Q3 2018 Commentary – Mackenzie Resource Team | Mackenzie Investments

Q3 2018 Commentary

Mackenzie Resource Team

Highlights

  • While US equity markets continued their near-linear upward trajectory, emerging markets and the resources sector experienced a substantial set-back during Q3/2018.
  • Leading indicators of global economic growth continue to point to moderating, but still sustained, economic momentum.
  • Resource equities are trading at undemanding valuation multiples. If economic growth persists while interest rates rise in a modest trajectory, we see an opportunity for value stocks, including resources, to outperform growth stocks which are generally more interest rate sensitive.

Market Review

  • While US equity markets continued their near-linear upward trajectory, emerging markets and the resources sector experienced a substantial set-back during Q3/2018. U.S. Growth indicators accelerated, which led to increasingly hawkish expectations for future action by the U.S. Federal Reserve, which in turn pushed up bond yields and the U.S. dollar. The stronger dollar, combined with concerns about the impact of trade tariffs led to a substantial correction in emerging market equities. While resources were similarly dragged down, physical indicators of the oil, copper, aluminum and steel markets suggested continued strength in physical demand.
  • Many current-day economic models infer that trade tariffs will slow the growth potential. We are reserving judgement, as trade barriers are rising for the first time in 30 years and economic models have yet to be reconstructed to account for these changes. We suspect there are offsetting variables. Specifically, we continue to think that wage growth in the bottom half of society could have a significant effect on economic multipliers. As a reminder, the average American worker has not seen real wage growth in 40 years. Most of the economic rent was shifted to workers in the emerging markets. We believe that moving operations back onshore will have some positive, but currently unknown, effect on wages and developed market growth.
  • Leading indicators of global economic growth continue to point to moderating, but still sustained, economic momentum. Divergence has however been widening, with the US outperforming, and Emerging Markets (particularly China), currently underperforming relative to trend. While earnings growth remains strong; valuation multiples are adjusting to the reality of higher interest rates, which continue to be required in the US to manage the go-forward rate of growth.
  • Until signs of a broad-based global economic slowdown appear, it is our opinion that investors should be prepared for the more likely scenario of a continued economic expansion. As we have enumerated in the past, there are five economic signals we watch closely for any warning signs of a sustained slowdown: Capex peaking, wage growth accelerating beyond 4%, sharply accelerating inflation, inversion of the yield curve, and global home and auto sales peaking. Of these five, four are firmly signaling continued growth. The fifth, global home and auto sales, have shown a recent moderation. Therefore, while the portfolio is positioned for the anticipated heightened volatility, current indicators suggest we remain in what we refer to as the “fall” season of investing; signified by late-cycle growth during which resource equities historically have outperformed the broad market.
  • Resource equities are trading at undemanding valuation multiples. If economic growth persists while interest rates rise in a modest trajectory, we see an opportunity for value stocks, including resources, to outperform growth stocks which are generally more interest rate sensitive.
  • Commodity sector returns were mixed over the quarter with oil and gas delivering positive returns while returns in the materials sector were generally negative.
  • We continue to see healthy global oil demand going forward as we enter what has historically been the strongest quarter of the year for demand growth and believe oil prices will be well supported into winter. Oil stocks broadly remain in deep value territory with oil prices hovering in the $70 per barrel range. It is now up to individual companies to execute on their business plans by growing and spending within their means, to support a re-rating of their share prices.
  • Elevated oil price differentials are weighing on Canadian oil producers. Differentials are anticipated to remain elevated until one more of the announced pipelines comes online (e.g.; Line 3, Keystone XL and/or TMX). Some relief could be underway with the anticipated late-2019 entering of service of Enbridge’s Line 3 from Edmonton to the U.S., and more crude-by-rail contracts.
  • Materials were down during the quarter due to US-China trade concerns and moderating economic growth in China that has been brought about by tightening financing and environmental standards. Non--traded commodities have fared much better and physical market indicators have remained constructive which points to weakened market sentiment, rather than a trade flow sentiment, affecting the pricing of metals (e.g., copper, aluminum) and construction materials (e.g., lumber).
  • Gold remained under pressure during the quarter due to rising real interest rates (nominal treasury yields minus inflation). However, with early indicators of inflation pressures and a Fed that will be data dependent in determining further rate hikes, we could be approaching the cyclical peak in real interest rates. Institutional gold market positioning is on the extreme short end of the spectrum, and any indication that real interest rates have peaked for this economic cycle could provide a strong positive indicator for gold. Combined with increasingly uncertain macropolitical environment, we continue to argue for gold and gold equities as a risk insurance complement to portfolios.

Outlook & Strategy

  • Leading indicators of global economic growth continue to point to moderating, but still sustained, economic momentum. Divergence has however been widening, with the US outperforming, and Emerging Markets (particularly China), currently underperforming relative to trend. While earnings growth still remains strong; valuation multiples are adjusting to the reality of higher interest rates, which continue to be required in the US to manage the go-forward rate of growth. Prior to recent market corrections, resource equities had been trading at undemanding valuation multiples and resource equities therefore might be less exposed to further volatility when compared to prior market corrections. Portfolio positioning in Mackenzie Resource Portfolios is favouring Energy over Materials, as supply/demand fundamentals in Energy appear relatively more attractive, and Materials are more dependent on China. Mackenzie’s Resource Team has been reducing volatility exposure and is generally overweight precious metals, which are delivering on their historical role as ‘portfolio insurance’. This portfolio positioning is anticipated to dampen the current market volatility; which the portfolio managers believe might offer late-cycle investment opportunities in Resources as long as underlying economic growth momentum is sustained.

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This document includes forward-looking information that is based on forecasts of future events as of September 30, 2018. We will not necessarily update the information to reflect changes after that date. Risks and uncertainties often cause actual results to differ materially from forward-looking information or expectations. Some of these risks are changes to or volatility in the economy, politics, securities markets, interest rates, currency exchange rates, business competition, capital markets, technology, laws, or when catastrophic events occur. Do not place undue reliance on forward-looking information. In addition, any statement about companies is not an endorsement or recommendation to buy or sell any security.

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