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INVESTMENT COMMENTARY FIRST QUARTER 2015
Strong U.S. Dollar Forces
Fed to Rethink Next Move
S
ix years of easy money conditions have propelled a huge run up in
equity prices and corporate bonds and once the U.S. Federal
Reserve’s tide of seemingly endless liquidity pulls back, no one knows
quite how the world’s financial markets will react. Or as Warren Buffett
memorably quipped: “Only when the tide goes out, do you discover who’s
been swimming naked.”
Based on the latest tidings from the U.S. central bank, investors can continue
swimming for some time as the surging U.S. dollar appears to have stalled the
Fed’s plan to turn the tide and start raising interest rates any time soon.
Policy Conundrum T
he strengthening of the U.S. dollar, due largely to stagna ng demand in China and most countries that trade with the U.S., poses a policy conundrum for Fed officials: The surging greenback is pu ng downward pressure on U.S. growth and infla on just as the Fed contemplates revising its signals on the interest rate outlook, intensifying the debate among rate‐se ers as to whether June is the right me to push the bu on on the first rate rise in nearly a decade. A few months ago, economists expected the Fed to begin raising its benchmark short‐term rate in June from near‐zero levels. Now most analysts doubt that the Fed will order its first increase before fall. If the Fed were to raise rates, the VIDEO COMMENTARY A video versions of our commentaries
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effect could be to further stoke the dollar because higher interest rates tend to a ract global investors to a country's bonds and bank accounts, boos ng demand for its currency. Unless U.S. job crea on accelerates significantly during the coming months, we may well see just one upward shi in the federal funds rate this year. Having previously predicted an overnight rate of 1.12 percent by the end of December, the Fed finally bowed to the long standing message from the bond market and now expects a year end level of 0.625 percent. That is quite a climb down and while policy makers also cut their forecasts for rates at the end of 2016 and 2017, these new, lower predic ons s ll remain well above what the interest rate futures and bond yields currently imply. The dollar's value against six other major currencies has shot up 22% since last June to its highest level since 2003. That is making U.S.‐produced goods more expensive abroad and turning overseas earnings for many U.S. mul na onal companies into fewer dollars. At the same me, it’s helping importers and suppressing the cost of imported goods. The Federal Reserve doesn’t really talk about the U.S. dollar, as dollar policy is the well‐defended remit of the U.S. Treasury Department. But the surge of the dollar seems to be genera ng some concern within the halls of the U.S. central bank. In mid‐March, the Fed removed the word “pa ent” from a key sec on of the statement explaining how it planned to ul mately raise the benchmark Fed funds rate, which has been parked near zero since the financial crisis hit in late 2008. But the statement also noted that “economic growth has moderated somewhat” and “export growth has weakened.” This is essen ally a backdoor nod to the strength of the dollar. Exhibit 1
U.S. Dollar Gains Bolster Fed’s Patience on Interest Rates
100
U.S. Trade-Weighted Dollar
Vs. Major Currencies
100
97.7
97.7
95
95
90
90
Keeping a close eye on the
U.S. dollar ~ Federal Reserve
85
+22% since
June 2014
Chairwoman, Janet Yellen, is in
no hurry to raise rates...
80
80
75
85
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May
2014
2015
75
Source: TD Newcrest (As at March 31, 2015)
Exhibit 2
Global Economic Growth Remains Moderate & Uneven
Canada’s growth is stalling at
below 2% as low oil prices impact
the overall economy. The export
boost from manufacturing and
weaker currency provide support.
U.S. economic
growth retreats
from 4-year high,
but still expanding,
driven by
accommodative
monetary policy,
consumer and
business spending,
and boost to
consumption from
lower oil prices.
2015 GDP Growth (%year-over-year)
<0%
0-1%
1-2%
2-4%
>4%
Eurozone hikes growth forecast,
but growth remains subdued and
the recovery weak and uneven.
Cheap oil, weaker euro, better
credit conditions and committed
ECB provide support.
Russia faces more gloom
ahead and a deeper
recession as low oil prices
and sanctions take their toll.
China’s slowdown leading to
stagnation as economic rebalancing
progresses. Even at 7% growth
(slowest in 24 years) the country
remains a key driver for global growth.
Japan is falling
back into recession
but upgrades
outlook. Delay of
further consumption
tax to 2017
removes important
obstacle to growth.
Source; IMF, OECD, Deutsche Bank
Key Takeaways: First Quarter 2015
From a wonkier perspec ve, the strength of the dollar is also a form of financial ghtening, much like an increase in interest rates, because it lowers infla on, and lower infla on raises “real,” or infla on‐adjusted, interest rates. In other words, even if the Fed isn’t ghtening yet, the strong dollar is. More important is that this means the Fed's hikes could come so slowly that its benchmark rate might not reach 2% before 2017. That could mean that long‐
term rates, such as on bonds and mortgages, also would be slow to rise from current low levels as long as infla on stays subdued. Impact in Canada T
he stronger U.S. currency is, of course, having the exact opposite effect on the weakening economies of its major trading partners, including Canada where the loonie has lost 7.3 percent against the greenback since the start of the year. That’s good news for Canadian exporters, whose goods become cheaper in the U.S. as the loonie erodes. Canadian sectors and stocks with high exposure to the U.S. economy, the des na on for 76% of Canadian goods, and in par cular the U.S. consumer, have done well. In fact, corporate profit margins in Canada hit a 27‐year high at the end of 2014 due largely to the falling dollar and so ening labour costs. The average profit margin of all non‐financial corpora ons rose to 8.2 percent of sales in the final three months of the year. That’s a full 3 percentage points above the average since 2001 and comes despite plunging oil prices that have since stalled Canada’s economic growth. However, much like corporate tax cuts, which le companies si ng on billions in cash, the lower dollar is boos ng bo om lines instead of leading to expansion and jobs, which is weighing on Canada’s economic outlook. Economists generally agree it's no picnic for Canadians when the dollar falls, especially as we rely heavily on a wide range of imports from the U.S., which are suddenly more expensive. On the upside, however, a weaker currency means that Canadians invested abroad will pocket more dollars when those investments are brought back home.
INVESTMENT COMMENTARY FIRST QUARTER 2015
Bulls, Bears & Bubbles
Returns are shown Gross of Fees
Signs that point to the Beginning and the End
As at March 31, 2015
S
ix years ago our Commentary focussed on the sharp rally in stocks
from the lows of early 2009 through October following 2008’s financial
crisis. Although we expressed some concerns, we concluded that stocks
were not in bubble territory but rather in the “sweet spot of moderate
growth, rising profitability and easy money”. We said at the time that we
expected equity markets to maintain their upward trajectory. It’s
remarkable how far markets have come since then and how long this bull
market (which celebrated its sixth birthday on March 9, 2015) has endured.
Genus Pooled Fund Performance
Compound Annual Returns
3 months
1 year
3 years
6.1
12.0
11.6
9.2
5.7
Canadian Alpha¹
2.1
4.5
8.8
5.2
6.1
Dividend Equity
6.8
14.9
15.1
12.5
Global Alpha²
13.8
23.3
22.8
18.0
CanGlobe Equity
8.5
15.0
16.3
11.3
Emerging Markets
10.1
11.0
6.8
Short-Term Corporate Bond
2.0
4.2
3.5
3.8
Strategic Bond
3.9
9.4
6.7
7.2
Commercial Mortgage
1.3
5.2
4.5
9.3
18.7
8.6
18.2
4.2
9.7
3 months
1 year
3 years
S&P/TSX Composite
2.6
6.9
9.6
7.4
7.4
S&P 500 Index (C$)
10.4
29.4
25.7
19.7
8.5
MSCI Emerging Mkt (C$)
11.8
15.7
8.9
6.7
9.3
MSCI World Index (C$)
12.0
22.3
22.1
15.6
7.5
DEX Universe Bond Index
4.2
10.3
5.1
6.0
5.6
Balanced Fund
5 years 10 years
Equities
7.6
Fixed Income
U
sing the Dow Jones Industrial Average as the benchmark, only two post‐World War II bull markets have lasted that long. There was the bull market of 1949 to 1961, with its 355 percent gain, and the bull market of 1990 to 2000 with its 396 percent gain. Many investors are wondering if the current bull run in stocks is nearly over, or if this ride to market peaks is the prelude to a correc on. The Dow is up a cumula ve 173 percent from March 9, 2009 to March 6, 2015 (18 percent annualized), the NASDAQ up 26 percent (compounded annually, including dividends, over this period), and the Standard & Poor’s 500 Index up 20 percent compounded annually over the same period (more than 10 percentage points above its long‐
term average). The numbers show that specula on does not appear to be excessive in some of the more obvious places such as mergers and acquisi ons, and venture capital world where the first seeds of a bubble or correc on are typically sown. As far as stocks in general are concerned, using the Standard & Poor’s 500 Index as a barometer, stocks today are trading at approximately 19x trailing 12 months’ earnings per share. This is above their long‐term average of 15‐16x but well below the 25‐30x typical of market peaks. Since early 2010, earnings growth of close to 85% has accounted for the vast majority of the doubling in stock prices. The small valua on gain may be considered reasonable in light of growing investor confidence as the global economy has recovered from the depths of 2008‐2009. On the other hand, the best returns are made when the star ng point is an extreme low— i.e., the point of greatest perceived risk. It’s safe to say that the growth in corporate profits over the last five years has been more rapid than most investors expected, as analysts and companies have steadily revised their earnings es mates upward. In 2010, the economic expansion was widely forecast to be weak, and indeed it turned out to be slower than in most post‐recession periods. Consumer and business confidence remained fragile un l recently, and the gradual unwinding of pre‐recession leverage served as a drag on the U.S. economy. Despite sluggish demand, however, corporate profit margins expanded as a result of the favourable combina on of low interest rates, a reluctance to hire new workers (or increase the pay rates of exis ng ones) and depressed commodity/raw materials costs. Perhaps the most important ques on facing investors is whether profits can con nue to grow at a rate sufficient to sustain today’s equity valua ons and produce meaningful returns over the next several years. We think earnings growth will slow over the next few quarters but will s ll remain posi ve. An interes ng study by Wisdom Tree Asset Management earlier this year provides historical evidence that U.S. equi es will con nue to perform well, although perhaps not at the same heady pace we’ve seen recently. The study looked at 139 rolling five‐year periods da ng back to 1871 (1871‐76, 1872‐77, etc.), separa ng them into quar les based on the returns over each five‐year interval. The five years ended December 31, 2014 ranked in the top 35 of 139 observa ons—first quar le, but just barely. It turns out that this top‐quar le group produced a median annual return in the subsequent five years of 9%— which is about what the return on U.S. stocks has been since the late 1920’s. In short, five‐year periods of unusually strong performance tend to be followed by five more years of favorable results. Benign backdrops support equities
T
he trend of modest improvement in the global business cycle remains generally favorable for asset markets. The benign, mid‐cycle backdrops in both the U.S. and Europe lay a founda on for moderate global growth, muted infla on, and low interest rates. These condi ons support equi es but have yet to present late‐cycle infla on that would threaten bond returns. European equi es may have the most cyclical upside due to their rela vely a rac ve valua ons and s ll‐muted investor expecta ons for economic ac vity. The biggest risk to the outlook for global improvement comes from emerging markets, where Fed ghtening and the strong dollar will likely make financial condi ons more difficult at a me when economic ac vity in these markets has decelerated substan ally. China is the biggest concern, though the base case is that it will avoid significant financial instability. We expect a modestly improving global backdrop through the remainder of 2015, but one that takes place within an environment of higher financial‐market vola lity. Overall, we con nue to favour equi es versus bonds in our balanced por olios with an emphasis on market segments (defensive dividend payers and select global growth stocks) that are good value and provide poten al downside protec on should an unfavourable global economic scenario unfold. In terms of fixed income, we con nue to avoid government bonds in favour of shorter‐term investment grade corporate issues and commercial mortgages. 4.2
Fossil Free
Biosphere Dividend Equity³
Biosphere CanGlobe Equity
Biosphere Corporate Bond
Index Returns
4
5 years 10 years
Past performance is no guarantee of future results.
1 Mandate change: Genus U.S. Equity mandate changed to Global Equity (Sept 14, 2012) and Global Alpha (June 30, 2014).
2 Mandate change: Genus Canadian Equity changed to Canadian Alpha on June 30, 2014.
3 Mandate change: Biosphere Canadian Equity (100%TSX) changed to Biosphere Dividend Equity (40% TSX, 30% S&P 500,
30% MSCI EAFE) as at April 1, 2013. Name change to Fossil Free Dividend Equity on March 31, 2015.
4 Mandate change: Biosphere Global Equity (50% S&P 500 / 50% MSCI EAFE) changed to Biosphere CanGlobe Equity (40%
TSX, 30% S&P 500, 30% MSCI EAFE). Name change to Fossil Free CanGlobe Equity on March 31, 2015.
First quarter proves
choppy for markets
I
t was a rela vely choppy first quarter for most developed equity markets, with Japanese (+16%) and Eurozone (+10%) equi es notable outperformers. European equi es have been fuelled by the prospect of the ECB’s QE, which finally became a reality in early March. The Canadian market with its combined 32% energy and materials exposure (two sectors that have been hit hard by the decline in commodity prices) has lagged behind the momentum of other markets. The S&P/TSX posted a 2.6% return for the first three months of the year. At the sector level, Health Care con nues to be the best‐performing sector, with an incredible +45.1% return year‐to‐date. Much of the contribu on to returns can be a ributed to Valeant Pharmaceu cals Interna onal Inc. In the United States, the S&P 500 managed to stay in the green by registering a quarterly total return of 0.95% in U.S. dollar terms (10.4% CAD) and extending its quarterly winning streak to nine quarters. This is its longest stretch of quarterly gains since 1998. The 22% rise in the trade‐
weighted dollar over the last six months has weighed on U.S. company earnings. The interna onal markets gained 12% in Canadian dollar terms as measured by the MSCI World Index, while emerging markets gained 11.8% (CAD). Expecta ons that bond yields would rise and hamper bond returns proved once again to be unfounded. Despite global uncertainty and geo‐poli cal instability, yields in most developed markets, including Canada, moved lower for the fi h straight quarter. Genus Balanced Fund
Asset Allocation
(As at March 31, 2015)
Asset Class
Percent of
Market Value
Cash Asset CAD
0
Government Bond
3.3
Strategic Bond
17.6
Commercial Mortgage
11.9
Total Fixed Income
32.8
Canadian Alpha
3.4
Dividend Equity
25.4
Canadian Equity
10.1
U.S. Equity
8.5
International Equity
6.8
CanGlobe Equity
31.3
Canadian Equity
11.9
U.S. Equity
10.6
International Equity
Global Alpha
8.8
5.1
Canadian Equity
0.2
U.S. Equity
3.2
International Equity
1.7
Emerging Markets
2.0
Total Equity
67.2
Total Portfolio
100%
Portfolio Equity Exposure
Total Canadian Equity
38.0
Total U.S. Equity
33.3
Total International Equity
25.8
Total Emerging Markets
2.9
Total Equity
The Genus Commentary is published quarterly by Genus Capital Management Inc. 6th Floor~900 West Hastings Street, Vancouver, BC, V6C 1E5
Phone: 604.683.4554 Email: [email protected] Website: www.genuscap.com
100%
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