2018 4th Quarter Commentary
SANTA’S LUMP OF COAL
Much is made about the “Santa Claus Rally” on a yearly basis. Historically, market participants, like eagerly awaiting children on the eve of the big day, view the year end as a welcome gift. With bated breath they anticipate the returns that can come with December.
We here at Accilent also saw the year end as an inflection point where the market would find some stability and insert a floor on expectations, at least in the short-term (6-9months). That floor would lead to muted volatility and a resumption of calmer trading. However, if there’s one thing that I’ll always bet on concerning the market is that nothing tends to go exactly to plan, especially the expected timing.
We went back almost 60 years to assess the significance of Quarter four performance. Only 13 times out of 61 4th quarters did we have a negative return.
If we can make the case that the full month of December (for trading and returns) constitutes trading only up to Christmas Eve then this December produced only one out of four months since 1950 in the SP500 that resulted in a loss greater than 14.5%. The reason we only take data up to the 24th is because after Christmas most trading desks and investment managers operate on a skeleton staff and trading tends to be very thin. Suffice it to say, Santa delivered a lump of coal up to that point.
The lump of coal didn’t come without its silver lining. As we had expected, and as detailed in our October Volatility Update, in years where a mid-term election occurred positive returns do tend to follow. However, we didn’t see these returns take shape until the days between Christmas and New Years, almost a full two months after the mid-terms. However, the rally witnessed during the holiday break continued into the new year buoyed by optimism of mending trading ties with China and a less hawkish Federal Reserve. We believe this is a signal that the rally during the thinly traded days between Christmas and New Years does indeed have legitimacy.
In this quarterly we’ll explore the drop in the markets and get a sense for what lies ahead in 2020. Also, we’ll address some annual housekeeping that will focus on how to access your tax reporting for the 2018 year and deal with our Annual Updates questionnaire to ensure that our plan for your remains sound, given your current circumstances and future expectations.
Lastly, as the old year turns over, it’s our sincerest wish that you’ll have continued happiness and health in 2019.
A see-saw battle of monetary economic policy played out before our eyes over the fourth quarter of 2018. Initially, in October and into November, central bankers seemed convinced that the North American economy was on pace to justify successive interest rate increases in 2019 that would see the rates increase by anywhere from 50 to 100bps (0.50% to 1.00%), with general consensus being at least three rate hikes for a minimum of 75bps (0.75%).
Inflation, non-seasonally adjusted, eased on an All-items basis from the middle of summer into the end of the year. Overall prices fell by 0.6% since the mid summer high. The majority of the drop in pricing came from the energy sector of our economy. Roiled by a lack of access to world markets Western Canadian Select (oil prices coming from our western provinces) dropped so far as to reach historical spreads. Historical low oil pricing that resulted in WCS WTI spreads that I feel comfortable in saying we will not see in a generation.
The impact of a continued lack of transmission capacity for our primary economy in the western provinces had a devastating impact forcing the hand of the Alberta government to enact rarely seen mandated production cuts across the board for producers.
We saw a similar event playout in 2008 in the financial sector worldwide but especially in the US. Yes, we realize they are different industries, but it’s the magnitude of drop and the regulatory / governmental compelled action that is highly analogous in both instances. Had investors allocated or rebalanced to financials in the ensuing months of the Credit Crunch, they would have realized a generational opportunity to buy very beaten up stocks. Likewise, the Canadian Oil Disaster of 2018 will playout in a similar fashion long-term.
The drop in oil is temporary, likewise its impact on overall CPI. Capital will flow into that sector to ameliorate the imbalances of transmission capacity which should bolster the industry and pricing. In addition, to the drop in oil the Recreation, Education and Reading subcategory in the CPI calculation also experienced a drop in pricing levels to the tune of almost 4%.
The overall impression that our own Bank of Canada governor, Stephen Poloz, has given is that inflationary pressures that were once evident in the economy in the past few quarters have abated, any further movement in interest rate hikes will be very much data dependent. He has been very consistent with his messaging and has given market participants a means to build out assumptions that shouldn’t be affected by drastic policy decisions.
Although we’ve seen a reduction in overall CPI numbers, Poloz has had to contend with the continued drop in unemployment, as a variable indicating potential overheating. [see graph below]
The Ferrari that’s more a Camry
Those who count themselves as being employed increase by almost 120k over the past quarter, producing a drop of almost 0.3% in the unemployment rate. This all against the backdrop of embattled China geopolitical issues, crisis oil patch conditions in the western provinces and grumblings of more plant closures in the automotive sector.
Our feeling is that the Bank of Canada will be reluctant to advance the bank rate over the course of the next year. If they do so it will be because of surprising news to the upside on all aspects of; US China trade, Canadian inflation and employment. Our view for 2019 is that Canada may not move interest rates at all, and if they do it won’t exceed 0.25% (or one rate hike).
The industrial capacity utilization rate — ratio of actual output to estimated potential output — remained high at 82.6%. Total industrial utilization fell year over year by -2.6% with a drop of 4.06% since Q2. These numbers still remain strong however it does denote a weakening of the economy. We doubt that we’ll be seeing sustained negative growth soon. With inflation low, employment high the general inertia of the current high consumption and increasing wage environment will still produce positive, albeit, decreasing growth numbers going forward.
The volatility that eventually emerged is a prime example of how the markets abhor inconsistent messaging and especially from those that have their hands on the monetary levers that either speed up or slow down the economy.
Late in November Chairman Jerome Powell of the US Federal Reserve gave a dovish speech (dovish – tone implying that central bankers are less inclined to increase interest rates or tighten monetary policy), which gave the markets impetus to rally hard from the depths of the October volatility that had posted a disappointing -9.52% loss (SP500), prior to that speech on 10/29/2018. The rally that ensued had the markets shoot up by more than 3.75% in three trading days.
This confirmed our suspicions that the mid-term elections would yield strong markets until the end of the year and for part of Q1 of 2019. [Recall that in our Q3 report we had indicated that we were closely watching the yield curve as an indication of slowing economic conditions and a leading indicator of economic output and recession, potentially in 2019].
Thematically it seems, the past few years have been plagued by poor and inconsistent communication from US policy makers. Why should this be any different – perhaps our hopes are too high. As such, not more than a week after his earlier speech Jerome Powell backtracked his messaging with a now puzzling hawkish tone (hawkish – tone implying that central bankers are more inclined to increase interest rates and tighten monetary policy).
What ensued was one of the most punishing whipsaw events that the market has seen in more than a decade and only 3 times before in the past 68 years – more on that in the equity discussion.
De-coupling of Markets and Economy
There’s a general acceptance that the equity markets are a leading indicator to future economic circumstances. Analysts and investment managers alike take current information and extrapolate into the future to determine the trajectory of company performance. Metrics like; Sales, Cost of Goods Sold and Net Income all need to be estimated to derive current value for equities. As such, those estimates are highly dependent upon macro economic factors – are people consuming, are they making more disposable income, are they saving etc. In most instances, analysts will produce estimates that are 2 or 3 quarters into the future. These estimates are highly susceptible to changes in assumptions based on economic circumstances affecting the aforementioned company financial metrics.
The markets saw their worst performance since 2008. With both major North American indices finding themselves in a Bear Market (a market that drops by at least 20% from the previous high).
Changing expectations and poor communication from the Federal Reserve coupled with continued uncertainty surrounding the US’ trade relationships continued to be a factor in increased volatility.
The quarter saw almost 14% come off of the SP500. The global markets as an aggregate, here represented by the MSCI World, fell by a similar amount ending the quarter with a negative 13.47% and our Canadian SP/TSX also produced a negative return with a negative -10.89% return. We did however see bonds rally from having been beaten up over the course of 2018, over worries of higher inflation and ensuing rate increases. They posted a modest gain of 1.76% over the same quarterly period.
Most all sub-groups in the TSX fell in 2018. The Tech and Consumer Staples sectors being the only two which posted positive returns. For the quarter the biggest loser was Health Care losing over a third of its value.
Energy experienced its largest fall since 2014-2015, precipitated by concerns of slowing international growth and a lack of transmission capacity to get our crude to ports along the west coast and into the United States, where further refining and value-add production typically takes place.
As of November, the Alberta government stepped in and instituted crude production cuts which went to ease the glut of inventory that was backing up and driving Western Canadian Select (a price for Albertan produced oil) to historical low. During November, the differential (difference between WCS and West Texas Intermediate WTI oil prices) hit a historical high of 40$, with WTI at $50.29 and WCS at $10.29.
The chart on the next page shows the relationship between the price of oil with the Energy sector. There’s no doubt a strong correlation is observable.
Our allocation to Materials was the bright spot in our portfolios as the underlying constituents of that sector have exposure to gold and gold tends to be seen as a safe haven when markets experience volatility. That sector provided a modest 0.43% gain against the backdrop of intense selling and uncertainty.
Portfolios v Markets
As you can see by the tables below, all our portfolios outperformed their equity benchmarks. Little consolation, I know, as they are negative. We always strive to be positive regardless what the markets do, however, the reality of investing is that if we are to invest in the markets we are also going to move in sympathy with those markets, to a certain degree. Our least volatile portfolio experienced only a 2.66% drop, the portfolio with the heaviest weighting to equities, and therefore highest volatility, only experienced half the drop of the SP500.
We were quite active at the end of the year, nearly turning over the portfolio by 40%. As you may recall during my initial discussions with you, I don’t believe in a high turnover (a high frequency of buying and selling). It tends to produce drag on the portfolios and adds an element of additional variability that is timing.
Having said that, every strategy also has its tipping point for taking action. Our first indication was that oil had the worst fall since 2015, and the Canadian Energy sector had just experienced its own version of the 2008 Credit Crunch. These are times to act and act we did. We were active in eliminating the broad-based energy holding XEG – iShares Energy Index ETF and buying underlying stocks that had fallen further than the broad sector. You’ll find four new holdings: IMO – Imperial Oil, CVE Cenovus Energy, CNQ – Canadian Natural Resources and SU – Suncor. For smaller accounts we’ve also used an allocation to HEE which is a good approximation of our strategy – to move portfolios toward beaten up positions that we’re holding in larger accounts.
Likewise, in the broad-based Canadian equity asset class we also added to XDV – iShares Canadian Select Dividend ETF, for smaller portfolios. For larger portfolios we included DOL – Dollarama Inc., NFI – NFI Group, ENGH – Enghouse Systems Ltd., QBR.A – Quebecor Inc. and ATD.B – Alimentation Couche-Tard Inc. All of which exhibit strong management, a good track record for growth and represent strong additions to the portfolio due their recent prices.
What will 2019 Bring?
So, where do we go from here? I explored 68 years of trading going back to 1950. As of December 24th – December 2018 was the worst on record. There were only 3 other months with a loss of greater than 14.5%. See the table below.
Keep in mind that Dec 24th doesn’t constitute a full month of trading but is part of the last non-holiday week of trading. I use this distinction because trading during boxing week happens on very thin volume and outcomes tends to be discounted because it is thought that there is a lack of conviction to trading during that week.
Two observations we can make based on our table above:
1) In all instances where the markets dropped by more than 14.5%, that drop signalled an end to selling (within 4 months, in the worst case, to that very month being the bottom).
2) One year from that drop the markets rallied between 6.96% to 37.93% with 18.56% being the average – the rally even happened in the 2008 fall, where the economy was in a continuing deepening recession one year later.
Lastly, the rally witnessed in the last week of trading should be viewed as a legitimate change in market direction as it was supported by a strong rally that continued well into the new year.
All told, we think the markets will move higher and portfolios will bounce off these lows.
Annual Client Updates
You’ll find in your Quarterly Reporting Package an Annual Client Update questionnaire. It is our responsibility to reach out at least once a year to discuss your current situation and whether changes in your circumstances dictate a deeper review of your investment plan. Please fill these updates in and mail them back to us for our review.
As always, I welcome your calls, and we can conduct these reviews over the phone. In most instances, we’ve either talked recently or if your circumstances are similar to our originally prescribed plan than no need to have a call, just mail in the completed form. However, if you feel you’d like to schedule a time to review the questionnaire and your investment portfolio, please don’t hesitate to reach out to me at my contact below.
Through your NBIN MyPortfolioPlus client portal you can view, print and download all necessary tax slips for your tax filing requirements. Alternatively, NBIN mails these same slips when they are produced. To access and monitor your accounts please go to https://myportfolioplus.ca/nbin where you can register online and setup your login. The number to call for Tech support is 1-855-844-0172, they can aid you if you have forgotten your login or password or need support to navigate the portal.
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.
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.