We are now living in a period of financial uncertainty and it is reflected in the financial markets. The bond market appeared to be at the end of a thirty year bull market, but now interest rates are falling rather than rising. Equity markets have had a major run for 10 years – it has not been a smooth run but they are up significantly. Since August of last year the Dow Jones Index has run into resistance above 26,000. The S&P 500 has just penetrated its old September 2018 high, while the NASDAQ is also just reaching old high territory. Are struggling equity markets trying to tell us that a recession with falling corporate earnings and equity market declines is coming soon?
Are struggling equity markets trying to tell us that a recession with falling corporate earnings and equity market declines is coming soon?
Historically, recessions have been a normal occurrence in free capitalistic economies. They serve as a cleansing mechanism as excesses build up in economies. In the past, excess production expansion has been the common cause of recession. However the nature of more recent recessions has been quite different from those after World War II. From the 1960s to 1980s, economies were dominated by manufacturing companies, such as the auto companies and General Electric. Recessions were caused by over expansion of production, which led to production cuts, which resulted in job losses and economic contractions until a stable demand and supply balance was reached. In more recent times, recessions have been set off by excess financial leverage. The 2001 contraction was largely the collapse of the dot.com craze (remember Nortel as a large percentage of the TSX). In 2008 it was the excessive U.S. housing expansion and the transfer of the risk to the mortgage derivative market that then collapsed. The fact that we have had an unprecedented long and relatively uninterrupted recovery requires some explanation. Western economies in general are no longer goods-producing economies, where the curtailing of production means a major increase in unemployment and a further contraction. They are now service economies where a contraction has a much milder impact on unemployment. While these economics are less vulnerable to recession than in the past, this does not mean economic cycles are eliminated. At this current time, there has been an alarming increase in BBB rated corporate debt. This is debt that is one rating away from non-investment grade (aka ‘junk’). Many bond covenants have also weakened to levels that would have been deemed unacceptable only a few years ago. As investors reach for yield in the low interest rate environment, we believe many have become too complacent. A new area of potential risk has appeared.
The other new risk element for world economies not faced for many years is the prospect of trade wars.
The other new risk element for world economies not faced for many years is the prospect of trade wars. In the Great Depression of the 1930s it was generally accepted that tariffs prolonged and deepened the economic decline. While service-dominated economies are less vulnerable to tariffs, are turn of a trade war could prove disruptive.
Where is Canada right now? As is always the case, Canada’s economic future is very dependent on what’s happening to our southern neighbour. The US Federal Reserve has again stated its intentions to lower interest rates. While the timing of its rate reduction is still an open question, some market predictions see a rate cut as early as July. There are signs that the US economy is already weakening, with forecasts of GDP growth reduced this year to 2.2% and next year to 1.2%. The ISM Manufacturing Index in May fell to a 31 month low reflecting weak global demand and supporting contention that world wide growth is declining. As of yet there are no indications the US economy is slipping into recession.
US importers are scrambling to switch to alternative suppliers rather than the Chinese.
Consumer confidence remains high and labour markets are still strong with unemployment holding at 4%. Inflation remains well under control and investment markets have been encouraged by the Federal Reserve’s dovish stance. However, the prospect of an escalation of the trade dispute with China is a significant cause for concern in corporate America. US importers are scrambling to switch to alternative suppliers rather than the Chinese. South Korea, Taiwan and Vietnam have seen shipments to the U.S. rise sharply. As major U.S. corporations announce plans to shift production out of existing Chinese sources elsewhere, such actions are likely to add to costs and affect the economies’ future corporate strategies for the worse. Further escalation of the trade dispute with China with the imposition of a full 25% tariff on all Chinese imports would potentially reduce the U.S. GDP by 0.7%
In Canada, GDP growth continues to exceed forecasts with estimates for the second quarter now at 2.5% annualized. The Bank of Canada (BOC) held the bank rate steady despite the strong indications of a looming Federal Reserve rate cut. But the BOC has seen the inflation rate edging over 2%. By holding the bank rate steady, the BOC faces the uncomfortable risk of a higher Loonie, which may hurt Canadian exporters, but this would be deflationary - something the BOC would welcome.
Again, US politics will be a major factor in Canada’s economic outlook.
While the Federal Liberal Government has approved the much needed Trans Mountain Pipeline Project, it is yet to be seen if it will proceed. Canada is also waiting for the US to approve the new NAFTA agreement with the US and Mexico. Again, US politics will be a major factor in Canada’s economic outlook. Added to this, the Chinese blockage of Canadian farm products is a further future complication. The upcoming Canadian Federal election campaign may produce some negative commentary on Canada’s prospects.
Given the foregoing, it is hard to see anything but a clouded and negative psychological atmosphere for financial markets in the next few quarters. Markets failed to see the 2008 crash coming so why should this time be different? With that said, given the trade concerns are self inflicted, it is conceivable that the Trump administration can roll back tensions if it hurts their prospects in the 2020 election.
Our strategy in the fixed income asset class continues to avoid exposure to long-term fixed income investments while favouring opportunities that focus on the “real economy” rather than the “financial economy”. The areas where we see the greatest return vs. risk is in the area of supplying growth capital for companies (private debt), hard asset lending (private mortgages) along with critical infrastructure.
In the equity portion of portfolios we favour the utilization of ETFs to gain a low-cost and diversified global exposure, which utilizes a combination of indexing along with low-volatility factor based strategies. For investors with long-term horizons and a reduced need for liquidity, private equity (both in the growth equity and secondary sectors) has the potential to create value in excess of the public markets over time.
As a compliment to fixed income and equity asset classes, we continue to view multi-family real estate as having good potential as strong rent growth should compensate for higher interest rates.