Posted: Thursday, October 4, 2018 - 21:15 EDT
Fundamentals are very strong - but risks are elevated...
Suzann E. Pennington, CFA, ICD.D
Chief Investment Officer, Foresters Asset Management
Ms. Pennington is responsible for overseeing the equity, fixed income, asset allocation and alternative investment strategies for the group. In total, Ms Pennington is accountable for over $10 billion CAD in assets under management. Ms. Pennington was previously Chief Investment Officer, Managing Director, and Head of Equities at CIBC Global Asset Management Inc, covering all portfolio management and research efforts and managed the Canadian all-cap equity mandates. Ms. Pennington has also held various senior roles at Mackenzie Financial Corp., including Chief Investment Officer at Howson Tattersall Investment Counsel, and was a founding partner of Synergy Mutual Funds.
- North American equities in 2018 have been pushed higher and pulled lower by different factors.
- On the bullish side, investors reacted positively to strong earnings reports, good economic data, rising energy prices and generally solid fundamentals.
- Prices were pushed lower due to fears of trade wars, higher interest rates and negative rhetoric from global leaders. The result of these bullish and bearish elements was the price action we saw; choppy, but with a slightly upward bias.
- U.S. equity markets have materially outperformed other equity indices this year and while valuations remain at the higher end of historic ranges, they are actually slightly below recent peaks, and are well-supported by strong corporate earnings growth.
- Market performance, going forward, will require continued expansion in corporate earnings, as valuations should be expected to compress slowly with rising interest rates.
- In Canada, the economy has been surprisingly resilient, housing markets are broadly stable, employment continues to improve, and there has been a very modest improvement in household debt.
- Trade uncertainties have primarily been absorbed through an adjustment in the Canadian dollar which has weakened nearly 4% against the US$, year to date. Given the recent trade dispute resolution, the Canadian dollar has started to strengthen.
- The picture in Canada is quite different than that of the U.S. Despite double digit earnings growth in 2018, Canadian equity markets are flat, year to date, resulting in a material decline in valuations from the 2017 high and a meaningful discount to U.S. equity valuations.
- Given the positive outcome to trade negotiations and modest interest rate increases, we remain optimistic on equities, believing that healthy corporate balance sheets and corporate earnings growth will drive stock prices higher, while valuations remain flat or lower.
- Rising rates, quantitative tightening, trade protectionism, and possible yield curve inversion all pose risks to equity prices.
- We are addressing the current risk-reward outlook by emphasizing quality in our portfolios. Average debt levels of equity portfolios are well below market levels.
Canadian equities - cooler in the north
It’s notable that the Canadian dollar is down for the year, despite higher oil prices. The recent uncertainty regarding U.S. trade, as well as the imposition of punitive tariffs by the U.S. administration, have clearly weighed on the currency. In addition, pipeline and rail transportation bottlenecks have limited Canada’s ability to benefit from rising crude prices and created uncertainty about the future value of reserves in the ground. Transportation issues have resulted in significantly lower realized prices for Canadian oil companies, than those received by their counterparts in other parts of the world.
On the economic front, the impact of government regulatory changes, combined with slowly rising interest rates, served to depress a very hot Canadian housing market during the first half of 2018. Despite these headwinds, the Canadian economy has continued to perform well, demonstrating both strong employment and economic growth.
U.S. markets - hotter in the south
The U.S. equity market has dramatically outperformed other key indices this year, including the Canadian Composite. Despite the extraordinary earnings growth, valuations south of the border have not risen. Much of the growth in earnings is simply the result of U.S. tax cuts taking effect. It’s important to note that profitable companies receive all the benefits from these cuts. In this regard, tax reform has exacerbated the difference between stronger and weaker companies. This is a key reason we believe higher quality names will continue to outperform.
U.S. valuations are near the high end of historic ranges, but unlikely to be the cause for a market correction, while Canadian valuations are only modestly above their historic averages. We would naturally expect multiples to compress somewhat, as interest rates rise, but as of today, signs point to rate increases continuing to be both gradual and predictable. Even though interest rates are acting as a bit of a headwind now, as long as corporate profits are rising, they are likely to be a sufficient tailwind to keep the bull market intact.
Of course, corporate profits (particularly in the U.S.) are rising because of robust economic fundamentals, as well as tax cuts and de-regulation. The U.S. consumer sector is incredibly strong, helped by a combination of tax reform and very low unemployment rates. We closely monitor data that provides a more “real time” snapshot of underlying U.S. growth, and recent signs actually point to parts of the U.S. economy accelerating, rather than slowing down.
On the subject of inflation, there are signs of price pressures beginning to build. This is happening both on the demand and supply sides of the U.S. economy. On the demand front, wages are rising, albeit not significantly. On the supply side, there’s a shortage of truck drivers, which is pushing up transportation and freight costs throughout the economy. Finally, existing and threatened tariffs may lead to higher prices, both for consumers and businesses.
While the U.S. economy is in great shape at the moment, whether this strength persists through 2019 and 2020 is an open question. Much will depend on whether companies, flush with cash, use those funds to invest in their businesses. If they do, the spillover effects can only be positive for U.S. growth.
Here in Canada, the economy has been surprisingly resilient, even though the most recent employment report was softer. Whether that report was one-off statistical noise remains to be seen. It’s a crucial question, because we view low unemployment as essential to ongoing economic strength. As a result of the resolution to trade talks, employment derailment is less likely, though a further deadlock in the Alberta energy infrastructure sector continues to pose a threat.
Europe has slowed more than we anticipated, which will keep a cautious ECB at bay. China has also slowed, but policymakers are already implementing stimulus measures that should have teeth. We believe that they will be able to maintain good growth rates. All in all, despite some weak data, the world remains (economically) a happy place, and central banks seem in no mood to adopt overly hawkish stances.
We remain cautiously optimistic on equities, believing the potential for significantly higher prices remains. Global economic growth has been positive, corporate earnings growth is strong, and inflation and interest rates, while rising, remain contained. Further, dividends are well-supported and generally rising, and balance sheets support further share buybacks. That’s the good news.
Unfortunately, while return potential is high, risk levels are also elevated. If interest rates rise faster than expected, equity valuations, which are benign in the current environment, could become expensive, and earnings growth could be impacted. There’s also the chance that growing trade protectionist policies or dramatic geopolitical events could have a materially negative impact on global growth. It's also possible that the Fed gets too aggressive with its rate hikes, inverting the yield curve and potentially causing a recession 12-18 months out.
All told, these factors, plus the fact that quantitative tightening is now well underway, could pose meaningful risks to equity prices. We are addressing the current risk-reward outlook by emphasizing quality in our portfolios. In our view, that’s the best way to achieve solid and long-term results for our investors.
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