Commentary July 2018

Reblogged from: First Sovereign Investment Management

After a January surge and pullback, market sentiment through the spring has been driven largely by the ups and downs of geopolitics. Meanwhile fundamental analysts work to see through the fog of the political posturing, observe the true economic performance, and strive to foresee the impact of current trade negotiations.

Bonds and Interest Rates

This year we’ve seen a gradual decline in bond prices (rise in interest yields) as there is increasing evidence that with a strong economy various central banks around the world are (or soon will be) raising interest rates. Back in November 2016 to January 2017 we saw a dramatic widening of the gap between government bonds (XGB) and high yield bonds (XHY). This portrayed an increased fear of economic crisis in the months post-election in the US; the gap was the widest around October 2017. Despite some zigs and zags, in the eight months since then the gap has steadily shrunk as investors become more at ease with the risk of high yield bonds relative to government bonds, comfort largely driven by evidence of strength in the US economy. That evidence has come in the form of continued solid growth in personal consumption (in the 2.5%-3% range for year-on-year growth), very low unemployment (4% in June 2018), growing corporate profits, etc.

Figure 1: Bond ETFs: Governments (XGB), Corporates (XCB), High Yield (XHY) – 2 years, Yahoo Finance

Late in an economic cycle there is a tendency for bonds to underperform, creating a strong temptation to get out of bonds and double down on the rising stock market. Investors with a long-term horizon should be focused on strategic (not short term tactical) asset allocation and recognize the important role of bonds in smoothing out the stock market ups and downs (low risk bonds tend to rise when stocks fall and vice versa) and also recall that many investment professionals recognize one of the most difficult things to do in market analysis is to pinpoint the market top (and thus leap from stocks to bonds to bonds). Many agree that the economic recovery is long in the tooth but we don’t know precisely when it will turn. When it does, we will be grateful to have some low risk income-oriented investments in the portfolio. The portfolios have been underweight but not out of bonds and the emphasis has been to remain focused on long term strategic mix.


Back in April 2017 the Canadian Dollar dropped to below 73₵/US Dollar before an abrupt turn that took it back up to almost 83₵/US Dollar in September 2017. In the several months since then we have seen the Canadian Dollar drop back to roughly the 75₵ mark. It seems there are primarily three drivers of the recent CAD weakness. First of all, the housing sector is starting to cool off as the effects of the new mortgage stress test rules (applicable since Jan 2018) took effect. This differs from the US economy where there is not such dramatic tightening of mortgage rules right now. Secondly the economy has broadly not experienced the strength that the US economy has. In general, the US economy often leads other global economies through an economic cycle so this is typical. Lastly the tough negotiations of NAFTA and international trade in general has made corporations more hesitant to make major long-term investments.

Figure 2: Canadian Dollar versus the US Dollar – 2 years, Yahoo Finance

These factors have all contributed to what is likely a slower path upward for Canadian interest rates versus the path upward for US interest rates. When a differential between interest rates the country with the faster rising rates (USA in this case) relative to the country with the slower rising rates (Canada in this case) then the fast riser will see its currency rise. That is what we have seen lately with the US Dollar rising relative to the Canadian dollar (i.e. the Loonie weakening). That pattern could reverse itself if various trade agreements (especially but not only NAFTA) are resolved so that there could be a boost from global trade which would boost Canada’s economy and tilt the table toward more interest rate increases in Canada (and thus a rising currency).

Stock Markets

Reviewing the past couple years in stock markets we can see that the widespread rise in September-October of 2017, when all four major markets rose together was steep rise in the US and Japan in January 2018, while Germany and Canada rose just modestly. Following that there was a significant sell off in all four markets in January-February 2018. Since then we have seen New York, Frankfurt, and Tokyo struggle to make gains while Toronto has risen, catching up some lost ground.

Rising Canadian interest rates have not only cooled the housing market but also cooled off the ability of Canadian banks to grow their Canadian mortgage business. That growth headwind led the banks to largely underperform the index so far this year with the most notable exception being TD Bank, with its large exposure to the US market. While in the past banking sector prioritization within the portfolios has been on the TD Bank position, at this point prioritization may shift to other banks as opportunities present themselves.

As banks were mainly a source of weakness in Canada (4 of the big six banks underperformed the index) energy stocks have done well in Canada so far this year. This energy stock performance was thanks rising in prices in part from the US government pulling out of the Iran nuclear agreement and re-imposing sanctions in Iran as well as from production challenges in a variety of places like Venezuela and Libya.

Figure 3: S&P500 (dark blue), TSX Composite (teal), German Dax (red), Japanese Nikkei 225 (orange) – 2 years, Yahoo Finance

Although oil prices and oil stocks have had a decent run, there is still potential for more because the current oil price regime incorporates some market fear of dampened near-term demand due to recession. To the extent that the US achieves some agreement in its several trade disputes around the world (Europe, NAFTA, China) then one would expect global growth to be reinvigorated leading to a rise in oil demand/prices.

As interest rates rise, the pipeline and utilities sector tends to face the same weakness as bonds face since investors often look at slow growth solid dividend utilities as somewhat of an alternative to fixed income. Indeed the position in Enbridge was challenged in the beginning of the year before recovering more lately. That sector is still a source of relatively low volatility to monitor and build on, as the long bull market extends itself.

Paul Fettes, CFA, CFP
CEO, First Sovereign Investment Management Inc. and Efficertain Corp.
Portfolio Manager, R.N.Croft Financial Group
Registered Agent, Centum Complete Mortgage Services Inc. FSCO #11743

Posted in Investment, Risk Management, Uncategorized

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