"It's a little like wrestling a gorilla. You don't quit when you're tired. You quit when the gorilla is tired."
Robert Strauss
As the third quarter closed off, we learned that an agreement was struck to create an updated version of the 25 year old North American Free Trade Agreement (NAFTA). Dubbed NAFTA 2.0, the new agreement will be called the USMCA (US-Mexico-Canada Agreement) which isn’t as catchy as NAFTA but does put the US first! Importantly, all three countries still have to approve the agreement in their own legislatures but that looks fairly certain.
This negotiation has been a huge overhang to the Canadian economy and has most certainly delayed capital investment decisions by corporations. While most thought that an agreement would eventually be struck (averting complete trade chaos), it was prudent to hedge against the “Trump factor” and wait for clarity. There are some important changes to the agreement such as labour costs and country of origin content requirements. Canada also agreed to marginally increased access to our dairy which was not entirely unexpected but will most likely cost the Liberals support in the next Federal election, especially in Quebec. Perhaps most notably, the USMCA does not lift the previously imposed US steel and aluminum tariffs. While a new deal removes some trade uncertainty, there is still the chance of headline risk to the Canadian economy as negotiations continue on the tariffs that the deal failed to remove.
Another milestone reached in the 3rd quarter was that the world finally has a $1 Trillion company! On August 2, Apple was the first company in history to attain that market value. While many thought that Amazon, Google or Microsoft had a better chance of snatching that brass ring first, I was always in Apple’s corner due to the company’s incredible earnings and capital allocation decisions. Over the last 5 years, Apple has bought back 25% of its shares outstanding and in total between stock buybacks and dividends, Apple has returned about $300 billion to shareholders over that period of time. It absolutely deserved to be the first $1 Trillion company. Of note, Amazon went on to hit $1 Trillion in market value about a month later but it could not hold that value for more than a few minutes before backing off while Apple continued to push forward.
Stock buybacks have been a hallmark of the latter years of this bull market with many companies directing their excess cash flow to reducing their outstanding shares (almost $650 Billion over the 12 months!). Home Depot is another prominent example as it has decreased its share count by 35% in the last 10 years! Some are critical of buybacks and go so far as to say that companies are “financially engineering” their earnings (less shares outstanding leads to higher earnings per share). I think it is a lower risk way of deploying cash flow and at this stage in the cycle is preferred to mergers and acquisitions that don’t always work out and can lead to layoffs. This buyback trend may also help to explain some of the volatility that we have seen around earnings season this year as companies cannot buy back their own shares during their blackout periods ahead of earnings (less buying support).
This quarter also witnessed the 10 year anniversary of the largest bankruptcy filing in US history. On September 15th 2008, Lehman Brothers slipped into bankruptcy when the whole world expected the US government would bail them out before that fateful Monday morning. This set off a chain of events which nobody could foresee and lead to the Financial Crisis. For their part, the media spent much of September marking the 10 year anniversary of the financial crisis by reminding everyone that the current expansion is getting really long in the tooth and therefore trouble could be lurking right around the corner!
While it is true that the current economic cycle is already old by historical measures, this expansion has been anything but normal on many fronts. The most significant difference has been the relatively low trajectory of the economic recovery out of the depths of the Great Recession. Lower for Longer applies to economic growth as well as interest rates. The USA is just now seeing GDP growth above 3% but many think this is due to the Trump tax cuts and will be a fleeting “sugar high”. In any event, stronger US economic growth and trade tariffs may lead to higher inflation rates. In response to higher inflation rates and a stronger economy, the US Federal Reserve has telegraphed a slow but deliberate increase in overnight interest rates over the next year. In addition, the Federal Reserve continues to reduce its Quantitative Easing (QE) program which is also causing bond yields to increase. All this points to higher interest rates and as we have seen markets tend to struggle with higher rates so we should expect more volatility moving forward.
The bull market will also need to contend with other significant risks going forward. The most prominent of these are the increased trade tensions between the USA and China, Italian Budget Deficits (that will test the resolve of the European Union, again), and Emerging Market debt levels which are denominated in U$ and keeps getting more costly to service due to the rising U$. Which leads me to the last temporary headwind in the upcoming US midterm elections. While the Democrats are expected to gain ground and have a chance to take back Congress, the Senate looks likely to remain in Republican hands. If the Democrats take Congress gridlock may return making Trump’s life harder, but that alone will not be enough to unwind his agenda. Of note, stocks almost always advance in the year following the midterm elections.
While we are in the latter innings of this expansion and the bull market is in fact getting older, we still have not seen the euphoria that usually marks the cycle peak. While there are pockets of ‘irrational exuberance’ (with marijuana stocks topping the list in my opinion) there is a healthy amount of worry and skepticism. In fact, so far this year, most global markets have experienced setbacks. Up to the end of September, the Canadian market is pretty much flat while Europe is down and Asian markets are off substantially (with China down almost 20% on the year). In spite of global weakness the US markets continue to outperform largely due to the outsized influence that mega cap technology companies have on the indices. Looking under the hood, the average US stock is not up nearly as much as the indices would imply. While 2018 is proving to be a much harder year than last year, I think it will still end up being a reasonably rewarding year that is back-end loaded much like the last couple of years. So I continue to remain, as always, cautiously optimistic!