Portfolio Compass: 2019 Outlook

Transcription

1 Portfolio Compass:

2 Contents Investment Philosophy & Summary... 3 Year in Review Caught in a Trap... 5 Canadian Equity Outlook... 6 U.S. Equity Outlook... 7 European Market Equity Outlook... 9 Emerging Markets Equity Outlook Fixed Income Outlook Disclaimers

3 Investment Philosophy & Summary Suspicious Minds was Elvis Presley s last number one-hit. The song, which was performed during his 68 Comeback Special, describes a dysfunctional relationship, feelings of mistrust and anxiety. It is an apropos subtitle for our. Toward the end of 2018, both policymakers and politicians exacerbated the market volatility that is commonly associated with maturing business cycles. While geopolitical risk is expected to dissipate during 1H19, monetary policy changes and the diminishing benefits of debt-financed fiscal stimulus are expected to increase recession risk toward the end of the year. Accordingly, we have reduced our equity overweight to market weight, extended the duration in our fixed income portfolios, lowered our allocation to preferred shares and maintained our position in alternative investments. Our Investment Philosophy Importantly, our opinions are principled, unbiased and underpinned by goals-based investing, the benefits of diversification and evaluating returns in the context of risk. Summary Our Asset Allocation Process Our asset allocation process provides a framework for tactically allocating capital among asset classes, geographies and securities that offer the highest riskadjusted returns relative to our long-term expectations. Our process comprises qualitative and quantitative analysis, which incorporates the use of economic, credit-related and technical indicators to maximize risk-adjusted returns. Key Themes and Long-Term Total Return Expectations We have made modest revisions to our long-term total return expectations, which are influenced by secular trends such as aging populations, mounting global indebtedness, and disruptive innovation. Lower expected returns reflect an increased likelihood hood of recession during the forecast time horizon, rising equity risk premiums and corporate credit spreads. Strategic and Tactical Asset Allocation Portfolios We have updated our tactical asset class recommendations by reducing our equity exposure to market weight and increased our fixed income exposure, though remain underweight relative to our strategic asset allocation. In equities, we maintain our overweight position to the United States and underweight position internationally. We lowered our Canadian exposure to market weight. We have increased the weight and extended the duration of our fixed income portfolios while decreasing our position in preferred shares. Benefits of Diversification Goals-based investing embodies a holistic and personalized approach to wealth management aimed at achieving an objective or sustaining a lifestyle. Shifting focus from the pursuit of absolute returns to managing risk through diversification can significantly reduce volatility and the likelihood of loss. A diversified, balanced growth portfolio, 3

4 consistent with our strategic asset allocation, outperformed the S&P/TSX by over 600 basis points during

5 Year in Review Caught in a Trap In a year marked by heightened financial market turbulence, diversification by asset class and geography substantially reduced portfolio volatility and improved risk-adjusted returns in Over the course of the year, the Canadian dollar depreciated 7.8% versus the U.S. dollar and 5.6% relative to a trade-weighted average of foreign currencies. As a result, unhedged foreign currency exposure increased portfolio returns during Despite periods of instability, many fixed income and alternative investments delivered positive returns, helping to offset equity market volatility (Exhibit 1). Exhibit 1: Returns by calendar year (CAD) U.S. 24.2% ASSET ALLOCATION 10.8% CANADA 10.6% SOVEREIGN 9.4% INVST GRADE 8.7% HEDGE FUNDS 8.7% GOLD 7.8% EM 7.1% HYBRID PREFS 6.8% INTL 5% HIGH YIELD 3.3% U.S. 20.7% INTL 16% HEDGE FUNDS 14.7% GOLD 6.7% ASSET ALLOCATION 5% SOVEREIGN 2% EM 1.7% INVST GRADE 0.4% HIGH YIELD -2% CANADA -8.3% HYBRID PREFS -14.9% CANADA 21.1% HIGH YIELD 15.7% ASSET ALLOCATION 11.8% U.S. 8.9% EM 8.7% HYBRID PREFS 7% INVST GRADE 5.8% GOLD 5% SOVEREIGN 3.6% INTL 0.5% HEDGE FUNDS -0.3%, EM 28.3% INTL 16.2% HYBRID PREFS 13.6% U.S. 13.5% CANADA 9.1% ASSET ALLOCATION 9% HIGH YIELD 7.5% GOLD 6.2% INVST GRADE 5.3% SOVEREIGN 1.8% HEDGE FUNDS -1.3% 2018 GOLD 6.8% U.S. 4% SOVEREIGN 2% HEDGE FUNDS 1.4% INVST GRADE -1.6% ASSET ALLOCATION -2.2% HIGH YIELD -2.8% INTL -6.1% EM -7% HYBRID PREFS -7.9% CANADA -8.9% inflation and growth prospects. In our view, near-term geopolitical concerns dissipate and equity valuations, which have been impaired by sentiment, improve. As evidence in exhibit 2, the price-to-earnings multiple of the S&P 500 Index contracted by %25 in Exhibit 2: S&P500 Index multiples have contracted PRICE Δ EPS Δ 1 MULTIPLE Δ % -1.8% 5.3% % -35.8% -2.6% % 9.2% 14.3% % 38.5% -25.7% % 14.7% -14.7% % 5.8% 7.6% % 7.2% 22.4% % 5.5% 5.9% % -2.9% 2.2% % 0.1% 9.4% % 12.9% 6.5% % 19.1% -25.3% The latter half of 2019 should see inflation and growth expectations pick up, leading to a resumption of monetary policy normalization in many developed market economics, such as Canada and the U.S. As such, credit conditions are likely to tighten and companies should experience rising debt servicing costs. Corporate profit growth and margins will likely come under pressure as rising interest rates and cost-push inflation drive up input costs and constrain consumers as producers passing along higher costs (Exhibit 3). Exhibit 3: Global PMIs vs. S&P500 Index YoY returns 60 50% 1 Fixed Income returns hedged to CAD 50 0% Prudent diversification will be imperative as we expect volatility to remain high amid slowing global growth, central banks removing stimulus and geopolitical tensions. At the outset, we expect central banks to remain data dependent and reluctant to increase policy rates given benign 40-50% GLOBAL PMI INDEX (LHS) S&P500 INDEX Y/Y (RHS) 5

6 EQUITY RISK PREMIUMIUM VS 20-YEAR AVERAGE Equity valuations in many markets are ostensibly cheaper than the U.S. Importantly, many emerging and developed market indices are more heavily weighted toward cyclical companies with relatively low returns on equity. Normalizing for differences in index composition (sector weights) and profitability suggest that a more attractive entry point should materialize in 2019 (Exhibit 4 & 5). We continue to favour developed markets to their emerging market counterparts despite the relatively cheaper valuations in international and emerging markets. In our estimation, current riskadjusted returns are not sufficiently compelling to warrant a significant allocation. Our preferred vehicle for emerging markets exposure is to through well-capitalized, developed market domiciled multi-national corporations. We expect a more attractive entry point to materialize in 2019 and will look for timely entry to highly quality issuers. Exhibit 4: Equity valuations remain fair Canadian Equity Outlook Following better-than-anticipated growth over the past two years, the Canadian economy (as measured by real GDP) is likely to expand at a slower pace (around 2%) in Aside from global macro headwinds, Canada-specific issues (lower energy prices and high levels of consumer debt combined with higher interest rates and regulatory changes on the housing market) are also likely to exert downward pressure on domestic economic growth. Exhibit 6 outlines the rising trend of household debt in North America. On a positive note labour market appears healthy, inflation is contained, and risks of an imminent recession are low. Exhibit 6: Rising household debt in Canada and the U.S. 170% 145% EXPENSIVE CHEAP 120% 95% 70% Exhibit 5: Relative valuations vs. the S&P % 9% 10% 0% -10% -20% -30% -9% -26% -40% -29% P/E PREMIUM (DISCOUNT) ROIC % DIFFERENCE We expect Canadian equity market volatility to remain elevated as U.S. economic momentum fades and concerns about global trade, Canadian household indebtedness and energy prices. Despite these uncertainties, consensus estimates project 9.5% S&P/TSX Composite earnings-pershare growth in Commodity prices will continue to be a big determinant of S&P/TSX Composite performance and earnings growth, as well as the performance of the Canadian dollar, which we expect to remain range bound in the short-term (Exhibit 7). While a lot of bad news has already been priced into Canadian risk assets, we 6

7 . believe cautious stance is warranted given the maturity of the business cycle. We continue to emphasize high quality and selectivity in our guided portfolios by focusing on businesses with sustainable competitive advantages that can generate growth across a variety of market conditions. As such, we have minimal exposure to commodity price risk, maintain a tilt to high quality issuers, and focus on companies operating in oligopolistic markets. Exhibit 7: CADUSD exchange rate forecast CADUSD (2-YEAR AVERAGE) FORECAST CADUSD (2-YEAR AVERAGE) U.S. Equity Outlook Equity markets in the U.S. ended 2018 in a bear market, fall more than 20% from their recent peak, amid investor concerns regarding global growth, central bank policy normalization and the outcome of the China-U.S. trade rift. The yield curve briefly inverted in early December and high yield spreads have widened out considerably (Exhibit 8). Exhibit 8: Current market dynamics The U.S. economy will continue to expand in 2019, albeit at a slower pace. On the heels of a strong showing in 2018, U.S. economic momentum is likely to wane as financial conditions have tightened, global trade tensions persist, and the benefit of fiscal stimulus fades. However, these factors, even in combination, do not indicate the end of economic or earnings growth (the key driver of stock returns). While we expect slower growth and more muted equity market returns, we do not foresee a recession occurring in Our longterm forecasts currently suggested a more moderate pace of growth than we experienced in the previous ten years (Exhibit 9). The most material risks to our outlook are a monetary policy mistake by the U.S. Federal Reserve, given the twopronged approach of rate hikes and balance sheet reduction, and escalation of U.S.-China trade dispute. We expect mid-single digit U.S. corporate earnings to continue on an upward trajectory. We also continue to selectively focus on companies that generate substantial free cash flow and have sustainable competitive advantages, clean balance sheets and, ideally, exposure to secular growth themes. Exhibit 9: Long-term return expectations FORECAST HISTORICAL CANADA 5.2% 7.9% U.S. 5.5% 13.1% INTL 5.7% 6.8% FIXED INCOME FORECAST HISTORICAL SOVEREIGN 2.7% 3.8% INV. GRADE 3.4% 5.4% HIGH YIELD 6.9% 11.9% BEAR MARKET YES PRECEEDS OR COINCIDE WITH RECESSION INVERTED YIELD CURVE NO INVERTS ~15 MO'S PRIOR TO RECESSION BREADTH 31% LOWEST LEVEL SINCE 2016 EARNINGS & MARGINS = LIKELY PEAKED IN 2018 HIGH YIELD SPREADS +100BPS WIDEN BY >100BPS PRE-RECESSION RECESSION RISK MODEL >30% READINGS ABOVE 40% PREDICT RECESSION 7

8 Exhibit 10: Financial conditions have tightened in the U.S. 2.5% FED FUNDS RATE +1.75% SINCE % 30-YR FIXED MORTGAGE +0.75% SINCE % CREDIT CARD ASSESSED INTEREST +2.5% SINCE % 15.0% 1.5% 3.5% 14.0% 0.5% YR AUTO LOAN +1.20% SINCE % % NEW HOME SALES -12% (OCT 2018) EXISTING HOME SALES -7% (NOV 2018) Exhibit 11: ISM orders, corporate earnings and inflation expectations 80 SOFT LANDINGS 50 RECESSIONS ISM new orders are highly correlated with earnings, benign inflation keeps fed on pause during 1h19 50% % 4.0% 0% % 0.0% -50% % % ISM NEW ORDERS (ADVANCED 9MO) S&P500 EPS (Y/Y) UNIT LABOR COSTS (Y/Y) CORE CPI (Y/Y) 8

9 TOTAL DEBT TO GDP European Market Equity Outlook We expect growth to moderate next year, with European GDP growth approximating 1.6%. Since mid-2018, consensus GDP growth for Europe has been revised down from 1.9%, as geopolitical risks, slowing economic growth, and monetary tightening have become more concerning. We are currently forecasting global growth to slow from an average of 2.0% from to 1.7% from (Exhibit 12). Exhibit 12: Global GDP growth forecasts are slowing 6.1% 5.2% 4.7% 3.9% 3.5% 3.8% 3.7% 3.0% 3.2% global vehicle demand and the country s reliance on auto manufacturing and exports. As the second largest European economy, France is now in the spotlight as its debt levels could increase as French President, Emmanuel Macron, responded to populist protest by announcing a number of spending measures and tax cuts. This could push France s deficit-to-gdp to 3.4%, up from 2.8%, and above the EU limit of 3%. While concerning, given a potential credit rating downgrade from AA, the impact would likely be less severe given France s debt-to-gdp ratio of 99% vs. Italy's at 130%. Notwithstanding the concerns in Germany and France, debt levels have risen significantly in the last decade amid easy money conditions (Exhibit 13). Exhibit 13: Global debt levels continue to rise 1.8% 2.0% 1.7% 400% 350% 22% SIZE OF BUBBLE = CREDIT GROWTH ( ) E ADVANCED ECONOMIES EMERGING AND DEVELOPING ECONOMIES 300% 34% WORLD 250% 20% 74% 12% There is also increasing risk of a recession in Germany, Europe s largest economy. German industrial production data for the month of November declined -1.9% month-over-month, well below consensus estimate for growth of 0.3%. This economic data suggests that German GDP for the fourth quarter (due on January 15 th ), may have contracted. This would follow a -0.2% decline in German GDP in the third quarter, marking a technical recession. Given that ~45% of Germany s GDP is driven by exports, recent US-China trade tensions have materially impacted growth. Over the course of 2019, any progress towards a US- China trade resolution would be positive for Germany, but we remain cautious given declining 200% In addition to the political and economic risks listed above, we should also be mindful that the European Central Bank (ECB) has stopped its quantitative easing at the end of December, after having injected 2.5tn monetary stimulus in the Eurozone since March While the ECB has said that interest rates will remain unchanged through the summer of 2019, we believe that given the deteriorating economic outlook in Europe and globally, the ECB will likely keep rates at current levels (-0.40%) until at least mid

10 Emerging Markets Equity Outlook We are becoming slightly more constructive in our Emerging Market positioning. The two countries we believe that could provide compelling riskadjusted investment opportunities are China and India. China China remains top of mind given the recent trade tensions with the U.S. This has resulted in a material deceleration in China s economic growth during the second half of 2018, which triggered a ~US$4.3tn decline in equity market capitalization. The Shanghai Composite Index now trades at a forward PE ratio of only 9.4x, among one of the cheapest markets globally. Despite the escalation in trade tensions, China GDP is still expected to grow 6.6% in The consensus GDP growth forecast for 2019 is 6.2%. Early signs of positive trade negotiations could cause growth estimates to be revised upward. In the interim, China is likely to implement stimulus to reignite its domestic growth which may include infrastructure spend, tax cuts, and monetary easing through lower reserve requirement ratios and policy rate reductions. Fixed Income Outlook Our outlook for fixed income is based on the expectation of moderating global economic growth, which suggests that short-term rates are unlikely to rise materially from the current levels. As such, our view is that both the U.S. Federal Reserve (The Fed) and the Bank of Canada (BoC) are approaching their neutral rate targets. This is supported by our analysis which indicates that global economic growth may have already peaked for this cycle. While financial conditions have tightened, inflation remains benign and modest reacceleration of growth during second half of 2019 will likely cause central banks in Canada and the U.S. to increase policy rates once this year (Exhibit 14). Exhibit 14: Expectations for inflation and central bank policy rates U.S. FEDERAL FUNDS RATE E E BANK of CANADA OVERNIGHT RATE E India India is expected to retain its status as the fastest growing major economy in Fuelled by better demand conditions, policy reform, and credit growth, India s GDP is forecast to increase from 6.7% in 2018 to 7.3% in With upcoming elections in Apr-May 2019, Narendra Modi is seeking re-election for his second term, and a win would see continued reform plans and moderate infrastructure spend to keep India s fiscal balance in check. The Nifty 50 Index is currently trading at a forward PE ratio of 16.1x, which is somewhat expensive compared to its historical average of 14x; thus, security selection is key in India E 2019E 2020E US INFLATION 2.1% 2.0% 10Y TREASURY NOTE 3.2% 3.3% 10

11 Our outlook and the level of current rates indicate that short- to medium-term bonds offer an attractive source of income, lower expected volatility, as well as an opportunity to reinvest at more attractive yields in case of more-aggressivethan-expected central banks. At the same time, given our view that policy interest rates in Canada and the U.S. are close to neutral levels, longer-term fixed income presents an opportunity to extend duration and provide a portfolio buffer should yield curve inversion precede recession. Furthermore, we believe upward pressure on the longer-end of the curve is limited given structural constraints and will therefore be sentiment-driven in the near term. Despite some widening recently, credit spread levels in both investment grade and high yield spaces do not offer very attractive forward twoyear return prospects (Exhibit 15). continue raising policy rates negatively affected performance in the space. Retractable preferred shares, which comprises only ~1% of the $75bn market (Exhibit 16), faired best in 2018 while rate resets, the largest segment of the market, lagged its peers (Exhibit 17). Exhibit 16: Preferred share market size 1% 7% 19% US$75BN 73% Exhibit 15: 2-Year forward returns muted given current spreads RETRACTABLE PERPEUAL FLOATING RATE RATE RESET INVESTMENT GRADE SPREAD 2YR FORWARD RETURN <100 BPS 3.2% BPS 6.1% >300 BPS 15.3% HIGH YIELD SPREAD 2YR FORWARD RETURN <550 BPS 3.5% BPS 8.0% >750 BPS 15.3% Exhibit 17: 2018 preferred share returns by type 1.1% Credit fundamentals remain strong, but moderating growth may pose a risk to valuations. As such, we would be reluctant to take on significant credit risk. Instead, we would favour a high quality stance with preference for high quality investment grade, with minimal allocation to BBBrated segment and no exposure to high yield. We continue to reiterate prudent portfolio diversification and place considerable premium on highly liquid issues, which we believe will be increasingly important given the maturity of the credit cycle. Preferred share investors will be happy to have 2018 behind them as bouts of volatility and tempered expectations for the Bank of Canada to -1.5% -6.0% -7.2% RETRACT. PERP. FLOATER RATE RESET In 2019, we expect further headwinds for the asset class as financial market volatility remains elevated and the Bank of Canada navigates the later stages of its policy rate hiking cycle. We expect the liquidity constraints experienced in 2018 to persist 11

12 as ETF ownership continues to rise. For the year, we expected investment grade issuers to outperform their non-investment grade counterparts and view short-term rate resets and perpetuals as relatively attractive (Exhibit 18 & 19). Exhibit 18: Spread by maturity date PFD-2 (BBBs) PFD-3 (BBs) Exhibit 19: Spread by credit rating PFD-2 (BBBs) PFD-3 (BBs) 12

13 Disclaimers This material does not include or constitute an investment recommendation, and is not intended to take into account the particular investment objectives, financial conditions, or needs of individual clients. Before acting on this material, you should consider whether it is suitable for your particular circumstances and talk to your investment advisor. The author(s) of the report and the supervisors of the may own securities of the companies included herein. Scotia Capital Inc. is what is referred to as an integrated investment firm since we provide a broad range of corporate finance, investment banking, institutional trading and retail client services and products. As a result we recognize that there are inherent conflicts of interest in our business since we often represent both sides to a transaction, namely the buyer and the seller. While we have policies and procedures in place to manage these conflicts, we also disclose certain conflicts to you so that you are aware of them. Please note that we may have, from time to time, relationships with the companies that are discussed in this report. The prepared this report by analyzing information from various sources. Information obtained in the preparation of this report may have been obtained from the Equity Research and Fixed Income Research departments of the Global Banking and Markets division of Scotiabank. Information may be also obtained from the Foreign Exchange Research and Scotia Economics departments within Scotiabank. In addition to information obtained from members of the Scotiabank group, information may be obtained from the following third party sources: Standard & Poor s, Morningstar, Bloomberg, Credit Suisse AG, Macrobond and FactSet. The information and opinions contained in this report have been compiled or arrived at from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness. While the information provided is believed to be accurate and reliable, neither Scotia Capital Inc., which includes the Global Portfolio Advisory Group, nor any of its affiliates makes any representations or warranties, express or implied, as to the accuracy or completeness of such information. Neither Scotia Capital Inc. nor its affiliates accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or its contents. This report is provided to you for informational purposes only. This report is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation or particular needs of any specific person. Investors should seek advice regarding the appropriateness of investing in financial instruments and implementing investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Nothing contained in this report is or should be relied upon as a promise or representation as to the future. The pro forma and estimated financial information contained in this report, if any, is based on certain assumptions and analysis of information available at the time that this information was prepared, which assumptions and analysis may or may not be correct. There is no representation, warranty or other assurance that any projections contained in this report will be realized. Opinions, estimates and projections contained herein are those of the as of the date hereof and are subject to change without notice. For that reason, it cannot be guaranteed by The Bank of Nova Scotia or any of its subsidiaries, including Scotia Capital Inc. This report is not, and is not to be construed as: (i) an offer to sell or solicitation of an offer to buy securities and/or commodity futures contracts; (ii) an offer to transact business in any jurisdiction; or (iii) investment advice to any party. Products and services described herein are only available where they can be lawfully provided. Scotia Capital Inc. and its affiliates and/or their respective officers, directors or employees may from time to time acquire, hold or sell securities and/or commodities and/or commodity futures contracts mentioned herein as principal or agent. Sharpe Ratio is the measure of risk-adjusted return of a financial portfolio. A portfolio with a higher Sharpe Ratio is considered superior relative to its peers. Standard Deviation is a statistical measurement calculated to indicate the extent of deviation for a group as a whole. The greater the standard deviation of an investment, the greater the investment may range in price. Trademarks are the property of their respective owners. Copyright 2018 Scotia Capital Inc. All rights reserved. 13

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