On July 12th, the Bank of Canada raised interest rates for the first time in seven years. While the pace of interest rate increases in Canada is likely to be slow and very gradual (0.25% increases at a time), it does reflect a significant change for the investment landscape, as it seems most major central banks are either raising or at least considering raising interest rates. Low and in some cases negative interest rates have been a central feature of the world economy since the financial crisis of 2008. This change in stance by the central banks could have significant implications on the world economy, investments and in particular our clients’ investment portfolios. In this quarterly report, in addition to a discussion of the past quarter, we will focus on what central banks do, why they matter and our views of the effects of the likely interest rate increases.
Following a strong first quarter, most world equity markets retreated from their highs during Q2. While market watchers may have rejoiced over US TV networks talking about all-time highs for US stocks throughout Q2, the reality for most markets was quite different. The TSX declined by 2.3%, Europe declined by 1.7% and the US market was up only 0.2% in Canadian dollar terms (it gained 2.9% in USD). Most of the drag came in the final few weeks of June when central bankers globally took a more hawkish tone with the Bank of England and the European Central Bank (ECB) both talking of potentially higher rates and less accommodative monetary policy in the near future. In particular, Mario Draghi of the ECB proclaimed that deflationary issues in the Eurozone were over. The US Federal Reserve reconfirmed that it plans to continue gradually raising interest rates and discussed reducing its balance sheet. The Bank of Canada, gave hints of raising rates as well (this was confirmed with a 0.25% rise on July 12 – the first increase in seven years). The Canadian dollar rallied against other currencies, particularly the USD as a result.
On a political front, the Centrist, Emmanuel Macron won the presidency in France and his party then won a majority in the legislature. His victory has already resulted in substantial increases in consumer confidence in France and throughout Europe with expectations that he will usher in pro-business reforms, such as tax cuts and needed labour policy reform, as well as pushing for greater integration in Europe. In the US, the Trump bump has diminished significantly with most analysts expecting the promised tax reform and cuts and / or infrastructure spending will not happen in 2017, if at all, as the Republican congress is not fully united and the President continues to be under pressure. Geopolitical concerns remain, including North Korea’s launch of more advanced ICBM missiles and continued military campaigns in the Middle East, but none of these concerns seem to be impacting equity or fixed income markets for the time being.
Overall, most of our clients earned positive returns for the quarter as our Fixed Income pool was up 1.4%, preferred shares were positive and the Pension Equity Pool was up 1.6%. The Fixed Income pool benefitted from holding bonds with shorter durations / terms to maturity and its 5% weight to rate reset preferred shares. These securities typically go up in value when bond yields increase. The TriDelta Pension Equity Pool gained from its overweight position in US health care and limited commodity exposure in Canada. Our Growth Equity Pool and High Income Balanced Fund were both down about 0.5% with losses concentrated in June.
Our short list of recommended alternative investment funds focused on private credit, factoring, and real estate benefitted client returns in Q2 averaging about 2% for the quarter.
Actions that we had taken at the end of Q1, which we described in the last quarterly report, helped protect performance as we took a more conservative tone by:
- adding to cash
- reducing our US equity overweight position
- reducing the duration / term to maturity of our bond portfolios.
For the quarter ahead we remain cautious, but opportunistic. Bond yields may rise a bit further in the coming weeks, but this could give us an opportunity to buy longer dated bonds at much more attractive yields. With interest rates likely increasing in the US, Canada, the UK and potentially in Europe, equity markets will be much more reliant on companies increasing their earnings to generate positive returns. The good news is that earnings in the US are expected to grow by about 8% this quarter and by over 20% for the year; European equities are expecting similar earnings growth as well. In Canada, earnings growth is expected to be closer to 30%, albeit from depressed levels due to the drop in commodity prices in 2015-2016. This is offset by the fact that equity valuations remain high, so strong earnings and beating analyst expectations will be necessary for the markets to move up in the short-term. Consequently, the changes that we put in place at the end of Q1 are still in place going into Q3, as we look for better opportunities to deploy capital.
Central Banks, such as the Bank of Canada, the US Federal Reserve and the European Central Bank, implement monetary policy to help control money supply. Most central banks attempt to keep inflation within a target range by either restricting or increasing money supply, primarily by setting the overnight interest rate. Some central banks, in particular, the US Federal Reserve, also have an agenda of using monetary policy to encourage full employment. Since 2008, the role of central banks expanded enormously as they provided emergency funding, lowered interest rates to zero percent and in some cases negative yields to encourage banks to lend, consumers and corporations to borrow to help kick-start the global economy while limiting the economic damage from the financial crisis. Central banks also attempted to stimulate the economy through quantitative easing, which is explicitly buying longer dated government, mortgage and in some cases corporate bonds in an attempt to lower longer-term interest rates and flatten the yield curve, e.g. if a corporation knows that rates will remain low for 5-10 years, they may be more interested in borrowing funds to expand production or for a longer-term project, which leads to more jobs, more consumer spending and economic growth.
These very low interest rates became the norm for nearly all major economies and they have had significant impacts on both the economy and the financial markets. These lower rates helped support fixed income (bonds) and stock returns in a variety of ways.
1) Bonds – when interest rates decline, longer dated bonds are more valuable because investors earn a much higher return relative to short-term cash investments. As a result, more investors buy bonds, their prices go up while their yields decline. As an example, a 10 year Government of Canada bond yielded approximately 3.7% in September 2008, prior to the financial crisis. For the next 8 years yields declined so that the 10 year Government of Canada bond was yielding less than 1.0% by mid-year 2016. These bonds are currently yielding about 1.8%. Easy monetary policy is a large part of the reason that bond investors have earned average returns of 4.5-5.0% per annum since 2008.
2) Corporate Earnings – easy monetary policy meant that it cost less for companies to borrow. Consequently, smart CEOs and CFOs issued a lot more debt over the past 8 years to make accretive acquisitions and expand production as well as using the funds to buy back stock and increase dividends. All of these measures have resulted in higher earnings per share for companies and higher returns for investors.
3) Stock Valuations – investors constantly have to decide where to invest their money to earn the highest return relative to their risk tolerance. The easy monetary policy over the past 8+ years has made stocks more attractive. When your options are very low rates on GICs and bonds, investors have been putting more money into the stock market. In fact, many investors earned higher levels of income by buying dividend paying stocks than they could on bonds and they had the opportunity for capital appreciation. As a result, stock prices continued to climb from their lows in 2009, with the exception of a few corrections along the way, and stock valuations, the multiple that investors are willing to pay of a company’s projected cash flow and earnings, are presently at much higher than historical levels.
While most major economies are now increasing or at least no longer cutting interest rates, what is still to be determined is the pace and total level of these increases. It is also uncertain as to what impact they will have on financial markets, but our thoughts are below:
1) Bonds – Higher interest rates typically are a negative for bond holders. Bond prices drop as yields increase. The offset has been that the credit spread, which is the additional yield you earn by owning a corporate bond vs. government bonds, tends to shrink, meaning that corporate bond holders earn higher returns. Presently, credit spreads are tighter than average, so the upside from spread compression will be limited. Our view is that passive bond investors should expect to earn the current yield of the bond index, which is approximately 2.5%, but with some volatility.
We actively manage our bond portfolios, adjusting duration, sectors, credit quality, and taking advantage of special opportunities, such as preferred shares, to enhance yield and overall return. While we presently have a cautious stance, we will take advantage of longer dated bonds when yields are at more attractive levels or investor sentiment changes, as well, we will continue to look out for opportunities to extract additional returns from high yield bonds, USD pay bonds and preferred shares. We believe that through active management and being nimble, additional returns can be earned in this asset class.
2) Corporate Earnings – Economic growth accelerated globally in the past year, particularly with Europe, Japan and most Asian emerging markets advancing at much faster paces. As a result, business and investor sentiment have been going up (although recently declining moderately in the US), purchasing manager indices have been rising and consumer spending has also increased. Consequently, while companies will be paying more for their debt, higher revenues may more than offset any of these increases. In addition, if operating margins continue to improve in Europe and Asia to levels similar to those enjoyed by US companies, corporate earnings could increase further.
3) Stock Valuations – Valuations are likely to decline as a result of central banks tightening the money supply, but higher corporate earnings may be able to more than offset this decline. In the US market for example, stocks currently trade at a price multiple of 21.5 times earnings, but with earnings expected to grow 20%+ over the next 12 months, the forward earnings multiple is closer to 17.6 times, which is much closer in line with the historical average of about 15-17 times earnings. The TSX is currently trading at about 21 times earnings, but if the earnings forecast over the next 12 months is correct, then it is trading at less than 16 times those projected earnings, a level more consistent with its historical average. Europe, Japan and emerging markets are presently trading at valuations similar to their historical averages, so if growth continues at its forecasted rate, they will actually be trading at a discount. Therefore, even with higher interest rates, equity markets can still provide positive returns if earnings increase at the anticipated rates and could generate stronger returns if corporate earnings beat analyst expectations.
Consequently, changes in central bank policy are important for us to monitor and anticipating those changes plays a role in our asset allocation and security selection decisions.
In closing, we think that the central bank slowly and gradually raising interest rates is warranted given the improving economic fundamentals. Stock markets should be able to absorb these changes as projected economic growth should lead to solid corporate earnings growth. There is likely to be some volatility along the way, especially if policy changes are misunderstood by the market. Companies meeting or exceeding projected earnings will become even more important without the support of the accommodative monetary policy of the past eight years.
We have positioned our portfolios defensively looking to take advantage of potential volatility, while protecting client capital. We believe that our patience will ultimately be rewarded with some solid buying opportunities.
Wishing all our clients and their families a relaxing, warm and sunny summer.
TriDelta Investment Management Committee
VP, Fixed Income
President and CEO
Exec VP and Portfolio Manager
VP, Portfolio Manager and