Outlook 2014: Q3
Strategies For Today’s Market
Thanks in large part to the monetary policies of the world’s major central banks, the global economy appears to be stable, but higher volatility could return. To help you plan for the months ahead, three of our investment experts give us their insights into equities, fixed income and the economy.
Outlook 2014: Q3
Equities, fixed income and where to invest now
TONY ELAVIA: The global economy has been moving along in the same direction that it has for the last two years. The trends have been very similar. We have had Europe showing a recovery from its recession. We have had the US growing at a faster clip than most developed countries. And we have Canada somewhere in between.
Europe has still not recovered fully from what has happened in the great financial crisis. Canada continues to face a competitiveness problem. And the US actually has pulled away from the rest. Despite the weak first quarter that we experienced in the US, most indications are that the second quarter and thereafter will be quite strong.
And this is not showing up in significant inflation. We have very subdued inflation in Europe. We have less than 2% inflation in Canada and the US. We are seeing some inflation in emerging markets. But in general the global economic situation is fairly benign. It's not as strong as it typically is coming out of a recession.
STEVE LOCKE: It's sort of a weaker growth profile than expected given all the stimulus we've seen in the last few years, but no real inflation, target or below, in most developed nations. Global markets have been pretty well behaved, in fact had a good quarter.
TONY ELAVIA: Yes, a good quarter, in addition to the quarter before that and the year before that in 2013. If you look at equity markets you will find that pretty much everybody is in that 7% to 9% range-- Europe, emerging Asia, the United States. In fact, Canada is doing extremely well compared to all these markets. Canada is in the low teens, largely driven by what's happening with commodities, especially gold-mining stocks and energy stocks. But in general, equity markets have shrugged off so many of the risks that people have been talking about, and which we'll discuss at some point soon. But in general, very good performance from the equity markets, and not too bad in fixed income either.
STEVE LOCKE: That's right. Government markets had a really good start to this year over the first half. Look at US Treasury yields. We've seen a decline of over 50 basis points to the end of June. Canadian 10-year yields as well, down about the same amount. If we look at European developed markets, including the periphery, we've see an even bigger rally. German government funds have come down significantly, over 60 basis points year to date.
So significant rallies in government markets, producing a pretty good total return. If you look at the US broad investment grade market, over 5 and 1/2% return for the first six months of the year. The government of Canada and the corporate investment grade market in Canada also collectively produced almost a 5% return in the first half. So good government markets all around for sure.
TONY ELAVIA: And a similar story for high yield.
STEVE LOCKE: Yes. In fact high yield has out-performed, given it had a spread compression as well over the course of the year. So yields coming down by over 50 basis points in those markets with a small spread compression. High yield bonds have produced greater than 5% total return year to date.
And it's significant because we've also had very low default rates. So we continue to see good fundamentals in that market. So risks remain to the low side. And we expect default risks and so on to remain low as we go through the rest of this year and into next year.
ALAIN BERGERON: What about the floating rate loan?
STEVE LOCKE: Yeah. I mean it's been a great run for them as well. Obviously it's been a very hot asset class in many ways. We saw over 2 and 1/2% total return in that market over the first six months of this year. And obviously with loans you don't get the benefit of that duration effect, with the yield curves moving lower.
What you get there is the carrying yield. And at a total yield of about 5%, or just under 5%, for the asset class, they performed very well and as expected during the first half of the year. Despite a lot of issuance, the market was able to absorb that quite readily and we see great liquidity around the loan product right now.
TONY ELAVIA: So good, stable macroeconomic growth, globally speaking. Very good capital market conditions. Equity markets having another good year, in addition to the last year. Fixed income doing much better than anybody had expected. So where should we allocate our assets?
ALAIN BERGERON: I see a lot of conflicting forces, or signals, when it comes to the broad allocation between stocks and bonds. On the one hand, there is devaluation. You touched on the duration, or the sovereign bonds. But then in equity it is also not cheap.
Of course, there are several models and they all show different valuation. But the one that highlights perhaps the highest level of valuation is the Shiller P/E, or the cyclically adjusted price earning ratio. It is now at 25.6. And the history has been only three periods since 1870 it has been at that type of level.
Now there are other valuation metrics that are not painting such a strong picture, but suffice to say that stocks are not cheap at that level. But the conflicting force, as I was mentioning, is the fact that-- and you touched on that-- is the macroeconomic conditions. Namely, we are in a recovery. Volatility is low.
And it's in large part driven by the central bank actions. Central banks have been, through their liquidity injections, through their policy, have been supporting asset classes. So yes, assets are somewhat overvalued. But there are reasons supporting that. And as long as these conditions persist, valuation can get much, much higher than where they are today.
But from a broad stocks versus bonds, my recommendation in that context is to stay neutral. Now the key in here is to remain very vigilant. Should the conditions that are very supportive to risky assets, should those conditions start to change, then my view would change.
TONY ELAVIA: Neutral meaning whatever long-term policy allocations are, that's where we should be.
ALAIN BERGERON: Yes, that's what I mean. So that's one thing. And the other thing that I would recommend in the context of those conflicting forces is for investors to ensure they have truly diversified portfolios. So that's something we really make sure when we do our managed solution, like symmetry portfolio
But if investors are building their own portfolios, to make sure that as they add active managers, as they add different securities, stocks, bonds, to make sure that they haven't introduced factors. And that could easily happen if you're not very careful how you put that together. And now it wouldn't be visible as markets are very, the volatility is muted. But if volatility returned to a normal level, that's something people should be careful.
TONY ELAVIA: And how should we think about currencies given this macro and capital markets backdrop?
ALAIN BERGERON: In terms of currency, especially the most important one for Canadian domicile investor, would be the US dollar. So I would say that in terms of the US dollar, as far as this is concerned, I think that it makes sense for investors to be long the US dollar, or underweight the Canadian currencies. And that's for two broad reasons, Tony.
The first one is on return. I think there's a positive return associated with that. And the second is in term of risk diversification. Now my horizon here is mid to long term. So there are two strong headwinds that are facing the Canadian dollar versus the US.
The first one is valuation. So we look at four valuation metrics, from absolute purchasing power parity, to relative purchasing power parity, behavioral equilibrium exchange rates. And all the four of them show that the Canadian dollar is overvalued. So that's one.
But the competitiveness is also another one not to neglect. The OECD computes something called unit labor cost and makes it a comparable number across countries. And if you look since 2000, the unit labor cost in Canada, since 2000, increased by 39%. At the same time its two trading partners, namely Mexico and the US, Mexico has stayed constant and US actually got even more competitive. So this I don't believe is sustainable in the long run. And the easiest way to restore that competitiveness is for the Canadian dollar to depreciate versus the US dollar.
TONY ELAVIA: Steve, we heard about concurrency strategies in terms of risky portfolios, ie. equity portfolios. How do you think about hedging strategies in fixed income portfolios?
STEVE LOCKE: Sometimes we will use an open currency position, an open US dollar position in particular, to hedge against some of the risks that come with being a high-yield investor or a loan investor. And that would be a tactical decision we would implement. So if you think about the portfolios that we're running, we have core portfolios which have no high yield in them. In those portfolios we're going to remain fully hedged.
If we have US dollar exposure, we're going to hedge that back to the Canadian dollar, because we don't want to introduce any currency volatility to the total return of the mandate. The yield on those mandates is quite low today. And the ability to generate a total return around that is quite constrained usually to your credit spreads and to the direction of yield movement. If we introduce currency volatility on top of that, we're very likely to swamp the effect of the yield itself, or the asset class return itself, in generating a total return overall. So it can become more volatile.
But when we include things like high yield in the portfolio, from our point of view we want to use the US dollar to hedge credit risk exposure at times by taking a small open position against what we would hold in, say, US dollar based high yield, for example. So that's a way of hedging the risk in an economic recession, or times when credit spreads are likely to expand.
And lastly on the global side, we think that there's tactical ability to move in and out of different currencies when being a global bond investor, where you can take an underlying yield curve and take a country that has significant positive fundamentals versus Canada or the Canadian dollar, and use that to your advantage by taking a small tactical open position in certain currencies. So we do do that in our global portfolio from time to time. And again, it's a very tactical use overall of that unhedged currency position.
Speaking of risks and mitigating risks, what are your thoughts on more generally risks globally as we look forward from here?
TONY ELAVIA: There are all the usual risks that people have been talking about. We have had the situation in the Middle East that has been exhibiting growing instability. We have had Russia trying to get bigger and bigger pieces of Ukraine, creating instability. That's causing a rise in the price of oil. It has not led to an increase in the price of gold, which is a little different than usual.
We have had some political uncertainty in some countries. Indonesia is having elections soon. India had elections and that turned out for the better. But in general, I would say that the political landscape is not extremely risky, but there are pockets of risk, especially in Russia and the Middle East, with influence on commodity pricing.
Beyond that, there are the usual central banking issues related to risk. Central Banks have been very lax everywhere, and accommodative. Particularly the Euro situation, which the European Central Banks have been talking about quite a bit lately. So how do you think about those risks?
ALAIN BERGERON: There was an important Central Bank action in the last quarter, so early June. The European Central Bank announced a series of measures to essentially increase their stimulus. And one example of that was a EUR 400 billion LTRO. And a couple of points here that I think are important for investors.
The first one is that liquidity is global. So as they made that announcement, if you look at the price action, you will notice that the stocks in Europe, as expected, went up when they announced this. But global stocks went up as well. So when there's an increase in liquidity in one country that's large enough, that makes its way throughout the system.
The second point I think is very related, and links to why these geopolitical risks have not affected the market so much, is this belief that the markets have adopted. So markets now, market participants, believe that Central Banks will do whatever it takes. And so that is both something that will-- as long as it continues-- that will support the risky asset prices. On the other hand, that's something to watch for. Because if that belief starts to weaken, then we can start to see a quick return of volatility to more normal levels.
TONY ELAVIA: So clearly there are all kinds of risks, as usual. We've discussed that the macroeconomic conditions are stable. Even though it is weak growth across all geographies, with Europe having the weakest growth, followed by North America, and then the strongest growth in the emerging markets. And we are seeing very good capital market conditions. Equities are up 8% in pretty much the entire world, with the exception of Canada, where it is up in the 12% to 13% range.
We have seen fixed-income markets generating roughly 5%, 6%, 7% returns this year. So capital market conditions have been very good. And as we discussed, the risks in the Middle East, the risks in the Ukraine and Russia, there are some things to watch out for, but that is no different from most of the market conditions.
I think it is important for investors to realize that they have to follow a balanced approach in terms of allocating their assets. We are recommending that they stick with the neutral positions in their equity versus their bond allocations. We are also recommending that they should have a long exposure to the US dollar in equity markets, and somewhat of a neutral exposure in government fixed-income markets. And maybe a small positive exposure to the US dollars in the high-yield markets. And I think that's how we should think about the world for the next quarter or so.