Market Review Quarter 3, 2017
What Worked What Didn’t
Canadian Dollar US Dollar
Emerging Market Stocks Long Bonds
Energy Stocks Gold Stocks
Third Quarter YTD
Equity Markets % Change (in Cdn$) % Change (in Cdn$)
S&P/TSX Composite 3.7% 4.5%
S&P 500 0.6%* 6.5%
MSCI/EAFE 1.6% 12.3%
MSCI/EM 4.0% 19.5%
TSX Energy 6.6% -7.6%
TSX Financials 4.5% 7.2%
*Closed at record high propelled by tech stocks but strength in the Canadian dollar has eroded the return.
Third Quarter YTD
Bond Markets % Change (in Cdn$) % Change (in Cdn$)
FTSE TMX Cda Bond Universe Index -1.84% 0.48%
Thirty Years Ago – NL
While it’s been no great fun being a Canadian investor so far in 2017, at least equity investors can now say that the Canadian stock market, as represented by the S&P/TSX Composite index, is finally in positive territory for the year, showing a total return gain of 4.5%. More than half of that number, though, is made up of dividends so the capital appreciation is much more modest. A $4 per barrel recovery in the price of oil during the quarter helped oil stocks, although they are still well down on the year. They are a large portion of the Canadian index and, along with financial stocks, were responsible for most of the quarter’s positive results. As in previous quarters this year, the rise in value of the Canadian dollar continued to nullify much of the gains stocks in other countries have achieved.
On the interest rate front, the Bank of Canada has now raised rates twice this year, once in July and once in September. We welcome the return to more normal interest rates in Canada as, for what has been too long, the Bank has kept rates artificially low since the financial crisis. In fact, at 1.0%, Canada currently has negative real interest rates as inflation is clocking in at 1.4% year-over-year. Those low rates, we believe, have had a marginal effect on corporate borrowers but have fanned the flames of the housing bubbles in markets such as Vancouver and Toronto and have hurt savers at the same time. As rates normalize, holders of bonds get hurt as the price of those bonds declines to reflect current bond yields. However, for new buyers, higher yields are a welcome relief, as for many years now, it has not really paid, after taxes and inflation, to hold bonds, considering their meagre coupons. Hence, our lower than historical allocation to fixed income. As (if) rates continue to rise, our inclination to increase our allocation to fixed income will as well.
I am writing my part of Commentary on October 19th, exactly 30 years since the stock market crash of 1987. Nobody who was involved in markets back then, both stock and bond, will forget where they were and how they reacted and were affected by the severe drop in equity prices that occurred on that day, which has come to be known as Black Monday. Actually, if you were a Canadian investor, it was the next day, Tuesday October 20th, when stock prices took their big fall on the TSX. I guess markets were nowhere near as coordinated or efficient as they are today.
At that time, I was a partner in a firm that managed billions of dollars of pension fund assets for corporations and unions across Canada. Interest rates were significantly higher back then with bonds yielding close to 10% (versus 2% today) and Treasury Bills yielding 9.5% (versus only 1.0% today). As a result, asset mixes were much more conservative with fixed income representing a higher percentage, as it actually paid to own bonds in those days. It was that higher exposure to bonds that saved the bacon of pension funds, a valuable lesson for today’s investors who pooh-pooh fixed income investments in favour of all-equity accounts.
There was no Internet at that time and TV business news networks were in their infancy (actually, BNN, initially known as ROBTV, didn’t come into existence until 1996), so we were left to watch the market ‘tape’ go by, showing ever lower prices as the day progressed. I mentioned bonds in the previous paragraph because, while stock prices collapsed, money poured into bonds and Treasury Bills as they were viewed as safe havens, driving their yields lower and their prices higher.
On the Tuesday, Canada’s bad day, I was in Montreal to visit a pension fund client, and it was my job to tell them what was happening. Something that was clearly impossible as I (nor anyone else at the time) really knew or understood what was going on or why. I did, however, do the best I could, and then wandered over to the trading room at Nesbitt Thomson to sit and watch the tape (with a couple of their analysts) and sit in wonderment at what I was seeing.
A number of things became clear in the days following, many of which can be relevant to today’s markets. Firstly, the crash of 87 was a Wall Street and Bay Street event, not a Main Street event. While our lives flashed before our eyes, Joe and Jane average were almost totally unaffected. There were virtually no economic consequences other than a temporary decline in interest rates. Stock prices went down, yes, but most ordinary Canadians didn’t own them, so they didn’t really care. If they were in a pension fund they were affected but most people didn’t understand. Also, as I said earlier, bond prices went up so even their pension funds were spared a great deal of the carnage that all-equity portfolios endured.
Secondly, we learned that emotions and thinking only short-term can be dangerous to your investment health. The immediate response from many people was to panic sell and not go near stocks again for a long period of time. It was totally the wrong response, but fear was in command and clouded people’s rationality. As I mentioned above, this was a Wall and Bay Street event and not a Main Street event, and the businesses of the corporations whose stocks traded on the various North America exchanges were not affected, the only thing that changed was the price of their shares. Their businesses were totally unscathed. The lower valuations made buying, not panic selling, the right decision. Buyers had no idea if they had already seen the worst or not, but they knew they were able to buy the shares of great companies at significantly lower prices than a few days earlier, something that would look brilliant in coming years. This same scenario repeated itself during the financial crisis of 2007-2009 as buyers during that period have reaped the rewards of other investors’ foolish short-term selling.
Thirdly, the crash was never supposed to happen as a ‘product’ known as Portfolio Insurance was supposed to protect equity portfolios in the event of a market decline. Long-time viewers of mine on BNN know that I bash ‘products’ quite often as they are never what you think they are and are most often better for whoever is selling them to you than they are for you. In this case, Portfolio Insurance did not insure portfolios from decline but actually exacerbated the decline as it had portfolios sell more stocks the more they went down in price.
Today, the most popular ‘product’ for investors are Exchange Trade Funds or ETFs as they are commonly known. Originally designed to be a cheap way of buying index funds, there are now ETFs for every country, industry, sub-industry or imaginary investing possibility, for stocks, bonds and preferred shares. They do serve a useful purpose for many investors as an alternative to owning index mutual funds. They are, however, untested in highly adverse market conditions. I would guess that most owners have a false sense of security owning ETFs as nobody knows how the product would act if a lot of their holders wanted to sell at once should another market panic occur. Only time will tell, but I become increasingly worried as they proliferate into esoteric investment strategies.
This brings me back to points One and Two. One day (sooner or later, nobody knows when) there will be another significant market decline. Chances are it will be in reaction to something nobody can predict, and it will most likely not affect businesses on a day-to-day basis but it will affect stock and bond prices for a period. History shows that stock markets eventually recover and go to new highs. Short-term panic selling rarely pays. Long-term buying of stocks when others panic almost always pays off, and usually pays off big-time in the end.
“Shaken, But Not Stirred” – Some Thoughts About Bonds (But Not About James Bond) – AC
Covering global equities and fixed income gives me a wide universe of investments from which to choose. Most investors believe that equities are the most exciting investment class. It can be hard to argue with that. But this quarter, I wanted to spend some time on fixed income which, at times, can be equally exciting.
The fixed income world is dominated by bonds, bonds and more bonds. A bond is essentially a loan from one party to another. When we look at bonds (or fixed income instruments), from a high level, we are making an assessment of 3 variables:
- the quality of the company we are investing in (credit quality),
- the rate we are getting paid (interest rate) and
- the length of our investment (the duration).
Please note that I put the investment lingo in brackets. There are obviously subtleties and nuances beyond those 3 variables (like terms and conditions written into the loan agreement, etc.), but let’s stay at a thirty-thousand-foot level for now.
Sometimes, it is easiest to walk through an example. I have made it quite extreme for illustrative purposes. Let’s compare two potential bonds that we could invest in – one from Basement Company Ltd. (“BCL” for short) and one from the Government of Canada (“GOC” for short). BCL is a one-person business enterprise, with one year of history and no assets, operating out of, you guessed it, a basement. On the other hand, the Government of Canada, although indebted, has not only the nation’s resources behind it, but the power to tax its citizens to repay any debt owed. Another way of thinking about this comparison is by asking the question: which party would you prefer to lend to?
Let’s start analyzing BCL based on the 3 variables we discussed above starting with credit quality. Given its limited business history, key-person risk and small size, we would assess the quality as rather low. On the other hand, the credit quality of the Government of Canada is very high. Why? Because of the backing of the country’s resources and taxing power.
How about interest rates? What rate of interest would we like to get paid from BCL? Given its poor credit quality, assuming we had to lend, we would want to be paid a very high level of interest. For the Government of Canada, given its high quality, we as investors would accept a much lower interest payment.
Now, how long would we like to lend our money to either of these entities? For BCL, assuming we had to lend, we would want the shortest period possible (even lending for a few hours may cause a serious bout of anxiety). For the Government of Canada, investors are willing to lend for decades.
The above analysis is summarized in the table below:
|Lending Variables||Basement Company Ltd||Government of Canada|
|Length of Investment||Short||Can be long|
The above is an extreme example. As investors, we do have additional choices. We don’t have to lend to either party. We can choose other investments or remain in cash.
Now, ideally, as fixed income investors, what we would like to have are high quality issuers like the Government of Canada offering high rates of interest. This has happened at points in the past. For example, long-dated bonds offered by the Government of Canada had interest rates in the high teens in the early 1980’s (remember the good ol’ days). But remember, inflation was also high then (recall the subtleties and nuances we discussed earlier). Long-standing clients will remember, with fondness, holding positions in long-term Canada bonds in the 1990’s and through to the late 2000’s.
In graphical form, here is a picture of what we would like to avoid as fixed income investors:
All is fine until it is not. The above graph represents the price of a Toys R Us bond. The issue traded around repayment value at maturity ($100) for most of this year, but fell in September to roughly $20. In this case, getting paid 7.375% in annual interest would not offset the near 80% capital loss in the bond price. Toys R Us was a great business in the 1980’s but more recently, the combination of competition from the likes of Walmart and Amazon.com and a lot of debt on its balance sheet became its undoing.
Quarter-to-date bond returns in Canada have been negative. Why are we invested in them? In addition to providing some income, bonds generally outperform stocks in times of stock market corrections. In other words, when equities “zig”, bonds “zag”. In essence, bonds have historically preserved capital in times of stock market distress.
Benjamin Franklin once said that “an investment in knowledge pays the best interest”. We constantly keep that in mind when we research and invest in both bonds and equities.
In a future newsletter, we will look at some of the subtleties around bond investing.
Fixed Income September 2017 June 2017
Cdn 91 day T-Bill 1.00% 0.68%
U.S. 91 day T-Bills 1.05% 0.95%
Cdn 10 year Bond 2.11% 1.73%
U.S. 10 year Bond 2.33% 2.13%
Commodities (in U.S.$) September 2017 June 2017
Oil 51.60 46.32
Natural Gas 3.02 3.04
Gold 1282.00 1241.50
Currency September 2017 June 2017
Cdn/USD 1.2467 1.2962
Cdn/Eur 1.4737 1.4809