Monthly Market Snapshot AUGUST 2016 Portfolio Strategy Global Portfolio Advisory Group Thoughts on Recent Market Volatility October 11, 2018 Hold Steady Recent market volatility is attributable to several factors that have weighed on investor sentiment, including ongoing trade tensions, the strength of the U.S. dollar, Italy s proposed budget deficit, upcoming U.S. mid-term elections and, of course, the rapid rise in bond yields. While our tactical asset allocation remains overweight equities, we have conservatively positioned our portfolios by including alternative investments, emphasizing high quality equities in developed versus emerging markets, and avoiding high yield issuers. Volatility and Financial Markets S&P 500 volatility (~24) is now within the top quartile (the lower bound of which is 22.7) of its historical range. Historically, the percentage of days with a +/- 2% (or greater) move in the S&P 500 within first quartile volatility regimes is ~12x that of lower volatility periods. See Ex. 1. Similarly, for investment grade (IG) corporate and high yield (HY) bonds, the frequency of daily moves in excess of 0.5% (up or down) increases by 3x and 8x, respectively. See Ex. 2 and 3 on the following page. Ex. 1: Percentage of trading days with ± 2.0% (or greater) move in the S&P 500 Sources: Bloomberg, Scotia Wealth Management Please be advised that this material is not to be distributed to residents of the European Union Registered trademark of The Bank of Nova Scotia, used under licence. Trademark of The Bank of Nova Scotia, used under licence. Scotia Wealth Management consists of a range of financial services provided by The Bank of Nova Scotia (Scotiabank ); The Bank of Nova Scotia Trust Company (Scotiatrust ); Private Investment Counsel, a service of 1832 Asset Management L.P.; 1832 Asset Management U.S. Inc.; Scotia Wealth Insurance Services Inc.; and ScotiaMcLeod, a division of Scotia Capital Inc. Wealth advisory and brokerage services are provided by ScotiaMcLeod, a division of Scotia Capital Inc. Scotia Capital Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada.
Global Portfolio Advisory Group Portfolio Strategy // 2 Percentage of trading days with at least Ex. 2: ± 0.5% move in U.S. IG Corporate Bond index Ex. 3: ± 0.5% move in U.S. HY Bond index Sources (both exhibits): Bloomberg, Scotia Wealth Management Asset Allocation Tactically, we continue to recommend overweight exposure to equities and underweight exposure to fixed income, relative to our long-term strategic asset allocation model. This recommendation is premised on our long-term total return expectations for each asset class. However, given our expectation for increased volatility, our equity overweight is marginal (please see our Tactical Asset Allocation [TAA] model). Furthermore, our TAA includes a 5%-10% allocation to alternative assets. These provide diversification benefits to traditional portfolios of equities and fixed income securities, which tend to be highly correlated during times of market stress. Alternative assets, as part of broader investment portfolios, can help investors preserve capital during market drawdowns and manage volatility. We expect inflation to increase as actual economic output continues to push above potential output. As a result, central bank policy rates in Canada and the U.S. should continue increasing over the near-to-medium term. This will likely spur an increase in short-term interest rates. We expect more subdued movement in longer-term (10+ years) interest rates (see Ex. 4 on the following page). Our recession probability indicator remains low. However, it has ticked slightly higher over the last several months (see Ex. 5 on the following page). The next change to our tactical asset allocation will likely result in a higher allocation to equity and fixed income alternative investments. In the interim, we have insulated portfolio volatility by conservative positioning within each asset class. Specifically, we have emphasized high quality equities in developed versus emerging markets and limited exposure to high yield fixed income securities. As a reminder, our TAA process provides us with a framework to tactically allocate capital across asset classes, geographies and securities and maximize risk-adjusted returns relative to our long-term expectations. Our TAA models have outperformed their Strategic Asset Allocation counterparts on a one-year basis for the period ending September 28, 2018, providing an average excess return of 110bps.
Global Portfolio Advisory Group Portfolio Strategy // 3 Ex. 4: U.S. 10 Year Treasury Yield Ex. 5: Recession Probability 7.0% 6.0% 0.9 0.8 0.7 5.0% 0.6 4.0% 0.5 3.0% 0.4 0.3 2.0% 0.2 1.0% 1996 1999 2002 2005 2008 2011 2014 2017 10 YEAR U.S. TREASURY YIELD (AVERAGE TTM) FORECAST 10 YEAR U.S. TREASURY YIELD (AVERAGE TTM) 0 1972 1974 1977 1979 1982 1984 1987 1989 1992 1994 1997 1999 2002 2004 2007 2009 2012 2014 2017 0.1 Sources (both exhibits): Bloomberg, Scotia Wealth Management Equities We remain overweight developed markets (DM) relative to emerging markets (EM). EM countries have amassed significant levels of debt over the last decade, which may prove more difficult to service as interest rates rise. On a yearto-date basis, DM equities (down less than 1%) have handily outperformed EM equities (-15%), with most of the outperformance occurring over the last four months. While we acknowledge a mean-reversion opportunity exists going into year end, we advocate a more conservative approach for most investors and recommend a U.S. bias to equity portfolios given the U.S. equity market s relatively higher earnings quality and growth profile. On a sector basis, we maintain very little exposure to materials and energy in our guided portfolios. Commodity-linked companies have few ways (aside from cost control) to differentiate themselves from peers, a characteristic that tends to diminish their longterm risk-adjusted investment returns. Fixed Income Within fixed income markets, credit has shown mixed results amid the recent spike in volatility. U.S. high yield bonds exhibited sharp losses, with credit spreads widening about 30bps on average over the past week. U.S. investment grade corporate bonds were much more resilient, with spreads widening only 6 bps over the same period. Heightened volatility could leave high yield bonds vulnerable to a pullback considering current valuations are rich by historical standards. At the moment, we prefer exposure to select higher credit quality instruments (i.e. investment grade corporate bonds). These tend to outperform their lower quality peers during periods of heightened market volatility due to the underlying issuers greater ability to repay outstanding debt. GPAG s tactical asset allocation model currently has no exposure to high yield corporate debt.
NON-INVESTMENT GRADE INVESTMENT GRADE Global Portfolio Advisory Group Portfolio Strategy // 4 Ex. 6: Fixed Income Characteristics by Credit Rating S&P CREDIT RATING YIELD TO MATURITY DURATION 1-WEEK RETURN CURRENT SPREAD [ ] VERSUS 3-YEAR RANGE AAA 2.8% 5.8-0.4% 10 16 16 AA 1.4% 8.3-0.5% 23 32 46 A 1.2% 8.3 0.5% 26 37 50 BBB 3.5% 6.5-0.7% 103 179 200 BB 5.3% 4.6-0.8% 204 274 496 B 7.6% 4.1-1.2% 359 471 789 CCC OR LOWER 10.5% 3.5-1.0% 717 744 2100 Sources: Bloomberg, Scotia Wealth Management Conclusion Given the maturity of the current business cycle and the prospect of higher near and medium-term financial market volatility and interest rates, we continue to recommend investors manage risk through diversification across asset classes and geographic regions. We also suggest investors focus on companies with sustainable competitive advantages, with low levels of debt, and that generate substantial free cash flow (FCF). Equities of companies exhibiting such characteristics have produced cumulative total returns that have doubled their respective benchmarks during the past fifteen to twenty-five years.
Global Portfolio Advisory Group Portfolio Strategy // 5 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 Global Portfolio Advisory Group 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 Global Portfolio Advisory Group 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. 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