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Strategy notes – May 1, 2019


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Reasons for our recent caution 

Stock market outlook

Making short term market forecasts is hazardous at the best of times – especially in this new age of extreme actions by central banks. In fact, as readers of these Strategy Notes will know, we were surprised at the speed and degree of decline global equity markets in Q4 2018, which culminated in the worst performance by North American equity markets since 1931. Similarly, we were also surprised by the speed and degree of improvement in equity markets in the first quarter of 2019, which has continued at a more subdued pace in the month of April. That continued improvement has seen both the S&P 500 and the TSX hit new all-time highs in recent days although each index has backed off those levels subsequently.

This Strategy Note will endeavour to explain why we have become more cautious in recent weeks – chiefly by raising some cash within the majority of our portfolios.

The reasons for our caution

With our above mentioned caveat about the difficulty of making short term market predictions, we will first discuss the various economic indicators we follow and how on balance they have lead us to take a more defensive tack.

a) Dovish central banks
Perhaps the key reason for the sharp increase in equity markets since Boxing Day 2018 has been the increased confidence in the fact that central banks had underlined that they continued to support equity markets by reversing any threats of tightening monetary policy. Chief among central banks in this respect has been the rapid pivot by the Federal Reserve Board from a hawkish position in mid-December when they announced a 25 basis point increase in the fed funds rate to a dovish stance before and after year-end. The volte-face initially caused investors to think that there must be some undisclosed systemic risks that the Fed was afraid of. This fear was not helped by the announcement that Treasury Secretary Mnuchin had spent the weekend of December 23 calling the CEO’s of the major U.S. banks to ask about any financial problems in their organizations.

The Fed’s response initially was to say that they would be patient with further interest rate increases and early in the New Year to suggest that there would be no more rate increases this year (using the “dot plot”). In addition, the Fed subsequently announced that it would cease their Quantitative Tightening programme by September.

The European Central Bank, the Bank of Japan and more recently the Bank of Canada have all in varying degrees indicated a more dovish monetary stance this year.

b) Continued decline in the U.S. monetary base
Despite the above mentioned bullish announcements by central banks, the monetary base is still dropping in the U.S. as under the current program, the Fed is allowing $30 billion in Treasury proceeds to roll off until May and then from May to September, this pace will decline to $15 billion a month. This further tightening will result in a 6% drop in the monetary base by September.

On the positive side, these recent dovish actions by the Fed could help prevent GDP growth from declining more sharply over the next six to nine months. A further positive implication of this would be 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.

c) Weak real money growth in the U.S. and globally
As readers of the Notes know, a key indicator we follow very closely is real M1 growth. Global annual M1 growth peaked in late 2016 and subsequent weakness that we have documented in past reports is now showing up in declining nominal GDP expansion, which, with the normal six to nine month time lag, is likely to continue into 2020 even if it starts to recover in the short term.

d) Stabilization of manufacturing indices after previous declines
Investors have been encouraged by recent initial or flash PMI results for the U.S. and the Eurozone which indicates a measure of stabilization in manufacturing. However, U.S. and Eurozone service PMI’s (Purchasing Managers Index) indicate that weakness is spreading to the services sector.

e) Markets were encouraged by the recovery in the March Chinese manufacturing PMI’s
It is possible that this improvement was the result of early purchasing to take advantage of favourable tax treatment ahead of a cut in VAT at the beginning of April. The PMI numbers in the first part of May will confirm or discount this guess.

f) As mentioned in a Strategy Note couple of months ago, global debt has hit a new peak at $244 trillion. Any economic slowdown will exacerbate servicing portions of that debt.

g) Seasonally, equity markets often weaken in Q2 and Q3 after strong starts to the year as portfolio managers seek to lock in profits.

h) In 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 their lowest reading of -6.5%, which presaged at a minimum slowing GDP growth through to Q3 this year. The WLI thereafter recovered to a slightly positive reading before slipping in the week ending April 26 to a slightly negative reading again.

In sum, Lakshman Achuthan, head of Economic Cycle Research Institute, put it succinctly at a recent conference when he said: “if our leading indexes turn back down, there may be a recession later this year. If they enter a fresh cyclical upturn, along with the FIG (Future Inflation Gauge), the Fed will find it hard to hold off on further rate hikes. In both scenarios, the inability to execute pre-emptive rate hike and rate-cut cycles is the real danger.” (Institute 2019)

Thus, the jury is still out but it is likely that we will see which way the wind blows in terms of the direction of the WLI and subsequently GDP in the next few months. In the meantime, we have judged it to be prudent to be raising some cash thus locking in some recent profits for our clients. Details appear in the section below.

Portfolio changes

We have interviewed all of the major six banks in the month of April. Banks revenues on the Personal and Commercial (P&C) side are very much affected by GDP growth. Particularly as mortgage growth is slowing to the low single digit area, domestic P& C earnings growth is likely to be half of what it was last year for the banks. In addition, the Bank of Canada also lowered its expectations for Canadian GDP growth significantly recently. Each of the banks has seen recovery in their stock prices either side of 10% year to date and we therefore elected to cut back our bank exposure significantly in the short term until we see a clearer picture of whether or not there is a reacceleration in Canadian as well as U.S. GDP growth. The worst performer among the major Canadian banks year-to-date has been the Bank of Nova Scotia. However, unlike North American GDP, the economies in the Pacific Alliance nations where Bank of Nova Scotia’s international operations are concentrated have been picking up of late. We have therefore maintained our holdings in BNS.

Our oil holdings have experienced decent recovery since the beginning of the year as has the price of oil. Often Q2 demonstrates some seasonal weakness in oil stocks before the summer driving season gets well underway. We therefore moderately cut back each of our oil stock positions of late although leaving our weighting at approximately 10% in our Advantage Equity, Dividend Growth and High Income portfolios.

Nick Majendie
Director, Wealth Management, Senior Portfolio Manager
ScotiaMcLeod®, a division of Scotia Capital Inc.