The purpose of this quarterly commentary is to communicate with you about our thoughts on the markets, provide some snap-shots of market metrics, and provide an overview of topical issues; however, it will also be married with some aspects of our monthly commentary, in order to provide you with a succinct update of our views on the market, without the need for two separate communications. We hope you enjoy this information, and that it allows you to better understand what we see going on in the market place.
“The individual investor should act consistently as an investor and not as a speculator” – Ben Graham
Cold Feet in a Hot Market
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way…” – Charles Dickens, A Tale of Two Cities
To open our quarterly letter, we begin with the oft-quoted excerpt from Charles Dickens’ classic work of historical fiction, A Tale of Two Cities, which we believe aptly articulates the air of trepidation and ambivalence inherent in contemporary capital markets. The S&P 500, Dow Jones, NASDAQ and FTSE market indices all remain at or near all-time highs, year-to-date index returns have all been positive, and investors’ portfolios, for the large part, have exhibited decent returns over the last several years. However, global economic activity remains sluggish, sovereign Central Banks are mired in uncharted monetary policy territory, and market valuations have become increasingly stretched. Every quarter, month, and day seems closer to a market top, rather than a re-acceleration of growth, however, markets continue to move higher. This feeling of contradiction and contrast is the signature of today’s investment environment, and remains the guiding sentiment behind our investment strategy.
In such a precarious environment, it remains our conviction to keep client portfolios positioned towards a goal of capital preservation and conservatism, rather than optimistic growth. While this strategy may forgo some short-term gains, we believe it to be the best solution for managing funds with a long-term mindset. To supplement this belief, we would like to put forth Exhibit 1, created by Goldman Sachs Asset Management, which exhibits the relationship between elevated market valuations and portfolio returns.
This exhibit shows that, in the short-term, nominal valuation levels have historically been a poor predictor of short-term (3 year) market returns. However, in the long-term (10 years), the relationship is exceptionally salient, showing a discernable negative relationship between elevated market valuations and 10-year returns. This chart has the largest implications towards the deployment of additional capital, as it alludes to markets with stretched valuations being historically poor entry points. It has always been our belief that our primary goals, as money managers, are to protect client capital, and to manage funds for the long-term; in such an environment, with valuation levels where they are, we continue to believe that a defensive and conservative tilt is the best way to accomplish these goals.
A Tale of Two Economies
Throughout the third quarter, the economic headlines have been primarily focused on two markets: the United States and the United Kingdom. The US has been at center stage for some time, as the world’s largest economy and sole relative economic ‘bright spot’; the UK has also commanded the limelight as of late, with the June Brexit vote and speculation of a ‘hard’ or ‘soft’ Brexit.
Economic growth in the US, albeit muted, has long been heralded as the underpinning of the ‘slow and steady’ global growth environment. This narrative has been supplemented with optimism of potential economic re-acceleration in the back-end of 2016. However, this quarter exhibited several set-backs to that commentary, as the forecast for economic growth in the world’s largest economy in 2016 was dropped to 1.6%, down from the forecast of 2.2%, which was made only three months ago. Employment figures, manufacturing data, and retail sales data have all been disappointing as of late as well. This string of poor economic data, combined with the upcoming election, leads many to believe that interest rates will remain steady through the next Fed meeting in November. However, there are fairly strong beliefs that the Fed will, as part of the November statement, commit to a rate hike at the final meeting of the year in December; this prediction has caused long-term yields to rise and the yield curve to steepen. More on this later. Exhibit 2 shows the breakdown of interest rate forecasts for the December meeting. 25 – 50 bps represents status quo. The November chart is showing ~90% of market participants forecasting no change in rates through the upcoming meeting.
The UK market has also been a major focus of attention as of late, largely due to speculation surrounding the recent ‘Brexit’ decision. The initial vote itself caused significant immediate volatility across global markets, although most have rebounded from the resultant June low. Most recently, the UK market has once again regained attention, as new Prime Minister Theresa May has stated the island nation will begin the process of separation from the EU, as early as the end of March 2017. Prime Minister May has accompanied this announcement with a bevy of comments that lean towards the original protectionist narrative of the Brexit decision; specifically, May has stated that she will not prioritize the financial industry, refuses to cede control on immigration, and vows to take a hard line with EU officials in Brussels. All of these comments have caused market participants to speculate whether or not a ‘hard Brexit’ – which would represent the introduction of significant economic turmoil – is likely, or not. In contrast, recent economic data out of the UK has been some of the strongest in the developed world, with the IMF actually raising their expected growth forecast for the group of countries. Based on 2016 IMF forecasts, the UK is now exhibiting the strongest growth out of the Group of Seven developed nations. In addition, UK stock markets have also benefitted significantly from a weaker pound, as three quarters of FTSE 100 constituent revenues are actually sourced outside of the UK. All major UK stock markets have broken to new highs as a result.
Internationally, global growth has been stuck in a general malaise for some time, with developed markets exhibiting structural slowdowns and Emerging Markets suffering from the end of the commodity super-cycle. This has resulted in unimpressive growth for the past five years or so, with global growth estimates being dropped further as of late by the IMF, down to 3.1%. However, for the first time in five years, economic growth forecasts for the Emerging Markets have been raised, providing a spark of optimism for future international growth. Exhibit 3 shows the current IMF forecasts for global economic growth.
As touched on previously, perhaps the most significant happenings over the third quarter have been in the Fixed Income market, which has seen medium and long-term yields rise significantly, across both US and European markets. In the US, the primary driver has been expectations of an interest rate hike in December, which provides upwards pressure on yields in multiple ways. Firstly, if rates are expected to rise in the immediate term, demand for medium and long term bonds – which have significant duration risk, or susceptibility to movements in interest rates – goes down. Bond prices behave inversely to interest rates, with this relationship increasing in magnitude at higher maturities; as such, investors are unlikely to demand medium to long-term bonds if they believe strongly that their investment value will be hurt immediately. This decrease in demand results in upward pressure on yields. Short-term bonds are preferred in such a situation, as they have lower duration risk, and any movement in price will be both temporary and muted, until capital is returned in short order. This results in higher relative demand, which results in both medium and long-term bond yields increasing faster than short term yields; the result is a ‘steeper’ yield curve. The other force at work is from a corporate side, who tend to issue more credit when they are expecting the future cost of borrowing to increase. Since more companies are looking to raise debt, the yields offered must necessarily increase in order to increase attractiveness relative to competing instruments. Companies tend to prefer to borrow long-term credit, in order to reduce the negative impacts on short-term cash flow.
Exhibit 4 below, sourced from the Wall Street Journal, shows a visualization of the widening US yield curve, measured by the difference between the 2 year treasury yield and the 10-year treasury yield.
Apart from the structural forces recapped above, the steepening of the yield curve, especially the rising of longer-term yields, also tends to represent forward expectations of international economic growth and policy. This most recent surge, for example, is being credited towards an increasing possibility of a shift away from global Quantitative Easing and negative interest rates. If such a shift were to occur, the lack of yield suppression and perceived increase in economic risk of many sovereign bonds would both likely work to increase long-term yields of most developed nations’ sovereign debt. This would also increase the competiveness of many sovereign bonds, from an investment standpoint, and possibly cause a reduced demand for ‘safe haven’ debt instruments such as US treasuries, which would in term cause their yields to increase as well, albeit for different reasons.
The driving force behind this belief of a possible shift away from zero or negative interest rates has been rooted in commentary by both the ECB and US Federal Reserve, as well as market pundits and economists who continue to ponder whether or not global Quantitative Easing has meaningfully helped, and if additional easing will improve economic growth. The Federal Reserve has stopped its outright QE, for now, and has been vocal about their desire to begin ‘normalizing’ interest rates. The ECB has begun ‘considering their options’, weighing their fear of deflation against potential future impacts of continued QE. The Bank of Japan and the Swiss National Bank, the two other major players in the global interest rate suppression picture, are continuing their programs, for now, although both economies are experiencing dubious benefits from their efforts.
Although we do not believe the ECB, Bank of Japan or Swiss National Bank will cut their QE programs any time soon, we do believe that it is time to begin seriously discussing the long-term impacts that these programs have had, as well as how to unwind them safely, if possible. Since the financial crisis, most developed nations have undergone a borrowing spree, in order to combat sluggish economic growth, with limited positive effects. One large effect, however, has been the increased indebtedness of most major economies. Exhibit 5 below, for example, shows how total global Debt to GDP has skyrocketed to 225%.
Additionally $13 trillion of global sovereign bonds now exhibit negative yields to maturity, including the entire term structure of Swiss debt. This is unsustainable, and the continuance of Quantitative Easing programs from major sovereign Central Banks will only make this picture worse, barring a return to significant economic growth.
Higher sovereign leverage, as a percentage of GDP, is fine if the additional debt is invested wisely and used to increase future GDP of the country. The danger is when leverage is significantly increased, with an ambiguous or absent benefit to underlying GDP growth. This increased debt does not necessarily have to be paid off, as it can be continuously rolled over, however, as interest rates rise, the cost of carrying this higher level of debt becomes a problem, unless principal repayments are made to lower the level of debt. Rising costs of debt means that funds need to be allocated from elsewhere, which means lower meaningful fiscal expenditure. As you can see, it is easy for this problem to escalate, unless GDP growth rebounds and allows the country to pay down debt levels before the cost of carrying the debt increases significantly and hamstrings annual budgets.
We are not suggesting that such a scenario is imminent or that any catastrophic scenario leading from global QE is certain, however, in the spirit of transparency, we would like to outline it as a significant and real risk to the markets, that is informing our defensive mindset.
In terms of immediate opportunities, we view the recent sell-offs in defensive sectors and traditional stores of value such as precious metals to be buying opportunities. Moving into the end of the year, it is our belief that markets are likely to remain volatile and sideways, as they have for much of this year, and that dividend income and alternative asset strategies will allow investors to out-perform. There has been a strong narrative that the impending interest rate hike is negative for gold and therefore all precious metal miners, however, we do not believe the scenarios to be mutually exclusive. As we saw with the aftermath of Brexit, there are numerous scenarios where the USD and gold can indeed move in tandem. Additionally, as we’ve touched on in this letter, we believe that the amount of risk inherent in the market continues to justify an increased weighting to precious metals.
The trend of a steepening yield curve tends to benefit banking stocks specifically, which are on our radar as a buying opportunity. Banks borrow short term funds and lend long term, benefitting from the interest rate ‘spread’; therefore, steeper yield curves provide wider margins for these stocks, which are already trading at valuation levels which we believe to be attractive. One of the primary drivers of these attractive valuation levels has been directly related to the historical flatness of the yield curve and resulting inability of banks to significantly monetize their asset base. If the yield curve continues to steepen, we believe that bank stocks have a lot of upside potential, barring further economic weakness.
Commodities remain in a difficult position, despite oil’s recent strength, which has been propelled by discussion of a potential OPEC curtail. Commodity prices are inherently linked to economic growth, which is muted. We do not yet see an environment that would allow us to be significantly bullish on oil, and therefore a large portion of the Canadian market, in the near term.
We approach the fourth quarter with an open and optimistic mindset, as always; we remain vigilant in our search for profitable and lucrative opportunities, while remaining cognizant of market risks and perils.
MacNicol & Associates Asset Management Inc. October 2016