2018 3rd Quarter Commentary
No, USMCA isn’t the new Village People song. It’d be a hard sell to supplant the fun of YMCA with the nuanced and tedious aspects of trade, of the sort the USMCA lays bare. Whether we can now start dancing in the streets is another matter. Yes, we’ve got a new deal, as we suspected would be the case in our last quarterly. However, is it really any better for Canada, as minister Freeland and our Prime Minister would have you believe?
Ultimately, until the full details of the deal are revealed some satisfaction can be taken that a deal was done, and some certainty has resulted from that. A small victory, yes, if only to better know that ‘sleeping next to the elephant’ won’t get us crushed (what a fuddle duddle).
The seemingly daily back-and-forth of trade tariff uncertainty and the everpresent threat of a trade war hung perilously above our collective Canadian heads. It provided for ample hand wringing and more than just a few sleepless nights, on my account at least.
Some solace is to be had that there is some stability and certainty for the 76% of our exports that go to the U.S. What remains to be seen from the study of the fine print are the impacts of the concessions made by our government.
Perhaps this prompts our federal government to focus on reprioritizing the management of our resources, to become more efficient (pipelines), rather than the optics of showcase progressiveness that is pot legalization? One can only hope so. Perhaps they may learn from this last round of renegotiation and make it a point to seek out other trading partners that rebalances the terms of our engagement with ‘the elephant to the south’. An elephant that seems all too comfortable at turning its trunk away from our peanuts.
Over the quarter the economy barrelled ahead producing lower levels of unemployment by adding an additional 65,000 jobs.
Year-over-year the Canadian jobs picture is as rosy as one can remember hovering at historically low unemployment rates, with an additional 222,000 new jobs being added. The overwhelming majority of those positions were full-time.
The jobs growth in the last quarter was somewhat surprising despite the uncertainty surrounding NAFTA negotiations. Which would, all things equal, cause employers to hit the pause button on any aggressive additions to the worker pool.
USMCA – NAFTA with a twist
As mentioned above, we finally got our trade deal. Negotiations had the drama of a high stake’s poker game (times a million). An 11th hour deal was struck to preserve tariff-free market access for Canadian companies. Albeit with Aluminum and Steel still being levied with hefty tariffs under the guise of Canada’s steel and aluminum imports being a threat to U.S. national security.
It wasn’t without pain that a deal was done, and Canada’s capitulation on access to it’s closed dairy quota system/market was the victory that the Trump Whitehouse was looking for. Such a small point, but one I’m sure Trump was looking for to bolster the GOP’s chances going into mid-term elections in November. Remember his whole fist-shaking stance on trade negotiations was to get a ‘winning’ deal where other administrations have failed? This small economic victory will no doubt feature in the messaging going into those mid-term elections.
In addition to dairy, Canadian negotiators acquiesced to a sunset clause that sees USMCA being renegotiated every 6 years. Troubling for those companies that may look to invest in Canada for the long-term in lieu of the constant uncertainty related to potential changes in the deal based on frequency of renegotiation.
For those two concessions negotiators fought, and won, to contain Chapter 19 of NAFTA alive in the new deal which provides Canada with the ability to seek impartial arbitration for dispute resolution.
The industrial capacity utilization rate — ratio of actual output to estimated potential output — remained high at 85.5%. Tight capacity has historically led to a ramp up in business investment spending and that relationship continued to hold in the second quarter. Based on solid imports of machinery and equipment in July, it seems investment spending found support in Q3 as well.
All fine and well, but without overall business competitiveness improving, such Capacity Utilization will amount to nothing more than spinning our collective wheels.
Ultimately, here’s my frustration with our government, it’s their lack of prioritizing management of the Canadian economy, especially in the context of compelling deregulation and better taxes south of the border – U.S. policies which are attracting significant investment. This will ultimately find our overall economic growth stunted. Who would choose to make a buck in Canada when it’s so much easier to do so south of the border?
Household debt servicing remained stable in Q2 at roughly 14% of household disposable income. This is comforting; however, we anticipate that interest rates will continue to move upwards thereby chewing away at disposable income.
What is somewhat troubling is that household debt reached a record C$2.2 trillion in Canada. Economists would have you take comfort in the fact that growth in that debt increased at its slowest pace in four years (4.3%), I tend to watch the absolute dollar figure…yikes!
‘Good Things, Sometimes Take Time’
Alas, this is the plight of a value investor, of which I am. I’m reminded of a scene in a movie in which an old grizzled investor walks onto a trading floor, populated by myopic stock brokers half his age, dispensing the sage advice that, ‘good things, sometimes take time’. The meaning behind that message was to set sightlines further out and buy quality as opposed to flash. It’s not an easy strategy to execute because so much of how we relate to money is based on our emotion. If we see positive numbers, we’re happy and continue to think, ‘let it ride’. The opposite is also true.
Our portfolios have echoed that above sentiment from day one. As is evident with our heavier allocation to Canada as opposed to the rest of the world. Oh, we have other geographies weighted in our portfolios, but they’re underweighted relative what our long-term expectations would be for a globally allocated portfolio. We call this a Value Strategy because the fundamentals would suggest that the market should be trading higher than where it is now. Growth on the other hand is a strategy seeking higher and higher earnings.
The two graphs show these strategies to each other over the past 10 years. You may be prompted to ask, ‘but Mark you made it sound as if Value has been beaten up relative to Growth?’ True enough, it may have come off that way.
However, the point to be made is that although the profiles of return may have looked different when comparing Canadian Growth Stocks (stocks which are growing the bottom line faster than the market) vs Canadian Value Stocks (stocks that tend to trade at a lower price relative to what their fundamentals would suggest), in the broader international markets most stocks in Canada would be considered value, regardless how they would compare domestically. Aside: Look at the U.S. graphs below, they even go further to illustrate this relationship.
What’s also true of Value investing is that sometimes it’s unpopular because it can tend to lag in the last stages of a market before the market corrects. Sometimes the lag can also be a negative.
Portfolios v Markets
How did our portfolios hold up over the quarter? Above are composite returns, which means that we’ve aggregated all the portfolios together to create a return. Your individual returns may be higher or lower depending when transfers came in, specific cash requirements and different fee levels.
All told, returns we were flat to slightly positive. Relative to the indices we’ve remained neutral and have chosen to take a wait and see attitude to making any moves especially in light of the disparity of market circumstances and uncertainty in trade discussions. It’s important to note that the volatility of our portfolios, to date, has approximated that of holding bonds.
The above table shows the annualized risk (volatility) of the S&P Canada Aggregate Bond Index – an index that is a cross section of all bonds that trade in Canada. Up to the end of the quarter our portfolios have demonstrated a similar, if not less, volatility than that bond benchmark.
The impact of having a NAFTA agreement unsigned and the potential of a trade war weighed on Canadian equity performance and didn’t allow for much investment conviction to take sides in a portfolio. As many of you have heard me say, concerning decision making from the Whitehouse, there’s little ability to forecast with any measure of confidence what policies and initiatives get announced and enforced. No doubt that uncertainty has been weighing on returns.
The S&P/TSX continued to struggle in Q3. Its price return was a negative 1.26%. All this coming from the impact of trade negotiations and how they would affect our major exports into the U.S. Energy and Materials felt the impact more than any other sector in the TSX other than Consumer Discretionary stocks. Keep in mind we are an economy that tends to supply the raw material needs of the world through our exports. With the U.S. being the main buyer of most of those inputs.
Fortunately, Banks, Industrials, Health Care and IT kept index total return in positive territory for the year to date. The doldrums of the S&P/TSX are not attributable to economic weakness. Canadian GDP continues to surprise on the upside and index earnings have come in above expectations. This development, coupled with potential tax relief for corporations in the upcoming federal fiscal update, could support earnings of companies in key industries that have been trading at a substantial discount to their historical average – VALUE.
With the skies over the Canadian economy now bluer, the current spread between U.S. and Canadian equity-market valuations is hard to justify. Our continued exposure to Canadian Energy stocks and Materials (VALUE) remains intact. This sector will ultimately benefit from shrinking the current record discount of the (Western Canadian Select – Oil) WCS price to the (West Texas Intermediate – Oil) WTI price.
Who invited boring Value to the party?
The 7.2% rise of the S&P 500 in Q3 was its best quarterly gain in 4½ years. The advance was driven by Health Care, Industrials, IT and Consumer Discretionary stocks. Most of that return came in the early stages of the quarter. Primarily on the shoulders of a strong economy, supported by a tight labour market, tax cuts and record stock buybacks, propelled index earnings to an all-time high.
The U.S. benchmark is trading at more than 17 times forward earnings (historical average: 15) with fairly aggressive expectations for the coming year (GROWTH). Bottom-up consensus of equity analysts sees EPS growth of 12.6% over the next 12 months, with more than half the increase coming from margin expansion and stock buybacks.
The theme of ignoring value stocks is not specific to Canada but evident in the largest equity market in the world. I show the relationship between Growth, Value and the SP500. As it stands, over the past 10 years, value investing has underperformed growth investing by almost half. The above chart depicts what would have occurred if you invested 1000$ into three different portfolios – a growth strategy consisting of stocks from the SP500, buying the SP500 on the whole, and finally buying a value portfolio with stocks from the SP500. The lag is appreciable. HOWEVER, this is where the years of following these metrics and strategies comes to bear, this relationship always, ALWAYS, rolls over.
Below is relative comparison of which strategy outperformed over the course of the past 10 years. As you can see, aside from a small period at the beginning of 2008 Value Investing has lagged it’s better looking, flashier brother. It is worth noting, that this ten-year lagged performance is one of the longest-lived style disparities. It’s coming to an end.
Mid-Terms to the Rescue…
From a calendar perspective, the fourth quarter is historically the best time to be in stocks. And the months surrounding mid-term elections are typically a very good time for the stock market.
Wall Street is generally happiest when Washington is too conflicted to enact significant change within the financial markets. Historically in mid-term election years, stocks have stumbled in early autumn (usually September rather than October) on the prospect for disruption. As investors consider the historical record – the President’s party tends to lose House and even Senate seats in the mid-terms – investors respond positively to the likelihood of increased Washington gridlock.
Since 1980, capital appreciation during November and December combined has averaged 3.1%. For the eight mid-term years between 1980 and 2014, November and December combined have averaged capital appreciation of 3.6%, or 50 bps better than average. The outperformance becomes more amplified as the following year unfolds and the fruits of gridlock are revealed. Since 1980, the S&P 500 has averaged capital appreciation of 6.0% from end of October through end of March in the following year. For the eight mid-term years between 1980 and 2014, the S&P 500 has averaged capital appreciation of 7.7% from November of the mid-term year through March of the following year.
Examining the more recent period, November through-March outperformance is even more impressive. While November-through-March for all years since 1998 averages 4.5% capital appreciation, Novemberthrough- March for mid-term years since 1998 averages 11.3% capital appreciation.
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.
This communication is intended for information purposes only and does not constitute an offer to sell or a solicitation to buy securities. No securities regulatory authority or regulator has reviewed or assessed the merits of the information provided. This communication is not intended to assist you in making any investment decision regarding the purchase of securities. Rather, Accilent Capital has prepared relevant documents for delivery to prospective investors that describe certain terms, conditions and risks of investment and certain rights that you may have. You should review all relevant documents with your professional adviser(s) before making any investment decision. This report may have forward looking statements. Forward looking statements are not guarantees of future performance as actual events. While every effort has been made to ensure the correctness of the tables, graphs – all data. Accilent Capital does not warrant the correctness, completeness or accuracy of financial data in this publication.