Mackenzie Asset Allocation Team
2016 got off to a rocky start for investors, and the uncertainty resurfaced again this summer with Brexit temporarily roiling markets followed by various Central Banks continuing to explore quantitative easing and other non-traditional monetary policy strategies.
In light of these events, it is remarkable that equity markets and fixed income markets were both up during the third quarter. Also surprising is investors’ growing appetite for risk. This is evident by the renewed performance of value stocks and the outperformance of resource, midcap and small cap stocks.
Equity markets were almost universally positive, and strongly so, during Q3. The MSCI EAFE Index gained 7.7% (all returns expressed in Canadian dollars). European markets were positive, and Asian markets were also up, led by Hong Kong (+13.3%) and Japan (+9.9%). Emerging markets returned 10.3%, with China, Brazil, and Korea outperforming the rest. The Canadian equity market continued to add to its string of positive returns in the third quarter, with Index up 5.5%. The S&P 500 Index underperformed other major equity market indices with a return of 4.9 %. In what may be the beginning of a more prolonged slump, Telecom, Utilities, and Consumer Staples sectors posted negative returns as fears grew that traditionally high-dividend-paying sectors may be overvalued in light of loomed Fed rate hikes.
The fixed income rally that was sparked by Brexit at the end of Q2 continued into the third quarter. The Canadian fixed income market (FTSE TMX Canada Universe Bond Index) returned 1.2%. Global bonds, as measured by Citigroup WBIG Index (C$), returned 2.0% over the quarter. This strength in fixed income that was due to the flight to quality that peaked in early July, but there was enough uncertainty and volatility that bonds were able to hang on to gains to close the quarter. Curiously, alongside this flight to quality, High Yield bonds also had another strong quarter, as measured by the BofAML US HY Master Index(C$), with a 6.8% return over the quarter. In this low interest rate environment credit remains attractive to many investors, especially during a period of increased risk-seeking activity.
Value added from asset allocation was positive in the second quarter. Earlier in the year we recommended underweighting equities vs. bonds, which worked well. We moved to a neutral allocation in Q2, and then became overweight stocks relative to bonds during Q3. In Q3, both our strategic positioning and our tactical decisions added value as global stocks outperformed global bonds, our overweight to EM and UK equities and underweight to US added value, our overweight to UK bonds helped and our currency positioning was net positive (in particular our negative view on the UK pound). Our underweight to credit, including high yield, was a detractor during the quarter, as was our underweight to Canadian equities and bonds.
Outlook & Strategy
What are key risks that need to be managed?
We continue to feel that China’s economy remains excessively unbalanced. Years of credit-financed investment have resulted in excess productive capacity, high debt and low profits. Since 2008, China’s total debt increased by about 80% of GDP to reach almost 2½ times the size of the economy. Over that same time, rapid credit growth has delivered an increasingly smaller kick. Such a rapid increase in credit alongside slower growth seldom occurs without triggering a financial crisis.
We continue to monitor tail risks in the UK, including the large government budget deficit and current account deficit. The UK depends on the continued willingness of foreign investors to fund these growing deficits. Theresa May’s new government will need to be cautious as they discuss a ‘hard Brexit’ scenario with the EU to ensure they retain the confidence of foreign investors in the UK’s longer term prospects.
More generally, the diminishing effectiveness of ultra-loose central bank policies to boost economic growth, especially in the Euro Zone and Japan, could lead to a shift towards greater fiscal stimulus. Greater borrowing by already indebted governments could have negative implications for longer duration interest rates. However, most G-20 governments remain unenthusiastic about another large stimulus given their limited fiscal space and need for ‘dry powder’ in the next recession.
Beyond the above-noted short and medium term risks, we remain concerned that today’s high asset prices have set the stage for a prolonged period of generally lower returns in the decades ahead. Popular valuation models for US stocks, such as Shiller’s cyclically-adjusted P/E ratio, indicate that equities have rarely been so expensive. Record low yields on high-quality government bonds also suggest historically rich valuations. Mackenzie's comprehensive valuation model – the Multi Asset Class Valuation Model (MACIV) – estimates the fair value of global stocks and government bonds by forecasting trends over 40 years in productivity, demographics, real interest rates and economic growth. Based on the MACIV estimates, we expect today’s high asset prices to be a significant headwind for expected returns over the next market cycle of seven to ten years.
What are the key opportunities you see? How are you positioning portfolios in response to this outlook?
We are positioned slightly overweight in stocks relative to bonds. Stocks are expected to benefit from strong market sentiment and supportive macro conditions, including historically attractive earnings yields relative to long-term bond yields. Global central banks are also expected to maintain accommodative financial conditions that benefit stocks. Both equities and bonds have unattractive valuations although bonds look particularly rich at today's current low yields.
Following a multi-year bear market in EM equities, EM valuations look relatively attractive and market sentiment has improved following a strong rebound in recent months. We recommend an overweight position in EM equities.
We also recommend an overweight in U.K. stocks, reflecting attractive valuations, improving sentiment after Brexit and a weak Pound that supports stocks in local currency terms. Our bearish view of pound-sterling and a bullish view of UK stocks in the weeks leading up to the Brexit referendum in late June added significant value for our portfolios. We maintained these views following the Brexit outcome because of highly negative market sentiment for the pound and unattractive macroeconomic conditions, including the Bank of England’s dovish policy bias. About three quarters of the earnings of FTSE 100 companies originate from outside the UK. The weaker pound supports UK stocks by increasing the value of foreign earnings in local currency terms and boosting the UK’s international competitiveness.
We continue to be bearish of U.S. equities. Despite strong sentiment, valuations for US equities are rich and macro conditions are unattractive as the Fed remains the only major central bank in tightening mode and the cycle looks increasingly mature with earnings and profit margins turning downward. Finally, Japanese stocks appear very unattractive at the moment because of rich valuations with highly negative sentiment that more than offset the impact of monetary stimulus. In Japan, the cyclical slowdown also makes us more bearish.
Within currencies, we remain underweight in the British Pound relative to the Canadian dollar given strongly bearish market sentiment and unattractive macroeconomic conditions. That said we have begun to trim our large underweight position in the UK pound now that the pound has declined by roughly 15% versus the loonie since June 23 and the position has produced significant return for our portfolios.
With respect to the US election, we can generally say that we are living in a period of heightened political tensions across the globe, marked by events such as Brexit and the rise of populist movements, most prominently in the U.S. as November’s election looms. These events remain top of mind for investors; however, forecasting the outcome of these risks and the impact on returns typically does not serve investors well in the longer run. For example, many forecasters failed to predict the Brexit referendum result and many over-stated its negative impact on the UK economy. Investors run the same risks by focusing too much on “predictions” of market reaction to either Democrat or Republican victories in the U.S. election, as many of the risks from either scenario have already been priced in to markets to varying degrees. We believe global diversification remains the best defense against shorter term political risks, particularly for longer horizon investors.