly mean disaster for struggling markets like Alberta’s, even though the authorities has made some steps in recent times to rein the marketplace. But it’s mortgage rates that remain key and, despite the Bank of Canada’s position on rates, RBC raised some of its rates in January. For instance, the five-year fixed rate rose to 3.04% from 2.94%. Is that enough to tip the scales? Probably not, even if the rest of the banking institutions follow. But a rate change of some significance over time could be the trigger for some housing industry pain.
“A collapse in housing originates from desperation so what’s that desperation going to seem like? It is going to originates from either rates going up and for that reason people can not afford their mortgages, so when do you get to the point where they walk away,” Hamilton-Keen says. “Other factors may be the ceasing of lending, weak economic position.” There is, however, a saving grace: foreign investors continue to plow money into this country’s real estate.
Another positive for investors is that many believe valuations are somewhere in the range of fair, so investors should be able to ride out the expected bouts of volatility if they can tune out some of the noise, pick high-quality companies with strong balance sheets and cash flows, along with some exposure to the U.S. dollar through either equities or bonds, plus some fixed income.
“We tell our clients that these are walls of worry and walls of worry in many cases are great for markets, since there is a lot of caution being exercised by investors,” Udiaver says. “But from the past, we all know that markets often climb these walls of worry. What’s not good for the market is really a state of euphoria and that we don’t think we’re anywhere near near to that.”