On this podcast, Chris Lane sat down with Brent Joyce to review how the market performed in 2018 and what to consider for 2019.
Hello, I’m Chris Lane, Vice-President Investment Business Development at GLC Asset Management Group. On today’s podcast I’m calling from Vancouver to speak with Brent Joyce, GLC’s Chief Investment Strategist who is based in Toronto.
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· We’re speaking with Brent about what’s in store for investors in 2019. We’ll be covering some of the highlights from GLC’s recent report – our 2019 Capital Market Outlook – striking a delicate balance.
· Hello Brent, Welcome back to our GLC podcast!
Brent: Hello Chris, it is great to be here with you.
· Brent, last year was bookmarked by extreme periods of volatility. More of the same for investors this year?
Yes would be the short answer. We continue to believe that the world economy is in the advanced stage of the economic cycle. The later stage of the expansion typically brings increased volatility to capital markets as the trends and rates of change in the fundamental data of economic growth, earnings and bond yields become more subtle. Everyone is on the lookout for signs of slowing, searching for the inflection point where slowing becomes decline. Add-in the uncertainty due to politics, geopolitical risks and trade and all of this is likely to keep equities and bonds moving around quite a bit.
So investors should remain buckled up! Pause for Brent . how would you characterize the back drop for 2019…
Our base case scenario is one where slowing turns to moderation. For market cycles, we believe acceleration is followed by moderation, before eventually giving way to decline, with moderation being a normal, albeit less desirable stage of the economic cycle. Importantly, this means growth has peaked, but that does not immediately give way to economic or corporate earnings decline, rather just lower growth. We believe today’s debate is around how much global economies and corporate earnings will grow and, importantly, not how much will they shrink.
In my travels through Canada, I have the opportunity to speak often with financial professionals and wealth advisors about what they are hearing on the ground, getting a sense for what the mood is amongst their clients and their peers when it comes to the markets, some of their greatest concerns …and so I thought we’d use this opportunity to see what you feel is the greatest risk to the equity markets this year?
The greatest risk is the ‘R’ word, recession - led by the U.S. and cascading across what is still a very integrated global economy. If the U.S. slides into recession or markets believe a recession is all but certain in 2020, then equities have a ways to fall from today’s levels. Our base case scenario does not call for a U.S. recession we believe corporate America has enough momentum to drive some growth, the consumer is in solid enough shape to drive growth and the government sector is more likely to be a net contributor, than net detractor in the year leading into a general election. Importantly for Canada, our economy continues to be tied very heavily to the US and no recession there, keeps the Canadian economy on track too.
The flipside is fixed income, if our base case is wrong and we do see a recession, then the upside from high quality fixed income is in the 5 to 6% range.
So what does your asset allocation recommendation look like…
So our base case scenario provides for equity gains and bonds to do no harm. The fact is the risks of a recession have risen, even though we don’t see it as our base case scenario, the risk is there. So this keeps us firmly rooted in recommending a neutral asset allocation, where investors have risk tolerance aligned exposure to both equities and bonds.
Let’s get into some specifics, starting in our own backyard – with Canadian equities. 2018 results were disappointing. How do you see Canadian equities faring in 2019?
We have a slight overweight recommendation to Canadian equities. We don’t believe Canadian equities are broken; we see it as more of a case of being misunderstood. Our views toward Canadian equities continue to be driven based on fundamental data (i.e., earnings and valuations). On paper, Canadian equities look good, in part because they are relatively cheap for the corporate earnings expected in 2019. Unfortunately, just because something is cheap, doesn’t mean it will go up in value. Canadian equities need a catalyst to unlock their value.
Where will we find the catalyst to unlock the value in Canadian equities?
Ah-ha, yes Chris, that is the question. We see several developments that could spark a revival of interest in Canadian equities. Just as negativity in our bellwether sectors (such as financials, energy and materials) has generally been contagious, we feel a positive development in any one of these sectors could also spread.
I receive a fair amount of calls on the banks which despite strong earnings last year were also disappointing. I’d love to hear your perspective.
The banks have been under a negative cloud due to a slowing housing market, credit exposure to the energy sector (or perceptions thereof), and a flattening yield curve. We expect some reprieve in the negative sentiment on these fronts. Housing markets are adjusting, we are a year or more past the beginning of the slowdown and close to a full year operating under the tighter financial lending environment. The recent sharp decline in 5-year bond yields is taking some of the pressure off of mortgage rates and certainly taking some of the worst case scenarios off the table for now. The expectation a few months ago was rising mortgage rates would pull hundreds of dollars a month out of Canadian households pockets as mortgages renew. The worst case scenarios here are fading somewhat. The financials sector remains inexpensive and boasts a solid and growing dividend yield of approximately 4%. Under a scenario where the financials turn around their -12% price drag in 2018 to a modest +5% to +6% price gain, the 10% total return goes a long way to getting the S&P/TSX Composite to our base case return scenario of a 15% total return for 2019. That would be low teens on price, plus a 3% dividend yield.
15%? That sounds like a big number?
I am glad you pause there Chris, because we have to address the fact that these full-year estimates are influenced by the low starting levels that prevailed at the close of 2018. The TSX has already clocked close to a 7% return in January, a pace and path that likely requires some check back. So we see about 5% of our total return as just a recoup of the very oversold levels at the end of 2018, beginning of 2019 and the other 10% needs to be driven by the fundamentals of earnings growth and valuations as we work through the rest of 2019.
Okay – so what about oil. Energy is another large component of the Canadian equity market. We’re back up above $50 now. What are the drivers there and do you see a return to higher prices in 2019?
Yes, we think WTI oil can return to the mid-$60USD/bbl range. For overall global oil demand, we are calling for a combination of growing demand and one or more of the following supply side developments: Production caps by OPEC/Russia and partners. We think U.S. shale production growth cools off. U.S. shale output is very flexible and price responsive. So as much as $75USD oil prices brought rising output, $50USD should curb some of the drilling enthusiasm, especially when labour is tight and capacity pressures remain. Lastly, there is a bit of a swing issue at play with the Iranian oil sanctions. What set oil prices tumbling back in the fall was the surprise move by President Trump to allow exemptions to the U.S. sanctions for eight of Iran’s major oil importers, including China and Japan. Should oil prices stay low, the end (or pause) of these exemptions is a possibility. These are only 180-day exemptions (ending May 3, 2019). The announcement of these exemptions, coinciding with the U.S. midterm elections, appeared to be very politically convenient for the U.S. President. Should oil prices stay low, this will bring about the opportunity to remove some, or maybe all these exemptions, potentially removing millions of barrels a day of global supply.
And what about the difficulties we had with extraordinarily low prices for Canadian oil? Even though global prices were decent?
I am glad you raised that because it bears pointing out that WCS prices have firmed up considerably since Alberta implemented mandatory production curtailments. This is not the way you want to see prices firm, but the strategy has delivered the desired outcome. WCS sits above $40 with the differential now below average at $11, not the $40-$50 discounts like we saw in Oct/Nov.
The US entered the longest bull run in history late August of last year - a year which saw very strong earnings growth yet a divergence occurred and returns turned negative. What is your expectation around US equities for this year?
Our views toward U.S. equities remain cautiously optimistic. Consistent with our theme of moderation, we expect S&P 500 corporate earnings to progress from accelerating growth to a period of moderating growth, but not decline. Despite significant P/E multiple contraction, U.S. equities remain relatively expensive compared to their global counterparts. Worries remain over higher bond yields, wider credit spreads and a strong U.S. dollar that all factor into earnings growth. Add in the slowing global economy story and the question is how much can U.S. corporate earnings grow?
So how much can they grow?
So as part of our over-arching strategy to err on the side of risk-mitigation, we’ve chosen what we feel is a realistic, and perhaps conservative estimate of 5% earnings growth in 2019. We expect the rate of change and magnitude of the headwinds we just described (bond yields, spreads and US dollar strength) to moderate in 2019. And of course our base case is moderating global economic growth, not contraction.
With the house of representatives flipping to Democratic control, we are back to a grid-locked Congress. Is your outcome predicated at all on politics?
We believe markets care about taxes, trade and regulations, and much less about investigations and scandal. Trade is obviously a risk, but under grid locked government we expect no change in taxes and regulation, so this should be less of a distraction in 2019. The investigations and scandals will no doubt continue to garner media attention, but outside of short-term, knee-jerk reactions, we expect capital markets to continue to turn a blind eye to these issues and focus on their main driver which is corporate earnings.
What does all of this boil down to in terms of a return forecast?
Once again we have to caution that our full year return forecast incorporates a chunk of return that simply represents a recovery from the end of the year’s, overly pessimistic levels. Given the opening year levels we see a 10% price gain and a 2% dividend yield for a 12% total return. But again 3-5% of that is the recovery from low levels and that, plus a little more has already happened with the S&P 500 up 6.5% so far in January. So a mid-single digit price return from today’s levels and like Canada, the recent move likely needs to see some pull back.
Overall, we have a slight overweight to U.S. equities. Part of this recommendation is grounded in risk mitigation. In a ‘risk-off’ market scenario, U.S. equities typically outperform other equity markets. An added bonus for Canadian investors, is the fact that this defensive quality in a ‘risk-off’ scenario is enhanced as the Canadian dollar would be expected to decline vis-à-vis the American dollar in those conditions, resulting in an attractive proposition.
On to fixed income - an important part of most investors portfolio. Fixed income investors have faced a challenge with rising rates affecting returns. What’s your view for fixed income investors in 2019?
We have been warning of very low-to-negative fixed income returns for the past two years as interest rates were rising from ultra-low levels. Finally, in 2018, some income returned to fixed income. Government bond yields have moved up from their 2016 lows, credit spreads widened somewhat. As a result, income flowing through to investors is now better than what it has been for the past several years. We expect further increases in bond yields from current levels, which will erode some of the income component, but our forecasted yield increases will leave a small positive total return. We see returns in the 1% range for Canadian fixed income. Furthermore, the risk mitigation qualities of fixed income are ever more powerful, and never more necessary. Fixed income is poised to offer many benefits to a well-diversified portfolio in what we expect will be a volatile year.
There has been talk of the dreaded inverted yield curve being a consistent predictor of oncoming recessions. How likely is it to occur in 2019 considering rates are so flat?
The yield curve inverts at the hands of Central banks, so we need to have a view on what we expect from central banks in order to discuss the yield curve. Our base case calls for the Bank of Canada to raise the overnight rate to 2.25% (currently at 1.75%) at which point they will be done. We expect at least one hike in 2019, but not until temperatures are much warmer than today. A further 0.25% could come in late 2019 or early 2020.
The yield curve measuring the gap between 10 year and 2-year bonds is running less than 20 basis points in both the US and Canada, but it has arrested the precipitous pace of decline that marked much of 2018 and has been running along sideways for 2-months despite extremely large moves in overall bond yields. The bottom line is I don’t see the yield curve inverting until later this year and it would need to be on the back of increased expectations for more than 1-more rate hike in the US and Canada that exist now. This sideways move for the yield curve is not unusual, it can last several quarters, sometimes a couple of years. Then once inversion happens there is a lag between that signal and an actual recession that has a wide degree of variability in terms of timing. So, the bottom line is an inverted yield curve is something we are watching closely, it hasn’t happened yet and may not be imminent.
Brent, if our listeners want to learn more about the topics and views you spoke to today as well as some thoughts on the international markets, where can they find that?
On GLC’s website www.glc-amgroup.com, or follow us on LinkedIN under GLC Asset Management Group Ltd. Or on twitter at #GLCASSET.
Thank you Brent, I look forward to chatting with you throughout the year as we follow the markets and dive into the topics and themes that unfold in 2019.
You are welcome Chris, good to chat with you.
Chris: This podcast was recorded from our London, Ontario office on January 23, 2019.
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