Market Insights: Second Quarter Wrap-Up

Market Update

Equity markets continued to push higher in the first part of the second quarter, after an extremely strong first quarter. Since the end of April, however, markets have mostly been in consolidation or pulling back slightly from those highs. We have seen new all-time closing highs for the S&P 500 in late June and the Dow Jones Industrials in early July.

The S&P/TSX Composite, however, has yet to push past its high from late April. This is mostly to do with the continued lackluster performance of the Canadian energy sector. The S&P/TSX Energy Price Index was up just 1% at mid-year, but down almost 14% from the end of April. For cyclical industries in Canada, this has been the one area of strong underperformance. By comparison, in the U.S., the S&P 500 Energy sector is up 11% year-to-date.

Most developed equity markets are up around 15% year-to-date on average. However, the rise of the Loonie this year has taken a bite out of those returns from a Canadian investor perspective. The U.S. dollar and the Euro have both dropped 4% and 5% respectively against the Loonie this year. The is evident in the MSCI World Equity Index (in CAD) up just 10.6% year-to-date versus 15.3% in local currency. 

From a Canadian dollar perspective, the S&P/TSX Composite has been the best performer year-to-date, followed by the S&P 500 (CAD) at 12.7%, then the MSCI Europe/Asia/Far East (CAD) up 6.9% and the MSCI Emerging Markets (CAD) index up just 4.5%.

The fixed income market in North America has been very strong this year, with long-term interest rates continuing to decline since the end of October. Due to the inverse relationship, this has pushed long-term bond prices, especially long-term government bonds, up substantially the last 6-8 months. For example, the FTSE Canada Long-Term Bond index is up 12% this year and over 15% since the end of October. We will discuss this underlying risk of holding long-term bonds in our strategy comments.

In other markets, the price of Gold and Oil have increased about 10% and 28% respectively in U.S. dollars. This has not translated into performance for Canadian energy equities.

Milestone strategy and outlook

We continue to focus on our long-term fundamental core thesis, which remains positive. Despite fears of slowing global growth, a trade war and a flat yield curve, the positive influences that drive this thesis are still present today. Please revisit our 2018 Second Quarter Wrap-up and our 2017 Third Quarter Wrap-up commentaries for more details on this core thesis. In terms of recession risk for the U.S., our Milestone Recession Risk™ Composite remains in a moderately low level of risk at mid-year. Our technical analysis shows that markets have moved into a new intermediate term uptrend in mid-June that could last two to three months. From a risk management perspective, we may look at seasonal adjustments later in the summer. However, longer-term, we continue to believe the secular bull market is still alive and well. 

There have been many headlines this quarter, but as has been the case for much of the year, the primary focus has remained on China and the U.S. Federal Reserve. The US-China trade story swerved from the sense that a deal was near in April to an abrupt breakdown of talks in May, then toward a possible agreement at the end of this past quarter to restart talks. It has been quite something to witness how the market has swayed back and forth intra-day on every 'Trump Tweet'. The Fed has continued its dovish (accommodative) monetary path recently with the last Fed meeting showing increasing support towards a possible rate cut in late July. The markets are currently pricing in a 100% chance of a cut in the Fed Funds rate on July 31. Markets are currently even pricing in almost a 90% chance of at least one more cut by the end of the year. Canaccord's lead strategist Tony Dwyer did some analysis on past equity market returns post first rate cut in recessionary vs. non-recessionary years. Since our Milestone Recession Risk™ Composite currently is not forecasting a recession in the next 6-12 months, the following chart provides added assurance.

                  Source: www.ndr.com, Canaccord Genuity

This accommodative stance helps set support for equity markets despite the first quarterly decline in year-over-year corporate earnings growth since 2016. That being said, we do believe that earnings growth will likely end with a positive annual number by year-end. Inflation also continues to be benign and supportive of above average equity valuations. The Fed’s favored inflation measure, the Core PCE and Inflation Break-evens, are currently well below their 2% average objective. Also, markets have been able to largely shrug off geopolitical tensions like the U.S.-Iran strife.

As we have highlighted quite extensively in previous posts (here and here) over the last few quarters, market breadth continues to be strong, with the NYSE cumulative advance-decline line hitting new highs. This important breadth indicator also held up very well during the large 20% correction in Q4 of last year (and bear market for some regions), as well as the recent 5-10% correction we witnessed in May. We continue to monitor this for any negative divergences and will comment on that if or when we see this occur. 

We wanted to focus on one primary theme this quarter, namely the fixed income market and depressed long-term interest rates, particularly from a portfolio construction standpoint. In addition, we will discuss the negative media surrounding the fact that part of the yield curve has inverted and its recession risk implications.

We will be first to admit that we did not think that rates would have declined to where they have this year, with the Government of Canada 10-year Notes hitting a low of 1.42% in June. The low this cycle was just under 1% back in July of 2016 when Canada had back-to-back quarterly negative GDP growth. However, we did not expect a possible retest of those lows after peaking at 2.6% last October which was the highest rate since early 2014. It is a similar pattern in the U.S., with 10-year Treasury yields dipping to 1.95% last week from a high of 3.25%. As you can see from the chart below, we are not alone in that surprise. Early in the year, the Wall Street Journal surveyed U.S. economists as to their mid-year and year-end predictions for the 10-year yield. The lowest analyst prediction at the start of the year was for a decline to 2.5%. That is a far cry to where it has declined to this year. As is normal, short-term economist and analyst predictions are not normally overly accurate, whether it be for interest rates or even currency exchange rates.

Source: Edgepoint Wealth Management Inc., Avantika Chilkoti & Daniel Kruger, "Some Investors Had Hunch Yields Were About to Fall", https://www.wsj.com/articles/some-investors-had-hunch-yields-were-about-to-fall-11560072600

That is a significant drop over a short period of time, resulting in very strong performance for longer-term government bonds in North America. Most professionally managed balanced mandates are benchmarked against the country's broad or aggregate bond market, which for Canada is roughly three quarters government (Federal & provincial) bonds with an average maturity of close to eleven years. Since 2016, with what we believe is still likely the secular low for yields, we have positioned our portfolios with lower duration (the sensitivity of the price of a bond or other debt instrument to a change in interest rates) and far more corporate than government bonds (i.e. higher yields, also less sensitive to interest rate changes) due to the inherent risk of rising rates. Bond prices have an inverse relationship with interest rates. When you experience very sharp short-term declines in interest rates, it is very difficult to match the broad bond market benchmark performance due the benchmark being far more sensitive to that yield decline and thus price increase.

We prefer to take a longer-term stance with our portfolio construction process since forecasting short-term rates has not proven to be a successful strategy for anyone in the past. As we do not believe we have an edge in forecasting short-term interest rates, we look to focus on risk versus reward as to where rates are at presently positioned in relation to the long-term trend. Even at a rate of 2.5% on a 10-year U.S. Treasury (0.5% higher than today), we do not believe the reward is sufficient to compensate for the inherent downside price risk. We continue to believe the room for rates to rise is greater than to fall, and thus based on a longer-term balance of reward and risk, our fixed income duration remains positionally well below average. We will not alter our longer-term process for short-term performance. To provide you with an idea of downside risk, if 10-year Treasury yields were to move back from 2% to 3% (which we had just this past November), the price of that Treasury would decline by approximate 8%. In absence of short-term interest rate predictions and taking on too much interest rate risk, we choose to focus more on taking on credit risk and using best in-class active strategies from the credit managers in this space.

The chart below is an example of analysis we consider when looking at reward vs. risk in terms of fixed income positioning. As you can see, the 6- & 8-year duration of the U.S. Aggregate and CDN Aggregate bond market is only paying 0.42% and 0.32% additional yield over 1-3-year credits, but with four times the duration. The simple math of this equation, regardless of the recent short-term interest rate decline, tells us to stay low duration and collect a higher coupon on good solid corporate credit.

               Source: IA Clarington Investments

The media has been focusing a lot of discussion on the recently partially inverted yield curve in the U.S. where 10-year yields have moved below 3-months yields. For those not familiar, the yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity. As you can see below, U.S. 10-year Treasury yields have been lower than 3-month yields for the better part of the last two months. There is reason to be concerned about this inversion, as all U.S. recessions of the past have been preceded at some point by an inverted yield curve. 

                Source: Federal Reserve Bank of St. Louis, fred.stlouisfed.org

Firstly, we want to reiterate that the timing of this inversion is not a good predictor of future negative equity market performance, at least over the short to intermediate term. Therefore, from a portfolio management perspective, it is certainly important and noteworthy, but not a signal to be used in the short-term. As we noted in our 2018 Second Quarter Wrap-up, based on the last seven cycles dating back to 1965, once the yield curve officially inverts, equity markets tend to perform extremely well for a median 19 months following that signal. We will also note that in the past three cycles, the lead time to recession has been 25 months with a gain of 32% from the first signal. 

And secondly, likely more importantly, one must discern what an official yield curve inversion is. From our standpoint, we have always preferred to look at both the 2-to-10-year yield curve and the 3-month to 30-year yield curve. As we noted in that same commentary last year, we specifically referred to the 2- and 10-year yields in our analysis, as that is more important than the 3-mth and 10-year yields because the former curve is what drives non-traditional bank lending. Back in 2006, we had, in our view, an official 2-to-10-year yield curve inversion, and we gradually adjusted for that signal. As we mentioned above, however, it is a long leading indicator. When the curve officially inverted in February of 2016, the S&P 500 Total Return Index advanced another 19% through the end of 2007, prior to the 2008-9 market collapse. At this point in time, although the 2-to-10-year and the 3-month-to-30-year yield curves have been as low as 15 and 40 basis points respectively of late, neither of these yield curves have inverted.

One of the primary reasons we constructed our Milestone Recession Risk™ Composite was to have a more robust view, one that doesn't rely on one signal. We have ten signals, including the yield curve, that span across fundamental, economic, credit, sentiment and technical factors.

We will continue to monitor rates and inflation in the context of equity market levels and sentiment and adjust our portfolios accordingly through a process based on long-term objective analysis. At present, the balance of factors continues to tilt our stance in a positive direction.

Here is our Milestone Market Report on economic data, capital markets, commodities and currencies through June 28th, 2019: (click image for PDF version)