Cautiously Positive vs Sanguinely Negative (Summer 2017)

Recent Market Activity & Mixed Outlook

So, over these last few months we have some more signs of markets and investments returning to “normal” though what that means precisely varies from person to person and from one day to the next.

Each management team interprets the current situation slightly differently and is taking different steps in keeping with their view, which is why we usually have different teams making decisions for everyone’s household portfolio. Looking forward we know one or more of the teams inside a portfolio will be MORE right in their outlook and decisions in the coming months.

And as a reminder, we will likely, after those same coming months, reward that more correct manager by skimming some excess return off that asset portion (called: selling high) to redistribute the excess to the currently lower performing management teams to rebalance the portfolio (called: buying low)

We do this to make sure that when (not if) the currently underperforming managers become the future “best” performing manager, we have added to them at a low price.

That said, there are some broad recurring themes we saw from the managers:

1.     Continued if reduced growth of the economy, globally with some countries doing better and some doing worse.

2.     A spreading of that ‘growth and recovery’ to the middle-low income earners for the first time in nearly a decade.

3.     Connected to that is new direction for the world’s governments in terms of seeing interest rates begin to rise-though only a little.

With that in mind let’s hear from some of the teams we use fairly consistently. (Bolding and extra comments are MINE)

Fidelity Populism Chart

This chart above, specifically Point B, shows how income for the middle class in the western world, namely Europe and North America, has shrunk whereas the poorest people in the world and the richest have both seen substantial income growth.

Ivy Management Teams (from Mackenzie)

Ivy is consistently one of my favourite “dark cloud” managers, looking in what others see as a silver lining. They worry about money on a full time professional level which means they tend to look for problems, keep lots of cash on hand and are suspicious of any good news… like many of my clients!

“Overall, markets have done quite well, but there have been a few ups and downs along the way. If we go back to last June, we had the Brexit and so there was lots of volatility around this event. We were actually able to find some pretty good opportunities in Japan at that time and some other select cyclical industries globally and then in November, of course, we had the US Presidential Election and so heading into the election, we were, again, able to find some good opportunities in Japan and then coming out of the election, we were able to find some good opportunities in the Hong Kong market. Since the election, markets have performed extremely

well, so a lot of those pockets of opportunities that we had seen have largely evaporated”

Translation: we like to buy stuff when the market is dropping

“…given the recent trajectory of most global markets and lofty valuations, the Ivy funds today, generally speaking, are operating with elevated cash levels…we are quite concerned about three broader issues. The first would be the state of global balance sheets, both government and consumer. The second would be the elevated market valuations that we see today despite the fact that global growth is actually quite weak and the third would be the market’s reliance on very accommodative monetary policy and then the potential long-term negative implications of these policies.

“The Canadian market has underperformed global markets, in part due to low energy prices, housing-related concerns and US trade talks. We don’t presume to know how those issues are going to play out, but our portfolios are not constructed with any particular outcome in mind. …We think about returns over a full market cycle…

“One of the more interesting events recently is actually a non-event and that is the absence of volatility. Market volatility has been very, very low this year and the expected volatility for the future is also very low. The VIX Index of implied volatility, the so called fear gauge, recently hit a 23-year low. Any time anything hits a multi-decade high or low, it is interesting to think what that might mean and, combined with what we consider to be high stock prices, it is a little bit concerning.”

Meaning they want to see more investors scared and nervous and focused on the short term and thus willing to sell their company ownership cheaply.

 Invesco: Looking ahead: Seeing the world in 3D

 “As I look to the back half of the year, there are three themes that I believe remain critical for the economy and markets:

  1. Demographics. Developed markets are aging and emerging markets have younger populations. This has important implications for economic growth as well as debt levels for governments and individuals
  2. Deceleration. We are seeing the potential for a deceleration in economic growth in Canada. Most indicators suggest the economy is growing nicely. However, storm clouds have formed that increased the downside risks to this base case
  3. Disruption. I believe that there is growing potential of disruption impacting markets – specifically two key areas: geopolitical risk and monetary policy risk

Monetary policy risk

This refers to several things but in the end comes down to the fact the markets have gotten ‘used’ to the government assisting the stock market by -over the last decade- doing things like creating artificially low interest rates and driving investors to the stock market. As they mention, this is becoming less likely and managers are worried about how investors will react to the withdrawal of this years-long ‘market methadone’ 

“Some major central banks, most notably the European Central Bank (ECB), appear to have signaled a turning point, as indicated by yields moving back up recently. It seems central banks are peaking in terms of monetary policy accommodation and will soon begin to proceed with monetary policy normalization, as the U.S. and Canada have already begun.

However, after such extreme policies as aggressive quantitative easing and negative interest rates, it will be difficult to normalize without potentially triggering some level of disruption. In the U.S., the Fed will soon begin the delicate task of balance sheet normalization while still in the throes of a rate hike cycle.” 

 Blackrock Canada-Article

We don’t actually use BlackRock because their main investment products, the ishares are not something we can offer plus I am not a huge fan of any passive ETF/Index investments. I’m including them here because of a recent comment by their fixed income head.

“We think the secular trend for falling interest rates is over and that we will be in a period of rising rates going forward,” says Aubrey Basdeo, Head of Canadian Fixed Income at BlackRock Canada. “We’ve seen the U.S. start to lead this change and while there is a divergence in monetary policy between the U.S. and the rest of the world, we think in time the rest will do the same thing.”…“Going forward, in the rising interest rate environment, investors will need a better balance of spread risk because it’s negatively correlated with interest rates,” Basdeo says. “This will also require investors to think about being more tactical and active management is going to be more helpful than a passive approach.The primary challenge for fixed income investors will be the need to rebalance the portfolio’s exposures to spread risk and interest rate risk.”

QV Investors-QV Update July 7, 2017

“In times like these our risk management process can feel more like a liability than an asset. In trying to maintain a reasonably valued portfolio with sound balance sheets, we end up trimming or selling holdings that continue to advance from expensive to really expensive, leaving gains on the table. We aim to recycle a dollar of capital into an investment that we believe has less downside risk and a greater likelihood of delivering above average gains into the future. This new investment may require a catalyst or change in market sentiment to begin to appreciate, therefore patience is warranted. Any type of “risk management” during a bull market tends to reduce the portfolio’s return. As difficult as it may be to watch the markets outperform when investors are feeling comfortable, we believe that long-term investing success depends not only on how much you make in the up markets, but also how much you preserve in the down ones… Looking forward we remain focused on ensuring our companies have balance sheet strength and reasonable valuations absent unsustainably low interest rates. …We won’t try to force a higher return by increasing risk levels, but will look to take advantage when quality businesses go on sale and investor comfort is replaced by anxiety.”

Capital Group

“With rates set to rise, many investors worry that it is time to get out of bonds. But basic bond math shows that these investments will often retain their value because the higher income will offset falling bond prices. For example, let’s say yields rise 1% over two years — about what the market expects. …more yield can actually help to produce a positive total return, despite the bond facing a capital loss. In fact, keeping other variables constant, it would take an additional 1.22% rate gain over the next two years for investors to see a loss. We expect rates to rise, but at a gradual pace, which should give investors comfort in their core fixed income holdings….”

So, though rising interest rates can shake the bond markets because of the new yield expected on new issues, the Capital Group believes the increases will be moderate and the bond market will adjust quickly. However the bold statement above considered only the raw math and discounts the psychotic actions of the bond market.

Mackenzie Financial

“What was a generally positive quarter for bonds, with 10-year yields drifting modestly lower in developed markets, turned on a dime during the last two weeks of June. A second 0.25% increase by the Fed, which was expected, combined with slightly more hawkish statements by several central banks to catch the market off-guard and produce the sharp sell-off. Most notably, the Bank of Canada seemed to abruptly change its tune on the near-term outlook for the policy rate. … Because of the reaction, the Canadian yield curve is now approximately priced for two 0.25% rate hikes through the rest of 2017, and pretty much for a third hike by mid-2018. In sympathy with Canadian yields rising more sharply than those in the US, the Canadian dollar rallied against the greenback at the end of the quarter.

… Current inflation levels and inflation expectations remain muted. It seems likely that longer term trends of economic yield sensitivity, global excess savings and excess capacity, past globalization trends, and continuing technological innovations will all conspire to keep inflation and yields relatively low.

Looking more specifically at Q3 and Q4, there are some potential risks that could emerge to ultimately delay or remove the potential for policy tightening. Growth trends have not proved robust and uncertainties such as continuing Brexit negotiations, credit tightening in China, lack of wage growth in the US, and contentious fiscal debates which may cause the US to hit the debt ceiling, remain near-term obstacles…”

Todd Matima, Chief Economist Mackenzie Investments

“The Global Reflation Trade refers to investors positioning for an increase in stocks, bond yields and the US dollar in anticipation of expanding global growth and inflation. Three pillars drove the Global Reflation Trade beginning in mid-2016. These include a strong rebound in global manufacturing activity and world trade, a sharp jump in business and consumer confidence, and the surprise election of Donald Trump with high expectations for deep tax cuts, higher infrastructure spending and deregulation. As the influence of these pillars faded, the acceleration in global growth slowed.

… First, China tightened its macroeconomic policies in 2017 by dialing back the unsustainable pace of debt accumulation following an increase by almost 100% of GDP since 2008. In 2017 Q1, China’s aggregate financing totalled about $1 trillion US, underpinning the rebound in world trade and commodity prices. Second, US economic momentum slowed in the first quarter of 2017, owing to weak consumer spending and a decline in government outlays. Third, the chaotic White House was unable to advance President Trump’s agenda in the Republican-controlled Congress, raising questions about the feasible size and timetable of passing tax cuts.”

Summary-My Interpretation

So the consensus view is mildly positive -that we will see continued though muted global growth for the foreseeable future. The chances that we will see a sudden strong, economic downturn or upturn are believed to be low. This means it is also believed there will be no sudden spike up in interest rates in Europe or North America but instead a continued, measured increase or ‘normalization.’

The holdouts on this view, the QV team and the Ivy team, believe prices for most current stocks are over-inflated and are building cash inside their portfolios believing the prices will get better. (ie. Come down.)

Going forward, the strategy will be to continue to add to currently performing positions in various management teams, make sure we maintain diversity of opinion inside the portfolio and continue to ignore-as best we can-short term headlines to maintain long term growth.

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