2018 2nd Quarter Commentary
TO TARIFF OR NOT TO TARIFF…
If this were a movie it would have to be a dark comedy. It’s the kind of funny that’s akin to the taste of mayonnaise that’s gone off as opposed to a Robin William’s stand-up routine. Kind of like, ‘hmmm that tastes funny’, mixed with a little, ‘I think I’m going to be sick’.
Enough with my feeble attempt at comedy. Geopolitical flip-flops have rendered the once stable conclusions, derived from long-standing generally accepted economic analysis, inert. Analytical conventions that would seldom be questioned, like the unencumbered and integrated nature of US/Canadian trade, NATO, and the polarized geopolitics represented by China and Russia, have all been thrown for a bit of a loop. Throw into that mix the ever present on-again off-again lovefest that is the relationships with EU countries (Italy, I’m primarily pointing the finger at you this quarter) and you have a soup with too many ingredients. I have remained up at night contemplating the effects of the changes we’ve seen, on more than one occasion. The end conclusion has always been the same, in that I believe cooler heads will prevail but that there will be a protracted period where the market remains increasingly uncertain. That uncertainty will play out as increased volatility.
All of this has manifested itself in higher volatility and an increased bearish sentiment concerning the outcome of the markets and the world economy on a whole. Not that we ever had rose coloured glasses on, as was apparent in our continued over-weighting in cash and my bias towards lower volatility when nearing a potential market top.
A trend reversal in the works?
Make no mistake, despite the beating drums of trade wars around the world, Canadians are still working in high numbers. However, our heavy reliance on international trade, especially trade with our continental brothers, does cause us to worry about how stable those strong employment numbers will continue to be, considering the new protectionist policies of the United States and the seemingly inevitable retaliation that will follow.
Over the quarter, employment remained strong at 6.0%. However, unemployment did edge up in June by 0.2%, a clear indication of uncertainty related to US tariffs.
Ours is an economy that has become deeply integrated with that of the US. Our manufacturing sector, primarily the automotive base here in Ontario, has developed seamless delivery of components and autos. Cars seemingly role off assembly lines at the speed of light these days. From the first nut, to being driven out to the final parking spot, in the finished
inventory lots, takes less than one day (Toyota boasts of an 18-hour production cycle). As if that wasn’t incredible on its own, factor into that equation that in certain instances a car goes across the border 6-8 times before it ends up in that parking spot waiting to be transported to a dealer for sale. Of course, this part of the manufacturing deals more with the components that end up at the final assembly, but still, the level of integration is at a level of complexity to make your head spin.
That’s why we’re still of the opinion that trade deals get done prior to harmful tariffs being put in place long enough to have serious irreversible effects on the Canadian economy. Why? Because tariffs will be reciprocated, and they will ultimately have a similar effect to regional economies south of the border. Most importantly, the impact will tend to be most felt in key voting states that saw fit to vote for Trump in 2016. A game of brinksmanship is underway with tariffs being the leverage to negotiate the best outcome. It’s a damaging policy for fruitful negotiation and if that course is left unchanged can have harmful effects on the economy.
Not all is dire. Much like last quarter, industrial capacity is marching higher. Again, this is a measure of the utilization of an economy’s assets in production. The table across the page illustrates this point. I’ve chosen to include only a few of the industries; the ones I feel to be most meaningful when it concerns the discussion about trade and inflation.
Only the Wood Products, Paper and Petroleum, Coal Products, Forestry and Logging categories saw slack build over the course of the most recent quarter. Not at all surprising given the new duties slapped on the forestry industry in Canada. All other categories remained robust and continued to reach highs in utilization (lessening slack). Most importantly, especially as it pertains to our overarching thesis, Mining and Oil and Gas Extraction are now at a capacity utilization rate that rivals that seen prior to the great recession of 2008-2009.
Total Industrial Capacity Utilization increased by 4.5%, a jump that hasn’t been seen for almost a decade.
All this continues to support the case that the Canadian economy, up until the end of Q1 (as timely a data set available to economists), showed improvement. All assets are being employed and we should now be cognizant of the potential for ‘red-lining’ the engine.
With employment remaining steadily strong and Capacity Utilization reaching new highs, inflation is becoming more evident.
The picture being drawn is clearly one that falls in line with the assumption that the economy is still firing on all cylinders. Employment is strong, the country’s assets are being used to produce, at seemingly peak output and wages are starting to rise. All good. Lastly, we point to the table below, which continues to feature prominently in our discussions of the markets and economy – the CPI data.
All items, except for Household operations and furnishings, experienced price increases. As an aside, I’m fond of always including food and energy in my discussions of inflation because – unlike most economists who dismiss these as just being too volatile a component to calculate ‘real’ inflation – something they refer to as Core Inflation – I still must eat and fill up my vehicles.
Year over year (June ’17 to June ’18) saw inflation come in at 2.5%. Special attention must be paid to energy which saw an increase of almost 13% from the same time as last year.
Climbing a Wall of Worry…
‘Climbing a wall of worry’ – if you listen to market pundits you would have heard this curious euphemism. What is really meant is that, although the last quarter gave us greater uncertainty regarding trade relations, the markets dismissed the news and climbed higher.
Oil saw the most dramatic advance in quite some time with the commodity ending Q1 at $64.00pb and ending the quarter at $74.25pb. Over that quarter we still saw a continued spread between WTI (West Texas Intermediate) and Canadian Select Crude index. However, from almost $30 difference, in Q1, to less than $14 near the end of Q2, that spread narrowed. Which is encouraging for the Canadian energy sector, one that we have over-weighted over the course of 2016 to today.
Our target for oil has been the $75 mark all along. From here, it’s evaluating whether there is significant headwind, in the way of additional supply, that will keep oil from proceeding higher. There is some merit to that discussion as US shale producers still have significant unused capacity that can thwart further price advances. In addition, with disruption in major oil producing nations like Iran and Venezuela potentially being resolved, one must begin to think about an exit point.
The Energy sector, along with the Materials sector, performed well, pushing the TSX to a mid-June high of almost 16,450 points. This, despite the ongoing babble of adding tariffs to Canadian automotive imports to the US. This we find troubling, as the automotive sector in Ontario counts for almost 2.6% of all employment in that province and well over 3.0% of provincial GDP.
The threat of an escalating trade war has us bolstering cash in all our portfolios with the average Accilent portfolio mandate almost holding 20%. The thought here is that we can mitigate any downward shocks by building a reserve should the environment get worse. To reiterate, despite new highs being achieved in the TSX, we are holding a larger amount of cash as we believe the risks of precipitating a recession globally have increased due to trade tensions.
Our portfolios performed well in the quarter. The table above shows the composite (grouped like portfolios) performance for the quarter, along with the volatility of those portfolios for the same period.
Our Growth mandate had the highest return with almost 2.5%. The volatility metric highlights our ever-vigilant pursuit to minimize large swings in our client accounts. Volatility here is interpreted as the standard deviation, it’s a measure of percentage deviation around the average. In this case it shows the deviation away from the posted return +/- the volatility. That said, in the Growth Mandate case, 65% of the time the expected return (given the volatility of 0.58%) would be somewhere between 1.9% and 3.0%, roughly. Similarly, our Balanced and Conservative
Mandates performed positively, all with smaller returns but also with smaller levels of volatility.
Comparably, the global markets were a mixed bag of nuts. Our growth portfolio, one that holds only 60% of the equity indices above, almost beat four of the same benchmarks. The S&P 500, MSCI World, MSCI Emerging Markets and MSCI EAFE Indices found it difficult to breach 3.0% for the month.
Only the Canadian market, the Japanese market and the UK’s FTSE 100 saw strong gains that surpassed expectations. Keep in mind that we had mentioned previously that there will be a point in the future that the laggard Canadian SP/TSX, with it’s anemic returns, will become a top performer. This month saw a good showing, however, there’s more still for the Canadian market to do to even the playing field and the relative outperformance enjoyed by comparable global equity markets from previous years. A good start nonetheless.
Because of the uncertainty in the markets as it concerns trade, we will continue to take steps to insulate the portfolio from surprise shocks. As mentioned above, we’ve intentionally increased cash. As this quarter unfolds, it’s our intention to deploy some of that cash into positions that have an insulating effect on portfolios relative to the broader market.
Protectionism and the Ghosts of Smoot-Hawley: United States
Every introductory economics class that I’m aware of has a lengthy chapter on trade. Free trade, tariffs, embargos, sanctions are all featured reading in that chapter. The key part to that mandatory reading is the focus placed on topics like Comparative Advantage, a concept that highlights that even if a country doesn’t have an absolute advantage in the production of a good, by focusing on products whereby the two trading partners have a Comparative Advantage, both trading partners increase the collective output and thereby the standard of living for each.
Is it a painless transition for all involved in that engagement? Obviously not. Through enhanced scalability and higher levels of efficiency in production, the means to produce the end good or service can change drastically, inevitably resulting in a change in the type of skilled labour needed to continue the production.
Such has been NAFTA. Arguably the most successful of all trading agreements in the world. Per capita income has increased across the board and wealth generation escalated. However, areas of “old economy” dependent on individuals working laborious positions have been eliminated by updated technology. Or, a transitional economy emerges whereby the once strong manufacturing sector cedes to high-tech industries producing intellectual property.
That’s why we are seeing what we’re seeing in the US. Workers who relied on steel, aluminum, coal and manufacturing as a source of a good income have now found themselves to be amongst the forgotten ‘old economy’. The bottom line has been the growing numbers of disenfranchised and formerly skilled workers seeking some remediation of the current status quo and a return of what used to be.
Tariffs and tensions of the sort witnessed today have been seen before. Many have cited similarities to the Smoot-Hawley tariffs in the 30s that exacerbated the economic downturn of the time, arguably forcing a severe recession to become the Great Depression. The difference in this instance is that the economy in the US is operating at full employment. Those wishing to work can find it and employers are starting to realize that if they wish to retain good talent they will have to start to pay-up for it. Although the increase in wage growth hasn’t hit the numbers, our view is that it’s right around the corner in the US, if the general economy remains strong. Compounding the current positive employment data is the new tax reform that President Trump’s administration has enacted. More people are finding themselves with a little more disposable income in their pockets and therefore more likely to spend those dollars.
In addition to the tax reform, this administration has aggressively cut the regulatory red-tape that previously beset businesses. Business in the US loves Donald Trump. Red-tape means costs, costs mean reallocation of resources from otherwise profitable endeavors of production and investment. Inject that with spending of the likes of post WWII and you have a good reason to want to invest in the US. Except for that nagging economics chapter that I so long ago read about trade.
Our concern is genuine. Where a seven-year-old chess player may have strategized a better approach to dealing with the need to renegotiate trade deals, the Trump Administration has failed in their approach by unilaterally taking on the world, as opposed to forming an alliance of close trading partners to address aspects of trade reformation with China first.
The yield curve is a graphical plot of government interest rates along the spectrum of maturities. I’ve constructed two such yield curves for our discussion. One a graphical representation of the change in yields for the US and another for those rates here in Canada.
Economists and bond traders are close watchers of what the yield curve is doing. An upward sloping yield curve, one that has smaller returns for shorter bonds, then higher returns for bonds that are further out in maturities, typically indicate an economy that exhibits growth and potential for increasing interest rates, primarily in the hopes of curbing inflation.
Where many fixed income watchers get nervous is when we have shortterm rates higher than long-term rates and the yield curve slopes down instead of up. This has historically been a strong indicator of recession. A very, very strong indicator.
The past year has seen the yield curve flatten quickly. We are keeping our eyes on rates to monitor for the potential for inversion. As it stands now, the current shape of the yield curve could just mean that long-term bonds may have their prices pushed lower to play ‘catch-up’ with the short-term of the spectrum. If that’s all we see, then the yield curve will resume its normal ‘happy’ upward sloping shape. However, integrating our research on implied volatility (of which I previously wrote of in 2017) and the conclusions derived from its current level, relative to future stock price movements, makes the current shape of the yield curve worrisome as we are now closer to a definite recession signal.
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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