9/30/2018 12:00 AM < Back
Sub-Advisor Commentary Q3 2018 - Markets
Canso Investment Counsel – Fixed Income
Contributed by Canso Investment Counsel
Interest rates continued to creep higher in the third quarter even though the drama with the NAFTA negotiations moderated their increase. Meanwhile, the U.S. Federal Reserve is very open about their desire to push rates back to “normal” levels and is acting decisively to do so. This makes perfect sense, given that the U.S. economy is booming from tax cuts, Government spending, and the fact that interest rates are still low versus inflation.

The Canadian Government seemed immensely relieved to have a tentative deal on the new NAFTA, now called USMCA. This agreement was reached right at the U.S. imposed deadline. More certainty on the terms of trade with the U.S. will make it easier for the Bank of Canada to also push interest rates higher.

In this environment, bond returns were mostly negative. Long duration Provincials were the worst performers at -1.5% while Canada bonds turned in a -1.0% return. Corporate bonds fared better as spreads tightened and they have an overall shorter duration than the market index. The Corporate Index was down only -0.5% with shorter duration Financials the strongest sector with a 0.1% return. The AAA/AA sector also did well due to a short duration and the BBB sector was at -0.4% with its higher yield.
QV Investors Inc
Contributed by QV Investors Inc.
The majority of global equity and bond markets struggled in the quarter. The U.S. market bucked the trend, surging by over 7%, posting its largest quarterly gain in nearly five years. U.S. stocks are now trading at their highest premiums relative to international shares as investors remain confident that the domestic economy will continue to outgrow its global peers. There is a decoupling in the U.S. market versus the rest of the world over the past couple of years. Typically, correlations are relatively high for equities, and it has been rare to see divergence of this magnitude.

What could derail the U.S. dominance? Rising U.S. interest rates. After languishing throughout the summer, yields have resumed their march upwards. While rates remain at relatively low levels, we expect them to continue to increase and likely surpass market expectations in 2019. After spending an unprecedented amount of time with a zero-interest rate policy, the Fed has been carefully removing stimulus and reassuring investors of their gradual approach to normalizing monetary policy.

Historically, tightening in the monetary landscape has been a precursor to more challenging periods for equity investors. Should there be any deviation to this gradual rate tightening cycle, we’d expect considerable volatility.

Should we be more concerned, the stronger the economy? The current consumer confidence in the U.S. is at extreme levels, and that high confidence levels, when the future looks bright, often precede a rate tightening cycle and a recession. As John Templeton wrote, “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.” The one thing that is for certain is there is little pessimism or skepticism being valued in the U.S. market currently. For all the excitement investors espouse of multidecade low unemployment rates and expected double digit earnings growth rates, they should watch what they wish for.

After over a year of NAFTA negotiations, it appears the parties have finally worked out a deal. For all the talk of the supposed worst deal America had ever entered into, in many ways the newly inked USMCA is not materially different from the previous agreement. What is significant, though, is that it represents a political win for President Trump and a reasonable outcome (compared to the potential alternative) for Canada. The potential for very damaging tariffs directed at Canada’s auto industry and an uncertain trade landscape have kept a dark cloud over the Canadian economy and stock market. At least this is one less thing for investors to worry about.

We highlight a number of points we feel are important to consider:
  • This most recent decade reminds us more and more of the 1990’s when both the U.S. stock market and the U.S. dollar generated significant returns. Back then, the bull market ended with the crash of the technology bubble. We’re not suggesting an extreme of that magnitude is brewing in the U.S. today, but we are cognizant of significant excesses.
  • Specific sectors and stocks are propelling the U.S. markets higher at the expense of slower growing businesses. However, it is these companies that are offering us better long-term opportunities in our global mandates.
  • A few years back the Canadian market looked fully valued to us. With the significant sell-off in energy prices in 2015, the worry surrounding consumer debt levels and lofty real estate prices, the onerous regulatory environment and the recent NAFTA uncertainty, international and domestic investors pulled away. This has created what we believe to be an opportunity to buy excellent Canadian businesses at fair prices again.
  • The amount of debt taken on by U.S. corporations has reached record levels, propelled by an unprecedented period of ultra-low interest rates. A significant amount of debt has been used for unproductive uses, such as share buybacks, without a corresponding investment in future growth to support the additional leverage. The low cost of debt has also led to abnormally high profit margins for companies.
  • The proliferation of passive investment and computer program trading strategies are exacerbating the market dynamic where growth/momentum stocks are the big winners. We anticipate the next market downturn will shine a bright light on the shortfall of this style of investment. Until then, active managers like us will need to be patient.
  • While higher interest rates may have an adverse effect on equity valuations and economic growth at some point, they are offering investors a more attractive yield within a fixed income portfolio. This is certainly welcome after years of punitively low rates for savers.
QV manages money with a value focus and a disciplined process which has been proven to deliver superior risk-adjusted returns over time. Does that mean we outperform in all time periods? No. Historically, we have lagged market benchmarks for many quarters, if not years, before making up the returns. For that, you can blame our risk management process which drives us to build a portfolio of quality businesses trading at reasonable valuations with strong balance sheets. Sometimes the market doesn’t care about that “stuff”, instead focusing on new technologies, growth, commodities etc. Also, sometimes we get our investments wrong and they significantly impact our concentrated portfolios. The QV Canadian Equity Fund illustrates this. Although it has not matched the benchmark in all annual periods, over the past 20, 10, and 5 years, it has delivered gross returns of 12.4%, 8.0%, and 6.7% respectively. These returns include the recent challenges we have alluded to. The strategy holds up well relative to the TSX benchmark returns of 8.0%, 6.3%, and 7.8% over the same time frames.

In analysing our returns over longer periods of time, our value-add stems from both our willingness to be different than the market and our downside protection during very difficult periods. We’re not talking about short term volatility, but rather more challenging bear markets (20%+ fall in the stock market). This attribute is easily forgotten when markets are not extremely volatile.

We are not investing in areas of excessive optimism, but rather in areas of uncertainty. Many of the businesses we have been adding to have already gone through a significant correction (i.e. bear market). Our portfolios offer differentiated characteristics from the indexes they are measured against. We remain disciplined, patient and focused. While our style of investing may not be in vogue at this stage of the market cycle, our process will not change. One thing we know from history is that markets will.

Mawer Investment Management Ltd. 
Contributed by Mawer Investment Management Ltd.
Global economic signals presented a mixed picture in the third quarter of 2018. The U.S. economy forged ahead posting 4.2% real GDP growth, China implemented policies to broaden domestic demand, the U.S. and China announced retaliatory tariffs, NAFTA trade talks dragged out (only to be resolved on the last day of the quarter), and the U.K. continued to prepare for Brexit.

One of the most prominent risks during the third quarter was the rise in U.S. interest rates (with rising rates globally being the key valuation risk for portfolios) which, along with central banks reducing stimulus, added to a tightening of liquidity conditions. Investors reacted by selling off emerging markets currencies in part due to the rising debt service costs for foreign governments and corporations with U.S. dollar denominated debt. Notably during the quarter, Venezuela devalued the bolivar by 96%, and relative to the U.S. dollar, the Argentinian peso dropped 30%, the Turkish lira declined 24%, the Brazilian real dropped 4% and the South African rand declined 3%. The yield on the U.S. 10-year Treasury continued to test what appears to be a psychologically important 3% level with inflation data supporting continued increases in the Fed funds rate.

With this backdrop, U.S. equities as measured by the S&P 500 Index set new highs over the third quarter, appreciating 7.7% (USD) while the resource-oriented sectors in Canada suffered and the S&P/TSX Composite dropped 0.6% generally as a result. The stronger Canadian dollar did temper an otherwise steady period for overall investment performance. In Canadian dollar terms, the MSCI All-Country World Index (ACWI) gained 2.5%, the S&P 500 Index gained 5.8%, the MSCI ACWI ex-USA fell 1.0%, the MSCI Emerging Markets Index dropped 2.8% and the FTSE Canada Universe Bond Index posted a 1.0% drop.

Overall, the warning lights seem to have shifted from an organized grid of synchronized greens, with the mixed data and trade-related concerns forcing some lights to change from green to yellow this quarter, introducing more uncertainty around the global economic growth picture.

​The end.

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