Market and Investment Commentary July Market and Investment Commentary

Transcription

1 Market and Investment Commentary July 2018 Market and Investment Commentary

2 a Miles Leutner, CIM Vice-President and Portfolio Manager 1501 McGill College Avenue, Suite 2150, Montreal, QC, H3A 3M8 Leutner Wealth Q2FY2018 Newsletter The second quarter was quite eventful. Market volatility continued amidst the back drop of intensifying global trade disputes, uncertainty over the stability of the Italian government and Eurozone, and a pullback in Emerging Markets that some strategists have labelled a crisis. During the quarter, the S&P 500 index in U.S. dollar terms posted a +2.88% return while the S&P/TSX Composite index surged +5.92%. For the year, the S&P 500 is up +1.67% in U.S. dollar terms while the TSX is up +0.42% (not including dividends. Source: Morningstar Direct). We might say ok, this isn t so bad, but let s look at some of the facts and statistics behind market dynamics to get a clearer picture. 20 Trillion In Market Cap Wiped Out Since January While market returns are somewhat positive for the year, we should note that 20 trillion USD was wiped out from global markets since peaking in January. The general riskoff sentiment and a strengthening U.S. dollar have hit emerging markets pretty hard. Economic Growth Continues at a Solid Pace The U.S. and Canadian economies are proving resilient and showing no signs of slowing down despite the nervousness over trade wars. Economic indicators continue to point to expansion and unemployment numbers remain at extremely low levels. While this might stoke some fear that both the Federal Reserve and the Bank of Canada will raise interest rates more than expected, both bond and equity markets appear to have this priced in. If we do continue to see wage gains and inflation above the Federal Reserve s target rate, this could change quite quickly and send bond yields up and equity prices down. One goal of our newsletter is to help explain what money managers look at when making decisions and to provide greater clarity into some of the headlines that financial media focus on. Every comment we have issued discusses some element of the ISM Purchasing Managers Manufacturing Index, known more commonly as the ISM Manufacturing PMI. The reason why we focus on this indicator is because it has shown to have great predicting power of future economic growth. Figure 1 - Approximately $20 trillion USD in global market capitalizaton was wiped out since the January peak. Source: Bloomberg Figure 2 - The ISM Manufacturing Prices Paid and Deliveries components have significantly increased indicating that inflationary forces are building. Source: Bloomberg The theory is that by conducting a survey of supply chain managers at many companies, we can get a sense for what they are seeing in terms of orders from clients, -2-

3 trends in input and raw material prices, and how long it takes to receive deliveries from suppliers. There is a wealth of information in this report. Currently, the PMI continues to post numbers in the high fifties to low sixties which indicates a strong economic expansion. However, the prices paid component which is a proxy for inflation is running at levels not seen since Supplier delivery times are getting longer, indicating that factories are nearing capacity constraints. These are all inflationary forces and could indicate that the U.S. economy is overheating. Corporate Earnings Growth Remains Extremely Optimistic In the long-run, the biggest driver of equity valuations is corporate earnings growth, which continues to be strong. Based on the optimism for Q2, analysts clearly don t believe trade frictions will affect current earnings. The first three months of the year saw earnings for the S&P 500 increase by 24% versus the first quarter of 2017 and the market shrugged it off (source: Bloomberg). Q2 earnings season starts in mid-july and analysts are expecting a similar increase in year over year earnings growth. It is difficult to imagine that this run-rate can continue and we expect to see earnings growth return to historic levels for the remainder of the year. U.S. equities reacted coolly to positive earnings surprises last quarter and punished negative surprises or companies whose guidance for the remainder of the year didn t live up to expectations. We expect this behavior to continue and we also expect a lot of attention on comments from companies with respect to curbs in investment due to trade war concerns. Market Breadth Could Be Stronger While the S&P 500 might be up +2.5% for the year, 10 companies account for almost all of that gain. Amazon alone is responsible for 50% of the positive return. This is a very misleading statistic and we would point out that it is not uncommon for market capitalization indexes to be heavily skewed to a handful of names. It is very important to understand how an index or benchmark is constructed if we are to use it as our frame of reference. We very often ask how New York is today, or how was the U.S. We normally respond by quoting either the S&P 500 or The Dow Jones Industrial Average. These indices represent a basket of stocks that we use as a benchmark against which we measure everything else. It provides a context to make a meaningful comparison. But how each stock within the index is weighted is a function of the index construction methodology. The Dow has 30 constituents that are weighted by their price. The higher the stock price, the larger the effect on the index. Boeing represents approximately 9.5% of the Dow while the second largest is Goldman Sachs at approximately 6.75%. The S&P 500 is weighted by market capitalization, or how much a stock is technically worth if we were to multiply its stock price by the amount of shares circulating in the market. In this case, the top ten names make up 20% of the total index, which would make the S&P 500 a much better index for comparison purposes than the Dow. Rank Name Weight Value 1 Amazon.com Inc % 2 Netflix Inc % 3 Microsoft Corp % 4 Apple Inc % 5 Mastercard Inc A % 6 Facebook Inc A % 7 Adobe Systems Inc % 8 Visa Inc Class A % 9 NVIDIA Corp % 10 Cisco Systems Inc % SPDR S&P 500 ETF Trust 2.52 Number of positive contributors: 260 Number of negative contributors: 245 Table 1 - The top 10 positive contirubotrs to S&P performance this year account for almost all of the positive return. Source: Leutner Welath, Bloomberg The point here is that by its very nature, the S&P 500 is a momentum index since recent winners tend to carry -3-

4 higher weights and will have a greater effect on the index. Why We Are Concerned About an Inverted Yield Curve An inverted yield curve occurs when short-term interest rates are higher than longer-term rates. As mentioned in our April commentary, we use the spread of the 10-year U.S. government bond yield over the 2-year U.S. government bond yield as our preferred measure. The spread continues to narrow and fell to 0.33% as of the end of June. An inverted yield curve has almost always signaled a looming recession within months. The yield curve also provides a significant indication about where we are in the credit cycle. If short-term rates pay more than longer-term rates, banks will not be able to roll over maturing assets such as loans and mortgages at higher rates. They would have greater incentive to invest in short-term bonds than to lend and this will cause a liquidity problem as companies and consumers will find it more difficult to borrow. Figure 3 - The spread (lower panel) between the U.S. 10-year and 2-year governent bond continues to narrow. Red bands indicate U.S. recenssions. Source: Bloomberg Growth and Value Strategies: What You Need to Know Investment managers, mutual funds, and exchange traded funds are often classified according to their investment strategy. Growth and value are two of the most common strategies or styles and there is no shortage of benchmarks that can be used to compare managers. For example, we can use either the S&P 500 Growth or the S&P 500 Value indices as benchmarks to assess the performance of managers that employ that respective style. A growth strategy typically looks for companies whose earnings are growing at an accelerating pace, pay little to no dividends, and trade at very high multiples. You don t care what you are paying for the stock as long as earnings are growing at such a high pace that it justifies the price. A value strategy tends to focus on companies that are trading at depressed valuations and that are out of favor. They tend to pay higher dividends, trade at cheap multiples, and earnings are expected to rebound off lower levels. For the past three years, growth strategies have outperformed as sectors with higher growth rates such as technology have been the preferred place to be. Articles on financial sites have also focused on the growth trade and have asked whether or not value investing (of which Warren Buffet is a huge proponent) is dead. A simple Google search of is value investing dead will return many articles dating back to It might be premature to come to this conclusion and such claims must be carefully examined. First, we need to look at exactly how we define value and growth. While the metrics used to classify companies are quite clear, managers might have very different opinions. Even some of the standard style benchmarks are flawed. Let s take the example using exchange traded funds since that would be a practical way of gaining broad based exposure to a particular style. Together, the ishares S&P 500 Growth and ishares S&P 500 Value ETFs have over $35 billion USD in assets. A careful examination of their holdings would reveal that they have 175 names in -4-

5 common, which represents over 30% of their assets (Source: ishares filings and Morningstar Direct). This is the case with many of the style ETFs and benchmarks out there and clearly should make us think twice about what exactly we are trying to do. How can a company be growth and value at same time? The Vanguard Growth and Value ETFs only have a 4% overlap so let s use those for our analysis. One of our preferred methods to evaluate strategies is to look at rolling periods since it allows you to see how things change over time instead of looking at just a snapshot in time. Figure 4 shows rolling 3-year returns over a 20-year period, meaning we plot the 3-year return at the end of every month. Since July 1998, there are year periods and growth has outperformed 55% of the time. Value and growth tend to behave cyclically and it is dangerous to assume that value is dead since the pattern could reverse quite quickly. Value ETFs tend to be more heavily weighted in utilities, financials, energy and healthcare. Growth has higher weights in technology and consumer discretionary. Given that differences in performance between technology and financial companies will have the largest effects on performance, it is no wonder that growth is outperforming. index has returned +149% versus +64% for financials (source: Bloomberg, as of June 30, 2018). It has definitely been a difficult period for value managers and it is not easy to stay disciplined and true to your strategy in the face of such strong investor sentiment. In a previous article, we described many of the behavioral biases that we are all subject to. A recency bias occurs when we chase short-term performance and ignore longer-term results. It is very easy to succumb to this bias and move heavily into momentum and growth forgetting that it is important to stay diversified and that style rotations do occur. Q2/FY2018 Asset Class Review S&P/TSX Composite (Canada) S&P 500 (US) Bloomberg Commodity Index FTSE TMX Canada Bond Universe MSCI EAFE (Europe, Asia, Far East) MSCI Japan MSCI Asia-PAC ex Japan Q2/FY2018 Asset Class Performance Gold MSCI Emerging Markets Year Return Jun-01 Feb-02 Oct-02 Jun-03 Feb-04 Oct-04 Jun-05 Feb-06 Oct-06 Jun-07 Feb-08 Oct-08 Jun-09 Feb-10 Oct-10 Jun-11 Feb-12 Oct-12 Jun-13 Feb-14 Oct-14 Jun-15 Feb-16 Oct-16 Jun-17 Feb-18 Vanguard Growth ETF Vanguard Value ETF Figure 4 - Looking at rolling three year returns provides a longerterm picture of performance. Growth has outperformed for the past three years but patterns are cyclical. Source: Morningstar Direct Over the past five years, the S&P 500 technology sub- Figure 5 - North American equities were the top performing asset classes within our broadest universe that we monitor. Source: Morningstar Direct Of the major asset classes we track, Canadian equities were the top performer gaining +5.92% during the quarter. In Canadian dollar terms, U.S. equities were up +4.97% and Canadian bonds rose +0.80%. Given the volatility in bond markets this year as investors come to grip with rising interest rates, the positive return for bonds is welcome and might be an indication that rate hikes are priced in. Emerging Markets fell -6.80% in Canadian dollar terms as a stronger U.S. dollar and concerns over slowing global growth have led investors to scale back investments in what has been one of the most profitable -5-

6 trades over the past two years. Commodities, especially base metals, have thus far been the largest victims of the global tariff showdown as metals are heavily correlated with global growth. Within sectors, Canada showed strength across most sectors, except financials, telecommunication services and utilities, which continue to feel the pressure of higher interest rates. These sectors are very sensitive to interest rates due to their high dividend yields. In both the U.S. and Canada, energy was the top performing sector, returning % and % respectively. U.S. industrials continue to bear the brunt of the trade disputes as most companies within this sector index are multinationals and have a significant degree of exposure to the E.U. and China. Energy Consumer Discretionary Information Technology Real Estate Utilities Health Care Materials Telecom Services Consumer Staples Financials Industrials Q2/FY2018 S&P 500 Sector Performance Figure 7 - Energy was the top performing sector in the S&P 500 during the sector. Consumer Discrectionary and Technology continue to lead. Source: Morningstar Direct Energy Health Care Information Technology Industrials Materials Consumer Discretionary Real Estate Consumer Staples Financials Telecom Services Utilities Q2/FY2018 S&P/TSX Sector Performance Figure 6 - Broad based strength drove Canadian equities higher in the quarter. Interest rate sensitive sectors continue to be pressured. Source: Morningstar Direct Summary We expect Q2 earnings to be the primary driver for the market in the short-term. While there are definitely some cautionary signs, growth in Canada and the U.S. remains strong and earnings will either convince investors that the bull market can continue or if expectations have become way too lofty. While we do have political risks associated with Italy, trade wars, and the U.S. mid-term elections, it is important to remember that political shocks tend to be quickly absorbed and markets tend to settle down once the initial shock has occurred. The credit cycle and liquidity have a much more pronounced effect on the business cycle. And while there are signs within the yield curve and widening of spreads on risky bonds versus safer government bonds, there are no clear signs that the credit cycle has ended. -6-

7 Q2FY2018 Book Recommendation Narrative and Numbers By Aswath Damodaran From Goodreads.com: How can a company that has never turned a profit have a multibillion dollar valuation? Why do some start-ups attract large investments while others do not? Aswath Damodaran, finance professor and experienced investor, argues that the power of story drives corporate value, adding substance to numbers and persuading even cautious investors to take risks. In business, there are the storytellers who spin compelling narratives and the number-crunchers who construct meaningful models and accounts. Both are essential to success, but only by combining the two, Damodaran argues, can a business deliver and sustain value. Miles A. Leutner, CIM Vice President, Portfolio Manager miles.leutner@rbc.com Cordell L. Tanny, CFA, FRM Associate Portfolio Manager cordell.tanny@rbc.com Through a range of case studies, Narrative and Numbers describes how storytellers can better incorporate and narrate numbers and how number-crunchers can calculate more imaginative models that withstand scrutiny. Damodaran considers Uber s debut and how narrative is key to understanding different valuations. He investigates why Twitter and Facebook were valued in the billions of dollars at their public offerings, and why one (Twitter) has stagnated while the other (Facebook) has grown. Damodaran also looks at more established business models such as Apple and Amazon to demonstrate how a company s history can both enrich and constrain its narrative. And through Vale, a global Brazil-based mining company, he shows the influence of external narrative, and how country, commodity, and currency can shape a company s story. Narrative and Numbers reveals the benefits, challenges, and pitfalls of weaving narratives around numbers and how one can best test a story s plausibility. -7-

8 a Miles Leutner, CIM Vice-President and Portfolio Manager 1501 McGill College Avenue, Suite 2150, Montreal, QC, H3A 3M8 Disclaimers Securities or investment strategies mentioned in this newsletter may not be suitable for all investors or portfolios. The information contained in this newsletter is not intended as a recommendation directed to a particular investor or class of investors and is not intended as a recommendation in view of the particular circumstances of a specific investor, class of investors or a specific portfolio. You should not take any action with respect to any securities or investment strategy mentioned in this newsletter without first consulting your own investment advisor in order to ascertain whether the securities or investment strategy mentioned are suitable in your particular circumstances. This information is not a substitute for obtaining professional advice from your Investment Advisor. The commentary, opinions and conclusions, if any, included in this newsletter represent the personal and subjective view of the investment advisor Miles Leutner who is not employed as an analyst and do not purport to represent the views of RBC Dominion Securities Inc. The information contained herein has been obtained from sources believed to be reliable at the time obtained but neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers can guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell or the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers is to be under any responsibility or liability whatsoever in respect thereof. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities which are affiliated. *Member-Canadian Investor Protection Fund. RBC Dominion Securities Inc. is a member company of RBC Wealth Management, a business segment of Royal Bank of Canada. / TM Trademark(s) of Royal Bank of Canada. Used under licence. RBC Dominion Securities Inc All rights reserved. -8-