December th, 1 Five investment themes for 1 MARTIN LEFEBVRE Asset Allocation and Investment Strategist (1) 1 87 martin.lefebvre@bnc.ca Monthly review November was another good month for the stock market. With the U.S. government shutdown not having a major impact on economic statistics and with the European central bank surprising the markets with a rate cut during the month, global equities gained 1.. The S&P was up %, outperforming EAFE markets (.8%) and the TSX ( 1.% in USD). Fixed income securities continued to tread water, with yields on U.S. 1 year notes rising from. at the beginning of the month to.8 at month end. Commodity prices ed downward for most of the month and the U.S. dollar hit a high for the year of more than $1.6 CAD. Asset allocation strategy 1 Negative bond returns again: Maintain a short duration, with government bond exposure at a minimum and a corresponding overweight position in riskier issuers. Search for yield: Continue to underweight REITS, favouring the U.S. over Canada. Keep a preference for high yielding dividend stocks and ETFs or issuers increasing payouts. Stocks in a secular up: Keep an overweight position in equities at the expense of fixed income securities, and favour developed markets over emerging markets. We believe that U.S. and EAFE markets should continue to outperform markets linked to commodity prices, and our preference goes to U.S. small capitalization stocks as opposed to large caps. U.S. dollar strength: Investors should benefit from being positioned in assets denominated in currencies other than the Canadian dollar. This argues in favor of U.S. markets and undervalued European markets, which still afford great opportunity and should be bought on euro weakness. Commodity prices range bound: Until there is clear evidence of a pick up in inflation, maintain a neutral allocation to commodity linked assets and favour oil relative to precious metals. Table 1 Market total returns Asset classes November QTD* YTD* Cash ( month T bills ).1%.%.9% Bonds (Dex Overall Universe).%.8%.8% Dex Overall Federal.%.7%.9% Dex Overall Corporate..9% 1.1% Dex BBB. 1.1% 1.7% World equity (MSCI AC) 1. 7. 1.% S&P/TSX. 6. 1.8% S&P/TSX Small cap.% 8.1%.8% S&P (USD)..7% 9.1% Russell (USD).9% 6.6%.6% MSCI EAFE (USD).8% 9.% 1. MSCI EM (USD) 1. 8.%.8% Commodities (CRB index) 1.%.%.% WTI oil (US$/barrel).7%.7%.9% Gold (US$/ounce).%.7%.6% Copper (US$/tonne).6%.9% 1.8%. Forex (JPM US Dollar index) 1.1% 1.%. USD per EUR.%.9%.% JPY per USD.%.6% 18.1% CAD per USD 1.8% 1.6% 7. * 1/11/9 CHART OF THE MONTH 1 1-1 Source: Datastream Performance spread between stocks and bonds Total return -1 Jan-1 Apr-1 Jul-1 Oct-1 US 1-year tresaury notes S&P Peak of % points 1 1 - -1 For investment professionals only
Investment themes for 1 While 1 is not yet over, it promises to deliver higher thanexpected returns for risk takers. Of note, at the end of November the performance spread between stocks and fixedincome securities reached (chart of the month). Although many continue to question the equity rally, we believe that a little more of the same is in store for 1. One certainty is that the expected relative outperformance of stocks is not going to happen in a straight line. This being said, the following five investment themes should play an important role in shaping portfolio returns for the coming year. 1 Negative bond returns again! 1 will certainly not be remembered as a good vintage for fixed income returns. In the United States, the value of 1 year treasury notes has fallen by more than 7% since the beginning of the year, putting the total return in U.S. dollar terms in the red by more than. In Canada, with a shorter duration and a mix of higher yielding corporate issuers, the DEX Universe overall bond benchmark did not fare as badly. But at.8% in CAD terms since the beginning of the year, its total return is nonetheless far from the 8.% average Canadian dollar annual return this index has posted for previous years. The big question: is 1 just a bad year in a winning streak, or does it signal the end of the no brainer bull market for bonds? One thing is certain: Janet Yellen will be at the helm of the Fed in 1. This means that monetary policy south of the border will stay highly accommodating for as long as the job market remains weak. And with inflation lower than expected, the Fed certainly has the leeway to lean against the wind for a little while longer (chart ). Not much inflation to worry about 6 1 YoY % United States YoY % 6 1 strong forward guidance, will likely put upward pressure on longer term bond yields and produce negative fixed income returns for the second year in a row. Bottom line: maintain a short duration and keep exposure to government bonds to a minimum, favoring riskier issuers and non traditional sources of fixed income instead. Search for yields In a context where interest rates are expected to remain at historically low levels, the search for yield will remain an important investment theme in 1. We reiterate our preference for stocks with high dividend yields, which have outperformed the S&P so far this year (chart ). Favor high dividend stocks for income US Equities 1 1 Jan-1 Mar-1 May-1 Jul-1 Sep-1 Nov-1 Source: Datstream S&P US Dividend aristocrats Canadian REITS should continue to underperform Real Estate Investment Trusts 1 1-1 1 1 1 - -1-1 -1-1 - - 6 7 8 9 1 11 1 1 - - -1 Jan-1 Mar-1 May-1 Jul-1 Sep-1 Nov-1 US REITs (USD) Canadian capped REITs (CAD) -1 Total inflation Core inflation Source: Datstream Source: Datstream However, in a context where the economy is improving, chances are good that there will be a tapering of the Fed s bond purchase program sometime in the first half of next year (a rather conservative call) which, even if accompanied by However, investors should stay away from interest ratesensitive assets such as real estate investment trusts (REITS), which have fallen sharply since the Fed started talking about tapering. Although REITs appear to have bottomed, downward
pressure should resume once the expected changes in monetary policy materialise (chart ). Bottom line: Continue to underweight REITS and favour the U.S. over Canada, overweighting high yielding stocks or ETFs, as well those with a history of raising payouts. Stocks in a secular up 1 has been good for stock markets, with the all country world index returning close to over eleven months. Returns in the United States for the period were even better, with gains of more that for the S&P and close to for the Russell small cap index. While we are not forecasting double digit price appreciation again for next year, investors should be aware of the following: 1) With no recession in sight (the IMF is forecasting US real GDP growth to accelerate from 1.% in 1 to.6% in 1, and. in 1), and with central banks maintaining a high liquidity backdrop, equities should continue to outperform other major asset classes in the coming year. ) Exceptional years are usually followed by strong years, not correction years. ) If this is the beginning of a long term rally, annualized growth over the past four years has been lower than that of the past three secular up s we've observed since 196 (chart ). ) Conservative earnings growth of % plus a dividend yield of % will produce a return that is higher than what the bond market is expected to deliver, which should continue to keep cash flowing towards equities. Bottom line: Maintain an overweight position in equities at the expense of fixed income, and favour developed markets over emerging markets. U.S. and EAFE markets should continue to outperform markets linked to commodity prices, and our preference goes to U.S. small capitalization stocks over large caps. We recommend maintaining an overweight position in early cyclical sectors until there is a reversal in inflation. U.S. dollar strength The U.S. dollar continued strengthening against most currencies in 1, except for a short period of depreciation against the euro and the pound sterling following the unwinding of some of the market expectations about U.S. monetary policy from the end of June till the end of October. The USD was particularly strong against currencies linked to commodity prices following weaker than expected emerging market demand. Eleven months into the year, the Canadian and Australian dollars had lost.% and 9.%, respectively (chart 6) against their U.S. counterpart. USD strong against most currencies YTD FX against USD YTD Growth similar to other secular equity rallies Start = 1 Dow Jones - - CAGR 19 18.8% -1-1 19.% 198.7% 9 18.% -1-1 - Jan-1 Apr-1 Jul-1 Oct-1 - Euro Yen AUD CAD 1 1 6 Source: Datstream 1 1 Years Source: Datstream ) U.S. stock markets are becoming more expensive, but with a multiple of 17, their average price/earnings ratio remains historical averages. Furthermore, accelerating growth should translate into higher earnings, which will keep valuation ratios at reasonable levels. 1 In 1, we believe the U.S. dollar will continue to remain firm against most currencies. While talks of tapering have been put on the ice for now, the expected acceleration in U.S. GDP growth suggests that the Fed s next move will be less, not more. Meanwhile, the euro remains resilient since the ECB is the only major central bank that hasn t yet opted for quantitative easing. However, with key rates down to. and with year over year inflation at only.7% in October, Europe's central bankers may well have to use what s left in their monetary tool box sometime next year. The yen remains
overvalued and the Bank of Japan s promise to double the monetary base should continue to put downward pressure on this currency. As we expect commodity prices to be rangebound (see ), the Canadian and Australian dollars should also remain under pressure. Finally, it should be said that while the U.S. dollar index is still on a secular down, it is at the bottom of its trading range, something that has historically preceded periods of rapid appreciation (chart 7). Maybe it s time for a sustained rise in the US dollar As the emerging markets try to achieve more balanced growth by steering their economies from an investment base to a consumption base, the marginal impact they have on the global economy will lessen (chart 9). Therefore, we think that after having risen by almost two standard deviations over the period from to 9, real commodity prices should slowly converge towards their long term line. Growth of that magnitude was simply unsustainable 1 USD index Trade-weigthed against major partners USD index 1 1. Annual real GDP growth ( US$) 1. 1 1 1. 1. 1 1 11 1 9 8 7 1 years 6 years above 1 years 6 years above 1 years 6 197 1978 198 1988 199 1998 8 1 1 1 11 1 9 8 7 6 8. 6.... -. -. -6. 199 199 1 Spread BRIC G 8. 6.... -. -. -6. 7 Source: Datstream 9 Source: Datastream Bottom line: Investors should benefit from being positioned in non Canadian dollar denominated assets, and therefore continue to overweight U.S. markets as well as undervalued European markets that still afford great opportunity, and should be bought on euro weakness. Bottom line: Until there is clear evidence of a pickup in inflation, maintain a neutral allocation to commodity linked assets, and favour oil relative to precious metals. Gold prices could find technical support at $1, but the long term fundamentals for this precious metal remain poor. Commodity prices range bound Historically, commodity prices have only increased in periods of high inflation (e.g. the 197s), when demand significantly outpaced supply (e.g. China in the early years of ), or when the U.S. dollar was depreciating. These periods, during which commodity prices increased three fold, have always been preceded by year periods of either stable or rangebound fluctuations (chart 8). A stabilization in commodity prices is to be expected $ US 6 Prix des Commodity matières prices premières $ US 6 X years 1 years X 1 1 years 1 years 19 19 196 196 197 197 198 198 199 199 1 1 8 Source: Commodity Research Bureau
Table Global Asset Allocation (Tactical vs Strategic) month horizon 1 to 18 month horizon Asset classes Weight Weight Asset classes Min Under Equal Over Max Min Under Equal Over Max Cash Cash Bonds Bonds (Duration) (Duration) Federal Federal Investment grade Investment grade High yield (USD) High yield (USD) Non traditionnal income Non traditionnal income World equities World equities S&P/TSX S&P/TSX S&P (USD) S&P (USD) Growth vs Value Growth vs Value Large cap. vs Small cap. Large cap. vs Small cap. Defensives vs Cyclicals Defensives vs Cyclicals MSCI EAFE (USD) MSCI EAFE (USD) MSCI EM (USD) MSCI EM (USD) Alternative investments Alternative investments Commodities Commodities Energy Energy Base metals Base metals Gold Gold Hedge funds (USD) Hedge funds (USD) REITS REITS Source: Consultating Investment Committee National Bank Financial is an indirect wholly-owned subsidiary of National Bank of Canada which is a public company listed on the Toronto Stock Exchange (NA: TSX). The particulars contained herein were obtained from sources we believe to be reliable, but are not guaranteed by us and may be incomplete. The opinions expressed are based upon our analysis and interpretation of these particulars and are not to be construed as a solicitation or offer to buy or sell the securities mentioned herein. National Bank Financial may act as financial advisor, fiscal agent or underwriter for certain companies mentioned herein and may receive remuneration for its services. National Bank Financial and/or its officers, directors, representatives or associates may have a position in the securities mentioned herein and may make purchases and/or sales of these securities from time to time on the open market or otherwise.