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Strategy notes – July 2, 2019

Quarterly market outlook

Stock market outlook 

A) The long term 

As we have pointed out in a previous Quarterly Market Outlook, the unprecedented liquidity injection by the developed world’s major central banks has made short term market forecasting very difficult. Since our last Quarterly Market Outlook at the end of Q1, the key Central Banks – namely the Fed, the ECB and the Bank of Japan – have all turned more dovish indicating that short term interest rates will stay low or decrease. Inevitably, if economic growth does not re-accelerate, we believe those central banks will resort to more of their same recipe post the Financial Crisis: quantitative easing through purchases of bonds. The prospect of such liquidity injection has resulted in $13 trillion of sovereign bonds selling at negative yields currently – higher than the previous record in 2016. As a result, financial markets – both bonds and stocks – have shown sharp gains in the month of June. 

We think it would again be helpful to update our views as to where North American markets in general, and the U.S. market in particular, might be situated in a longer term perspective. 

As regular readers of our Strategy Notes will know, we have always been interested in market cycles. The current bull market in North America has now lasted well over 10 years from its inception on March 9th 2009 albeit that it came perilously close to turning into a bear market in Q4 last year. In our 2019 Market Outlook report at the beginning of January, we stated that; “After the dramatic downside action in North American equity markets in Q4 2018, which included the worst December since 1931, it would not be unusual to see a dramatic counter trend rally in Q1 this year, even if it subsequently turns out that we are into a bear market.” What precipitated the turnaround to the upside starting on Boxing Day was the announcement by Fed Chairman Powell that the central bank would be patient in terms of future interest rate increases. In addition, in early January, he also said that said the Fed would consider halting its QT (Quantitative Tightening) programme sometime in the latter part of 2019 and on March 20, the Fed brought down its 2019 rate hike forecast to no increases from two hikes. It also specified that it intended to start slowing the shrinkage of its $4.2 trillion balance sheet in May and end the reduction by September this year. At its June meeting, the Fed effectively indicated that interest rate cuts were on the table and financial markets have assumed that at least a 25 basis point cut will be announced after the July Fed meeting. 

A key judgment – as we expand on in the section below in regard to the shorter term market outlook – is whether or not there will be a recession in North America starting in the next year. Although this cycle is certainly extended, the moderate recovery in U.S. GDP would tend to result in a drawn out cycle. The question is whether that recession occurs this year or next or even later. This subject has attracted heightened investor attention in recent months as the U.S. yield curve (90-day money to 10-year Government bond yields) has inverted. In the U.S., this has happened 16 times since 1962. On nine occasions, the equity market was lower six months later and on six occasions, it was higher. The last seven U.S. inversions have ultimately been followed by a recession (on average 18 months after inversion which would suggest some time in the second half of 2020). 

To sum up our current conclusion, which we explain in the following section detailing the shorter term outlook for equity markets, we thought at the beginning of this year that the odds of a recession starting in North America within the year were about 50/50. As we document in the short term section of this Quarterly Market Outlook, we believe that the U.S. economy in particular, but also the global economy, is more demonstrably slowing but not sufficiently to justify a recession call at this stage. In recent months, we have reduced our forecast of the recession odds to 80/20. The concomitant good news is that slower growth has removed the upwards pressure on long term interest rates at the same time as not only the Fed but also the European Central Bank has become more dovish and the Bank of Japan continues to be extremely accommodative. 

That has lead us to wonder whether we might see a blow off or melt up in equity markets before this long bull market comes to an end. It is legitimate to ask whether, if U.S. and European GDP growth remains relatively lacklustre, there will be any possibility that those two central banks would do as the Bank of Japan and the Swiss central bank have already done and decide to purchase equities. That would create a dangerous 1928/1929 type situation of equity market boom and bust although we do regard it as unlikely that the ECB or the Fed would go to that extreme. However, we do not rule out a final melt up in this long bull market as investors are currently sitting on a lot of cash still fearing the onset of a major bear market of the sort that we saw in 2008/2009. 

Regardless, there is, in our view, a key strategic fork in the road that potentially could occur over the next year or two or three and that is whether the current disinflationary environment will continue or whether they will be a shift towards an inflationary environment. In this respect, the outcome of the November 2020 U.S. Presidential election could be a key short term pointer as to which environment is likely to pertain. If Trump wins, we will likely see zero interest rates, more QE (if both are not already in place) and long term bond yields staying relatively depressed. If a Progressive Democrat wins next November, the higher likelihood of Modern Monetary Theory (MMT) being put in place would mean a totally different investment strategy would be required. In this scenario, the Fed would print money and inflation hedges such as gold and commodities would outperform. Our Dividend Growth portfolio is adaptable to this scenario (potential high exposure to gold and commodities). 

Even without the adoption of MMT, it could also well be that there will be a shift towards a more inflationary environment. The U.S. budget deficit is now over 5% of GDP despite an economy operating at full employment. This is similar to what happened in the late 1960’s and early 1970’s and was the precursor to a sharp rise in inflation later in the 1970’s decade. 

Our point here is that we will likely have to make a critical judgement at some point over the next while as to whether the current disinflationary environment will continue or whether there will be a switch to a more inflationary environment. Our favoured indicators (ECRI Weekly Leading Indicators and real M1 for the U.S. and the G7 plus E7 countries) will help tell us whether the North American and global economies would be decelerating or accelerating thus increasing the odds of one scenario or the other (disinflationary versus inflationary). Each scenario requires a very different portfolio mix although we are agnostic as to which way we will have to go. For the moment, we have a disinflationary portfolio mix. 

B) Short term outlook 

As for the U.S., as always, we pay particular attention to the ECRI Weekly Indicators (WLI). These peaked in early 2018 at +8.8% which presaged good GDP growth last year into Q3. However, the WLI fell steadily to the lowest reading of -6.5% early this year. The WLI have since recovered modestly to a reading of -2.4%. 

It is likely that Q2 2018 represented a peak in U.S. GDP growth. Why was this? The year-over-year growth rates of real personal income and consumer spending started to roll over in late 2017. Consumer spending growth is now at a two-year low and income growth is even weaker so that the difference must be made up with borrowing. With quantitative tightening and Fed rate hikes (now on hold), monetary policy was tightening at a time when the consumer, representing two thirds of the economy was under increasing pressure. However, to quote from ECRI: “the U.S. economy is approaching a recessionary window of vulnerability. But it isn’t yet in that window, so the economy remains relatively resilient to shocks. Therefore…it’s premature to conclude that a recession is imminent.” (Lakshman Achuthan, 2019) 

The other indicator we follow very closely is real M1 growth: six-month growth of U.S. real M1 for the first half of 2017 which, like the WLI, tends to have a six to nine-month lead time versus GDP, was the strongest since early 2014, which itself was followed by two quarters of 4% plus annualized GDP expansion. This suggested that the U.S. economy would regain momentum around year end through to the spring/summer of 2018. However, real M1 then barely grew between December 2017 and June 2019. GDP growth therefore peaked in the second quarter last year. U.S. real narrow money trends still remain weak, indicating that monetary policy is restrictive and a meaningful U.S. economic slowdown still lies ahead of us. In our opinion, the Fed should have been cutting rates as early as last September. Recent dovishness by the Fed through calling a halt to rate increases and ceasing QT by September, however, could help prevent GDP growth from declining more sharply over the next six to nine months. The one positive implication of this would be the continued softness in U.S. 10-year Treasury yields since both U.S. GDP growth and inflation are likely to fall short of Street expectations. On the other hand, there have been 11 occasions since 1957 where the Fed has initiated a rate reduction cycle of at least 50 basis points and on nine of the 11 occasions, they were late in doing so as the U.S. economy suffered a recession (the two exceptions were 1967 and 1996). 

We also track real money growth of the G7 countries together with that of the major emerging markets. This measure started to pick up in late 2015 and continued to strengthen through the summer of 2016 with the August 2016 peak matching its fastest pace of growth since 2009. It softened subsequently but accelerated in the March through June 2017 period. It then stabilized for a few months before starting to fall in October/November 2018. This suggested solid global GDP growth in the first half of 2018 but deceleration thereafter. Real money growth for the G7 plus E7 countries moved sideways after February 2016 before falling to a new low in October 2018. Since that time, it has only recovered very modestly and remains under 3% – the trigger point for global GDP re-acceleration. Real money growth last fall was the weakest since the 2008/2009 recession suggesting that the global slowdown will be worse than the 2011-12 and the 2015-2016 global slowdowns. On the positive side, however, G7 plus E7 real money growth has edged up modestly in recent months. However, a likely rebound in inflation through Q3 on account of higher oil prices could reverse any recent recovery, meaning an extension of global economic weakness into early 2020. Nevertheless, this global cycle is different in that the global slowdown started in China whose yield curve inverted in 2017, then spread to Europe and is now just starting to hit the U.S. The Chinese yield curve has now normalized indicating that China could lead any global recovery late this year or into 2020. 

As referenced above, we will be closely watching the progress of global real money growth over the next number of months to determine the extent of slowdown in global GDP later this year and beyond. The current slowing global picture is supported by the OECD’s Leading Indicators. According to the OECD’s June 6 2019 release, “Composite leading indicators (CLIs), designed to anticipate turning points in economic activity relative to trend six to nine months ahead, continue to anticipate easing growth momentum in most major economies (they have been steadily declining since December 2017). Easing growth momentum remains the assessment in the United States, Japan, Canada and the euro area as a whole, including Germany and Italy. In France, the CLI continues to point to stable growth momentum. The CLI for the United Kingdom now points to growth momentum stabilizing, albeit around historically low trend growth rates. However, large margins of error remain due to continuing Brexit uncertainty. Among major emerging economies, the CLIs continue to signal stable growth momentum in China (in the industrial sector) and India and now also in Russia and Brazil.” (OECD, 2019) 

We will continue to closely monitor the PMI’s and OECD and ECRI leading indicators over the next few week/months. It will be important to watch these closely over that period to assess the ensuing economic impact of geopolitical developments not the least of which would be resolution of the continuing trade uncertainties generated by the Trump Administration (at least an agreement between the U.S. President and President Xi Jinping at the G-20 meeting to continue trade discussions was encouraging). Any turnaround in these indicators as well as G7 and E7 real M1 growth over the next few months would lead us to be less cautious than we have been since last November. From that time, we have advocated that clients have a preponderance of our Defensive Income portfolio complemented by a portion of our Infrastructure portfolio (to provide predictable income) in their portfolio mix if they have not already been so positioned. Despite the strong countertrend rally in the first half of this year, we believe that currently it is better from the perspective of a full year’s outlook to continue with a more defensive portfolio mix until it becomes clearer whether we will see a re-acceleration or a further slowdown in North American or global GDP growth. Which way the economic direction goes should be more evident within the next few months. 

In essence, in normal times, we take a historical multiple range for the appropriate investment criterion (EPS, CFPS and Book Value) and apply it to consensus forecasts for those three metrics for the TSX and to EPS alone for the S&P 500. We use the average multiples that prevailed for these metrics for the last ten years. Applying these to Bloomberg consensus forecasts provides a target for the TSX of 17,280, which makes for a high single digit positive total return from current levels (8-9%). 

In the case of the S&P 500, if we use a projected P/E of 16.8 times (above the TSX’s 10-year average P/E of 15.8 times) on blended forward 12-month EPS, we get a target of 2,920 representing a zero total return from current levels – significantly inferior to the TSX. How realistic is to look for a turnaround in the performance of the TSX relative to the S&P 500? 

Last year for the Canadian market was a particular anomaly in that generally speaking the fundamentals of the companies were as satisfactory as, and generally even better, than we had been predicting –with the one clear exception of the oil and gas sector. We have interviewed pretty well all the companies in our equity universe in the first half of 2019 and despite strong gains in the first half, Canadian equities and particularly so in the back end of cycle sectors remain historically cheap in terms of next 12 months consensus fundamentals. As long term interest rates in North America have declined sharply year-to-date, valuations of the interest sensitive groups such as the pipelines and utilities have started to improve meaningfully. On that point, the current level of long term interest rates still is a powerful incentive to invest in solid dividend growing companies. For example, our Infrastructure and Dividend Growth portfolios have current dividend yields respectively of 4.5% and 3.2%. For a taxpayer in the top marginal tax bracket, the net after tax return on each would be approximately 3.0% and 2.1% respectively. The current Government of Canada 10-year bond yield is 1.48% and so the net after tax return would be approximately 0.74% or roughly a quarter to a third of the after tax income return on both the above mentioned portfolios. 

The net result of all these observations is that Canadian stocks have been recovering but are still cheap and that now is not the time to be abandoning ship. They have certainly been outperformed by U.S. stocks which, up until the end of September last, continued to rise as investors jumped on the momentum bandwagon. In our experience, Canadian stocks tend to outperform in the latter stages of a market cycle as the back-end-of-cycle groups and financial stocks come to the fore in terms of performance. Of course, a continuation of the recent turnaround in the oil price would help provide a boost to TSX valuations as there is certainly a “Canada discount” for the TSX currently. These cheap valuations for Canada are evident in the prospective total returns that we estimate for the TSX versus the S & P 500 over the next year (8%-9% versus zero% for the S & P 500 over the next 12 months). Performance of the S&P 500 has been about 2.5% better than that of the TSX year-to-date offset by a 1.2% lower dividend yield for the S & P 500 versus the TSX. 

Mid-November last year, we recommended a much more defensive portfolio mix (generally two thirds in our Defensive Income portfolio and one third in our Infrastructure portfolio). This mix helped protect against more severe losses in Q4 and, in the first six months of this year, it has allowed healthy double digit returns. 

Since fundamentals (earnings and cash flow) have not improved commensurately with equity markets, we took profits about a month ago and have healthy liquidity in our portfolios currently. Our increased exposure to money market and short term bonds together with increased gold exposure where permitted should better protect in any market downturn. We suspect equities are susceptible to weakness between now and the fall. If our favorite indicators suggest real GDP reacceleration by the fall, we stand ready to become more constructive in our portfolio mix at that time. If these indicators on the other hand suggest increasing recession odds, we would become even more defensive in portfolio construction. 

Portfolio changes 

There were no trades in our portfolios in the last two weeks. 

Due to summer holidays, we will be publishing our next Strategy Notes on August 15. 

Nick Majendie 
Director, Wealth Management
Senior Portfolio Manager

Works Cited 

Achuthan, L and Banerji, A (2019, 03). Recession or not, it’s out of Trump’s hands. Fox Business, Retrieved from 

Composite Leading Indicators (CLI), OECD, June 2019. Retrieved from