"In the business world, the rear-view mirror is always clearer than the windshield." ~ Warren Buffett.

 

Strategy Update Highlights:

 

1) While I expect an equity market correction in the near term, the outlook through 2019 and early 2020 is still positive.

 

2) Canadian and US interest rates will continue increasing. Cash, short-term, and floating-rate debt exposure will continue to help protect from these increases.

 

3) We are not surprised by increased market volatility. The NAFTA resolution, however, reduces some Canadian uncertainty. The good news is the worst-case-scenario trade uncertainty was averted as the USMCA agreement replaces NAFTA. With that out of the way, I focus on interest rate hikes, commodity prices, and a whole host of other variables to analyze in managing your portfolios.

 

Fixed Income:

 

Both the Bank of Canada and the US Federal Reserve are well into the interest rate normalization process that
began in 2017. For now, I expect to see three more Bank of Canada rate hikes over the next year, and possibly four from the Fed. The table to the below shows current Canadian Government bond yields.

 

Bank Rate 1.75%
2 Year 2.32%
5 Year 2.48%
10 Year 2.62%
30 Year 2.58%
 

To us, it makes no sense to have any meaningful medium or longer term fixed income exposure. Floating-rate index and short term bond index exposure has served us well in providing specific protection for the fixed income portfolio from rising rates. 

I recently added a couple of direct bond holdings to the fixed-income portfolio instead of using fixed-income indexes, mutual funds, or closed-ended investment trusts. So why did I buy short-term bonds directly? Some bonds are yielding higher than some of the floating-rate indexes with the same or lower risk. The recent drop in bond prices has resulted in some high-quality short-term bonds trading at a discount to par (which we have not seen in some time). This means that when the bond matures at par, some of the return is in the form of a more tax-efficient capital gain. This provides additional tax efficiency in non-registered accounts as well as interest income and insulates returns from the negative impacts from the anticipated interest rate hikes.
 

Equities:
 

The medium-term equity outlook remains positive (though, as noted, we expect an equity market correction), and portfolios are positioned to take advantage of any market corrections. The NAFTA resolution reduced some Canadian economic uncertainty; however, the anticipated US interest rate hikes and continuing global trade tensions increased equity market volatility.

We are currently slightly underweight Canadian, US, and International equity term target weights in all portfolios. Additionally, for most of our US dollar accounts with US Equities, 50% of the portfolio is, on average, insured against a drop below 279 on the S&P500 SPY ETF index, and, after the cost of the insurance, the protection will kick in at 269.70 SPY ETF index. This insurance remains good until December 31, 2018 unless we close it out.
 

The Canadian resource sector still drags on Canadian equity markets. US West Texas Intermediate crude sold as high as $76.90 a barrel recently and Brent Crude sold as high as $86.74. Canadian oil sells as Western Canadian Select fetching over $40 less per barrel. Canada has a major problem as it cannot get our oil to the refineries and so Canadian oil sells at a substantial discount. This negatively impacts Canadian oil companies and the Canadian economy. Americans are profiting by buying Canadian oil at a massive discount.
 

US economic activity continues to be strong with US consumer confidence at a 17-year high. It is no surprise to see some increased market volatility, especially in some interest rate sensitive and dividend paying equities. That has translated into some growth sectors pulling back as investors assess how much growth could slow if interest rates rise too rapidly. Currently, the consensus is that any meaningful US economic slowdown will not happen until 2020.
 

Conclusion:
 

Portfolios are still slightly underweight both equities and fixed income. This approach deflected the negative impacts on the fixed-income positions due to rate hikes. I anticipate using cash to take advantage of opportunities in short-term fixed income. Our systematic equity selection process remains focused and cash will be used as opportunities arise.
 

We always love to speak further by phone or meet in person so please don’t hesitate to call and set something up.
 

I wish everyone a great autumn!