Market Review Quarter 2, 2016
Equity Markets % Change (in Cdn$)
S&P/TSX Composite 4.2%
S&P 500 1.9%
MSCI/Far East 1.0%
TSX Energy 8.7%
TSX Financials 0.1%
Interest Rates June 2016 March 2016
Cdn 91 day T-Bills 0.49% 0.46%
U.S. 91 day T-Bills 0.25% 0.18%
Cdn 10 year Bond 1.06% 1.23%
U.S. 10 year Bond 1.47% 1.77%
Commodities (in U.S.$) June 2016 March 2016
Oil 48.40 38.16
Natural Gas 2.93 1.96
Gold 1324.70 1234.40
Portfolio Management Strategy
What Worked What Didn’t
– Long Bonds – European Stocks
– Gold – Chinese Stocks
– Mining Stocks – Pound Sterling
You Can’t Have It Both Ways – NL
Despite lots of ‘expert’ prognostications that the world would come to an end twice so far this year: after the January market meltdown and then again following the Brexit vote in the U.K., equity markets in North America ended the second quarter in positive territory. In Canadian dollar terms, the S&P/TSX Composite Index gained 4.2% while the S&P 500 rose 1.9%. Stellar, no. Positive, yes. Lesson to be learned: Don’t get carried away by dramatic headlines and dire predictions. They are meant to get your attention, but are rarely right and, if they are, they are right only in the short term. Panic is never the correct reaction. Long-term (which is how we invest our clients’ money) nobody knows so don’t pay attention to the ‘so-called experts’. I learned long ago not to predict stock prices or market movements or returns. If anyone does, they are guaranteed to be wrong.
As I mentioned above, nobody knows anything about the future but there are some pretty good guesses. While the if, when, and how of the U.K. leaving the European Union (EU) is debated, one prediction that is likely to come true is that many financial services companies will be moving jobs out of London to financial centers within the EU. Who will be the big winner is up for debate and it is far too early to foretell. Dublin, Frankfurt, Brussels, Paris, Amsterdam? What is known, though, is who the big losers will be: owners of London commercial properties, as office vacancies are expected to rise dramatically when those financial service office-occupying jobs move elsewhere. This has caused a run on British mutual funds that invest in commercial office buildings. Yes, you read that correctly. In the U.K. you can invest in mutual funds that directly invest in property. In that universal search for yield, the value of property funds issued by British investment companies has exploded to £35 billion from £5 billion in 2009. Not surprising, as recently these funds have offered yields in the 4% area, quite attractive considering 10-year British government bonds (gilts) currently yield about 0.8%. One thing investors in these funds neglected to consider was liquidity. Mutual funds, by definition, are open-ended (they will sell as many units as investors want to buy) and are instantly liquid. Call your broker and say sell my mutual fund and you are redeemed at the end of the day. Real estate, by definition, is inherently long-term and illiquid and generally takes weeks, months, or even years to be sold. A recipe for disaster, no? And that is what has happened in Britain as fund after fund has halted redemptions, for the time being. All sellers and no buyers. From time to time we may own shares in REITs (real estate investment trusts) in Canada. These are closed-end funds (a finite number of units exist) that own real estate properties. The big difference is that they are not open-ended and they trade on the TSX, just like a stock. Huge difference from how it works in Britain.
On July 5, I celebrated my 40th year in the investment management industry. Over that period I have witnessed many unusual events but nothing has come close to what former investment manager and current newsletter publisher Jesse Felder calls ‘The Greatest Dichotomy in the History of Financial Markets’.
In normal times (which I can assure you we are not witnessing at this time), stocks go up and down on earnings and economic outlooks while interest rates on bonds go up and down on inflation and economic expectations. Stocks generally rise when the economy looks good and corporate earnings are increasing. This bright economic future, at the same time, causes interest rates to go up (bond prices to go down) as it is usually accompanied by increased demand for credit and higher inflation. Conversely, stocks generally go down when corporate profit growth slows or declines and the economic outlook dims. This normally causes interest rates to decline and bond prices to rise as the demand for credit wanes.
Right now, though, bond prices are at all-time highs as interest rates around the world are close to zero or even negative in some countries. At the same time, stock prices are near or at all-time highs as well. Bonds are saying the economic world is close to collapse while stocks are saying everything is hunky dory. How is this possible?
Free money is the answer. In an effort to stimulate economies around the world, central banks have bought up huge amounts of government bonds (Quantitative Easing) in order to lower interest rates. Investors buying debt therefore have fewer government bonds to buy and the result of their buying has been record high prices and record low interest rates. At the same time, these historic low yields on bonds have sent investors searching for yields in stocks, pushing up their valuations despite the lack of earnings growth and so-so economic outlooks in most countries.
While low interest rates are usually good for stocks, the extremes such as we are currently witnessing have never happened before and it is doubtful this situation can exist for an extended period of time. Either the bond market is correct and the economic outlook will be dreadful or the stock market is correct and the economic outlook will brighten and corporate profit growth will accelerate. They can’t both be right. Sooner, rather than later, one view will prove to be correct. Or, both will be proven to be wrong and stock prices will fall and interest rates will rise. You can’t have it both ways.
In light of this great uncertainty, as Rhonda highlights below, we are doing our best to protect our clients’ assets and earn them a decent rate of return without taking outsized risks. We have hedged our bets as we, along with everyone else, have no idea how it will end. In other words, we are doing our jobs.
Low Growth World – RD
If you take only one idea from our newsletter this quarter let it be this: Portfolio Management Corporation’s objectives are the safety of your principal and then, beyond this, to earn you a reasonable rate of return.
Continuing the discussion from last quarter’s write-up there are a host of concerns in the global economy. Interestingly, on a day in which the stock market has a downturn, the market watchers blame the move on one of those global concerns. Conversely, on up days, these same market watchers dismiss these concerns. At PMC we don’t let short-term market fluctuations dictate our emotions or our strategies.
Recall last quarter we wrote about negative interest rate environments in some portions of the world and the unknown ramifications of this. One thing negative interest rates broadcast is that global economies are struggling to find growth. Stock markets across the globe were already grappling with this when the Brexit vote hit. The fundamental concern of growth and its lack there-of is the overarching challenge element for us. However, there is a buffet of other concerns. For starters, lack of growth is a significant force for political change. This change has been ushering incumbent political parties out in favour of politicians that promote protectionism. Other concerns on the watch list are 1) the U.S. elections, 2) the Brexit fallout, 3) debt levels in China and the stealth devaluation of its currency, 3) geopolitical unrest, 4) commodity prices and its effect on Latin America. These all have the potential to become trigger points for a market malaise or a more sustained downturn.
Sustained low interest rates result in wonky capital allocation choices and throw survival of the fittest on its ear. This is because it allows the weakest debt laden businesses to continue to limp along. An industry full of zombie-like companies only prolongs the pain of excess capacity and competition for all companies involved. Monetary stimulus, as evidenced with low interest rates, is not generating economic growth as hoped. An important question with no ready answer is whether governments can insert enough fiscal stimulus to stave off a downturn or will upheaval within government ranks be enough to stall pro-growth measures. Anti-globalization forces are poised to take further hold and are likely to further restrict growth which is already hard to find.
Our plan to address these challenging global economic conditions is multifaceted. Specifically, we will: 1) have a higher than typical cash position, 2) lengthen our bond maturities, 3) hold high quality dividend paying stocks, and 4) invest in market sectors that are less volatile than other areas.
Last quarter we reduced our exposure to China by selling Tsingtao and HSBC. This quarter we sold Vodaphone on Brexit concerns and repurchased another UK stock, Diageo, a liquor company which will benefit from a lower pound sterling given its global sales base.
Our higher than typical cash position and lengthened bond maturities are ways in which we play defense. It serves to insulate the portfolios from increasing volatility in the stock market but also when the time is right allows us to take advantage of that same volatility. The low to negative interest rate environment looks here to stay quite some time so in many accounts we have purchased mid-term bonds in order to lengthen the maturity of our bond portfolio. We purchased a liquid 10 year bond that gives us flexibility to sell for cash quickly should other opportunities develop elsewhere in the markets.
As interest rates stay low, demand for yields will remain high. Expensive stocks today seem to be anything that pays a sustainable dividend yield but we see demand for such stocks staying high. We will continue to hold high quality dividend paying stocks with stable earnings such as BCE, Emera, Morneau Shepell and PepsiCo. This environment calls for investment in defensive areas like consumer staples, utilities, telecommunications, some healthcare and infrastructure stocks like SNC which are expected to benefit from government stimulus spending in North America.
Circling back to the first sentence on earning a reasonable rate of return, in a world as described above, the definition of reasonable will likely be lower going forward than it has been in the past for a similar level of risk. However, we have sound strategies to address the global economic challenges in order to deliver on our objectives to preserve your capital and earn a reasonable rate of return.