Due to the heightened uncertainty regarding the Coronavirus in the GTA, we, unfortunately, canceled our last remaining luncheon and seminar event. After having discussions with clients and being notified of cancellations from other similar functions in the city, we felt this was the most prudent action to take. In our best effort to keep clients updated with the seminar content that was missed, we have summarized the key themes below.
The macroeconomic picture has drastically improved since this time last year. At this moment, the US Fed has paused their commitment to raise rates, trade war tensions have eased, with the most recent ‘Phase 1’ trade deal completed, and fears of a global economic contraction seem to have plateaued. The global economy is benefiting from world central bank stimulus during 2019, when we notably saw the US Fed cut rates 3 times and resume asset purchases to keep yields low. China also continued to add liquidity into its banking system, while cutting its bank reserve requirements. Although there still remains a cloud of uncertainty around the upcoming US Presidential Elections, the implementation of Brexit, and re-escalating global trade negotiations, the consensus view appears to have pushed the risk of recession at least into 2021.
US Economic Fundamentals
The health of the US economy remains a key focus for North American investors, as its sheer scale and impact on global GDP can drive global investor confidence. They say a picture is worth a thousand words, so we will highlight a few charts that portray strong fundamentals.
Chart 1 – Inflation remains low, signaling to investors that the Fed should not be in a rush to raise interest rates. It also throws some cold water on claims that tariffs and trade wars would lead to higher prices for Americans.
Chart 2 – The ‘U3’ Unemployment remains at a low of 3.5% with an anticipated 2-2.4 million new jobs to be created in 2020. The ‘U6’ Unemployment rate includes discouraged workers and those working part-time for economic reasons. The U6 rate is also near a record low at 6.9%. There are currently 2 million more job openings than those unemployed. This leads to what economists refer to as a “tight” labor market, which usually bodes well for wage increases. Wage increases are tremendously important for an economy that is over 70% dependent on consumer spending.
Chart 3 – New Home Starts continues on its expanding trend. This reflects the strength of the housing market, which undoubtedly influences consumer confidence and spending. Private residential investment has contributed 4.63% to GDP on average, but currently sits below at 3.72%, which signifies there is still more room to grow. The peak year for births of the millennial generation was 1990, and as this cohort now turns 30 years old, they will marry more, have more children and buy more houses. This bodes well for housing and overall spending.
Chart 4 – The consumer confidence index jumps to 131.6 which is close to record levels, buoyed by strong employment and wage growth trends. Equally, The Small Business Optimism Index remains elevated, but below its high of August 2018, signaling there is room to rebound in 2020.
Chart 5 – Consumer net worth continues to reach new highs as the economy, stock markets, and real estate rise. More notably, personal savings rates have also risen from the lows of 3.5% in 2007 to the current 8%. Due to increased wages, consumers have not needed to dip into their savings. Encouragingly, consumers are also not increasing their spending on credit. In past cycles, 60% of spending comes from wages and 40% on credit. In today’s environment, 80% has been from wages.
Taken in aggregate, the current expansion is expected to continue throughout 2020. Although this expansion is one of the longest on record, it is also one that has unfolded slowly and is considered the weakest expansion since WWII. Surely, this is an expansion that exhibits the characteristics of a jogger rather than a sprinter. It could, however, indicate that this market and economy has much more stamina than people think.
How about Canada?
Canada’s macro fundamentals have some shining points as well. Notably, the economy generated about 300,000 new jobs in 2019, with increasing wages and the unemployment rate is also at a decades low of 5.6%. However, global oversupply of oil continues to remain a headwind for western Canada. Finance Minister Bill Morneau has forecasted that the 2019-2020 budget deficit will be C$26.6 billion, which is larger than the C19.8 billion that he projected in March 2019. Despite the softening domestic economic conditions, the Bank of Canada (BOC) continues to resist cutting interest rates. Although some investors expect one rate cut by the second quarter of 2020, Canada continues to post the highest policy rate in the G7. This resistance to cut rates is likely because the BOC does not want to encourage more lending, as Canadian debt levels have elevated to cautionary levels. The chart below shows the household debt as a percentage of income for Canadians and Americans. Note the divergence and continual leveraging from Canadians that resumed throughout the financial crisis and recovery period.
Bond & Fixed-Income Investing
The trend towards lower rates has remained persistent since 2007, driven by the aim of global central banks to stimulate their economies by lowering rates. Long-term yields are further depressed by asset purchases and “Quantitative Easing” programs. This has led to over $17 trillion of negative-yielding global debt in August 2019. Unquestionably, the ability for conservative income investors to clip coupons into retirement has been hampered by low rates. Over 90% of global bonds now yield less than 3%, whereas, in 2007, 85% of global bonds held yields of 3+%.
At this moment, it is important to remember that bond yields can be simply seen as being made up of two parts: the real interest rate and an inflation assumption. Currently, inflation has been muted, however, we find it prudent to include inflation-linked bonds in a portfolio, as a hedge against an increase in inflation, which can creep up unexpectedly. These inflation-protected bonds can still yield around 2%.
As for the real interest rate part of the equation, portfolio managers are understandably nervous about purchasing long-dated bonds that could drastically fall in price, should interest rates rise. When looking at the current 10-year bond yield, relative to the equilibrium ranges (yellow trend lines), we can see that it currently sits at the lower end of the trend line. This indicates that a potential reversion back to the midpoint of the range could cause some pain for bond investors.
Although it is possible that further price gains could arise from Canadian and US bond yields continuing to fall below their lower trend line (which is where Eurozone, UK, Japanese bonds have fallen), we feel that a US treasury yield that is sustained below 1.45% would be signaling a major global recession; This is currently not our base case assumption. For this reason, we recommend bond investors to purchase shorter-dated bonds that would be less impacted by any potential rise in rates. We also prefer to move higher up on the quality spectrum (ie. Government Bonds/Treasuries and Investment Grade Corporate Bonds). In this environment, bonds with those characteristics will not generate an impressive income, but they will provide some ballast to an equity portfolio, as they are in the best position to be negatively correlated to stock market movements.
Equity Market Investing
It has been said before, “Don’t Fight the Fed.” This phrase suggests that when the Fed is keeping interest rates low, stocks and equities should be purchased. On the other hand, when the Fed is raising rates, investors should steer clear of stocks. Ultimately, this simple rule-of-thumb relies on the notion that if the Fed is determined to expand an economy, it is more likely than not that they will get their way. At this moment, our team would adjust this phrase of “Don’t Fight the Fed” to “Don’t Fight the World’s Central Banks.” It is apparent that we are in the middle of a global trend towards lower rates. As the chart below shows, 85% of countries’ last rate change was a cut. This time last year that number was under 40%. Statistically, since 1989, when 50% or more of central banks are in this interest rate easing mode, the MSCI ACWI (All Countries World Index) has grown by over 8% per annum.
As for the US S&P500, there is much concern from investors regarding the “all-time highs” that have been reached. Although we do not disagree that markets could dip lower without any warning, we believe these moves lower will be contained, and may even represent opportunities for investors who are underweight in their equity positioning. The positive macro fundamentals and the unattractive alternative in bond yields mentioned above both continue to make the case for equities. Moreover, as the chart below shows, nearly 50% of companies in the S&P500 paid a dividend higher than the US 10 Year Treasury. Should this data point fall to 25%, then it may warrant some caution from investors.
With that said, the current S&P500 PE equity valuations of 18.8X 2020 and 17.0X 2021 are slightly elevated from the long-term average of 15-16X. Hence, companies will need to prove that they are able to grow their earnings and provide favourable guidance. We suspect that this coming quarter’s earnings season will be important for this market.
Two other clouds hover over the broader markets, including the Coronavirus outbreak and the upcoming presidential elections. You can read our thoughts on the impact of the coronavirus to markets in our previous blog HERE. Moreover, check back next week for a blog specially dedicated to the US elections.
Highlighted Equity Sectors
For many investors, US banks’ performance is a by-product of the overall health of the economy. Therefore, the set-up for US banks should be favourable with the aforementioned strength in private residential investment, strong small business optimism, and elevated US consumer confidence. We can see positive core operating leverage from US Banks, with 4-5% growth in revenue, compared to 1-2% growth in expenses. Return of capital will also be a key theme for bank shareholders, as the latest CCAR stress test (Comprehensive Capital Analysis and Review) permits banks to give back increasingly more in the form of dividends and share repurchases. We also expect consumer lending to grow off the back of strong consumer fundamentals and increased home purchases, which will help offset the modest growth in commercial lending. Much commentary has also been written regarding the industry’s Net Interest Margins (NIM). This represents the spread that the bank makes from the interest earned on loans and the interest paid on deposits. As rates rose in 2016, banks were able to generate more profit from their loans while being slower to raise the rates they paid on deposits, thus increasing NIMs. However, at a certain point, this comes at the cost of lower loan volumes. Therefore, rising rates are only beneficial for banks to a certain point. With 7 rapid rate increases between 2017 and 2018, some analysts believe that this restricted loan volumes. Fortunately, with the recent cut in rates and the expectation that rates will remain lower for longer, analysts believe that loan growth should resume. Therefore, although NIMs may be pressured, the overall net interest income should grow. Finally, some analysts believe that we can expect an increase in larger M&A deals, similar to last year’s blockbuster merger between BB&T and Sun Trust. Overall, as the chart below shows, US banks’ valuation on a PE and PB level remains attractive to historical levels and the overall market. Should there be a macro event that leads to a broad market sell-off, the expectation is that this sector could provide some defensive characteristics and relative outperformance.
Canada Financial & REITs
We recently covered the fundamentals of the Canadian Banks in a blog entry, which you can view HERE. Cost management will be vital for the Canadian banks in 2020. Currently, the Canadian banks trade below their historical levels due to a lacklustre domestic economic outlook, concerns for further loan losses and an outlook for lower margins. The chart below shows RBC Capital Markets forecasted loan growth around 4-5%, rather than the historical average near 8%.
In the short term, with expectations quite low for the Canadian banks, there is room for upside surprise and perhaps a recovery in stock prices; However, we do not expect the Banks will be able to command the same historical valuation of 11.4X PE in the long term (it is currently 10.5X PE). That said, income investors should not fear a cut in the dividend.
REITs have increasingly been popular investment vehicles that allow investors to own a portfolio of income-generating real estate properties. Diversification is the key advantage of REITs as they include a variety of property types in many geographical regions. The property market fundamentals remain generally attractive, as vacancy rates are low and owners are able to command high rental fees. Overall, REITs seem poised to continue their growth trend with moderate GDP growth, low/falling interest rates, declining recessionary fears, and favourably low vacancy rates.
The five largest tech companies (Apple, Microsoft, Alphabet, Amazon, and Facebook) now represent 17.5% of the S&P500. In our presentation, we highlighted the 10 Internet trends that our analysts believe will continue to drive the industry. They are listed as follows:
- Increasingly volatility around regulation while Tech companies help guide the conversation
- Streaming will continue to grow in popularity: Video, Music, Gaming
- The retail industry continues to be disrupted by innovative technology like ‘Amazon Go’ Stores
- Despite growing ‘price-per-ad’, advertisers continue to flock to FB and Google as their Artificial Intelligence and Machine Learning capabilities helps optimize ad targeting and improve returns
- Augmented Reality and Virtual Reality find more practical applications and entertainment applications
- Wearables will continue to dominate: Smart glasses, rings, earbuds, watches, etc.
- 5G will begin to boost the adoption of everything from Streaming, AR/VR, Internet of Things, and Autonomous Driving
- Advertising Dollars will grow exponentially, with the 2020 trifecta of Eurocup, Olympics and Presidential Elections
- E-commerce and Advertising will converge as applications create easier checkout (Instagram), dedicated shopping sections (Pinterest) and increased marketing services (Amazon)
- 2020 could be the year for the recovery of the Broken IPOs. See chart below.
This blog has covered the main topics that we had planned for the seminar. In recent seminars, we also discussed other topics, including China. Please check back in a couple weeks for an upcoming blog about China. Overall, the fundamentals of the market look healthy, however, investors should brace themselves for volatility and downside in the near term due to coronavirus-related headlines or from bellwether stocks that report earnings below expectations. These periods can represent good buying opportunities for long term investors, however, it can be distressing for investors that have shorter-term liquidity needs. For more information, please reach out to your advisor. Remember, the year is still young. If you have not done so, we suggest that you complete a review of your current portfolio and an examination of your ability to take risk through a comprehensive financial plan.