Commentary January 2020

Reblogged from First Sovereign Investment Management

A year has passed since markets made their big dip at the end of 2018. While the rise from that dip dominated investor thinking in the early part of 2019, later in the year investors started wondering “where to now?”

At the heart of everything is how various economies are doing around the world and more specifically, can various economies weather the rough ride they are experiencing. It appears there has been a slight détente in the US-China negotiations and with NAFTA-2 very close to full approval some of the biggest challenges seem to be abating. That may lead to increased comfort among consumers and corporate spenders to keep the economy strong.

Another point worth noting is the rising role of emerging markets in the global economy. I want to point this out because these are “secular growth” economies that are modernizing and continuing to contribute to growth through the cyclical rising and falling of the mature developed economies. After years of strong emerging market growth, economies like China and India have expanded to the point that they represent a substantial share of world economics. To illustrate, if we look at the top 10 world economies by GDP using 2017 statistics, China, India and Brazil were 2nd, 5th, and 8th in the list (Russia was 11th). The top 10 economies had combined GDP of $53.8 trillion, of which the emerging three had GDP of $17 trillion (32% of the top ten). Compare that to back in 2007 with the top 10 economies had combined GDP of $38.4 trillion, of which the emerging two (back then only China and Brazil but not India and Russia were in the top ten) had combined GDP of $2.8 trillion (7% of the top ten).

This leap from secular growth economies representing 7% a decade ago to 32% of the top ten now is dramatic and illustrative of how and why the global economy can experience the longest growth trend in recent history. Growth economies play more of a role now.

Of course, all is not perfect and there are at least two points worth noting in this evolution. First, the dominance of the US and Europe is fading and this is partially due to lax restraints of new competitor countries (labour, environment, intellectual property, government intervention, …). I expect that for many years to come this will continue to cause pushback from dominant countries to get the emerging players to “play by the same rules.” Thus, I don’t see substantial trade friction disappearing anytime soon, Trump or no-Trump.

Second, when it comes to investment markets, emerging markets tend to be more jittery than developed markets. This means that even if there is a long-term secular growth trend in those economies (which spills more secular growth all across world economies as a whole), that doesn’t preclude stock market ups and downs.

With those two points in mind, I think we could see going forward more market ups and downs even in growing markets. How do we roll this expectation into our financial planning? We must remember the axiom that for most of us, it is time in the market, not timing the market that leads to long term investing success.

Bonds and Interest Rates

Through the first 7 months of 2019 we saw bond prices rise (and interest yields fall) as investors grew increasingly concerned about the US-China trade war and the need to keep interest rates low (and thus stimulative) to offset the cold shower that the trade war was giving the economy. Later in the year, hints began to surface that the US and China were making some progress on at least a few issues. That evolved to the point where the two countries announced a so-called “first phase deal.” In my opinion that deal did not achieve much on the trade front but it did at least convey to the investment community that the White House was going to dial back its aggressive rhetoric a notch. This was enough to provide some relief and we see this illustrated in the falling bond prices (and rising interest yields) after August of 2019, when investors concluded central bankers would not need to be quite as “accommodative.”

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

Over the same period, ironically, the US Federal Reserve reversed its trend and stance on gradually raising rates and decided it did not need to raise short term rates in the near term. You might wonder why the central bank’s decision to stop raising short term rates could cause longer term rates to rise this fall. The logic is like this: Investors felt the Federal Reserve was wrong to be raising rates and could trigger a recession, causing short term rates to eventually be set lower. Now that the market feels the Fed is not going to inadvertently trigger a recession, the conclusion is that rates will not eventually need to be brought extremely low (stimulative). The conclusion is that since the Fed is no longer sabotaging growth, long term rates no longer need to be extremely low to reflect where short rates would eventually go. Hence long rates have somewhat risen up to a more “neutral” level. As I mentioned in the October letter, the result is that more conservative investors will likely be in a position to hold slightly more income-oriented investments in the months ahead.


The fact that the green line in Figure 2 below has been relatively flat through the year illustrates that the US Dollar been roughly flat versus a basket of currencies. On the other hand, the blue line in Figure 2 shows that there has been meaningful movement in the USD-CAD exchange rate in the past year. In late 2018 the rate was 1.36 CAD per USD (73.5 US cents per CAD) whereas now it has shifted to about 1.30 CAD per USD (76.9 cents). That is great news for snowbirds who want their Canadian Dollar to go far south of the border but also means our US investments have faced a currency conversion headwind this year when viewed in CAD terms.

Fig. 2: US Dollar Index and Canadian Dollar versus the US Dollar – 2 years

Of course, as we have seen many times before, this is very common during strong equity markets and produces a comforting moderating effect where our bull-market returns are slightly dampened by currency and then when markets pull back we benefit from the support of a strengthening US Dollar. There is nothing on the currency front that signals anything but “stay the course.” Note that like the US Dollar (and to an even greater extent) the Swiss Franc and the Japanese Yen are considered very strong defensive currencies with the tendency to rise when stock markets are falling.

Stock Markets

Even though the US market illustrated by the purple line in Figure 3 below shows the most dramatic decline back in December of 2018, the reality is that if you look back at performance throughout 2018 it was Germany and Japan (in green and in red) that had the worst 2018. Furthermore, it was those two along with the UK that faced the weakest rebound in 2019.

Fig. 3: Equities: USA-purple, Canada-blue, Japan-red, UK-yellow, Germany-green – 2 years

Of course, we can easily link the UK challenges to the Brexit gridlock but with respect to Germany and Japan we should note that those two countries are very big exporters and even more to the point are very involved in industrial equipment such as factory robots, etc. We noticed through 2019 that while consumers were somewhat holding strong, business spending was faltering. Trade tensions around the world impacted business spending everywhere from the UK, Europe, China, Canada, Mexico, Iran, and the list goes on. Hence it is no surprise that Germany and Japan struggled. Canada did somewhat better but nothing compared to the US market. That was in part due to the US concentration in IT which is nowhere near as prevalent in other economies. Although the auto industries (big in both Germany and Japan) will continue to be sources of weakness, the differential between the US and other markets will likely fade in the year ahead.

Respectfully submitted,

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

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