Equity markets in North America suffered significant declines in the last quarter of 2018. The TSX fell to levels not seen since 2016. This should not surprise investors as market corrections are a normal part of equity market history.
Some observers see market corrections as predictions of recessions, but history has shown this is not necessarily the case. One of the most violent market sell-offs in 1987 was not followed by a recession. Numerous market corrections have been followed by resurgent markets. If an investor has purchased a stock for dividend cash flow the focus should be on that dividend. If the dividend is secure then the fluctuations of the stock price in the market is irrelevant. Although the price of the asset fluctuates, the dividend payments seldom change. An example would be Canadian banks or BCE during 2008.
The question that naturally arises is why a correction now? There are a number of concerns that have surfaced that create uncertainties for the future concerning interest rates, trade relations and political events.
The U.S. Federal Reserve has proceeded with a number of interest rate increases and has also reversed its stimulative securities buying program, which was known as quantitative easing or QE. This reversal of policy, which is called quantitative tightening, aka QT, means that no new purchases are being made, allowing for the bonds to mature. The result is that recently some $50 billion have been removed from the fixed income markets monthly, or $600 billion per year! This tightens fixed income markets - a pattern that has in the past preceded a move into recession. However, after reaching a Treasury rate over 3.46%, U.S. government bond rates have substantially drifted lower. Also inflation rates have not risen - despite high economic growth rates. Recent comments by the Federal Reserve indicate future rate increases anticipated in 2019 have been reduced from three to two. With overall interest rates still at historically low levels and the prospect of further increases in rates limited, a Fed-generated recession is unlikely in the near term. An inversion of Treasury bond rates (that is short rates above long rates), also considered a precursor of a recession, has not happened.
Recent developments in the trade sector are a potential threat to world economic growth. The U.S. has launched a number of tariffs on foreign imports that are disruptive to long standing trade relationships and corporate profitability. Despite signing a trade agreement to replace NAFTA, Canada and Mexico have had the unfortunate experience of U.S. tariffs on steel and aluminum. However, the main target of U.S. tariffs has been China, and Investors’ fear of an escalation of this trade dispute into a wider trade war, and the negative impact on world growth in general, has made investment in multi national U.S. corporations seem more risky. Recent press releases however indicate that the U.S. and China have scheduled meetings in early 2019 to resolve the ongoing trade dispute.
Politics can also have a negative impact on investor sentiment. In the U.K. Brexit negotiations between the U.K. and the European Union have yet to produce a workable plan for a smooth exit. London as a financial centre is under threat, as are a number of major U.K. financial institutions. In Europe riots caused by a backlash to excessive taxation on fuel in France, have done damage to France’s leadership role in Europe. In Germany Angela Merkel has announced her retirement - again the loss of a stabilizing influence in Europe.
While it is natural for investors to worry, most of the worries are about what might happen in the future not what has happened. The chances of a recession in 2019 are relatively small and would require a very sudden slowdown in economic growth. In the meantime, the economic background remains positive in the United States, Canada and much of the world.
In the U.S. unemployment is the lowest in decades and a significant number of new entrants have joined the workforce. Wage levels are also rising, the consumer sector is in good shape, and inflation remains muted. Projections for corporate earnings growth in 2019 are still in the high single digit range. Most financial forecasts see a small decline from the 3% U.S. GDP growth rate in 2018 to 2.8% in 2019. Assuming the Federal Reserve does not push rates aggressively higher the possibility of a recession in 2019 seems remote.
In Canada, despite poor political policies which have severely damaged our energy industry, resulting in the loss of high-paying jobs and corresponding tax revenues, the Canadian economy has chugged along at a reasonable growth rate of plus 2% in 2018. Employment has also increased, which is attributable to Canada benefiting from high U.S. growth. Real estate markets in Vancouver and Toronto are a continuing source of concern. Housing prices in Vancouver and Toronto have fallen slightly and the number of sales is down sharply. So far it appears that some further easing in these two overheated markets is to be expected, but no collapse is anticipated. Despite the Bank of Canada forecast of plus 2% GDP growth in 2019, somewhere just less than 2% seems more likely – but still positive growth.
Financial markets in 2019 are likely to remain volatile. In the absence of a recession in 2019, and the market realization that a recession is not in the cards, equity markets in North America should recover modestly. In Canada oil prices should rise as 2019 progresses, which should improve energy equity prices - a major TSX component. Fixed income markets will likely see interest rates moving sideways to slightly up. An inversion of the yield curve, a good predictor of recession to come, is unlikely. With inflation rates remaining low there will be little pressure on central banks to aggressively push bank rates higher.
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 utilize 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 complement to fixed income and equity asset classes, we view multi-family real estate as having good potential, as strong rent growth should compensate for higher interest rates.