2017 3rd Quarter Commentary: Up, Up, and Which Way?
The economy and the market are flexing – but which factors are ‘Capes’, and which are the ‘Kryptonite’?
DOLDRUMS TO DARLING?
As a kid, back in the late 70s and into the early 80s, I remember reading comics of my favorite superheroes. I wasn’t a fan of the Superman types of stories where the protagonist was inherently gifted with superhuman abilities but more the Spiderman, Batman or Ghost Riders that had to come by their powers another way. There was something about the “Ordinary Joe” who had an impactful event happen to them to force a change that would forever alter the course of their story. Interesting reading when you’re 10.
As a kicker, once you finished you could read some of the super funny ads at the end of the comic. As my son turns the age where he’s starting to read those old rags, I’m reminded of one ad with the slender under-built gentleman courting a bathing beauty on the beach, being bullied by the local “heavy” and returning to the beach after having read the “how-tos” of strength and muscle and thrashing that bully. When I was writing this commentary I instantly thought, ‘well, if that weakling isn’t the Canadian market’.
There’s no way around it. For the better part of a year, Canada has played the role of that ‘weakling’, especially in relation to it’s global ‘bully’ counterparts. Despite the underlying strength in economics, equity investors have felt little to no joy when it comes to their investments.
ECONOMIC STRENGTH, MARKET STRENGTH
Getting Muscled Up [CANADA]
In my last commentary, the title that started off my discussion about the Canadian Markets, was “Economic Strength, Market Weakness”. I featured a table provided by StatsCan, that can be referenced in our Q2 Commentary 2017, which showed that more people were participating (working or looking) and were employed. Below you’ll find the update:
As my title here suggests, perhaps now a change of the headline is in the offing- from the previous Economic Strength, Market Weakness to today’s title Economic Strength, Market Strength. Or perhaps, we should take it a step further and look to call it Economic Breather, Market Strength?
From an employment perspective (see the chart on the previous page), Canada has continued on its trajectory of adding more bodies to the column of the gainfully employed. The real kicker was the jump in employment that came mostly in the form of the private sector (the real strength of an economy) and full-time work. It’s the full-time work which is material as this tends to translate to people having more money in their pockets, fewer people will be looking for work, and -wait for it- the labour market is getting tighter.
‘Of course, Captain Obvious’, you’d say, ‘the labour market gets tighter when more people are working.’
But what implication does having a tighter labour market have for spending, inflation and standard of living? Should the Canadian economy remain strong through the course of the next year we will finally begin to see the hints of wage induced inflation. I’m a bit of a loner on this one. There’s the odd analyst and portfolio manager that has this view but I think if we delve a little deeper into the numbers we can see a trend in both demographics and economic metrics that lead us to a stronger inflationary outcome long-term.
Demographically, the baby boom is now fully flirting with the idea of what to do after work. Most of that bulge is in the throws of deciding about downsizing, lighter work schedules, last year consultancies and travel. This is a major part of the work-force that will look to do something other than work. Also, with fewer people raising their hands as being eligible for work, or even looking to work, employers will find it harder to get good employees on the cheap. Wages will have to rise to attract the good, long term employees. At least this is my prediction for a long-term trend. In the short-term, many things can stand in the way and act as a noise disruptor to that trend.
On its own, labour slack wouldn’t have me change my outlook concerning wage driven inflation. In fact, I still think from solely a wage perspective it wouldn’t be enough to move the needle of inflation. However, let’s have a look at general capacity utilization in the Canadian economy as an adjunct variable in support of the higher inflation thesis. Capacity Utilization is a metric I’ve used before in my discussion of economic strength – see my Q1 Commentary regarding how Capacity Utilization had stalled around the low 80% range because of poor performing energy assets. To reiterate, Capacity Utilization is a measure of the actual output of an economy relative to the potential output of an economy. The last two quarters have seen a reversion higher for this metric to the point where we now show the highest utilization of our economy’s assets since prior to the great recession.
Therefore, if you’re a business owner and you find that your business is chugging along on all cylinders but there’s more opportunity for you to grow, what do you do? Invest! Much has been said about the “fortress balance sheet”, or “iron balance sheet”. In the past decade there has been an ever-increasing cash build-up in companies as opposed to targeted deployment in projects and assets that can spurn growth. Businesses tend not to spend until they can be assured that their next dollar of investment will result in higher or continued strong earnings. I believe we are now at that point. Therefore, with a strong labour market and a push to corporate investment I believe we’ll see some pressure on inflation. I’ve included the last CPI data table from StatsCan for your review. In all categories, save Household Operations and Furnishings, and Clothing and Footwear, we’ve seen higher prices. Furthermore, is it any wonder that with the demise of SEARS both Household operations and furnishings and Clothing and Footwear showed weakness? Continued weakness will remain until the slack brought on by the liquidation of SEARS abates and pent up demand builds for these items.
Our conclusion is that the economy will remain strong, although we will not see the type of GDP numbers we’ve seen in the earlier part of this year as it’ll be time to take a breather. What we will see, however, is all that hard-work in building economic muscle will now shine through in the equity markets as earnings will see the benefit of that strong economic data.
ARE THE ECONOMICS TRANSLATING TO MARKETS?
Making Sense of Reflections
Up until the last few weeks of the quarter the Canadian markets seemed destined to again look like the weakling. However, with the strength in oil prices and financials we finally saw a respectable return from our market.
The TSX posted a 3.0% return for the quarter and only a 2.3% return for the year. On a yearly basis, it was the worst performing market but it managed to stay middle of the road for the quarter.
Remember in my Q2 Commentary I mentioned that there can be a lag in economic data and market response? True to form, we are only now starting to see the good news be digested and show through in earnings, and pricing in the markets.
The table above gives a rundown on each sector making up the S&P/TSX Composite. The culprits a quarter ago are now heroes with Energy and Materials both posting strong gains. Although, there is still some work for Energy to turn a profit on the one-year number the quarterly result is encouraging. When you combine the performance of Energy and Materials with that of the Financial sector which forms the basis of the majority of the TSX Composite, the result has been mediocre. The TSX Composite Year-to-date returns were only 2.3% and 3.0% return for the quarter.
The encouraging story remains that oil is well below its highs and the longer five-year average and that economies around the world continue to be strong. This may indicate that Canada could be set for encouraging equity market returns.
POTENTIAL HURRICANE RELATED ECONOMIC WEAKNESS
Full Steam Ahead- But With A Pause [UNITED STATES]
U.S. Employment Data – Unemployment Rate
Featured last month was the graph of the US Unemployment Rate and so it appears again in this commentary. Despite the fearsome weather-related news impacting Florida and the Gulf during this hurricane season, employment in Sept fell again to 4.2%. Are we close to full employment yet? Some would say yes and the impact would be a tighter labour market and the potential for wages to increase and affect long-term inflation.
As is typical during quarters experiencing heavy weather-related incidents GDP tends to slow. This quarter in the US was no exception, and many components to GDP showed small contractions in growth. Industrial production slowed along with retail sales – a very important data point as the US economy is dependent on it’s consumer driven service sector for much of its economic output.
Having said that, what’s also true of hurricane impacted economic growth is that there tends to be a rebound in following quarters given reconstruction efforts and new economic initiatives to deal with decaying infrastructure in the affected regions.
Despite the slow downs in output and weather-related crises, the S&P500 charged forward with a strong 4.0% return for the quarter. The YTD return broke double-digit levels with 12.5%.
It’s important to note that our portfolios have been positioned to take advantage of a weighting in the S&P500 and we have been the benefactors of the appreciation in the index. In addition, given our Canadian centric objectives as investors, this position was hedged against an advancing Canadian dollar.
It’s worth noting that we continue to invest in the United States only when we can hedge the effects of currency. Rightfully so, as the US dollar continued its fall relative to the Canadian dollar to the tune of almost 3.8%. We continue to be bullish on the Canadian dollar and less so in American equities. Hence, we continue to hold a disproportionate amount of cash in all our portfolios.
GLOBAL ECONOMIC STRENGTH
Eating Up Supply, And Potential Debt Heartburn [GLOBAL]
Good news first? Sure. Economic growth was strong in the third quarter of 2017 globally and is expected to be in the mid 3% range. Most industrialized nations have found that labour markets are enjoying strong employment. In addition, there is an expectation for an increased investment in fixed assets around the world as capital expenditures grow to fund future investment and business opportunities. This should have the effect of providing continued economic strength globally. However, to expect the global economy to continue to churn out high economic growth, as in the past few years, is not reasonable. A slower pace of economic activity remains the common consensus of many economists.
As a response to the continued economic strength and as can be seen in the table on page 3, showing the returns of the various world indices, the MSCI World Index posted another strong return of 3.5% for the quarter and approximately 10.8% YTD.
Ok, so now for the bad news. As I mentioned in my last commentary regarding the world economy, there is continued worry stemming from the reliance of debt to spurn on some of the aforementioned economic activity that I spoke of above. This circumstance hasn’t changed, and at some point, those turkeys will come home to roost. We continue to closely watch the growth of debt in economies like China, the second largest in the world. Should economic output not match the ability to service the leverage that drives those numbers, the resulting economic downturn will be harsh.
I mentioned last time that this debt bubble is a little different than the one everyone remembers in 2008. Again, that one focused on levering the margin on investment whereas much of the debt growth we’ve seen in emerging economies has tended to be earmarked for industrial output. The inevitable pop might not be as deep but it will however sting.
INTEREST RATES ON THE RISE
The Fixed Income Inflection Point
It’s now becoming our mantra – watch-out for rising interest rates. Each quarter we continue to feel that risk in interest rate sensitive securities could have a lasting effect on pre-retirees and retirees – who have traditionally flocked to assets like bonds and real estate to find stability and income.
We’ve seen both the Bank of Canada and the US FED raise rates and telegraph their hawkish view of future rate hikes. So, it’s no doubt why we’ve seen the Canadian DEX Broad Bond Index drop -1.84% in the past quarter. We anticipate that it will continue to experience headwinds as interest rates continue to rise, compromising returns from both bonds and real estate.
Should you have any questions related to our services, your account, or this commentary, please don’t hesitate to contact Mark at email@example.com or directly at 905-715-2260.
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