Some people believe that the grass is always greener on the other side of the fence. Well in 2015 it was true, if you were a Canadian and your fence looked over at the U.S. border. From an equity and currency perspective, the U.S. meaningfully outperformed Canada.
Although 2015 was a difficult year, with Canadian equities down over 11%, most TriDelta clients, depending on their asset mix, were roughly flat on the year. No one heads into a year hoping to have a flat investment year, but given the very weak Canadian markets, and our focus on protecting capital in tough times, we believe that we added meaningful value to clients in 2015.
It was a challenging 4th quarter and year as a whole, for investors in Canada. Canadian bond returns were mildly positive and Canadian equities remained very volatile, down 2.2% in the quarter. The economic and stock market weakness in Canada, unfortunately, was driven by excess global supply of oil and other commodities, causing commodity prices to fall.
Even with Europe’s issues in the first half of the year, China dominated the world stage this year with its economic slowdown. The lion’s share of growth in global demand for virtually all commodities, including oil, has emanated from China over the past decade. With its economy growing more slowly, prices of most commodities have weakened materially. Moreover, due to China slowing along with many emerging market economies, the U.S. Federal Open Market Committee (FOMC) was reluctant to raise rates until the end of the year. On December 16th, the U.S. Federal Funds rate was finally increased by 0.25%.
China still faces deflationary pressures
- Dragged down by sluggish domestic demand, weak exports and a property downturn, China’s economy expanded by 6.9% year-over-year in the third quarter, the lowest quarterly growth rate in six years.
- China’s consumer inflation (CPI) grew 1.6% year-over-year in December, which is well below the government target of 3%. Moreover, producer prices (PPI), a measure of cost of goods at the factory gate, fell 5.9%, marking the 46th straight month of decline. Price fluctuations usually first appear at the production level before being passed on to consumers; therefore, the deflationary forces acting on China’s PPI does not augur well for its CPI. Prolonged deflation will pose risks to the Chinese economy by eroding growth potential and could possibly put the economy at risk of a downward spiral.
- To combat the economic slowdown, the central bank of China has cut the benchmark interest rates and the reserve requirement ratio of its banks several times since the beginning of 2015. We suspect more aggressive policy easing will be forthcoming to stabilize growth in the coming months. There certainly is ample room for more measures to fight deflationary pressures and stabilize growth, such as reserve ratio cuts, relief in tax and fees, and increases in fiscal spending.
A Tale of Two Markets: International Developed Equity Markets were up (in Canadian dollars) and the Canadian Equity market was down
- The Canadian equity market, as measured by the S&P/TSX Composite Index, was down 2.2% in the 4th quarter, ending the year down by 11.1%.
- Due partly to the weakening of the Canadian dollar over 2015, European, U.S. and Asian developed equity markets were up generally for the 4th quarter and for the year as a whole, as measured in Canadian dollars.
- TriDelta made the decision to not currency hedge our U.S. and International equity investments, which was beneficial to our clients’ portfolios.
- TriDelta remains cautiously optimistic about 2016 as the U.S. and Europe appear to be on more solid ground; however, China will continue to be challenged in its efforts to stabilize its economy as it transitions from an export-based to a consumer-based economy.
- The economic outlook for 2016 is supportive of developed market equities with inflation and oil prices remaining low, a continued mid-cycle U.S. economic expansion with cyclical leadership coming from the U.S., the U.K. and Europe, and with the U.S. FOMC possibly moving rates up gradually.
- Since 1950, the median performance of different asset classes six months after the first U.S. Federal Funds rate hike has been very positive for markets: U.S. Equities up 9%; Developed Market Equities up 7%; Emerging Market Equities up 8%; Commodities up 4%; and, Investment Grade Bonds up 1%.
- Oil prices will continue to be weak in 2016 owing to global excess supply, exacerbated by the expected rise in Russian and Iranian oil production, as well as weaker economic growth from China. China has accounted for roughly 45% of growth in global demand for oil during the past decade.
- We have been actively adjusting our clients’ portfolios, reducing our exposure to Canadian equities in favour of U.S. equities, given our concern with continued weakness in the Canadian dollar and commodity prices, especially oil.
- We continue to closely monitor European equities for purchasing opportunities as they represent good relative value.
- With low positive returns expected from bonds in 2016, we believe our clients need to maintain their equity exposure, especially given that many equities have dividend yields in the 2% to 5% range.
- We expect returns to be lower than long-term averages. We are now recommending alternative investments, from our well researched approved list, where appropriate, to clients for additional diversification in their portfolios to reduce risk and to enhance returns.
Risks to the Outlook
- China fails to stabilize growth, increasing deflationary forces globally.
- China’s renminbi continues to depreciate.
- A credit crisis occurs in the emerging markets.
- Heightened geopolitical instability (e.g., Saudi Arabia and Iran tensions, Russia, ISIS, and the like).
- Profit trends weaken in the developed equity markets.
- Faster-than-expected improvement in the U.S. labour market causes the Fed to raise rates faster.
The 4th quarter witnessed a decent bounce in global equities after a very rough 3rd quarter. Most equity markets rallied and came close to recuperating the losses suffered in the third quarter. Unfortunately, Canada did not participate in this rally.
In local currency, global equity markets were some of the top performers. Germany and Japan represented the best performing major equity markets, up more than 11.2% and 10.7%, respectively. Closer to home, the S&P/TSX Composite Index continued its losing streak, down 2.2%; whereas, the S&P 500 Index bounced back, returning 6.5% in local currency. The strong U.S. dollar was again a positive factor for our portfolios as measured in Canadian dollars. The U.S dollar strengthened 4.1% relative to the Canadian dollar, adding to the total return of U.S. holdings.
For the S&P/TSX Composite Index, volatility in the 4th quarter was substantial as the Index had a number of moves up and down greater than 5%. October turned out to be a positive month as the market rallied 1.3%; however, November and December were down months, consistent with the fall in the price of crude oil. November declined almost 2% and December was down 3.4%. The three worst performing sectors in the quarter were Health Care, Consumer Discretionary and Telecommunications, down 37.0%, 5.7% and 2.8%, respectively. In contrast, the three best performing sectors were Information Technology, Materials and Financials, up 10.3%, 3.1% and 0.6%, respectively.
The S&P 500 Index performed much better than the Canadian market, up 6.5% in the 4th quarter. The Index posted a great October, up more than 8%. Despite a couple bumps in the road, it eked out a small gain in November before falling 1.8% in December. All sectors in the 4th quarter were up except for Energy, down 0.6%. The three best performing sectors were Materials, Health Care and Information Technology, up 9.1%, 8.8% and 8.7%, respectively.
TriDelta Core Equity Model
Our Core Equity Model was up 2.1% for the 4th quarter, outperforming the S&P/TSX Index by 4.3%. During the last three months, the Core Equity Model was very active.
- In October, we sold a couple of stocks, redeploying the cash during the November correction. We also increased our weight in U.S. equities in early December to take advantage of a stronger U.S. dollar, which has continued to strengthen since our purchase.
- We purchased the Canadian energy market opportunistically, using the exchange traded fund, XEG, as it looked as if seasonal, technical and fundamental factors were turning positive, but sold it quickly thereafter. Unfortunately, this was a losing trade as Saudi Arabia revealed it would increase production, leading to potentially lower prices.
- Other detractors from performance that were sold at a loss were Valeant Pharmaceuticals, which fell due to some concerns about accounting irregularities; and, Amaya Inc., the online gaming company, which fell as revenue and profit guidance from the company was cut.
In contrast, a number of our stocks, especially those in the U.S., had a great quarter and positive results were found in all sectors, including Energy.
- Our holding in TransCanada Corp. was up over 8%.
- Other top performers were Avago Technologies Limited, AmerisourceBergen Corporation and Verizon Communications Inc., up 20%, 13% and 11%, respectively.
- Five companies, in the Core Equity Model, raised their dividends in the 4th quarter with none reducing dividends: Alimentation Couche-Tard Inc., AmerisourceBergen Corporation, Zoetis Inc., AbbVie Inc. and Sun Life Financial Inc.
TriDelta Pension Equity Model
Our Pension Equity Model was up 0.7% during the 4th quarter, as our more conservative strategy, outperformed the S&P/TSX Index by almost 3%. The Pension mandate focuses on stocks with solid and growing dividends and other less volatile characteristics, leading to less trading relative to our Core Equity Model.
- We entered the quarter with excess cash, and opportunistically added a couple of new holdings during periods of market corrections in November.
- Positive performance for the quarter was driven mainly by our U.S. holdings as the strong U.S. dollar helped bolster returns.
- Health Care stocks in the U.S. led the gainers in the portfolio as Abbott Laboratories, Johnson & Johnson and GlaxoSmithKline were all up more than 10%.
- In contrast, Canadian Utilities Ltd. declined along with the rest of the Utilities sector as investors feared higher interest rates would threaten earnings and dividend growth. Home Capital Group Inc. declined on fears that the economy was weakening and the real estate market would burst, leading to an increase in homeowner mortgage defaults.
- Ten stocks that we hold in the Pension Equity Model increased their dividends during the quarter and only one stock reduced its dividend, namely Cal-Maine Foods. Some of the stocks that raised their dividends include Emera Inc., Enbridge Inc., AbbVie Inc., Telus Corp. and the Canadian Imperial Bank of Commerce.
Quarter Ahead for Equities
At the end of the 3rd quarter, we believed that the majority of the decline in the equity markets was over, and we were looking for opportunities to be fully invested again in the coming months. Looking forward, we continue to believe that the September 2015 lows will hold for the S&P 500 Index, but may be temporarily breached by the S&P/TSX Index. We still have some cash in the portfolios, and are looking for the right time to become fully invested again.
We believe that the heightened volatility that we have experienced in the 4th quarter, and throughout 2015, will continue in 2016. The equity markets generally appear to be fairly valued, which could lead to more volatility if economic headwinds or geopolitical events surface. Earnings, as usual, will continue to be a major focus for investors, looking to be reassured that earnings are continuing to grow and valuations remain fair.
For the majority of 2015, volatility in the fixed income market was unprecedented. The initial cut to the Canadian overnight interest rate in January, to be followed by another cut in the subsequent months served as a testament to the Bank of Canada’s concern over the negative impact of much lower oil and gas prices on energy companies, and its impact on the Canadian economy.
For most of the year, investors have been wrestling with the following:
- The prospect of the first U.S. interest rate hike in 9 years;
- A substantial decline in commodity prices;
- A strengthening U.S. dollar; and,
- The relentless negative headwinds from the Greek default drama and the Chinese economic slowdown.
As noted earlier, the U.S. FOMC finally raised the Federal Funds rate by 0.25% in December.
TriDelta Core Bond Model
Our Core Bond Model maintained its exposure throughout the year in high yield bonds as we were, and we continue to be comfortable with our holdings. Given the heightened investor concern over the U.S. raising interest rates, we started the year owning bonds that had shorter average maturities and gradually raised the average maturities of the Model through the investment in a 30-year Government of Canada Bond in the fourth quarter.
We were able to add value to the portfolios with this strategy towards the latter half of the 4th quarter. In addition to raising the average maturities of the bonds, another purpose of owning this 30-year high quality Government of Canada bond was to reduce the overall risk of the portfolio, especially in the current environment where investors are uncertain about the U.S.’s resolve to hike interest rates and its ability to continue with a series of hikes in the coming year.
TriDelta Pension Bond Model
Our Pension Bond Model benefited from not having any exposure to high yield bonds this year and in the 4th quarter. The strategy of managing the Model with a shorter maturity bias at the start of the year, followed by extending the average maturity with the purchase of the 30-year Government of Canada bond, mirrored the same strategy as the Core Bond Model.
Quarter Ahead for the Bonds
With an eye towards 2016, we expect the volatility that we have experienced in 2015 to continue. With continued Bank of Canada concerns over our economy, heightened geopolitical risk, and an uninspiring global macro-economic environment, we will continue to limit risk in the bond portfolios by maintaining our bias for the long-dated Government of Canada bond. However, our aim in 2016 is to take advantage of this volatility at the opportune time, and eventually move funds out of Government of Canada bonds and into investment grade corporate bonds.
Not since the financial crisis has the preferred share market witnessed such a negative period. One fundamental difference between 2008 and today was that the drop in 2008 was disorderly – panic driven – while the current environment is slightly less disorderly and driven by three converging factors working to conspire against the preferred share asset class.
- The Bank of Canada’s surprise 0.5% cut to the overnight interest rate was contrary to the market consensus expectation of multiple rate hikes in 2015;
- Bond and equity investors became more risk averse, producing a great deal of volatility in the markets, which negatively impacted the preferred share market; and,
- Canadian chartered banks issued Non-Viable Contingency Capital (NVCC) compliant preferred shares due to a new regulatory requirement. In short, an abnormal supply of preferred shares from the banks was issued into the market, causing downward pressure on preferred share prices.
The beneficial characteristics of preferred shares within a well-diversified portfolio remain very much intact, but the recent weakness in this asset class has left many disenchanted. Considering the attractive yields and the beneficial tax treatment of dividend income, we still believe that preferred shares will be a positive investment in 2016.
- The Fund was up 2.1% in the 4th quarter, but down 4.2% for the year. Since inception, the Fund has earned an annualized return of 5.5%.
- The performance of the bond component of the Fund started 2015 very well; however, the unanticipated interest rate fluctuations – both interest rate levels and corporate spreads – were negatively impacted by the leverage employed in the Fund to generate a consistent targeted overall bond yield of 8%.
- Until December, the Fund had a substantial U.S. dollar exposure to take advantage of U.S. dollar appreciation. This position was held because of the divergent monetary policy in Canada (i.e., a bias towards reducing rates) versus the U.S. (a bias towards raising rates). Given the uncertainty surrounding U.S. interest rates and possible geopolitical events in 2016, the leverage employed as well as the exposure to the U.S. dollar have been reduced.
- In contrast to the bond component, the equity portion of the Fund had a good year in 2015. U.S. equities, which were consistently about half of the equity component of the Fund, were the major driver of positive performance. This positive performance was mainly due to U.S. dollar appreciation, since it was up 19% for the year.
- The performance of the S&P 500 Index, in local currency, was slightly negative for the 2016; however, the hedging strategy used by the Fund with respect to U.S. equities was a positive contributor, adding 1% to the return.
- Canadian equities, which constitute the other 50% of the equity component of the Fund, outperformed the S&P/TSX Index, since the Fund held cash in the range of 5% to 10% throughout the year, and had a very small exposure to Energy relative to the Index. The Canadian equity strategy started out the year overweight income generating financial stocks. These positions were reduced during the 1st quarter and the Fund shifted into some gold and other resource stocks like Cascades Inc. and Claude Resources Inc.
- The Fund also increased its Consumer Discretionary and Industrial sector weightings during the year, including Air Canada, Hardwoods Distribution, New Flyer Industries and Transcontinental, as we were searching for stocks that showed value with earnings growth potential.
2015 was a challenging year for Canadian equities and bonds, although the 4th quarter was generally up across international developed markets. As mentioned, there is potential for negative surprises in 2016 given the large number of global issues, including currencies volatility, political turmoil, increased terrorism activity, low oil prices and very low global economic growth. As a result, we forecast markets to remain volatile this year, but expect returns to be generally positive, however lower than long-term averages.
Happy New Year and All the Best in 2016!
TriDelta Investment Management Committee
VP, Fixed Income
President and CEO
Exec VP and Portfolio Manager
Chief Operating Officer
VP, Portfolio Manager and