October Monthly Market Commentary & Forecast
From Our Founder
Despite being the spookiest of all months, October certainly served up some pretty strong results, thanks to improving corporate earnings. So far, approximately 400 companies in the S&P 500 Index have reported earnings, with 71% of companies surpassing bottom-line estimates by 6.4%. Quite impressive when compared to the past three years, where 68% of companies beat bottom-line earnings by 4.7% .
In other words, the earnings recession is a thing of the past. While valuation multiples creep higher in this bull market – the second-oldest in history – earnings are keeping pace and, in fact, exceeding expectations. This is allowing for tolerance amid price-to-earnings multiples north of 18 times.
This month, we outline new areas of US economic strength and our prudent re-examination of the energy sector. We also delve deep into Canada’s economic progress, the mounting challenges for the Bank of Canada (“BoC”), and the housing market, including the impact of new mortgage rules.
Richard G. Stone
Chief Investment Officer
|* In Canadian dollar terms as at October 31, 2017|
Green shoots of inflation and traction
All of our funds delivered solid performance during the month as several key themes unfolded simultaneously, including the US dollar reversing its precipitous declines from previous quarters and gaining 3.3% during the month. Last month, we mentioned that we’re more constructive on the US dollar, given the tone coming from the US Federal Reserve Board (“the Fed”), and economic data revealing some green shoots of inflation and continued positive economic traction. Even though the reversal has been abrupt, we continue to be positively skewed toward the US dollar at current levels, in light of the challenges developing around the Canadian economy.
On a sector-specific basis, the areas of greatest strength were the Canadian Financials sector and US Information Technology sector, which posted monthly gains of 4.6% and 10.1%, respectively (in Canadian dollar terms). Both of these areas have been long-term investment themes for several funds in our complex. The portfolios also reaped the benefits of remaining underweight in the Energy sector. We are carefully monitoring this particular sector, especially given the behaviour of the underlying commodity of late, as well as the recent investigations of corruption among Saudi Arabia’s aristocracy.
Cautious and prudent return to energy
While asset allocation plays an important role in generating excess returns (alpha), we cannot ignore the contributions of stock selection during the month. After all, these two core activities are the very essence of our value proposition. Stellar quarterly results came from Google, Amazon, Stryker and Microsoft.Technical analysis of both West-Texas Intermediate (“WTI”) and Brent crude oil prices indicates that a multi-year decline has formed a “basing” pattern in the low-to-mid US$50s for WTI and mid-to-high US$50s for Brent – suggesting the potential for rapid upward price breakouts. Going forward, there is a distinct possibility that our asset allocation could increase investing in both domestic and multi-national exploration and production companies. So far, as we return to this sector, being prudent and cautious has been an advantage. However, we are well aware that there are risks to overstaying one’s welcome in any particular thesis. To that end, we are currently undertaking the necessary analysis to determine which areas and companies are sources of risk-adjusted capital appreciation.
Those results were complemented by company-specific catalysts impacting Maxar Technologies Ltd. and Aecon Group, which announced its agreement to be purchased by China’s government-run CCCC International Holding Ltd. at a price of $20.37 per share. These transactions, however, open the door for discussion about potential risks for Canada, from both policy and economic perspectives.
Contractions lead to Canadian GDP decline
As shown below in Figure 1, gross domestic product (“GDP”) data released during the month revealed that Canada’s economy shrank by 0.1% in August versus economists’ estimates for 0.1% growth. It marked the first monthly decline since October 2016 and follows a flat reading in July. The prime causes of the decline were contractions in manufacturing and the conventional oil industry.
Even though the price per barrel of oil is recovering, it does not mean that the headcount of oil companies will return to previous levels. If anything, it means that the management teams who were once forced to cut costs can now ramp-up production with less costly inputs. This also means that provinces such as Alberta and Saskatchewan will have large portions of their residents facing secular economic displacement.
Declines masked by surprise Quebec growth
Lately, secular declines have been masked by the surprise growth coming from the province of Quebec. It is, however, doubtful that the drivers of Quebec’s growth will be of the magnitude and duration needed to completely offset the secular declines in the Western provinces. Canada is still very much a resource-driven economy and the pains felt in the oil patch will likely ripple through Canada’s broader economy.
In addition, there are still several unanswered questions and anxieties related to Canada’s growth prospects vis-à-vis the North American Free Trade Agreement (“NAFTA”) renegotiations and consumer debt-servicing capacity amid rising interest rates.
The Parliamentary Budget Officer reports that the country’s deficit for the current fiscal year is $2 billion higher than the Minister of Finance’s forecast of $18.4 billion. In addition, the reductions anticipated over the next five years suggest that economic growth will slow during that period, as consumer spending moderates and residential investment declines alongside higher borrowing rates and lower gains in disposable income.
BoC challenges amid an overheating housing market
The Parliamentary Budget Officer’s report also predicts that economic growth (measured in terms of real GDP) will slow to 1.7% annually, beyond the year 2020. Given this tepid outlook for Canada’s economy, we see mounting challenges for the BoC in its pursuit of rising rates. The BoC’s interest rate increases this year simply reverse the emergency cuts made in response to the energy slump in 2015.
Our next source of concern for the Canadian economy is the housing market. There has been talk of whether Canada is in a housing bubble. The Canadian Mortgage and Housing Corporation (“CMHC”) warns that Canadian housing markets are highly vulnerable to being hit by overbuilding, overvaluation and rapid price appreciation. House prices have increased nationally by 3.0% in the past year and the CMHC is not forecasting much bigger gains than that for the next two years.
To help manage the overheating housing market, the Office of the Superintendent of Financial Institutions (“OSFI”) released a more stringent set of mortgage-qualification rules during the month in an effort to curb risky lending practices at banks. Under the new rules, buyers who are making down payments of more than 20% of a home’s value (and do not need mortgage insurance) will need to prove that they can still afford their mortgage payments if interest rates were to increase by 200 basis points more than the rate they had negotiated.
Mortgage rules may breed unregulated loans
We do not think that the banks are facing a great risk, because a significant part of their mortgage books of business are insured by the CMHC and their provisions-for-credit-losses and gross-impaired-loans are well contained. Where banks may face some challenges is in the pace and volume of their loan growth. Critics of the new OSFI stress test argue that the rules will push borrowers toward alternative lenders that are not regulated and, as a result, unintentionally add more risk to the financial system.
It still remains difficult, however, to envision a scenario where the government of Canada would willingly induce a housing crisis. In short, Canada has got its work cut out for it, but that has not deterred the management teams of Canadian companies to strive for growth.
Always striving for dynamic execution
While we have turned in a solid monthly performance, we will continue to optimize our portfolios in order to participate more meaningfully in what is currently driving markets. We are refining this discipline every day while reviewing the inter-relationships between macroeconomic and microeconomic forces that are driving markets higher.
We will also continue to exercise prudence and patience in identifying businesses that we would like to own for the long term. And we will always strive to be dynamic in our execution, thereby allowing us to be bold, early and just right as we uncover opportunities for our clients.
CELEBRATING 150 YEARS WITH CANADIAN FACTS
November 7, 1885
Donald A. Smith (Lord Strathcona) drives the “last spike” at Craigellachie, British Columbia, to complete the Canadian Pacific Railway.
There are risks associated with investing in mutual funds. Please refer to the simplified prospectus for details of the risks associated with these funds. All mutual funds carry the risk that the mutual fund may decrease in value. The degree of risk varies depending on the investment objective and strategies of the mutual fund. Before investing in any mutual fund discuss with your financial advisor how it works with your other investments and your tolerance for risk. Please refer to the simplified prospectus for more information regarding the risks associated with these funds.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the Simplified Prospectus or Offering Memorandum before investing. Any indicated rates of return are the historical annual compounded total returns including changes in security value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. The payment of distributions is not guaranteed and may fluctuate. The payment of distributions should not be confused with a fund’s performance, rate of return, or yield. If distributions paid by the fund are greater than the performance of the fund, then your original investment will shrink.
Distributions paid as a result of capital gains realized by a fund and income and dividends earned by a fund are taxable in your hands in the year they are paid. Your adjusted cost base will be reduced by the amount of any returns of capital. If your adjusted cost base goes below zero, then you will have to pay capital gains tax on the amount below zero. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.
Information contained in this publication is based on sources such as issuer reports, statistical services and industry communications, which we believe to be reliable but are not represented as accurate or complete. Opinions expressed in this publication are current opinions only and are subject to change.