Reblogged from First Sovereign Investment Management
With stock markets pulling back in the 17%-20% range before recovering, this fall various market concerns that were percolating under the surface began to impact securities markets. From economic cycle factors to international geopolitical factors, several started to weigh more heavily in investor decision-making. As always, I have broken the discussion on market drivers of investment portfolios into interest rates, currencies, and the stock market, the three broad groups I think primarily drive the behaviour of our portfolios. Within currencies I have broadened the discussion to consider the Canadian oil industry, not with the goal to talk about oil stocks but more to show the impact the oil industry has on our currency.
Bonds and Interest Rates
The best place to start in understanding economic drivers is the heart of the real-world economy and how central banks respond with interest rates. Across the globe, and especially in the US, the central banks are given the unenviable task of maintaining a goldilocks economy; not too hot and not too cold. They do that by monitoring the economy and tweaking interest rates either to cool things off or to coax the economy along. Some investors mistakenly think the central bank should be acting to keep the stock market stable but at it’s core the central bank’s concern is not Wall Street; it is Main Street.
So what is the Fed doing? For the past couple years the US Federal Reserve has been tepidly raising interest rates, gradually retreating from the rock-bottom rates that were used to jump start the US economy (and indirectly in the global economy) after the sub-prime meltdown. Back in the post-2008 years they jump started the economy in two basic ways: 1) as is standard practice they dropped short-term interest rates to coax banks to lend money at cheap rates and get consumers spending again. 2) In the post-2008 cyclical pullback they also tried a second tactic we call quantitative easing. In addition to pushing down short-term rates the US Federal Reserve also started buying up long term bonds in the open market. By creating that artificial extra demand for long term bonds they bid up the price of bonds and when the price goes up the interest rate goes down. In this way they also forced down rates of long-term bonds so that things like car financing, mortgages, etc. got much cheaper so consumers would spend more (on credit). This second tactic was a new (and somewhat desperate) innovation after the 2008 crisis and with the 2018 economy now doing better than back in 2009 the US Federal Reserve has been eager to unwind these two stimulative tactics.
With employment numbers looking strong and various markets looking a little bubblish (housing, corporate loans, etc.) the Fed is seizing the opportunity to “tighten up” lending while they can. Usually this tightening is a response to inflation however at the moment inflation is not yet a problem. A key question is investors are asking is why inflation is not yet showing up but the Fed is tightening. To generalize, there are usually two phases of tightening as the economy gets going again. The first phase is to take interest rates from an accommodative (easy money) policy to a neutral interest rate. This is like taking your foot off the gas pedal. This is usually done once the economy is on solid ground again but not overheating. The second phase is to move from a neutral interest rate to a tight interest rate policy. This happens when the economy is overheating and the Fed needs to really put their foot on the brake pedal.
Right now the big two questions for investors are 1) are we just moving from accommodative to neutral or from neutral to tight and 2) could the Fed be wrong and overtighten? Note that the Fed needs to raise rates long before inflation becomes a problem because it takes around 6-18 months for higher rates to really slow down an overheating economy. So on the one hand some interpret the current tightening as an anticipation of soon to be worrisome wage inflation since the unemployment rate is so low. Some investors dispute this “emerging inflation” concern, observing that many people are underemployed, doing jobs below their capabilities or working part time when they could be working full time. Investors also observe that we are going through an intense period of automation and efficiency improvements (e.g. online banking, Amazon-style retailing) and so there are major background forces stopping the labour market from overheating. As such, as a whole the investment community worries the Fed is going too far in tightening interest rates when inflation is not around the corner.
This is complicated by the new need to understand how much the Fed is actually tightening interest rates when the Fed is now working with two tools rather than one. A traditional measure of how much the Fed has raised interest rates is to compare the 2-year rate to the 10-year rate, that stays more stable. When the 2-year interest rate rises past the 10-year interest rate we conclude that the Fed has really tightened a lot to rein in the economy and that a recession is likely around the corner. That logic used to work back when the Fed only altered short term rates but now the Fed is directly altering long term rates too. At the same time as the Fed raises short term interest rates, they also impact long term rates by ceasing their buying of long term
bonds. Investors must now ask, “how much tightening has happened?” (enough to trigger a recession or not?) when the Fed has tightened both the short-term rate and also the long term rate. The normal 2-year versus 10-year comparison may not be valid this time around.
In the 2008 recession, a core problem was US homeowners gorging on relatively cheap debt to propel higher the housing market. This time around there is concern that the core problem could end up in the corporate debt market. Corporations have loaded up with all kinds of cheap debt and when interest rates rise things could turn nasty.
With the preceding discussion in mind, the key question in our investment management process is what are we doing in income-oriented investments? The chart below illustrates that in general an investor can earn higher yields shifting from short term bonds to longer maturities and also earn higher yields shifting from government bonds to AA-rated corporate bonds to CC-rated corporate bonds. All that “higher yield” works in reverse when things turn bad. Risky corporations face bankruptcy and as interest rates rise long-dated government bond prices fall more than short term bonds.
Figure 1: Conceptual Bond Yield Curves
In past years I have had the income component of our portfolios heavily weighted in high yield (junk) bonds where yields were much better. As the economic cycle matured and risk began to elevate money was taken off the table in high yield and the weighting was gradually shifted to more investment grade corporate bonds instead of high yield bonds.
This past year bonds as a whole (both corporates and government issued) became unappealing. I was concerned that more and more of the “investment grade” corporate bonds in the pools we used were teetering on the edge of “high yield” reclassification plus a possible downturn (driven by rising rates) could impact investment grade corporate bonds and government bonds too! Most parts of the bond market became unappealing.
Figure 2: Bond ETFs: Governments (XGB), Corporates (XCB), High Yield (XHY) – 2 years
Now we are pretty well completely out of both high yield bonds and broad corporate bond pools. Furthermore, we own no government bonds. Our focus in the income-oriented portion of our portfolio has shifted primarily to a preferred exposure to the dividends of banks and insurance companies, an area I consider extremely solid. I doubt the economics of the high yield space will look appealing again for some time to come.
What seemed to be summer stabilization in the Canadian Dollar (versus the US Dollar) fizzled in November as the loonie further weakened. As a reminder this weakening of the loonie is a positive for the value of our US investments when converted back to Canadian Dollars.
Figure 3: Canadian Dollar versus the US Dollar – 2 years
Sometimes people refer to our loonie as a petrocurrency that goes up and down with the price of oil. If you look at the chart below showing 15 years of oil prices and our exchange rate you can see why they say that. Oil is one of Canada’s major exports so when global oil prices rise and foreigners must pay more for Canada’s oil, that boosts demand for the Canadian Dollar and its value rises.
Figure 4: Historical Canadian Dollar exchange rate and Crude Oil Pricing
With that in mind, it is always worth keeping one eye on the oil industry to understand the Canadian Dollar’s trajectory. There are three factors impacting oil pricing.
- First of all, there is demand. For oil prices to do well there needs to be solid demand around the globe, not just in one region. Thus, we see strong global oil pricing when economies are doing well around the world. Present worries about a slowing Chinese economy impact global oil prices and the domino effect impacts the Canadian Dollar.
- On the supply side, the oil industry is plagued with constant geopolitics. We see these at present in place like Venezuela, Iran, Mexico, Libya, and Saudi Arabia, to name a few. In the oil industry it often seems like political instability is the norm. That instability can curtail production in some countries and boost prices, benefitting other countries.
In Canada we have recently realized that there is a third factor impacting our own local oil industry (and therefore likely our currency) that few on the global stage ever talk about. That is the challenge of getting the barrels out of oil-soaked Alberta. Existing pipelines are at capacity, railcar exports are at capacity and even trucking is being used from time to time. These days Canadian oil is generally priced at a steep discount to US oil.
Figure 5: Pricing of Western Canadian Select, West Texas Intermediate Oil
While the recent year end spike up in WCS (triggered by Rachel Notley imposing an Alberta-wide production curtailment) has not yet induced the Canadian Dollar higher I expect anything that leads to a sustained improvement of Canadian oil pricing would be constructive for the value of the CAD. The most likely mover would be an approval (again) of the Trans Mountain Pipeline proposal.
What started out as a routine pullback in September turned into a full-on stock market rout by the end of December. The US market got walloped around 20% peak-to-trough while the Canadian market (which already had weaker performance previously) fell around 17%.
This fall there has been ongoing concern about the US Federal Reserve raising interest rates too fast and possibly plunging the economy into recession. That has been making the stock market jittery. This fall that concern was exacerbated by increasing White House hostility towards China, which is in large part triggering a slowdown in China’s economy. At the same time worries are rising about the negative economic impact of a Brexit without any deal between Britain and Europe, negative impact of a US government shutdown, and a host of other factors.
Figure 6: Equities: USA-purple, Canada-blue, Germany-green, Japan-red, UK-yellow 2 years
In light of these global economic problems stock market participants were hoping to see the Federal Reserve at its December meeting stop its series of interest rate increases. Although the Fed did dampen down its talk of future rate increases, it still indicated some increases in 2019 and therefore did not ease up enough to appease the markets.
Short term speculators will try to leap in and leap out of the market to time things right for the positive and negative news flow. This is generally a failing strategy in the long run. Meanwhile as long-term investors we can use the impact of stock market price declines to open our wallets and buy stocks cheaper. Indeed, that is what we have done this fall.
One stock we have purchased is Patterson Companies. This is a distributor of products for the veterinary and the dental industries. The industry is a tight oligopoly, mainly dominated by 3-4 competitors. In recent times the company and its competitors were chastised by US federal regulators for what looked like restricting competition however no financial penalties were imposed. That plus concern about online entrants like Amazon pushed stock prices lower, making the business an appealing investment opportunity.
Another recent purchase was a company called LKQ. This company sells automotive repair parts to repair shops and aftermarket auto parts retailers. Generally, the sweet spot for LKQ is 3-10 year old vehicles: old enough to have repair needs but not so old to be scrapped. In recent years there has been a real boost in new car sales after the 2008-2010 dearth of activity. The result is that now many aging cars are now entering that sweet spot for the repair parts sold by LKQ. Company management expects to do well in that strong market.
A third stock we have been buying is Shaw Communications. This is a cable operator that has recently undertaken two major changes. It has decreased its focus (through Corus Entertainment) in the content development business and it has increased its effort (through Freedom Mobile) in expanding into the cell phone business. At the same time Shaw has taken significant efforts to improve the efficiency (and hence profitability) in its core legacy cable TV business.
A fourth stock we have bought is Quanta Services. This is a company that provides technicians and maintenance services to electrical and pipeline companies in the USA, Canada, and abroad. Numerous factors are driving this business including a) utilities with aging and decrepit infrastructure due to lack of preventative maintenance, b) distributed power generation due to solar/wind leading to more complex networks, c) pipeline operators wanting to maintain pipelines to keep them operational longer due to rising costs of spillage remediation and increasing barriers to getting new pipelines built.
Any longer-term clients will know that to build four new positions in such short time is quite uncharacteristic of me. The recent purchases have been driven mainly by some rebalancing of overweight positions and from putting cash to work. While there may be more speculative stocks out there with higher return possibilities, I feel all the businesses we have just invested in are very stable and I am aiming for stable returns more than speculation. As the stock market recovers from this recent decline, I am looking for opportunities to continually upgrade the calibre of our portfolios by selling weaker positions in favour of stronger ones. As such the pace of new stock introductions will likely return to the slow and steady pace of the past.
Paul Fettes, CFA, CFP
Portfolio Manager, RN Croft Financial Group
CEO, First Sovereign Investment Management Inc. and Efficertain Corp.
Registered Agent, Verico Relance Mortgages, FSCO #10357