2019 1ST QUARTER COMMENTARY
True to form there’s rarely a dull moment when it comes to the markets. Suffice it to say, the first quarter of 2019 provided little to counter the previous statement. With December 2018 being one of the worst months on record (counting from the beginning of the month to the 24th) to the market rebounding in January and February which played out as we had anticipated.
As we mentioned last quarter, when sentiment gets this dire it typically results in a snap-back that has the market come to its senses and revalues asset prices higher given the previously over pessimistic selling.
In this quarterly we’ll explore the prevailing economic circumstances in Canada and the US, how the markets have done over the quarter and how we positioned portfolios to take advantage of what we felt was undue pessimism and extreme volatility.
As a result of the aforementioned volatility you are no doubt aware of the activity taking place in your portfolios, as extremes tend to trigger significant turnover and contrary to the slowly plodding markets, before Q3 2018, where little buying and selling took place.
Lastly, some house-cleaning, we want to remind you to complete the Annual Update Questionnaire and send it back to us. It helps us to better understand your current circumstances and whether our strategy still remains suitable for you.
Below you’ll find a graph illustrating the current state of the Canadian economy as it pertains to Capacity Utilization, Inflation and Unemployment.
Unemployment data grew slightly in the beginning of the quarter. This shouldn’t be viewed with any concern as this increase tends to be seasonal in nature, reflecting part-time Q4 holiday staff ending their work engagements (typically in the retail sector). The increase of 0.2% to 5.8% still represents an unemployment rate at historical lows.
Likewise, Inflation also eased over the course of the first quarter. On a year over year basis inflation started to decline during the middle of the 3rd quarter, last year, and continued into March. No doubt this will give Stephen Poloz some breathing room at the Bank of Canada easing concerns of rampant inflation and the need to increase interest rates while the Canadian economy struggles to produce robust growth.
Below is another graph – an extension of the one we discussed on the previous page. This time Inflation and Capacity Utilization are ploted on the backdrop of Real GDP for Canada. This is the primary driver to what I believe is the cushion that Stephen Poloz is happy to see.
Above Real GDP (which is the economic output of Canada expressed without inflation) decreased over the past 6 months of 2018 and continued that decline into 2019. Part of which could be explained by the increase in the green line (inflation), as it increases, GDP, all things equal, decreases. Combined in the analysis is also Capacity Utilization, here in blue, which has also decreased over the quarter. We should be cognizant that the data above details a slowing of the economy. To reiterate what we said in our Q4 commentary:
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).
No change here.
Total Industrial Capacity turned lower, year-over-year, as at Dec 2018. Counter to equity markets where energy equites sunk in the fourth quarter of 2018 Capacity Utilization increased for that sector. The Energy and Mining industry saw an increased intensity in asset usage. This added capacity was a desperate attempt by industry participants to operate at high capacity to offset lower crude pricing.
This rarely happens and tends to go against established micro-economic theory that when prices fall producers produce less. In this instance as prices fell producers ramped up their production until the Alberta gov’t curtailed output with a quota system limiting the amount of daily production. This exacerbated that crunch in Canadian Western Select (oil prices). It goes without saying that had this mismatch of Demand and Supply continued, market forces would have forced the inevitable cut-backs in production even without the Gov’t of Alberta’s interference.
In the US – Despite the weaker than hoped for first quarter economic numbers, we remain bullish on the prospects for the US economy (at least until the end of the year). That first quarter weakness was primarily driven by the government shutdown. In no small part due to the rudderless White House administration, the US saw the longest government shut-down in history.
An interesting historical tidbit: each time there’s been a government shut-down, the economy responds positively in subsequent quarters. The short-term shutdown, in conjunction with the strong labour market and a cash-flush consumer in the US should produce a positive GDP in Q2. Shutdown related weakness in the past has tended to be followed by sharp rebounds for U.S. real GDP growth in subsequent quarters e.g. 1996 Q2 (+6.8%) and 2014 Q2 (+5.1%). More importantly, the primary engines of the U.S. economy, namely consumers, are in pretty good shape.
The Federal Reserve signalled a dovish perspective with a shift in tone early in the quarter. Their “focus on the data” has led them to catch-up to what many market watchers were echoing months earlier which was that the economy was slowing and that further rate hikes would cause a screeching halt to positive economic output. Thus, stable to lower interest rates should ensue now for the remainder of this economic cycle.
The rampant labour market in the US, unemployment at time of writing is 3.8%, was still at record lows. Everyone looking for work could find it. Coupled with a new dovish perspective from the Federal Reserve and this goes a long way to mitigate the effects of a slow down, especially in an economy so dependent on the consumer. We should also see the housing market in the states firm up.
As the economy inevitably turns into recession and a new round of rate hikes takes place we will, as always, consolidate and move higher (which shouldn’t be for 2-3years). I don’t see a major recession on the horizon but more of the plain-vanilla varieties with duration of 2-4 quarters of negative economic growth.
Despite our constructive view of the economy south of the border, it isn’t without a caveat. All the potential for continued upside could be drastically derailed by unhinged tariff policy enacted by the White House. Tariffs are inherently a brake on economic growth.
Around the world – Brexit continues to weigh heavily on the fortunes of the UK and the implications for the European economic union. Hardline extraction of the UK from the union, without a renegotiated trade agreement, will have long-lasting effects on trade and output from the UK. This “Hard-Brexit” would force the UK to rely on old negotiated WTO (World Trade Organization) trade deals implementing old tariffs on goods to-and-fro the island. Not good for either the UK or Europe.
In light of the potential economic impact of a hard Brexit, the ECB (European Central Bank) will react with accommodative monetary policy (not as if they aren’t doing so already now) to soften the effects of a resulting headwind. I see that accommodative policy as being nothing more than “pushing on a string” and the inevitable recession will ensue.
Also, we may finally see Germany take a long overdue breather from their ballistic economic pace witnessed over the past decade. They have had it too good for too long. After the Euro was created, with a too-low Deutschmark exchange rate which benefited Germany immensely, they exported their way to prosperity. As a result of the disequilibrium of mispriced exchange over decades of export goods their export markets are saturated. In combination with long-term prevailing low interest rates, one can conclude that these are the seeds of trouble. Hampering further, is the fact that European banks tend to have a local bank structure which is difficult to understand and fragmented. Economies in Europe rely more heavily on banks for financing than North America. It’s a risk. We shall see.
Lastly, China continues to consume oxygen in the discussion of potential lurking economic landmines. Chatter about US-Sino trade deals has abated which has allowed for stability in markets. Tariffs continue to loom large against the potential successful outcome of negotiated trade deals. The only benefit garnered by US imposed tariffs has been the snap-to attention by the Chinese to the realization of how dependent they are on the US consumer which has translated into a more genuine and sincere approach to resolving the trade dispute with the Americans. How genuine and how sincere remains to be seen, especially from a nation that has openly focused on the policies which have arguably precipitated the tariff war imposed upon them by the US. In the end it could all be a duplicitous ruse to make nice and play. Again, another lurking detractor to continued global economic growth.
Santa’s gift came in January
It goes without saying that Quarter 1 was indeed a relief for many watching the markets over quarter 4 2018. As we wrote last quarter in our year end commentary, in a section titled What will 2019 Bring:
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 market fall, where the economy was in a continuing deepening recession one year later.
And so, as we predicted, the market rallied off the lows of Q4 2018 with one of the most impressive quarters since the Great Recession of ’08 – ’09. We’ve exceeded the lowest recovery return (as seen in point 2 above 6.96%) in the last three occurrences of a recovery subsequent a greater than 14.5% drop in the markets.
Both the S&P 500 and the S&P TSX Comp bounced in Q1, dramatically. The SP500 gained almost 13.07% in the quarter and the TSX gained 12.47%. Even longer maturity bonds (longer than the maturity than we currently hold for clients) rallied on the confirmation, from both sides of the border, that interest rates will hold-pat or even drop in response to challenging economic circumstances.
Our prognostication of a one year bounce still has 3 quarters to play out to fully be realized, as the analysis was focused on what happens one year after a market correction of the likes of Dec ’18, however, Q1 is a strong indication that we are well on our way.
Below is a table showing the sub-groups of the TSX and performance over the past quarter. Almost the exact opposite of the previous quarter, we saw every major industry rally significantly off the lows of last year.
Healthcare, Technology and Real Estate led the way with significant gains, greater than 15%. Healthcare and technology advanced 48.93% and 25.18% respectively, although one should always view the returns associated with these industries in light of the fact that there are very few companies which make up these categories and so returns tend to be volatile.
The three major categories in the TSX are Energy, Materials and Financials – all of which play major roles in our portfolios. In late 2018 we repositioned our portfolios to take advantage of beaten up energy names like: Cenovus, CNQ, Suncor and Imperial Oil. All of which have rallied with Cenovus leading the way with approximately 20% bounce.
We continue to hold these four positions especially in the light of production cut-backs imposed by the Albertan government and the initiative to bring on transportation capacity for Canadian landlocked crude.
Despite the toughest circumstances not seen in a generation for Canadian oil producers, our combination of equities had positive Earnings before Interest Taxes Depreciation and Amortization (EBITDA) for Q4 last year. This bodes very well for them through-out 2019 especially in an environment where oil prices are increasing.
We continue to be constructive on the energy sector, but we will also take profits in instances where we believe the rally in energy has run its course.
Materials and Financials also played a role in the broader market rally each with above 8% returns. We still hold materials because of the exposure it has had to gold and the resulting hedge it provides to general service sector-based industries. Although, as we near the last hurrah for the markets a disposition of materials will eventually happen.
Financials remain a staple in all our investing as this sector offers companies with robust dividends and banks which, still continue to produce robust profits and increases in dividends.
Our mandates performed as expected and rallied into Q1. The new energy sector additions allowed us to take advantage of the robust bounce in that sector and benefited our client 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.
Annual Client Updates, we need yours back…
Last quarter we sent out Annual Update Questionnaires. We require that you fill in these updates and mail them back. We will be sending to you another mailout containing the questionnaire. Please have them filled out and sent back to us.
As always, I welcome your calls, and we can conduct annual 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.
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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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