Market Insights: Third Quarter wrap-up

Third Quarter wrap-up

After enduring a lengthy correction that ended in February, North American equity markets have showed continued strength in the last two quarters.  The U.S. equity markets pushed to a new all-time high in August, while the Canadian market has had a healthy bounce and moved to its highest level since June 2015.  After a difficult 2015, the TSX Composite has returned 13.2% year-to-date (YTD) to the end of September.  One of the primary reasons for this is the short-term strength in the energy and materials sectors, which make up about one third of the composite.  Yet, as strong as the Canadian equity market has been this year, the TSX Composite is still 6.5% away from reaching its all-time high set all the way back in September 2014.  Down south, the S&P500 Index is up 6.1% YTD, but only up 0.6% in Canadian dollars.  Internationally, we have seen developed markets struggle, while emerging markets have come alive.  As long as the U.S. dollar strength can be relatively contained, we see much more upside to emerging markets and feel it is important to have an allocation there.  The MSCI World index is down 1.6% YTD (Cdn$), while the MSCI Emerging Markets Index has advanced 7.9% (Cdn$).  These numbers are all higher in local currency terms, so this illustrates that the Loonie has been a detractor from performance from a Canadian investor perspective.

Fixed income markets have been strong this year with prices pushing higher as yields have continued to fall.  The FTSE TMX Canada Bond Universe is up 5.3% YTD.  For the first time in history, we witnessed the 10-year Government of Canada bond yield fall below 1%.  The U.S. equivalent also hit a new all-time low at 1.34% in July, while its 30-year bond yield hit 2.1% (also a new low).  This seems very low indeed, however, nowhere near as low as Japan and German, where the 10-year government bond yield in Japan has been negative for much of the year and the equivalent in Germany also dipped down into negative territory in the third quarter.  We have seen bond yields jump back up of late, but the long-term trend for bond yields globally for developed markets is still overwhelmingly down.  The secular (very long-term) bull market for bonds is still well intact; however, there are many pundits who feel this has come to an end.  This may be the case, but we feel more evidence is needed on that front to come to that conclusion.  That being said, with the U.S. Federal reserve likely moving short term rates again later this year, and with Europe and Japan running out of accommodative monetary policy tools, we can't deny this interest rate risk is becoming more predominant.  Likely the best longer-term strategy at this point is to keep duration low, and to use active management to seek out higher yield in quality corporate credits and exploit short-term bond yield spread movements.  

Our overall intermediate to long-term view on the markets is still the same as it has been for a few quarters now, which is generally positive.  Our Milestone Recession Risk (MRR) Composite™ is currently at a comfortable level, which signifies very low U.S. recession risk in the next six to twelve months.  It moved into neutral territory and almost flashed red late last year and early this year, but as we indicated back then in our commentary, we remained steadfast and kept our equity weighting close to our long-term target.  This proved to be well served as we have had two consecutive quarters of positive equity performance since then.  We rely on these objective indicators to help guide us through volatile periods, avoiding hasty short-term decisions.  This enables us to keep the long-term focus at the fore-front of our investment management process.  

We are focusing on some of the positive signs we see from the U.S. economy.  There is no doubt negative news at every turn, but that is what the media revels in.  However, we would like to point out the following:  the widely followed Conference Board Consumer Confidence Index is now at the highest level since the last recession (highest since August 2007).  This is a strong leading indicator of consumer spending and income, employment and business conditions.  The unemployment rate in the U.S. is currently at a healthy 5% and the 4-week average of the Weekly Initial Claims report is at a 43-year low.  In addition, we are starting to see evidence of a turnaround in the participation rate, which is the portion of population employed or actively seeking employment. This has been a negative in the recent past.  The service sector in the U.S. also remains strong.  This is an indication of strong personal consumption which makes up the bulk of their economy (GDP).  Lastly, investor sentiment is still fairly negative, which is usually a positive for markets (contrarian indicator).  According to the American Association of Individual Investors (AAII), bullish sentiment has been below 40% for 49 straight weeks and 82 of the last 83 weeks, even as the S&P500 is not too far off its all-time high.  This streak is the longest since 1987.  There are still three months left, but 2016 is on pace to be the first year in the history of the AAII survey that bullish sentiment has stayed below 40%.  Tops do not form with this lack of optimism.

Over the last many weeks, essentially since August, markets have been unable to make a convincing move, stuck in a sideways and somewhat volatile pattern.  We will likely see this trend change soon, either positively or negatively, however, we remain neutral on equities in the very short-term.  We feel there are likely three main uncertainties that are weighing on market participants right now.  These are the U.S. Presidential election, the upcoming Federal Reserve meetings in November and December, and the stability issues surrounding Germany's largest bank, Deutsche Bank.  These are all uncertainties, and until participants see more clarity, it could put a lid on markets pushing higher for the time being.  That being said, we still view the fundamental backdrop for equities as positive. 

One theme we want to discuss this quarter is the bull market which began in the U.S. back in 2009.  It is our contention that this has been an interest rate-driven bull market.  In other words, it has been on the backs of Central Banks around the world, with zero interest rates and quantitative easing policies, that equity markets have pushed higher than they otherwise likely would have.  What we believe we are starting to see evidence of is that this is transitioning to a fundamental earnings-driven bull market.  With long-term rates at historically low levels and inflation still relatively tame, we continue to view the environment as a positive one for equity valuations to continue higher.  However, we need to see more evidence of corporate earnings expansion in the U.S.  The annual earnings for corporations has been negative for a year and half, but there is some indications that this troughed in the first quarter and that we could see this return to a positive number either this quarter or next quarter as the hurdle rate is lower.  

As we move inter the latter stages of this cycle, we believe active management will become even more important as we see greater divergences in sectors.  We are hopeful this pro-cyclical move should benefit the Canadian stock market as a whole, but even more so here in Alberta.  The potential trend change for interest rates from down to up is also a potential major concern that needs to be actively managed going forward. This is not something that occurs overnight, but something that needs to be navigated.  The seasonably strong period for equities starts near the end of October, so the current volatility we have seen in September and now in October is definitely not out of character.  With some uncertainties near-term, this general pattern may evolve a bit later than usual.  In any case, we continue to monitor our leading indicators and will make adjustments as we head into the balance of this year if we see any heightened risk on the horizon.  

Here is our Milestone Market Report on economic data, capital markets, commodities and currencies through September 30th, 2016: