Commentary April 2019

Reblogged from First Sovereign Investment Management

After the steep descent many markets experienced leading up to Christmas of 2018, this winter we witnessed a significant and broad-based recovery. This has led stocks in many cases back to relatively lofty levels although upcoming reports will tell if this spring’s earnings growth justifies the growth of stock prices. A key factor was the US Federal Reserve’s about face on a projected series of interest rate hikes, easing worries of market participants.

Bonds and Interest Rates

As usual, we will start with the bond market and interest rates as an indication of the overall macroeconomic situation. In the fixed income market, the US Federal Reserve had been telegraphing through 2018 that the economy was in a strong enough recovery that interest rates were expected to experience a rising trend. That signaling was leading bond prices lower/interest rates higher. Throughout the industry many economists were worried that despite the Fed’s point of view the US economy was actually showing signs of weakness and that it was in no way able to tolerate the series of interest rate increases the Fed was planning to force through over 2019.

Finally, at the end of 2018 the Federal Reserve board joined the chorus and concluded the economy was faltering. They completely dialed back the rising interest rate expectations. To push that reversal of stance even further, during the winter of 2019 there was an increased notion that the US economy may actually need an interest rate decrease, not an increase, to cope with its lacklustre performance.

While the US economy dominates overall global economic demand, the US weakness was coupled with weakness seen in Europe and China, too. It seemed a global slowdown was around the corner. In addition to base consumer demand, the US trade negotiations/tariffs with China and Brexit-driven hesitation in European economies were contributing factors.

Both the bond markets and the stock markets were relieved that the Federal Reserve ultimately decided to abate with the interest rate increases that market participants feared would topple the economy. Looking at our bond performance chart you will observe that regardless of whether you look at government bonds (XGB), investment grade corporate bonds (XCB), or high yield bonds (XHY), all began a recovery in December 2018. While that recovery helped them make up lost ground, as of March 2019 they were still far from fully regaining the prices they had reached two years ago. Of course, when looking at overall return from bonds/bond funds we must also look at coupons/interest paid, not just the movement of prices.

We are now seeing some possible stabilization in economic outlooks. There has been stabilization in US consumer worries. There are signs that some sort of trade agreement between USA and China will happen (although I believe it will be a watered down agreement that merely helps politicians on both sides save face and say they accomplished something). In Europe we see that the Brexit deadline has been extended and there seems an increased commitment to avoiding a disorderly exit. All these are stabilizing factors which should let the global economy advance.

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

While some economic pundits and for sure Trump regime politicians still argue for the need of interest rate cuts to stimulate the economy, I expect that will not happen. We are seeing stabilization and rebuilding of strength without it. Nonetheless, all bets are off if Trump, as per his negotiating style, throws a figurative grenade into geopolitics and throws the economy off course. With Trump running for re-election in 18 months and presumably wanting a strong economy when that election happens, with each passing day I believe he will have increasing bias towards peace and tranquility on the economic front. The hostilities will shift to less economic-centric issues such as immigration.

As a fixed income investor, I therefore see no major opportunity from interest rate cuts and in fact in a year from now see an increasing chance for interest rates to rise. This dictates not holding long duration and or economically sensitive bonds. I will continue to look for opportunities to earn steady income from yield providers with moderate exposures to both.

As a brief further note, in Canada, the Federal and provincial governments have doused the housing markets with cold water. This has been most acutely observed in the Vancouver market (with a major pullback in prices and sales volumes) and somewhat in Toronto. With that in mind, the need for the Bank of Canada to raise rates to cool things off is basically non-existent. We have seen, for example, a pullback in the stock prices of the big Canadian banks last year because investors expect the cooling housing market will a) stall growth for banks and b) increase the number of mortgage defaults that will force banks to increase their loan-loss provisions. In the chart of bank stocks shown here you will notice that none of the banks have regained their previous peaks. TD has performed the best recently, in my opinion due to it having the largest exposure among Canadian banks to US operations.

Figure 2: Bank Stocks [TD Bank, CIBC, Bank of Nova Scotia, Royal, Bank of Montreal] – 2 years

Due to the Canadian disincentive to raise rates there is slightly more ability to lock in longer interest rates in Canada than there is in the USA, however on a currency adjusted basis we need to consider that there would be counteracting currency fluctuations if one country raised interest rates and the other did not. Thus, if both the Canadian and the US fixed income markets were considered in the same currency (CAD values), we would assess the outlook for fixed income returns to be modest (low single digits) on both sides of the border. At this point in the economic cycle we should consider the use of fixed income to protect value, not create value, and to provide “dry powder” for when a stock market pullback creates opportunities once again for cheap stock purchases.


Back two years ago over the summer of 2017 the Canadian Dollar had strengthened from about 73 US cents in April to about 83 US cents by September. It then experienced a long relentless retracement to around 74 US cents by December of 2018, before stabilizing in the 75-cent area where it sits now. This has been driven by the differential outlook on economies and interest rates I have mentioned in previous writings.

Cross border cash flows typically drive exchange rates. If lots of people could borrow at 3% in Canada and reinvest at 4% in the US then there would be a lot of money flowing from Canada to the US, pushing down the Canadian Dollar and pushing up the US Dollar. That and the currency flows related to paying for exported oil really dominate the determination of where the Canadian Dollar trades in USD terms. The capping of oil production in Alberta combined with the cold shower Canadian governments gave the housing sector weakened the Canadian Dollar.

Now we must ask ourselves where things go from here. The stabilizing US economy and continued weakness in Canada tell me that as a currency driver, the interest rate differential between Canada and the US will not propel the CAD substantially higher although if/when Canada sees the light at the end of the tunnel in housing, it could have a positive effect on the CAD value. That is at least months down the road.

Figure 3: Canadian Dollar versus the US Dollar – 2 years

The other big factor is oil exports. Those exports remain pipeline-constrained. While there is a chance for a Trans-Mountain Pipeline approval in June 2019, completion would still be a long way off so it is not clear if that would boost the Canadian Dollar in the near term. At this point it seems the approval of Trans Mountain Pipeline comes down to political calculus more than economics. With a federal election just months away and Trudeau basically written off by Alberta voters, he may focus more on retaining support elsewhere in Canada, particularly in areas where anti-pipeline attitudes may outweigh the pipeline advocates. Thus, major factors considered, there appears no big driver of Canadian Dollar strength in the near term, although there is further down the line.

Stock Markets

This winter most stock markets around the world recovered from the painful rout that took them down to December 2018 lows where they basically gave up two years of gains.
After the end of the winter quarter, in April some markets did essentially recover to near their 2018 peaks although this varied.

As mentioned in the bond discussion, market analysts far and wide were concerned the US Federal Reserve was going to raise interest rates more than the economy could tolerate and trigger a recession, with a backdrop of an anti-China rhetoric from the White House. You can see from stock market declines how much short-term investors were panicking. It was rampant until in December the Federal Reserve did an about-face on interest rate trends and the stock market began its recovery immediately. Furthermore, through the winter the Trump team routinely released commentary on the progress being made in Chinese trade negotiations.

Figure 4: Equities: USA-purple, Canada-blue, Japan-red, UK-yellow 2 years

Among our stock portfolio, roughly 2/3 of companies’ stocks experienced gains and 1/3 experienced losses this quarter, so gains clearly dominated. That was a welcome reprieve from the tough times of the fall quarter when markets experienced a broad-based slide that took almost everything with it.

One of the challenges being experienced in the stock market is the increasing concentration of gains in the technology sector. While it is not only the tech sector that is advancing, the increasing dominance of tech stocks is reminiscent of 1999 when Nortel and various dot-com stocks began to outperform so much it was hard for long term investors to keep up without holding those hot shot high fliers. Of course, those stocks eventually fell back to earth but it does not change the tendency for the market in the meantime to have a bit of a split personality with euphoria driving one sector up while other sectors have a fundamentally different performance.

Historically, most of the stocks we have sought to own have enduring competitive advantages, with the emphasis on enduring. Often in the tech world we see companies with competitive advantages but those advantages are fleeting, not long-lasting. The challenge is that we can often only see how robust (or precarious) that competitive advantage is after the fact. Indeed even if it lasts a few years, most technology companies eventually flounder under the pressure of the need for never-ending innovation to just stay on the treadmill. A very select few break beyond this.

Because the term “technology stock” has become so widespread that it encompasses many different businesses, I believe we are at a point when we can begin to discern (no guarantees) technology businesses where the competitive advantage is more robust and thus the business more investible. One of the key factors there is executive arrogance/humility. We have seen past technology stocks crash when their leadership relentlessly insists that their way is the best way. This is most common among new technology companies where they have not yet needed to change their business model to avoid certain death. Often they have just one single star product. On the other hand, some older technology companies have been through product boom-and-bust cycles and have had to change, adapt, and respond to obsolescence. In general, these now-wiser technology companies that have had to reinvent themselves are probably less likely to face a company-ending surprise than companies that have never yet had to go back to the drawing board.

During the winter quarter, other than some rebalancing, there were no major new positions nor divestitures. As mentioned last quarter, the fall season’s purchases of 3-4 companies depending on the account was uncharacteristic and a level of opportunity that presented itself only as a result of the major stock market pullback that dominated the fall’s market environment. Now I would say our bias will be toward liquidating positions that have risen substantially in value or where the enduring competitive advantage is less than great as I continue to focus more on “high-grading” the portfolio.

Respectfully submitted,

Paul Fettes, CFA, CFP
Portfolio Manager, RN Croft Financial Group
CEO, First Sovereign Investment Management Inc. and Efficertain Corp.

Posted in All Archives, Investment, Uncategorized

Leave a Reply