Outlook 2014: Q2: Strategies for today’s market
Our investment experts discuss equities, fixed income and where to invest now
In this video our investment experts tackle a number of questions. Among them: What region has the best equity valuations? Will interest rates start to rise and how should portfolios be positioned for today’s market?
From left: Alain Bergeron, Mackenzie Asset Allocation Team Lead; Steve Locke, Mackenzie Fixed Income Team Lead and Tony Elavia, Mackenzie Investments’ Chief Investment Officer.
Outlook 2014: Q2
Strategies for today's market
TONY ELAVIA: Let's review the economic situation as we enter the second quarter of 2014. We can think about the economic situation in terms of GDP growth rates across different geographies, and we can think about central bank policies across the board as well. And then we can talk about the interaction.
So in terms of GDP growth, the story we've been telling is that absolute returns in terms of GDP growths have been slow and they've been slow for many years now. And the interesting story is the relative differences in returns because that's what matters from an investment perspective. There the story, again, continues to be similar to what we have talked about in the last quarter.
The US is exhibiting the strongest growth amongst developed countries, followed by Canada, followed by Europe. Now the interesting thing is that while the US and Canada seems to be stable at those growth rates that they have been having for the last few years, Europe has been moving from a recessionary move-- which is negative rates of growth through 0 and now at 1%-- and that's why there's an interest in European markets. And we will talk about valuations from a different perspective later on.
In terms of central bank policies, the US has been engaged in tapering as you all know. It's been going on now for quite some time, which is the reversal of the accommodative stance that the Fed has had for almost seven years. The European Union has followed an accommodative stance as well and continues to do that because they are concerned that economic growth in Europe has not recovered to the extent it has recovered in Canada and the United States.
And then finally, the growth of the emerging market countries, and especially the BRIC countries, is important to understand that this block is no longer a monolithic, homogeneous block. Chinese growth has slowed down from 10 to 7 and 1/2%. Growth has slowed down everywhere. The Chinese government is trying to engineer a move from export-led growth to a consumption-led growth. And if they can pull it off, that would be a very successful macroeconomic policy going forward.
The elections in India that are due in the summer of this year are likely to create a government or put in place a government, which is going to be growth friendly. And the markets have started anticipating that so the Indian markets and the Indian currency has been appreciating in the last few months.
ALAIN BERGERON: We continue to recommend a neutral stance between equity and fixed income. Talking about fixed income, while it's true that government yields, domestic in the US and in Germany are low, but when we think about fixed income allocation, we think about it in a broader sense. And by that I mean that we also consider the opportunities to invest and spread products, such as high yield, investment grade, or leveraged loans.
In terms of the equity, we have a mixed view. And that's because as we highlighted last quarter, stocks are on the expensive side. On the other hand, the cyclical conditions are positive. By that, I mean the global economy is in a recovery. Growth rate in 2013 was very low, 1.3%. This year-- although it remains not a high growth rate, it's much higher than it was in 2013-- is expected to be at 2.9. And when you have an acceleration of growth, it's typically a good environment for stocks.
We maintain our small, overweight European equities. This is based upon the fact that according to our valuation metrics it is cheap. For example, the cyclically adjusted price earnings in Europe is 14 while it is 22 for the US. The second reason is the growth prospects in Europe are accelerating. And this is highlighted by the PMI manufacturing survey that is more timely than GDP.
And if you look at it and read above 50 suggests that the economy is expanding. It's been in an uptrend for the last year and it's been above 50 since July. So from a growth perspective, Europe is recovering and it's recovery is at an earlier phase than it is in the US. And that tends to be also supportive for stocks.
Now part of the story is that there has been the reduction – or there is in 2014 the reduction in austerity. And often, people equate austerity with a negative contribution to growth, but the reality is that it's the change in austerity that affects growth. So as there is a reduction, austerity is a positive contributor to GDP.
Now, we recommend only a small overweight, and that's because of the risk associated with this exposure. First, Europe hasn't fixed its governance issues that led it to the crisis to begin with. The second is that its financial institutions are more exposed to emerging markets and as such, that makes them more vulnerable to a financial contagion.
We are removing our small, underweight emerging market and Canadian equities. So on the emerging market front, well, they've underperformed the SNP by 9% since our call. And so given this price movement, as well as the broad bearishness that investors have about emerging markets, we recommend and think a neutral stance is more appropriate.
On the Canada front, really, that's a question of timing. Similar to the US, the Canadian equities remain expensive. The imbalances that we identified last quarter are still there – the level of indebtedness, the housing sector – but the recent economic indicators have surprised on the upside. And also the fast appreciation of the Canadian dollar is providing more support for stocks. So we'd like to see more evidence on the weakness in the economic picture before reinstating an underweight.
Coming into Q1, we were recommending an underweight to Canadian dollar or overweight US dollar. Since then, the US dollar appreciated by 5%. Now, our hasn't changed based on that price movement. And we maintain a small bearish view and that's driven mainly by the fact that the Canadian dollar is still overvalued based on our valuation models. So on all our valuation models, the overvaluation ranges from 3% to 11%.
But also from a monetary policy standpoint, although we don't expect the Bank of Canada to cut interest rates any time soon, if the Fed continues to taper-- which, effectively, means that it's tightening its policy – that should provide negative pressure on the Canadian dollar versus the US dollar. Now also, a nice feature of having a positive USD exposure or a US dollar exposure in a portfolio is its risk management benefits. By that, I mean if there was a big negative shock to either the Canadian economy or the global economy, such as a global emerging market contagion, the US dollar versus the Canadian dollar would like to provide a good protection to that portfolio.
Now, the risk associated with being bearished Canadian dollar is that, of course, the Bank of Canada becomes more [INAUDIBLE] relative to the Fed. Another is that commodity prices appreciate significantly. And a third is that from a positioning standpoint, this bearish view is now very popular, which wasn't as much a quarter ago. And that also means that it's a risk of ongoing in the short term.
STEVE LOCKE: So we did have that to look forward to with Janet Yellen coming into Chair of the Fed and the FOMC to start 2014. And since she's taken over from Ben Bernanke, what we've seen is really a continuation of the same policies that have been implemented in the last year of Ben Bernanke's chairmanship. And what we're seeing then of course is a continuing of the tapering of bond purchases with another $10 billion taken off of the monthly purchase of the Federal Reserve.
So they're reducing the size of their bond purchases month in and month out, and that is the course that they're on. But Yellen, in her testimony to the Senate and to the Congress in the banking semiannual address that she gives, said that in fact, they're not on a preset course. If there are conditions that change such that risks, for example, enter the US market and cause volatility or there is a change in the economic data in particular that shows a slowing of US growth, then she's very likely to, perhaps, not taper the purchases going forward. But for now, we should expect a continuation of that tapering.
Well, as we came into 2014, we thought that there would be some differentiation among yield curve movements and policy rates. And so far this year, we're starting to see just that. As we came into the year, yields were a little bit higher. And we've seen in most markets, including most developed markets, like Canada and the US, their bond yields have come down. 10-year yields dropping by about 30 to 40 basis points. And that's been the case in Europe as well.
We've seen European yields really fall about the same level overall. However, if you look at the emerging markets where we thought we'd see a little bit more volatility this year, in fact, that's come forward. Some markets, like Mexico and Chile, have had their yields come down to a similar degree as US and Canadian curves. But other markets, like Turkey and Russia and the Ukraine, for obvious reasons, today, have seen a move up in their yield so a little bit more volatility there. And we expect this is likely how things will continue to play out through the rest of the year absent any real policy changes that affect individual countries as well.
So to start this year, we came in with a shorter than the benchmark duration in our investment-grade portfolios. And that was reflecting the idea that we're in a very low yield environment today and we expect that range to continue. And in fact, we are starting to see some evidence of slight tightening in monetary policy from different regions of the world, really reflecting an idea that we've had a lot of liquidity in the system and we're going to start to gradually remove it. So the Fed tapering is one expression of that.
Now we have seen a couple of central banks raise rates as well this year gradually. And we've also seen the ECB lower rates earlier this year. So we're seeing a little bit of a change in direction among countries. However, overall, we still maintain a fairly short duration in our portfolio tilt because of that absolute low yield environment that we're in, and that helps protect capital in fixed-income portfolios from rising yields in the future.
The second tilt that we have in the portfolio is really to favor corporate debt overall. We continue to favor that in our portfolios and we're overweight in investment-grade corporate debt, as well as in high-yield bonds. Now in that particular area of the market, in high-yield debt and including floating-rate loans, we're having to become a little bit more selective over time with each and every deal that we look at because not all areas of those markets are cheap today.
So like a lot of risky assets, they've benefited from all that liquidity that's been provided by central banks over the last number of years such that their prices have risen or their yields have fallen. And as a result, we're starting to find some deals that are quite expensive from a valuation basis. Overall, fundamentals for corporate debt looks pretty good today, especially for North America. So we continue to tilt portfolios in favor of that in an overweight position.