We are joined by GLC's Chief Investment Strategist, Brent Joyce, to discuss our 2018 Capital Market Outlook.
Hello, I’m Christine Wellenreiter, Vice-President of Marketing and Communications at GLC Asset Management Group. On today’s podcast we will be taking to Brent Joyce, GLC’s Chief Investment Strategist.
Today, we’re speaking with Brent about what’s in store for investors in 2018. We’ll be covering some of the highlights from GLC’s recent report – GLC’s 2018 Capital Market Outlook – Striking a balance.
Hello Brent, Welcome back to our GLC podcast! Brent, we’re back from holidays, into the second week of January of 2018, and, well, so far so good for markets.
Christine: Do you see this as a continuation of some of the themes that drove strong market results in 2017?
Brent: To some extent, yes. With a couple of caveats. What we witnessed last year was a powerful combination of synchronized global economic growth. We haven’t seen growth synchronized across the major economies like this since before the 2008 financial crisis. When that growth is coupled with modest inflation and generally accommodative monetary policy the result is robust corporate earnings growth. That mixture is very positive for equity markets.
There were two major themes playing out in 2017, on one side was a theme that came to be known as the ‘reflation trade’. This is the notion that with the world economy in synchronized economic expansion; that will bring inflation and as a result central banks will normalize monetary policy through interest rate increases or reduced quantitative easing, a.k.a money printing. You add on top of this, expectations for a growth and inflation boost from expansionary fiscal policy in the U.S., namely tax cuts. When this theme ruled, bond yields rose and pro-growth economically sensitive cyclical equity sectors financials, energy, materials and industrials benefitted.
On the other side was what we call the “secular” growth trade. This view holds that economic growth would fade, inflation would remain elusive, and stimulative U.S. fiscal policies wouldn’t see the light of day. When this view was in vogue, bond yields fell, and investors looked for companies whose growth isn’t so dependent on the business cycle; so called, secular growth stories. These are companies with growth prospects unique to the company’s business model. Many of these stocks are found in the information technology sector. Notably, the two
themes don’t have to be mutually exclusive.
Heading into 2018, I feel that the global economy has enough momentum and that inflation and financial conditions will remain accommodative long enough that the ‘reflation’ trade will continue and I think it will take the leadership. The secular growth trade can remain intact, but given valuations, I find it difficult to justify it outperforming. Indeed valuations pretty much everywhere are a concern. Across the globe there is nothing cheap, certainly not in equities but credit spreads are narrow especially in high yield and I see government bond yields heading higher – dampening the return prospects for bonds.
Christine: Given that, is it still your view that equities should be favoured over fixed income investments?
Brent: Yes. But within that outlook, we acknowledge the attractiveness of equities over bonds on a risk-adjusted basis has narrowed. I believe the world economy and financial markets are progressing through the later stage of the business cycle. How long the currently favourable conditions can last is the key question. There are few easy answers, and timing is always tricky. Today, investor and consumer optimism is high. Yet as a natural progression, the further along the economy rolls the harder it becomes for conditions to improve. Eventually a normal slowing of the economy is healthy and to be expected. I believe we are closer to the end of the expansion cycle than the beginning and we see the relative outcomes for asset classes subject to greater uncertainty.
Christine: Has that view changed?
Brent: My view hasn’t radically changed, and I could be accused of being cautious too early, however we are still recommending an equity overweight. We see supportive conditions lasting long enough that we believe it is too soon to move to a neutral stance, but caution is warranted, and we need to be nimble in our investment positioning. It is precisely at times like these that investors need to strike a balance. I don’t believe now is the time to become aggressive, rather investors should remain disciplined, striking a balanced approach as they look toward, and prepare for, a time when the prevailing narrative is less rosy. Rebalancing out of equities that are scaling to new heights, and allocating into fixed income assets that appear less attractive is difficult.
Christine: So a tempered risk-on position?
Brent: Yes. We must recognize that equities are not cheap, but the fundamentals remain solid enough that we see equities offering a modest degree of further upside potential. We also recognize that the outlook for fixed income remains challenging. Yet fixed income remains a valuable risk mitigating tool. When the sentiment shifts to one of risk-off, fixed income positions will be very valuable to the overall portfolio as a risk mitigating tool. I believe that value, as a risk mitigator, increases the longer we go under the current conditions and the closer we get to the end of this business cycle. At this stage of the cycle, we believe it is prudent to reduce equity overweight positions and increase fixed income to less underweight positions.
Christine: Okay, let’s get into some specifics, because there are some unique considerations and risks within given regions. Industries, and asset classes. …not to mention some hot topics like bitcoin and cryptocurrencies – we’ll make sure we touch on that today too.
Let’s start in our own
backyard – with Canadian equities. 2017 results were positive, but still lagged
other global markets. How do you see Canadian equities faring in 2018?
Brent: We hold a positive view toward Canadian equities calling for a total return in the neighborhood of 7%, with a good chunk of that coming from the solid dividend yield estimate of 3%.
A continuation of synchronized global growth is generally supportive of commodity markets and Canadian equities as a whole, as would be a stable Canadian dollar in the U.S.78¢ - 82¢ range. This is especially true when anchored by a solid backdrop of U.S. growth that includes an uptick in business capital expenditures. We would welcome higher commodity prices, but a sideways move is sufficient to support our
earnings growth forecast.
Canada’s equity market valuations are not cheap, but Canadian Price /Earnings are closer to their 10-year average than their U.S. counterparts. Our forecast does account for a further decline of the trailing price-to-earnings multiple into the high teens.
Christine: Okay – so on the topic of oil. We’re up above $60 now. What are the drivers there and do you see anything
tempering the rise in oil prices in 2018?
Brent: On the plus side:
• estimates of global oil demand have been rising, consistent with the acceleration of global growth;
• global inventories of crude oil are shrinking;
• U.S. oil production is back to previous peak levels, it can rise further, but the pace of increase is slowing; and
• OPEC has extended its production quotas
On the negative side:
• Oil producers will respond to the higher prices with hedging and more supply;
• the OPEC production deal could be wound down quickly; and
• for Canada there is a general lack of interest in Canadian energy on the part of foreign investors. And our companies face pipeline bottlenecks getting their product to market, resulting in a significantly lower price than normal for our benchmark Western Canada Select crude oil. The difference between WTI and WCS averages $U.S.16, it is currently $U.S.25
All in all, we forecast an average price for WTI of U.S.$53/bbl ($U.S.50 - $U.S.55 range bound) over the course of 2018. Clearly we are starting off higher than that, and the negatives I have outlined would be expected to come down the road as most are spurred by the higher prices. If OPEC and their production cap partners think they can pump more and still get above $55, they will be motivated to do that, if not formally, then by cheating which they are prone to do. I think that would cut a few bucks off oil prices. The good news is, my forecasts for energy company earnings, are not predicated on WTI holding above $60, so if that happens, my view on Canada improves.
Christine: So, let me get this straight. What you’re saying is that, while higher commodity prices would be nice and likely boost Canada’s resource sectors, your forecast doesn’t actually need commodity prices to do anything heroic, rather just to hold steady, and that would be enough to still see solid company earnings with hopefully higher stock values to follow?
Brent: Yes. We are beginning to see the extent to which the Canadian energy patch has adapted to the new environment of
today’s oil prices. 2017 brought modest improvement in oil prices, offset somewhat by an appreciation in the Canadian dollar. Never-the-less, the Canadian energy sector has brought its return on equity (ROE) back above 7%. After being negative for two-years and plummeting as low as -10%. ROE is now closing in on levels only previously achieved with much higher oil prices. The narrative on the part of energy investors has moved too. In the heady, high price days, investors cried “Drill, baby, drill!” rewarding growth at any cost. Today (and for now, as
investors can be fickle) investors are demanding more discipline; pushing companies to show competitive returns and capital efficient growth.
The energy sector provides a 3.5% dividend yield and equity prices have not chased the latest move higher for the commodity. The bottom line: Canadian energy companies are doing more from less, sector level earnings have rebounded and need only flat line at their latest quarterly level for all of 2018 in order to reach the modest 16% y/y earnings growth that underpins our forecast.
Christine: What about Canadian banks – or maybe the financial sector in general. New mortgage rules hit in
January, and changes to accounting laws – I understand both those things to be
headwinds for financial services companies.
Brent: Yes, Canadian banks are facing a changing landscape that may dampen earnings growth, our forecast takes that into account. Higher interest rates and a halt to the flattening of the yield curve should allow Canadian banks and insurance companies to reach their modest
6% earnings growth target. This growth estimate is less than half of 2017’s growth rate, reflecting the changed landscape and our view that the Canadian economy is likely to see growth that is slower in 2018 after the well-above-potential growth of 2017.
The Canadian banks and insurance companies are diversified businesses with broad reach outside of Canada. We expect Canadian bank earnings growth to slow, but still remain solid.
Given the healthy estimated dividend yield of 3.75% on a total return basis, financials only need to make small price gains to deliver their expected contribution to our market return forecast.
Christine: Let’s talk about the US. 2017 US stock markets were incredibly strong, but valuations are way up there
now, aren’t they?
Brent: Yes, the U.S. market delivered returns in-line with the very solid earnings growth we saw in 2017. We had expected higher interest rates would weigh on valuations. Instead, valuations remained elevated, I believe this is largely due to the expectation that tax reform would come and earnings will be boosted because of it. So tax reform is now here and we are seeing some follow on gains in the U.S. because of that,
but I remain tepid in my outlook for U.S. equities.
There are many positives for the U.S. market, but we have to ask ourselves how much of this good news is already baked into prices, not to mention how long the good news can continue to surpass expectations. We have long been talking about positive catalysts for U.S. stocks, including better than expected U.S. and global growth; a weaker-for-longer U.S. dollar; and leaner U.S. corporations better able to turn a dollar of sales into net earnings through higher return on equity. But expectations have now moved up to reflect the fact that many of these catalysts
have been coming to fruition. Today, the S&P 500 faces elevated valuations and elevated investor sentiment. Sentiment is finicky, you don’t want too much of a good thing, strong sentiment can be a positive for momentum in the short run, but often coincides with some sort of exhaustion in the medium term.
Fundamentally, we see moderating return on equity and earnings growth. Even if we don’t have a recession, which I think remains at least a year away, ultimately, improving growth conditions sow the seeds of their own undoing. Stronger growth leads to less economic slack that should lead to wage and price inflation, that in-turn will justify tighter monetary policy and higher borrowing costs. In addition, the stronger growth will eventually lead to some combination of over-stuffed inventories and supply-side bottlenecks for labour and other inputs to production, a situation where even if companies want to continue to expand, they may find it difficult.
When you add all these up, higher interest costs, higher wages, higher input prices, these all chip away at net earnings, even if top-line growth remains solid. This is not the scenario that we face today and markets are certainly not priced for it today. But it is a scenario that I believe will eventually come and we need to start to think about it well in advance as any or all of those conditions would be expected to lead to lower corporate earnings growth and/or lower equity valuations. This doesn’t mean that economic conditions will necessarily turn unfavourable, but capital markets are concerned about outcomes versus expectations, as well as the rate of change at the margin.
I find it difficult to see outcomes continuing to top expectations. This combination leaves us with a muted outlook for U.S. equities. What is most concerning is that we hear very little about these possible (I’d say eventual) risks at the moment. This could spell quick trouble when investors maybe forgetting what equity volatility feels like. Without a 3% correction in over a year, investors might get spooked at the slightest sign of trouble and then the moves could be quick. That is paramount to my view on fixed income. It is not that I think investors are going to make great gains in bonds anytime soon, but they remain the best defense and keeping or adding to those positions today is the only way to
prepare for a rainy day that will I believe will eventually come. Even if today it seems like it may never rain again.
Christine: Brent, let’s breakdown the international markets. Starting with the UK. The Brexit reality will continue
to sink in as we approach the deadline in early 2019.
Brent: Yes, the consequences of Brexit remain to be fully understood. In fact it is such a big change that I’m not sure we will fully understand the impact until well after the fact. It is immensely complex thing to try and model outcomes. So the uncertainty that stems from that has us leery of UK equities. But fundamentally, UK equities face muted earnings growth and high valuations just like everybody else, so there isn’t much attraction from a price appreciation standpoint. Having said that, it is noteworthy that UK stocks do come with a robust dividend yield as the UK FTSE 100 index boasts a dividend yield north of 4%.
Christine: And Europe? The economy has surprised to the upside there, but there always seems to be a lot of
political uncertainty that risks derailing the markets.
Brent: European equities are our favourite risk-adjusted choice of the developed international markets. European real GDP growth has accelerated and forward looking measures of economic strength are some of the best you can point to. For the stocks, we see a similar earnings growth outlook to the U.S., but with relatively cheaper valuations. Furthermore, the potential pinch-points we discussed when we talked about U.S. equities appear to be farther off in Europe. The European Central Bank remains more accommodative and the region has a longer runway for growth and inflation before reaching full potential. As such, European stocks will benefit from easier financial conditions for longer. If we see less strength for the euro currency in 2018 that boosts eurozone corporate earnings and if the euro does strengthen, then foreign investors such as ourselves benefit from that currency translation.
Christine: In Asia you’ve got developed markets like Japan, and many emerging markets. Japan was a surprise performer last year and emerging markets the top performer. What are your thoughts there?
Brent: I was surprised by the strong return in Japanese equities last year, but that is because everyone was surprised by the up-tick in the Japanese economy. What typically happens is even though Japanese equities are levered to the global growth story, and they had yet to react to that, in the past, a boost in Japanese stocks for foreign investors has largely been eroded by a weakening yen. Not so last year, the
domestic strength kept the yen in check, so investors were able to hold on to the equity gains. To the positive, Japanese companies are benefitting from historically high rates of return on equity and offer some of the highest earnings growth estimates for 2018 and 2019 of the developed markets. However, Japanese and Chinese economic growth rates are expected to moderate in 2018. Likewise, Japanese valuations are high and traditionally are higher than many other markets owing to the extremely low yield environment that has persisted for decades. We don’t see P/E multiples expanding. Factor in a paltry 1.8% dividend yield and we hold a neutral view on Japanese equities.
We hold a positive view on emerging markets. They come with high earnings growth estimates and the least expensive valuations. I think they offer the greatest upside potential, but you always have to risk-adjust that, they would be the hardest hit in any kind of risk-off scenario. So they come with the highest potential risks. In consideration of that we are recommending a neutral stance.
Emerging markets are highly levered to the global synchronized growth environment that we see continuing. Additionally, the complexion of emerging markets has shifted. While never a homogenous group, emerging markets have diversified from their traditional heavy cyclical sector exposure in financials, materials and energy to a more broadly diversified basket. Tech companies in Asia are now a dominant factor in
emerging market equity benchmarks. We now have the Asian BAT’s these are the internet giants of Baidu, Alibaba and Tencent and are Asia’s version of the U.S.’ ‘FAANG’ (Facebook, Apple, Amazon, Netflix and Google). Today, information technology is the largest sector in the MSCI Emerging Markets Index at 28%. Even though emerging markets offer the highest earnings growth estimates of any market we cover like everywhere else, emerging markets are not cheap, but they remain some of the least expensive markets especially relative to developed markets. We do need to stress that emerging markets are inherently volatile; the MSCI Emerging Markets Index fell 35% into early 2016, and has since rebounded by more than 60%, but that kind of strong return is not all that unusual, unfortunately neither are the big declines.
Christine: On to fixed income - an important part of most investors’ portfolio. Fixed income investors have faced a number of years in a row of people like you and me telling them to temper their expectations. It’s a conundrum to suggest anything different with yields this low, but last year things turned out better than expected. What’s your view for fixed income investors in 2018?
Brent: In fairness, while the worst outcomes have not been realized over the past three years and we are thankful for that, as fixed income is
still about 50% of our assets here at GLC. The returns in Canadian fixed income have been modest at 3.5% in 2015, 1.7% in 2016 and 2.5% last year.
For 2018 I continue to drive my forecast through fundamentals and go where the mathematics leads me. The beauty in fixed income is that one can mathematically model return scenarios with a high degree of accuracy, you just have to know which scenario will come true! Figure out if yields will go up down or sideways and whether credit spreads will widen or narrow and you have it. Tongue in cheek, but I am amazed at how many people think fixed income is easy. My outlook for fixed income returns remains weak. However, as I mentioned earlier, the value of fixed income as a risk mitigation tool increases the longer we go in the cycle and closer we get to an eventual pull back in equity markets. Our base case scenario calls for higher bond yields and bond market returns of 1% to 2%.
The probability of divergence around this forecast is high. A risk-on, better growth and higher inflation scenario could weigh on Canadian bond returns, seeing them down -1% to -2% for the year. On the other hand, a risk-off environment with disappointing growth or a recession ‘scare’, could lead to 3% to 4% bond returns. It is this kind of protection I think will be necessary at some point.
Christine: …”Looking at the cover of the wall street Journal yesterday morning, the topic of rising treasury yields is front page news… Does the
recent jump in rising yields raise concerns for you? How do you see that affecting things?
Brent: Both the U.S. and Canadian bond markets have moved considerably since we wrote our outlook in mid-December, and they are moving in the direction of our forecast, but for now at least it is more rapidly than we expected. The moves are noteworthy and I am keeping an eye on them, but for now I am not alarmed. It would take real changes to central bank policy to make me alter my forecast and we haven’t had any of those yet.
In fact, short-term Government of Canada bond yields reflect expectations for two to three rate hikes from the Bank of Canada. We are siding with two hikes as inflation remains muted. Should the two anticipated rate increases become reality, short-term bond yields will need to move higher from today’s levels, but we don’t see a repeat of the doubling of 2-year yields that we saw in 2017, at 1.75% today we would be surprised to see them hold much above 2%.
For longer-term yields, we still believe that the effects of major global central bank monetary stimulus will weigh. North American bond yields remain chronically below their theoretical fundamental levels suggested by current inflation rates and real GDP growth. The weight of the European Central Bank and Bank of Japan’s quantitative easing operations is set to lighten up, but only marginally. In fact to open the year,
this has been a key focus of markets and part of the reason why yields are rising. Although, I believe yields are also rising for the right reasons,
namely to better reflect where growth and inflation sit. None-the-less, the question is now being asked, whether the ECB and Bank of Japan will in fact stick to their guidance or could there be some surprises lurking there.
For sure, I would be raising my yield predictions and lowering my fixed income return expectations if the extent of this central bank intervention was set to change – for now both central banks haven’t made any official pronouncements. However, even if this were to happen, I would be reluctant to change my longer-term view that fixed income’s role as a risk mitigation tool is its most important quality at the moment. In our estimation, 10-year Government of Canada bond yields are now about 2/3rds of the way through our expected adjustment. We see the yield on a 10-year Government of Canada bond at 2.5% to end 2018. The net result of our 2 and 10- year bond yield forecasts sees the yield curve steepening, something we are already witnessing so far this year.
In terms of how the recent yield moves are impacting things, bonds are getting hit with the Canadian bond market off 2/3rds of a percent so far in 2018. For equities, the reflation trade is getting a boost, financials, energy and materials are performing well, up 3 to 6% in the U.S. also up in Canada, but not by as much. The interest sensitive telecoms, utilities, consumer staples and real estate sectors are down as much as 3 to 4 % on the S&P 500, here Canada is not down as much. Info Tech is marching to its own secular drum, up 4% in the U.S.
Christine: What about along the credit risk spectrum? So, government bonds versus investment grade corporate bonds or even high yield bonds?
Brent: With last year’s higher government bond yields being offset by gains made from yield spread compression in provincial, municipal and corporate bonds, the net result leaves us a bit of a double-edged sword. While some of the adjustment to higher sovereign bond yields is behind us, the ability for spreads to narrow further driving gains from credit is less attractive, given our starting point now. We see investment grade corporate bonds as most attractive given their mix of yield pick-up and modest safety. Spreads have narrowed, and given the unprecedented state of affairs in fixed income globally, certain sectors could see further appreciation on this basis, but the main attraction is the higher running yield that will help to mitigate losses as yields rise.
For high yield bonds, given the very narrow spread and their lack of risk-mitigation characteristics as an asset class, we see the risk/reward trade-off in high yield becoming unattractive. Provincial and investment grade corporate bonds, to varying degrees, deliver the risk mitigation characteristics that we see as most valuable from fixed income today. High yield bonds in a risk-off scenario should not be relied upon for risk mitigation qualities. As such, the attraction of high yield lies in its higher yield and greater potential for capital appreciation as spreads decline. At the asset class level, neither of these metrics (yield offered or capital appreciation potential) appears very attractive to us at present. Having said that, we recognize that high yield bond issuers are not a homogeneous group and our active fixed income managers continue to uncover selected unique opportunities through individual security selection where the risk/return trade-offs are appealing.
Christine: Brent, for the last few minutes of our podcast, I want to touch on something that’s been all over the news. Bitcoin. What do you make of the incredible rise of Bitcoin?
Brent: In a nutshell I think Bitcoin and other cryptocurrencies are a symptom of the dislocation that exists in certain capital markets. Unprecedented liquidity globally is resulting in excessively cheap money and this is where bubbles will look for places to erupt. I also think the strict capital controls we see in certain countries like China are fueling the phenomenon as investors unable to move their money freely around the world seek alternatives. I don’t think it is a coincidence that the largest bitcoin activity is in Asia and steep declines in the cryptocurrencies have come on news of crackdowns by authorities in Asia. Unfortunately, once something like this takes hold financial mania can take over and bitcoin certainly has many of the hallmarks of previous financial manias. Historically, financial innovations are often accompanied in their initial stages by bubbles, and we acknowledge that the inevitable bust doesn't necessarily kill the innovation. Many intelligent people agree that the block-chain technology that underpins crypto-currencies can, and is likely to, be useful for a wide variety of applications.
Christine: What are some of the risks in considering Cryptocurrencies as part of an investment portfolio?
Brent: The risks are many, while the only risk I see by participating is to avoid FOMO – the fear of missing out, those who choose to stay away can take solace in JOMO – the joy of missing out. To me the risks of getting involved at the present are numerous. As a currency it lacks
governance, transparency, stability, scarcity, strong backing, and it is not widely accepted for payment. As an asset, it’s unproven and unregulated, suffers from extreme volatility and is difficult to make any reasonable judgement of valuation.
Christine: Brent, any particular point you want to end it on?
Brent: Investors should be happy, these are the glory days, stocks are doing well, the economy is doing well, inflation is low, interest rates are
low. Enjoy it! But don’t get complacent. Understand that things will not always be this good. Don’t make your future plans by extrapolating the current environment forward indefinitely. Stay disciplined, stick to your plan, save regularly, set realistic return assumptions. Stocks deliver high single digits over the long-term with plenty of volatility – not high teens with no volatility. There will always be uncertainty, control what you can - your emotions, your actions and your reactions.
Christine: Brent, if our listeners want to learn more about the topics and views you spoke to today, or check out the charts and data for themselves, where can they find that?
Brent: On GLC’s website, or follow us on LinkedIN.
Thank you, and I
look forward to chatting with you throughout the year as we follow the markets
and dive into the topics and themes that are moving the markets in 2018.
Copyright 2017 GLC. You may not reproduce, distribute, or otherwise use any of this article without the prior written consent of GLC Asset Management Group Ltd. (GLC).
This commentary represents GLC’s views at the date of publication, which are subject to change without notice. Furthermore, there can be no assurance that any trends described in this material will continue or that forecasts will occur; economic and market conditions change frequently. This commentary is intended as a general source of information and is not intended to be a solicitation to buy or sell specific investments, nor tax or legal advice. Before making any investment decision, prospective investors should carefully review the relevant offering documents and seek input from their advisor.