2018 1st Quarter Commentary
TO TRADE OR NOT TO TRADE:
How are your stomachs after this quarter? I’m sure the last three months have provided some queasy moments. Observing the seemingly non-sensical up and down of equity markets can lend to a reliance on antacids. As each of you have heard me say before: forecasting the markets is much like forecasting the weather but with the opposite relationship as it pertains to time and probability of outcome.
To illustrate this point, turning on the daily news one can observe that meteorologists demonstrate a high success rate at predicting the weather tomorrow, the next day and maybe even for the week. However, once you look at longer forecasts, the success of actually hitting the mark reduces dramatically. I constantly use this analogy because it’s similar to watching the markets and trying to determine what will happen tomorrow, the next day, or even month out. Market forecasters suffer from the daily distortions we call noise. There’s little sense that can be made by large sweeping moves in the markets on a day by day basis. Sometimes a mere tweet can send the markets into a tizzy that roils the hardiest of us.
The past few months has exemplified this concept of noise. The markets, it’s said, abhor uncertainty. Well, what but uncertainty have we just borne witness to? Without cessation, the constant stream of unintelligible off the cuff tweets on trade, fiscal policy and diplomacy initiatives have been nothing short of breathtakingly spectacular. A constant stream of non-sense has poured forth, seemingly without reservation from a political figure that most pin their hope on being a stabilizing, calming presence, acting on well thought out initiatives. Who would have thought that the past three months would have the average political news watcher fatigued to the point of needing a vacation just to get away from the incessant stream of chatter. But there is hope. Before too long, mid-term elections in the United States will be upon us. More volatility will lie ahead, undoubtedly, however the direction and balancing aspects of democracy should take some steam out of the engine that underlies much of the uncertainty and noise.
To get to the point everyone should really be asking, ‘have these tweets resulted in material changes to the economic environment justifying the moves we’ve seen’? In most instances no. Unless, concrete long lasting impediments to trade are announced, the longer trend still remains positive, albeit another weather system could sweep in and change that in the short-term.
A slight pause but still rosy:
As a young kid I remember trips into the US, traveling to our yearly destination in St Augustine, to visit family, and then on to Disney. I remember being told, ‘when the US gets a cold, we’ll get the flu’. I thought it odd, being so young, how a country had the ability to influence my current state of health, it wasn’t until later that I came to understand that the metaphor was apt in it’s description of the state of our economy.
This adage is no more pertinent than today. Until recently, the United States’ largest trading partner was Canada – only lately being surpassed by China. In 2016 we collectively traded almost $627 billion in goods and services. Much of that was predicated on the highly integrated auto and related manufacturing industries of Quebec and Ontario with the north-eastern states bordering those provinces. Over $500 million alone crosses the ambassador bridge daily. There are certain instances where just a single car part crosses the border multiple times, in various states of work-in-process, to finally be sold as a finished car. What this means is that, the US, through trade policy, general economic performance or structural economic change can have an impact to the Canadian economy on orders of magnitude larger relative to the broader US economy. NAFTA has integrated manufacturing, travel, security implications that have evolved into a complex interwoven, interdependent structure that would rival that of a conjoined twins separation surgery.
Canada’s quarter 1 economic performance still would constitute a ‘good quarter’ although January did have the first negative month in five months. We also saw a 2.2% increase in year over year performance for All-items CPI (inflation). With one of the largest jumps month over month in Clothing and footwear, indicating the slack built into the system by SEARS’ demise has cleared itself out. As everyone across the country has come to discover, energy prices have done nothing short of shot through the roof – resulting in a little twinge when filling up at the pump, even more so west of the Rockies. Energy prices increasing primarily on strengthening oil is both good and bad. The resulting higher energy prices at the pump can act like a general tax on Canadians.
We continue to believe that inflation will remain a concern for central banks and this concern is highlighted by the Capacity Utilization of the economy. We’ve discussed this metric in the past and the insight that it can provide into the health of the economy, the amount of slack left to exploit in production and the expectations for future investment and pricing. To review, Capacity Utilization is the amount of economic output that is realized with existing industrial potential. To simplify, if you have a printing press that can produce 100 newspapers an hour and you are currently producing 87, your capacity utilization is 87%.
Let’s review the table above. As you can see the top line Capacity Utilization number has been very strong each quarter of 2017, with a 3.3% increase year-over-year. The assets of the Canadian economy are operating at 86% capacity. One would think that there still remains an easily attainable capacity latent in the system for growth, but the real story is that these types of situations are indicative of diminishing marginal returns. With every uptick in utilization an ever-increasing “effort” is needed to achieve it. Much of that “effort” is simply paying more to squeeze the proverbial lemon for another drop of juice. All this leads to a few conclusions:
- Squeezing that lemon harder to achieve higher utilization manifests as inflationary pressure at the producer’s level – which gets downloaded to consumers as inflation.
- Productivity in the Canadian economy may improve as a result of companies opening up their purse strings and investing in property, plant and equipment to achieve higher levels of output.
It’s worthy to note that our impressions are that (2) won’t happen until NAFTA gets signed, although we’re still optomistic, albeit, frustrated due to the flip-flopping, that a deal will get done.
As per the first table in this quarterly, employment remains strong in Canada only conceding one point in June to tic up to 5.8% from 5.7% in December of 2017 – a result of seasonal holiday staff being let go and the implementation of minimum wage laws forcing many to be laid-off in the service industry.
Our view on Canada is cautiously optimistic given the general health of the economy but tempered by the uncertainty in completion of Kinder Morgan pipeline and NAFTA. Although, the threat of higher interest rates loom as year over year inflation has now crossed into the Bank of Canada’s ‘comfort zone’ – 2% to 4%. [Not too hot and not too cold]. Relative to last quarter, we did see inflation tic up by 0.1%, indicating that the trend for inflation remains intact and rising.
Markets have felt the pinch of an unhinged, without focus, public communications stream from the White House that has rivaled any that I can ever remember. As an aside, this reminds me of a few articles I’ve read whereby even those who had a hand in creating this new medium of communication and social interconnectedness (facebook/twitter et al) condemn it. Tim Cook, no less, the CEO of apple, forbids his children from accessing popular online social platforms that have kids these days all abuzz. Perhaps Tim Cook needs to call the White House to see if a policy of restraint can be imposed on it’s primary resident?
We started this article talking about noise, and I’ve also wrote about it in the past, but the past three months exemplifies perfectly what it is exactly. From one day to the next, the markets would advance by an obscene 500 to 1000points and then drop the very next day with the same magnitude. All on what seems to be the unhinged social media ramblings from the White House. “Tariffs On”, “Tariffs Off”, “NAFTA ON”, “NAFTA Off” tweets were so common that they reminded me of riding a roller coaster and their toll was clearly evident in the markets.
Such disregard for communicating policy I’ve never seen in any administration while managing money. The two best performing markets were the S&P500 and MSCI Emerging Markets. The S&P500 with a negative -1.22% and the MSCI Emerging Markets Index with an almost non-existent 0.37% return. World Markets on a whole, represented by the MSCI World Index dropped -2.67%.
How does this stack up against our portfolios on a whole? The table below shows how each one of our existing mandates have performed in the light of current market volatility.
Our portfolios held up admirably against all market indices except for the S&P500 and the more volatile MSCI Emerging Markets Index. Relative to our own Canadian S&P TSX Composite Total Return, our portfolios reduced the downside by well over half the drop. Relative to Europe Australia and the Far East, again better by half. We’ve been fairly conservative with all our portfolios from Conservative to Growth.
Canadian markets have been plagued by the volatility stemming from a lack of clarity regarding trade from our largest trading partner. NAFTA, although years ago primarily focusing on the domain of manufacturing and industrial sector, covers all aspects of trade between the three nations that makeup the trading block. When first negotiated, the energy and materials sector didn’t have the prominence they have now. As such, they felt the sting of constant uncertainty that played out over the course of the last quarter.
Valeant Pharmaceuticals, the heavyweight Biotech/Pharma corporation in the SP/TSX pulled down the Health Care sector with almost a 21% loss in value. The other major impact to the TSX came from Energy stocks, sinking to new lows with many names like TransCanada and Alta having dismal quarters with losses in excess of 15%.
Financials and Materials were middle of the pack sectors, buoyed in part by the hopes of rising interest rates (financials) and resolutions to NAFTA being around the corner.
PURSE STRINGS HAVE OPENED
Spending time: United States
We won’t dwell any further on the noise and volatility felt around the world. Let’s just say that what we experienced here in Canada was a given south of the border. Despite that, economic data coming from the United States remained strong. Employment continued its relentless drive forward with continued job growth. The Non-Farms Payroll, representing employment in construction, goods and manufacturing was an astonishing 313k new jobs in February. One of the largest NFP numbers since 2016.
Wage growth was the only lack lustre metric over the quarter with a year over year increase of 2.6%. Despite this factor new Federal Reserve Chairman Jerome Powell felt the need to increase interest rates again in March. Our thoughts are that he and the other FED governors feel that the prospects of the job market will continue to tighten. Also, on a demographic basis, tens of millions of baby boomers are eyeing retirement, with a demographic cohort following, fewer in number, ready to replace those workers.
Compounding those concerns are the new Bipartisan Budget Act just passed, resulting in the injection of several hundreds of millions of dollars into infrastructure and military projects at, arguably, a time that fiscal stimulus is not necessary.
All of this speaks to the Output Gap, a measure like that of Capacity Utilization but more focused on the demand for products relative to the ability to create those products. Currently in the US the Output Gap is high – demand is high. However, employment is arguably at full employment and inflation is starting to creep upwards. The analogy I used before about trying to squeeze that additional drop out of an already squeezed lemon is apt. More effort needs to be employed, and that results in inflationary pressure. Although the Fed remains focused on watching these variables they are still not prone to make massive moves in the fed rate without seeing higher inflationary numbers than the low 2 percent range that have lately been evident.
Again, the rosy news, and potential for continued economic growth, are bound by the trade policy of the United States. Tariffs don’t work in mature industries like manufacturing and industrial sectors. The technology now employed in manufacturing, on a global basis, makes for products closer in quality to their domestic counterpart. In combination with the relatively low wage that the other countries’ workers are willing to accept, results in products that can be easily substituted for domestically produced products. For me this tweet storm is indicative of a poorly implemented negotiating tactic. There’s simply far too much evidence, and recent evidence at that, to indicate that placing tariffs on goods and services renders a cost, like a tax, on the consumers of that nation. Given some of Trump’s advisors, most notably Wilbur Ross (a battle-hardened turnaround hedge finance expert), I can’t believe that these threats are anything but poorly formulated trade negotiation tactics. As recently as the George Bush (senior) administration we saw the effects of similar tariffs on aluminum imports, which resulted in their lifting no more than a year after being instituted.
INTEREST RATES ON THE RISE
The tipping point
I should apologize for the broken record approach before you read this section…very little has changed in my messaging since our last writing in Q4 2017, EXCEPT, that far too many Canadians are far too levered. This isn’t anything new, but it is increasingly pointing towards a tipping point. Credit cards will have a few more months of unpaid balances. Discretionary items like a night out at the movies or a new item for the wardrobe will be forgone in order to pay the mortgage.
I’ve recently been asked about investing with leverage, and I would caution strongly against it, especially here in Canada with the current levered circumstances of our populace. We now rival, and in certain categories, exceed the indebtedness of our American cousins to the south prior to 2008 credit crisis.
Real Estate here in Canada will feel the effect of increasing interest rates the most. Already housing sales have slowed in Toronto and Vancouver. Prices have come off their highs and will continue to trend lower. All of this in the context of inflationary pressure that might see interest rates continue to rise. Homebuyers a year ago will soon see 3,4,5-year renewals where the value of their home is less than what they originally paid for or even the mortgage that they currently have. Remember well, that investing on leverage, in this circumstance, can cut both ways. If real estate falls, or your stock portfolio, and interest rates increase you have to pay higher costs for now something you don’t own and need to pay back. Think instead of times like the bottom of 2009 when central banks around the world forced interest rates to historic lows and one could buy a bank stock here in Canada that yielded north of 10% on the dividend. No, now’s not the time. Stay safe and keep your powder dry. If you are levered start looking at reducing your overall debt exposure.
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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