2017 4th Quarter Commentary
TOUGHING IT OUT:
We enjoy a lot of advantages living in Canada. Beautiful landscapes, no political or geo-political issues that threaten us specifically, generally a free society to go about our business and carve out a future, and four seasons that would make many around the world envious of the opportunities afforded to those who are inclined to enjoy the outdoors. There’s always something to ruin a good party though – as the adage says, ‘with some good, a little bad’. The Canadian markets in 2017 seem to be that “bad”, standing in the way of smiles all around. You would think, with the tone I’ve used, that I was writing about a year that saw losses instead of gains – we did see 6% return on the TSX Composite index, but relative to the rest of the industrialized world, it’s another story; we were the runt of the litter. Indeed, it wouldn’t be too far fetched to label our relative global market performance a disappointment.
Much like a cold long winter before a hopeful warm spring, our markets have languished against the backdrop of iffy global circumstances concerning energy, raw materials, and as a knock-on effect for Canadian financial services. With those three sectors you’ve summed up 65% of the TSX Composite and certainly a very close reflection of how our larger economy is allocated between industries. Everyone else seems as though they’ve been out in the proverbial springtime of market returns – canoeing, enjoying the patio parties as we enviously look on by shoveling another snowfall off our driveways. Odd to think that our markets would languish so against the back drop of other, seemingly similar, industrialized nations that have posted returns that constitute the types of positive return years one relies on to buffer the always possible losses that eventually come. Disconcerting yes, but not out of the question, what with our resource and energy based economy.
As I’ve written in many of my commentaries in 2017, a thaw is in the works. I’ve written about how labour was beginning to tighten on both sides of the border, and as a result, this provided the breathing room that both the Federal Reserve and Bank of Canada were hoping for to start normalizing interest rates (remember that interest rates are still well below their long-term averages). As the end of year approached, many of us were looking for that definitive sign, signalling the thaw and the approaching spring of strong market activity. As with every year, in the latter part of December, the question is always will Santa bring a rally or a lump of coal? It would seem this year Santa delivered his “Santa Claus Rally”. It’s that rally that may very well equate to the ground hog declaring an early spring for Canadian equity returns… a harbinger of good times ahead.
Continued economic strength:
Thematically, and from a stylized perspective, you will recognize the above chart as a mainstay feature in my last few commentaries. I assure you it appears less so because of a lack of quality topics to discuss but more so because the employment story in Canada should still feature as a top-of-mind variable when it comes to investment decision making.
I can’t imagine a more compelling set of data than what we have seen being produced by the Canadian economy and, specifically, the resulting labour statistics.
Again, Canada posted another strong year-over-year employment number. If you recall, I mentioned last quarter that whispers of inflationary wage pressures may start to creep back into the watercooler conversations at various central bank offices around the world, not least of which our own Bank of Canada. The result of which would provide our monetary stewards ample ammunition to act with conviction on the path of normalization of the credit/rate environment in this country. However, Stephen Poloz, Governor of the Bank of Canada, has been and will continue to be quite leery of creating headwinds by telegraphing interest rate moves, the result of which may find the dollar strengthen too quickly – causing consternation for those in the exporting part of our economy and creating resistance to continued economic strength.
The table above continues to describe the momentum in employment in Canada with an improvement that had an additional 422,000 more people in our country working that weren’t a year ago. Employment increased by 2.3% and has resulted in the strongest employment data that we’ve seen in 40 years. Yes, that’s right, 40 years.
It’s also worth it to note that the strength in employment has primarily come on the back of the private sector. This is always a good indicator as it gives us insight into the sentiment of all kinds of private ventures, not least of which, small to mid-sized businesses run by entrepreneurs. Confidence of that sort bodes well in general and typically results in business investment and consumption. That sentiment was echoed in the latest Bank of Canada Business Outlook Survey. The Business Outlook Survey showed continued capacity constraints, labour tightness and strong conviction to pour money into capital expenditures and hiring.
All this supports our earlier thesis that we would start to see the effects of a strong labour market, good economic growth and stable oil prices that may cause inflation to be the topic of 2018. Please see my Q3 commentary where I mentioned that I was “the loner” concerning discussing wage inflation.
Above is a table provided by Stats Can that describes the status of prices in our country. Last month showed continued increases, year over year, for many of the metrics that make up the CPI. Again, as indicated in the last commentary, Clothing and footwear still weighs against the overall upward trend as the retail environment continues to digest the liquidation of inventory from Sears.
It is, however, important to note that significant price appreciation has been seen in energy, both an indication of stability returning to the supply/demand pricing mechanism and general geopolitical circumstances.
Our conclusions from last quarter need to be revised, as we were not totally off the mark by saying that we’ll continue to see growth, albeit muted. Stepping back now and benchmarking our expectations as of last quarter we acknowledge that we didn’t see the strength in the economy we’ve observed in this past quarter. Indeed, the Canadian economy will most likely post close to 3.0% growth in 2017, which was beyond our expectation.
How does this factor into our view going forward? Clearly, we are seeing a credibly strong economy. In the context of the broader world economy, further credence is lent to the thesis we will continue to see the Canadian economy produce positive growth because trade in commodities and energy should become stronger. We remain constructive on Canada with approximately 40% of our Growth Mandates being invested in Canada. Of that 40%, 28% is dedicated to Energy and Materials, both sectors we believe will shine through 2018.
The Turning Point for Canada Equities in 2018?
Last quarter’s commentary focused on how the next couple of months and weeks in 2017 could potentially signal the point that all the economic good news started to translate into the returns we had been waiting for.
Strong market results around the globe were the main story in the last quarter of 2017. However, the Canadian market has consistently been an underperformer and the last few days of trading confirmed its second to last place position.
The table below illustrates the returns from 7 major indices (the TSX having an additional measurement known as the Total Return Index which includes dividends). The TSX posted a 3.67% return for the quarter which was second last relative to all other major indices, with only the FTSE 100 having a poorer showing over that period. Over the year, the TSX produced a 6.03% gain – an additional 3.00% would have come from dividends for a Total Return of 9.10%.
It comes as no surprise that much of the anticipated equity returns in Canada will be dependent on the pick-up of demand in oil and commodities. Our economy is very dependent on these sectors, as over 30% of the TSX index is dependent on both Materials and Energy stocks. Another one third of the index is weighted to Financial stocks (i.e. Royal, Manulife, TD, etc.).
The chart above shows the underlying returns associated with the industries that make up the TSX. As can be seen, the Energy component finished the year in the red with a negative 10.05% return; a component that weighed heavily on the outcome for the TSX overall. Last quarter’s 5.68% positive return in the energy index failed to continue through to the end of the year. However, further support came from the Materials sector with a strong showing that was enough to push that sector to a positive return for the year. As of last quarter, the Materials sector was only marginally positive for the year with 1.6% return.
Our thesis for all of 2016 and 2017 was that we would see a rebound in oil and commodity prices. The call to be “early to the dance” has resulted in muted returns in our portfolios. Through the course of 2016 and 2017, oil tended to be range bound with prices fluctuating from the high $40s to low $50 range. Our 5-year price expectation was that oil would cross the $70 mark and at the time of writing (early January) oil had a significant appreciation and began trading 2018 north of $60.
So why the slow pick up in the energy weighting for our portfolios? From our Conservative Mandate to our Growth Mandate, our portfolios have an additional overweighting to the Energy sector that range between 10% to 15%. One would conclude that a general appreciation in world oil prices would result in a commensurate showing in equities. The difficulty for Canadian energy stocks is that many are dependent on discounted pricing from the world oil price. Keep in mind that much of our oil reserves are landlocked in Alberta and Saskatchewan, in tar sands. A form of reserve that demands far more processing and refinement than other producing regions.
Additionally, the landlocked nature of our oil producing region has oil trade at a discount because it takes more to process and transport it to areas that can demand prices that are closer to the world standard. With the political and environmental hurdles that many in the oil sands have faced to get pipelines built to access those markets, it would seem a long-time before we see our oil make it to areas that can demand higher pricing. With proposed pipelines going through the Rockies to the west coast – Northern Gateway – and another – Energy East – going across Canada to the east coast still mired in red-tape, it would seem a while before we find Canadian producers finding any relief of their current discounted pricing position. Although there have been significant moves to ensure that Keystone XL is still well positioned to come to a fruitful end, nothing yet is written in stone [Keystone is a pipeline that would run from Alberta into the United States and eventually into US refining capacity].
The recent pipeline spills that caused inventory buildup because of pipeline shut-downs, will alleviate and cause a more short-term narrowing of pricing differential between what the world pays and what Canadian producers can demand. This should result in higher energy stock prices in Canada. We therefore continue to remain constructive on our over-allocation to Canadian oil and energy producers.
IN SPITE OF ITSELF…
Full Steam Ahead – Don’t Mind the Icebergs: United States
All of this is not without its risks for Canada and primarily those risks lie to the south of us and will be dictated by the policy initiatives of the US government.
We continue to see a distracted White House deal with investigations and seemingly incoherence and a lack of focus in executing its election platform. A confusing approach of ill-advised twitter posts have many in the government undecided as to which direction the administration will go. From one day to the next, it seems as though there are surprises that are weighing heavily on policy makers.
Not least of which are the ongoing negotiations for NAFTA [North American Free Trade Agreement]. It would seem unfathomable that an undoing of NAFTA may be at hand. It would certainly be difficult due to the degree of integration in many industries in Canada and the United States. There is great support on both sides of the boarder for a negotiated up-to-date version of NAFTA. However, the talks surrounding these negotiations have not been easy. We are focused on the outcome of these discussions and believe that, if an adverse outcome comes to pass, Canada may experience significant disruption to our economy, as our largest trading partner absorbs almost 75% of our exports annually.
Some comfort for us Canadians is that an unwinding of NAFTA, as ill advised and potentially harmful to Canada that it is, is in many ways as harmful to our trading partner. I would still wager that cooler heads prevail, and a deal gets done although as seen with Brexit, one can’t always bet on rational outcomes.
In general, however, the United States economy still pushed through the general distraction provided by the Trump administration and continued to charge forward. A glimmer of light came from a successful policy win by the Trump administration that crystallized major tax cuts for corporations and the country’s wealthy – the latter to factor little in any improvement. These tax cuts aren’t the most useful of economic tools, especially cuts for the wealthiest, as evidenced historically with that new-found money tending to sit idle in bank accounts and not used for reinvestment. Corporately, however, tax cuts at the right time tend to have a greater impact on the actions of companies and find that added cash reinvested into profitable projects. Much of this is already being observed with smaller cash balances on corporate balance sheets and more initiatives of corporate expansion.
Despite all the worries of government, trade and global unrest, the S&P 500, an index with the largest 500 stocks in the United States, posted a significant gain for the quarter at 6.15% and a strong, almost 20% gain for the year. Many have raised concerns that valuations are getting stretched and that we may very well be positioned for a pull back in equity prices. The chart below shows Price-Earnings for every year going back to 1900 up to Jan 1, 2018.
Above you’ll find three plotted series; a blue line which shows the yearly price-to-earnings, an orange line which shows the long-term average of the SP500 and a grey line illustrating a 15-year rolling average of PEs. As can be seen, we’ve had very high PEs over the past few decades. Primarily as a result of the tech bubble and the latter spike from the Credit Crunch of 2008. It’s of note that the peak PEs come after those bubbles burst as earnings drop precipitously in the denominator of the ratio leaving prices on a relative basis playing the catch-up game.
What’s encouraging in this cycle of expanding PEs is that earnings have kept the market buoyant. Each quarter naysayers of continued market expansion come forth to predict drops, based on elevated PEs relative to historical averages but earnings have kept pace and allowed the elevated PE environment to continue. Expectations have been met on earnings and therefore PEs remain intact. At the point we receive our first bundle of disappointing quarterly news for top line revenue numbers that’s when we should become cautious related to where PEs are and their future trajectory.
All our portfolios have exposure to the US through XSP – iShares SP500 Index ETF. This position also has the added benefit of being hedged for currency as our continued belief is that as inflation creeps back into Canada the Bank of Canada will continue on it’s path of increasing interest rates which should strengthen our dollar, diminishing any returns from US equities.
INTEREST RATES ON THE RISE
The Fixed Income Inflection Point
Interest rates on both sides of the border have seen increases over the past year. Those increases have primarily been substantiated with the strong economic news allowing for the ending to overly loose monetary policy and accommodation. Markets have not been hurt by the hawkish tone on either side of the border as an easing of monetary accommodation is a signal that our economies are slowly becoming self-sufficient and not dependent on the emergency measures enacted by central bankers.
In the next few years those same central bankers will raise rates to guard against the spectre of inflation. I believe that may happen within a two-year time frame where in Canada the central bank’s band of “comfortable” long-term inflation between 2%-4% may very well be tested.
Uncontested and holding all other variables constant, should the current trend in global economies remain, the Bank of Canada and the United States Federal Reserve will have to act to restrain the pressures of general inflation, through wages or demand driven commodity prices, by slowing the economic engine. It’s at that time that I expect to see the drop in equity markets that many have called for over the course of the past 2 years. Especially, if we are missing on top line revenue numbers, as stated above.
Should you have any questions related to our services, your account, or this commentary, please don’t hesitate to contact Mark at firstname.lastname@example.org or directly at 905-715-2260.
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