Thoughts from MAST’s Corner Office - February 2019 Monthly Commentary

The meltdown of equity markets in December was a great opportunity to test investor’s thesis’ regarding the economic and Capital Markets outlook.
February 2019
“There’s a tide in the affairs of men” — Brutus, Shakespeare
  • Thanks to Fed Chair Powell and his new found “patience”, markets extended their post-Christmas rally and registered strong gains in January. Even the “auto-pilot” of the Fed’s balance-sheet run-off seems to be on table to keep investors happy.
  • Fears of a recession have not entirely disappeared, but U.S. jobs keep surprising to the upside while housing is seeing better support as mortgage yields retreat from their Q4 peak.
  • A patient Fed coupled with slower investor’s expectations for global growth and corporate earnings leaves the bar lower for equities to extend their rally, especially for U.S. stocks if peak trade anxiety is behind us.
  • Canadian stocks joined the global rally last month, but even a 17.5% surge in oil prices was not enough to make the energy sector outperform the broad index. The loonie took off on oil, rising 3.9%, which seems ahead of its fundamentals given the weakening economic outlook for Canada.


The Fed that lifts all boats

The meltdown of equity markets in December was a great opportunity to test investor’s thesis’ regarding the economic and Capital Markets outlook. But divesting away from equities in a largely sentiment driven sell-off meant missing out on the January rebound. Between December 24th and January 31st, the S&P 500 rallied nearly 16%. As Shakespeare’s Brutus character noted, seizing the opportunity is crucial for success. Sometimes, it merely means maintaining course during the storm to arrive at the destination.

Thanks to the U.S. Federal Reserve (Fed) and the revival of the “Fed put”, pretty much every financial asset enjoyed a spectacular rebound last month, from stocks to commodities, and even bonds. For the key market benchmarks, S&P 500 and TSX 60, the monthly gains stood at 8.0% and 8.7%, respectively. Such numbers would generally be enough that if the calendar year ended there, we would be content to declare that it had been quite a decent year for stocks. Gains were solid elsewhere with the Nasdaq 100, MSCI Emerging Markets and MSCI Europe up 9.2%, 8.7% and 6.1%, respectively.

Fed Chair Powell did such a good job at convincing investors that he would be “patient” on future rate hikes, that even Treasury bonds gained a little despite the solid equity rally. However, for those fearful of an inversion of the 2Y-10Y Treasury yield curve, the collapse of rate-hike expectations finally steepened the curve a bit after the Federal Open Market Committee (FOMC) meeting, although inversion is still less than 20 basis points away. Lingering uncertainty over a U.S.-China trade deal may cause another round of government shut downs, or drama over the upcoming debt-ceiling negotiations may contribute to further slowing of the inversion, although it may still happen by early summer.

Oil prices experienced a sharp rebound, gaining 17.5%, as overblown fears of a recession receded and threats of OPEC supplycuts were enough for investors to lift prices to mid-50s. Given Canada’s dependency to the energy sector, it’s noteworthy that Canadian stocks merely matched the performance of U.S. stocks when oil prices were surging this much. This illustrates why making the case for Canadian stocks to outperform their U.S. counterparts in the next 12-18 months is not easy and cannot just lie on an oil play—clearly it isn’t enough. Higher oil prices, however, helped the loonie rebounded 3.9% despite a weakening domestic economy, which tells us the loonie is probably trading ahead of its fundamental drivers.


Factor Investing: Growth Rules Equity Bulls

The death of Growth and return of Value-style equity investing received much press in the 4th quarter as Growth stocks lagged significantly. But January was a new year and the rebound was led by Growth stocks (+8.5%), followed by Small-Caps (+8.3%), whereas the more defensive style Low-Vol (+5.2%) and High-Dividend (+5.7%) lagged, with Value (+7.3%) in the middle of the pack. We continue to like Low-Vol and High-Dividend stocks in a market environment of heightened uncertainty, but we do so while broadly remaining overweight equities. For fixed-income assets, a flat yield curve favors shorter bond durations.


A New Patient Fed, but next Move is Up—Not Down

We believe the market’s realization that Powell is not as hawkish as feared is by far the most important development for financial markets since the initial market sell-off in October. As much as we thought the U.S. economic backdrop warranted at least a couple more rate hikes into 2020, a tighter Fed policy stance clearly represented a hurdle to equity appreciation— because of either slower economic growth or simply via a higher rate at which investors discount future cash flows. We continue to think the next move by the Fed is up, not down. A hike in the latter part of the year is probable, as trade uncertainty dissipates and growth and inflation justify policy rates a little above the pace of inflation (i.e., positive real rates).

Beyond the willingness to hike or pause, what will dictate future FOMC policy is whether the U.S. economy re-accelerates this summer after the recent softening in growth. Recent economic indicators have been mixed: job creation has strongly surprised to the upside in the past few months, which helped dissipate fears that the U.S. on the cusp of a recession; but soft goods-producing indicators are pointing to some weakness as supply chains are disrupted because of recent tariffs, or the threat of more in the future if U.S.-China trade negotiations stall. Lastly, U.S. housing ended 2018 with poor momentum. We think this slowdown is temporary as mortgage yields retreat from their Q4 peak.

For the Bank of Canada (BoC), the hurdle to hike is not only higher because of a more dovish Fed, but also by the significant challenges that households are facing as they adjust to higher rates, consistent with our long held view. Rising interest rates and an elevated debt load are a tough mix for them, and we are not surprised to see Canadian real retail sales contracting on a year-over-year basis, something that rarely happens outside of recessions. The weaker dynamics of Canadian retail sales is quite evident versus the U.S., or even Europe (Chart 1). This means the BoC can, at best, match the Fed in rate hikes over the next 18 months. In our view, the odds that the next move by Governor Poloz is a rate cut are clearly higher in Canada than in the U.S., not the opposite as interest rate markets are pricing a 70% chance the Fed cuts rates by 2020, whereas the BoC is 50% priced for a hike this year.

Chart 1: Real Retail Sales for Canada, Europe & U.S.

Chart 1: Real Retail Sales for Canada, Europe & U.S.

Source: Bloomberg

Equities: Risk On, Cash is not King in the Long Run

While there are months like December, when the proverbial “cash is king” is true, it remains needless to say that it’s a lousy investment strategy in the long run when investors seek reasonable capital appreciation in excess of inflation—otherwise why bother saving and investing? In the long run, what generates appreciation to stock investors is the compounded return from equity appreciation, which arises from earnings growth. But in the short- to medium-term, investor appetite for risk can cause significant repricing of share multiplies, i.e., the so-called Price-to-Earning (P/E) ratio. A good way to illustrate our point that investors were pricing a very pessimistic outlook last December is shown in Chart 2, which compares the historical P/E ratios for the S&P TSX and S&P 500. The drop in the multiples of the S&P 500 was nearly as brutal as the de-rating that occurred in 2008. This is not 2008 – not even close.

In our view, a few important goalposts in favour of equities remain intact. First, the chance of a Fed policy error seems at best a low probability risk given the recent pivot regarding future policy. Second, earnings growth, while cooling, is still expected to run in the mid-single digits by analysts and we see some upside risks. Third, wage growth is still running at a benign pace and poses no threat to earnings despite the noise over labour shortages in Canada and the U.S.

Chart 2: MSCI World EPS Growth Forecasts

Chart 2: MSCI World EPS Growth Forecasts

Source: Bloomberg

Outlook and Positioning: Steady Views in North America, but Multiple Headwinds for China

After upgrading Emerging Market (EM) stocks to neutral in early January, there were no meaningful changes to our investment views last month. While we got a loud and clear confirmation that the Fed would be “patient”, which should broadly weigh against the greenback, although the impact of the trade wars is still uncertain as the publication of macroeconomic data lags. For China, the outlook is doubly clouded by its trade relations with the U.S., but domestically it faces lingering growth challenges where the goal is not so much for a re-acceleration but to slow the inevitable deceleration. As much as we are optimistic on the trade negotiations, a more likely scenario as we approach the March 1st deadline is that an extension will be announced. This means uncertainty over trade-wars will remain intact and should limit investors’ conviction on broad EM stocks for the near term.

Because we are in the camp of expecting another Fed hike this year on the back of a robust economy, government bonds with duration above 7 years remain unattractive at current yield ranges, so we maintain our short-duration call on fixed income.

For the loonie, January performance appears overdone in light of the softening pace of economic growth and we expect it to resume its downward trend to below $0.75 before the summer. Our view on the Canadian economic outlook has not materially changed; we remain convinced Canada will underperform the U.S. The broad USD seems to have peaked, but that might just be it – a peak – not a big drop from here.

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This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

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