Mackenzie Asset Allocation Team
What happened in the previous 3 months? What contributed positively to performance? What detracted from performance?
Economic, financial market and political uncertainty continued to be the order of the day in the second quarter of 2016. Global financial markets opened the quarter with volatility related to fears of potential Fed rate hikes and closed the quarter amid the volatility related to the U.K.’s Brexit referendum. Markets reacted particularly strongly to the unprecedented uncertainty around Brexit, triggering a flight into global safe haven assets including high-quality government bonds, gold and the Japanese Yen.
Despite the uncertainty, many equity markets ended in positive territory for the quarter. The Canadian equity market continued its first quarter strength by again being among the top performers in the second quarter. The S&P/TSX Composite returned 5.1%, led by the Materials sector which returned 26.9%. Gold companies were major contributors, partially reflecting an increase in the price of gold due to growing macro-economic and political fears. Showing broad sector strength, the S&P 500 Index returned 2.3% in USD where eight of ten sectors posted positive results. On the international stage, the MSCI EAFE index fell 0.7% in local currency terms. Eurozone stocks, due mainly to Brexit, and Japanese stocks, due largely to a stronger Yen, dragged on performance. Emerging markets had a positive quarter, with India and Brazil outperforming.
Value added from asset allocations was positive in the second quarter. Earlier in the year, we recommended underweighting equities and overweighting bonds. This recommendation worked well, as global bonds outperformed global stocks by 6.3%. This also led to less overall portfolio volatility, due to concerns regarding China and Brexit, respectively. Over the quarter we tempered our views and moved to a more neutral allocation. This allowed us to benefit from the positive tone in equity markets over the quarter, despite the selloff right around quarter-end. However, we were neutral to underweight Canadian equities and held a similar allocation to US equities, which tempered our gains from asset allocation a bit as these were markets that performed relatively well. Our underweight to Japanese equities produced positive results.
In terms of currencies, the Pound sterling attracted a lot of attention this quarter due to the UK referendum. We recommended being tactically underweight the Pound in our Q2 outlook. This view worked very well for our investors, as the Pound dropped by 10% versus the Canadian dollar in the days following the referendum. We were also overweight the Japanese Yen which also paid off handsomely upon the surprise Brexit vote.
Outlook & Strategy
What are the key opportunities you see?
The Federal Reserve is now less likely to increase U.S. interest rates until it can better assess the full impact of Brexit on global markets and its spillover effect on the real economy. This likely means lower North American interest rates, for longer. Within Europe, the ECB reiterated that it can take steps as needed to offset any slowdown caused by Brexit. One option for the ECB is to accelerate direct monthly asset purchases if it sees a tightening of financial conditions, especially in peripheral Europe. Looser monetary policy should act as fuel for equity market gains in the near term, and offset financial market risks stemming from the political outlook.
Meanwhile, relative valuation is widening between stocks and bonds. As US 10-year bond yields have decreased from around 2.25% to around 1.50% over the last two quarters, this has made the equity earnings yield look relatively more attractive from an asset allocation perspective.
While we expect continued volatility and uncertainty given the result of Brexit, we believe that UK equities have become priced attractively enough to warrant a moderate overweight to the asset class. UK companies are also getting additional support from a weak British Pound, which has severely depreciated following Brexit, and could benefit from supportive monetary policies from the Bank of England reflecting concerns about a slowdown in UK private spending.
The increase in global uncertainties and the recent weakening of several US labour market statistics have pushed the expectation of the Fed raising rates much further back in time. This is positive for risk assets, for example, equities and high yield bonds. As a result, assets that were already considered overvalued by many measures have been benefitting from strong sentiment-driven inflows.
What are key risks that need to be managed?
Brexit has created a number of important uncertainties.
First, there is a small chance that the UK will not exit from the EU. The referendum was not formally binding. The UK Parliament will need to approve imposing Article 50 of the Lisbon Treaty, which is the only legal mechanism to exit the EU.
Second, once Article 50 is imposed, it will trigger two years of contentious discussions with the EU about the terms of the UK's exit. The EU has a strong incentive to ensure exit is very costly for the UK, mainly to discourage other member states that may wish to exit in the future.
Third, businesses face a lack of clarity about which of the almost 7,000 EU regulations will remain in effect in the UK after the 2-year exit period. This is likely to delay new investments and job creation.
Finally, perhaps the greatest long-run uncertainty is the risk of political fragmentation. In Europe, Euro-skeptic parties are gaining ground in many countries. In the UK, we see that Scotland and Northern Ireland prefer continued integration with the EU. The Scottish National Party already said another independence referendum is inevitable following the Brexit result, threatening a breakup of the UK.
How are you positioning portfolios in response to this outlook?
The Brexit bombshell has potentially massive political implications for the EU and the global economy. We anticipate that markets will remain bumpy in the coming months and will not normalize until a roadmap for the future of the UK and Europe becomes clearer.
We have returned to a generally neutral asset mix for Q3, in part because of the relative valuation that is widening between stocks and bonds and the resulting attractiveness of the equity earnings yield. At the end of Q2, our measure of cyclically adjusted earnings yield was 3.72% higher than 10 year government bonds, versus a spread of 2.84% at the end of 2015.
As a result, we are now slightly overweight total equities versus an underweight three months ago. We remain slightly underweight in global government bonds, but less so than three months ago. While bond valuations are unattractive given historically low interest rates and given tentative signs of rising U.S. inflation, the shift to a smaller underweight in bonds reflects recent momentum as investors seek safe haven assets following the uncertainty surrounding Brexit.
Within global equities, in local currency terms, we continue to like UK equities the most, as they are priced quite attractively compared to other markets. We also like the improving investor sentiment around the asset class and the weaker pound that we expect will support local currency earnings. We remain underweight Japanese stocks because of unattractive valuations and highly negative market sentiment.
We remain fairly neutrally positioned in U.S. equities as market sentiment remains strong despite stretched valuations. We are also slightly overweight versus our neutral position in Canadian equities because of improving market sentiment.
In terms of the Canadian dollar, we recommend a neutral stance. The loonie is still somewhat undervalued compared to the U.S. dollar in our assessment, but only by about 9%. We like a bigger valuation spread to recommend an overweight due to valuation alone. Our sentiment indicators are somewhat neutral, and the macroeconomic pressures that the two countries are facing are less differentiated than they were two quarters ago. The increase in global uncertainties and the recent weakening of several US labour market statistics have pushed the expectation of the Fed raising rates much further back in time.