July 2017 Monthly Market Commentary & ForecastMarket Commentary
Commentary Date: August 10, 2017
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From Our Founder
In February, we spoke about the risks of the new US administration struggling to pass legislation. Over two quarters into 2017, we have now witnessed the unsuccessful repealing of the Affordable Care Act, which refreshes our concern as it relates to the US government’s ability to affect positive change on tax policy and/or infrastructure spending.
What’s surprising is the manifestation of these geopolitical risks being projected onto the US dollar and taking it lower. US stock markets are reaching new highs while sentiment in the US grows darker. This currency disconnect has played out over the past 60 days with a 7.8% decline in the value of the US greenback relative to the Canadian loonie.
Adding further to marketplace confusion, we have central bankers in Canada and the US expressing opposite tones. In Canada, the economic outlook is getting polished brighter, giving way to the possibility of further interest rate increases. Meanwhile, the US Federal Reserve Board’s tone suggests that economic growth will be moderate. Overlay this disconnect with a commodity market that lately appears directionless and one might be asking: ‘where do I invest my money?’ In this commentary we’ll consider some options.
Richard G. Stone
Chairman & Chief Investment Officer
|* In Canadian dollar terms as at July 31, 2017|
Sizing up today’s economic environment
So, where does one invest their money? Perhaps this is best answered using a process-of-elimination technique. Let’s gather up the main facts first:
- We are in a globally concerted rising interest rate environment, which adds risk to bond investing
- Developed countries are being exposed to higher taxes, which is inflationary
- Bonds and bond proxy investments are becoming less attractive
- Real estate assets are facing the same challenges as bonds, if not with even more risk
- Holding cash currently yields few returns after the negative impact of inflation and taxes
This leaves us to surmise that the best place to invest money is in the realm of equities. The latest weekly data shows that global fund flows are favouring equity investments. Excluding US equities, equity fund flows were positive on a magnitude of US$2.3 billion, second only to South Korean won money market instruments, which posted an inflow of US$3.4 billion. During this same period, US equity fund flows were negative US$1.7 billion, perhaps another sign of the country’s continued geopolitical challenges.
However, we must recognize that some of the largest contributors to US markets are multinational companies whose earnings are tied to growth in several foreign jurisdictions. Also, we recognize that the latest weekly data is simply a five-day period, but it does differ significantly from the global fund flows experienced in 2016 when bond fund flows outweighed equity fund flows. During that period the Canadian equity market roared ahead as commodity prices recovered, posting one of the best performances among developed markets.
A mixed picture in commodities
As impressive as last year’s recovery in crude oil had been (from roughly US$37 a barrel to US$53), the question now is where do oil prices go from here? While we see forecasts for West Texas Intermediate crude oil ranging between US$30 to US$60, we believe the commodity will remain within a tighter trading range, likely between US$40 to US$52. We also believe that the range-bound price is a by-product of the inability of the Organization of Petroleum Exporting Countries (“OPEC”), non-OPEC and US shale producers to agree on a long-term production discipline. Meanwhile, alternative sources of energy are becoming cheaper and easier to procure.
The oversupply issues are not limited to oil. Precious and base metals also face similar economic challenges pressuring the prices of these raw materials. That said, in our view the sentiment has gotten exhausted in the near term and a lucrative trade opportunity could emerge as more constructive economic data from China and the rest of the emerging markets complex lead to improved future demand. The high degree of volatility surrounding these sectors notwithstanding, we believe that exposure to these areas reflects more of an opportunistic trade than a long-term investment thesis.
Gold, on the other hand, is also viewed as a historic alternative currency and a barometer for market jitters. Historically speaking, it has also been a participant in the rise of inflation, but now this relationship remains disconnected as well. Weakness in the US dollar and the relative strength of other currencies have kept gold prices suppressed, but we anticipate that a modest exposure can be beneficial since gold is currently such a disconnected asset. The correlation of gold to broader equity portfolios tends to be very low – if not negative – and this can have a smoothing effect on a portfolio when partnered appropriately. Gold tends to spike in abrupt reversals of market sentiment and/or geopolitical strife. Having some protection in such uncertain times is prudent for many investors.
Intertwining of the US and Canadian economies
A lack of logical responses to events is not exclusive to just the US administration or the world’s oil producers. In the UK, for instance, investors are trying to figure out whether the exit from the European Union (“EU”), known as Brexit, will be “soft” or “hard.” Considering the makeup of the new UK parliament, the probability of an exit deal with the EU has diminished but not disappeared. Any exit deal could cause a second referendum, and the state of the UK’s economy may be different at that time. To quote our friends at Rathbones Investment Management in the UK, ‘Owning UK assets is going to be a rollercoaster ride for the next six months at least.’
Given the disconnects and indecisiveness affecting various parts of the world, one might conclude that the best place to invest is here in Canada. However, we are also disconnected from that thesis. Although the International Monetary Fund (“IMF”) boosted its forecast for Canada’s gross domestic product (“GDP”) growth for 2017 to 2.5% from 1.9%, and even though the Organization for Economic Co-operation and Development bumped its Canadian GDP growth forecast to 2.8%, we see some challenges on the horizon.
Canada exports nearly 80% of its goods to the US. The meteoric rise in the relative value of the loonie will surely have some dampening effects on exports. If the forecasts on US economic growth are tempered by the inabilities of the US administration, it’s only a matter of time before economies tied to the US get impacted. Positive market sentiment on the US economy has dissipated in recent months despite the fact that corporate earnings growth is currently living up to expectations.
The IMF lowered its US growth forecasts for 2017 and 2018. A lack of faith in the US political process is rewarding the loonie by punishing the US dollar. We have conviction in our thesis that the US economy is one of the main underlying driving forces for Canada’s economic growth. If we didn’t already hold long positions in the US dollar, we would begin doing so at this stage today. The Canadian dollar appears to be overbought as we view the rapid rise to be primarily the result of a record number of short positions on the currency being unwound. At the end of May there were 98,187 short positions on the loonie – an all-time high – and now there are fewer than 5,000. We’ve said before that short squeezes can be sudden and violent, and test the conviction of even the savviest investors. While our view on currencies hasn’t been well timed for the past two months, we have conviction to stay the course, as prudent long-term investment discipline must look through short-term events. In reality, the strong loonie is a reflection of negative geopolitical sentiment on both the UK and the US. If you look at the foreign exchange rate of the loonie against the euro, the result is less dramatic.
Time for a balanced approach
We’re convinced that political gridlock in the both the UK and the US are temporal factors. Thus, we stand with conviction remaining invested in high-quality equities – both in Canada and the US – that can benefit from a rising interest rate environment, secular technological and/or demographic change, and pricing power. Our call to action would be to advise investors to remain mindful of short-term volatility and economic risks surrounding areas like the UK, and consider a balanced approach to investing, such as our Stone & Co. Flagship Growth & Income Fund Canada, which provides exposure to both North America and continental Europe, along with a healthy dose of corporate bonds to mitigate volatility and capture the benefit of tightening credit spreads.
In our current environment of economic and geopolitical upheaval, along with a number of notable market disconnections, many people are hard-pressed to know where to invest their money. That’s why we believe a balanced approach, left to professional asset managers to navigate, is a sensible choice.
CELEBRATING 150 YEARS WITH CANADIAN FACTS
August 3, 1876
Alexander Graham Bell holds the world’s first definitive telephone tests, and makes the first intelligible telephone call from building to building to his uncle David Bell.
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