Investment Newsletter | 3Q 2016
With increased political noise and unanswered questions carrying over from previous quarters, uncertainty and instability remain stubborn themes across financial markets.
One of the biggest concerns over the summer was the Brexit vote and its potential consequences. The “leave” outcome caught many by surprise, contradicting the air of optimism that had preceded the referendum. Two days after the vote, the FTSE 250 Index had lost nearly 15%, the sterling had fallen by 10%, and the U.S. dollar gained broadly. However, following the initial shock, it did not take long for these losses to mostly reverse. Central banks promptly announced their readiness to provide liquidity, and by mid-July, most asset classes had surpassed their referendum day closing prices.
Another major theme dominating the headlines was the U.S. presidential race between Hillary Clinton and Donald Trump. Polls were very close by the quarter’s end and although Mrs. Clinton had pulled ahead slightly by late summer, Mr. Trump was able to close the gap leading up to their first debate. Regardless of who wins the November 8th election, the odds have increased that the U.S. may shift to somewhat more protectionist trade policy.
And, though the potential for the Federal Reserve to raise interest rates keeps getting kicked like a can down the road, the Fed continued to sit on its position throughout the quarter. While a year-to-date inflation rate of 1.83% and an unemployment rate of just under 5% may have historically been compelling enough for the Fed to increase its benchmark interest rate, the Federal Open Market Committee’s (FOMC) concerns have—so far—outweighed these positive statistics. Between external events (like Brexit), inflation that appears tepid, an already strong dollar, and weaker projections for growth (the IMF is predicting ~1.5% for 2016), the FOMC has erred on the side of caution.
Markets in general appeared to remain appeased by the readiness of central banks to provide liquidity in response to events such as Brexit. Consequently, we continued to witness yields in core fixed income markets reach new lows. The pool of government debt trading at negative yields increased this past quarter, briefly exceeding $10 trillion in July. A handful of European corporates also issued debt at negative yields, and central banks in Japan, Europe, the U.K. and China pursued more accommodative policies. This is worth noting given that some central bankers have started to admit that their current policies might be reaching the limits of their effectiveness. A growing consensus has emerged among advanced economies that all monetary, fiscal, and structural tools should be employed to encourage more economic growth.
Of particular note, The Bank of Japan (BOJ) announced a new and unconventional monetary policy near the end of the quarter. As the negative rate that was introduced last February was generally unfavourable to banks, the BOJ has now shifted its focus from the amount of money they push into the economy to trying to keep longer-term rates higher than shorter-term rates. Their solution: “The Quantitative and Qualitative Monetary Easing with Yield Curve Control” policy. Essentially, the BOJ will purchase whatever volume of government bonds it takes to keep 10-year yields at current levels (around 0%). The BOJ also abandoned its target for expanding the monetary base, proclaiming that it will simply expand the base until they hit the Consumer Price Index target of 2%. Will this “whatever it takes” approach to stimulate their economy work? Time will tell, but the BOJ’s arsenal of tools appears to be running low.
Questions continued to linger over the third quarter about the banking sector’s ability to deliver adequate profits in an environment of low growth, a flat yield curve, and increasing regulation. The price-to-book ratios of banks in many advanced economies now trade below 1.0.
In Italy, a number of strategies for removing toxic assets from its banks’ balance sheets were debated, although the proposals have so far been challenged by the European Union. Italy’s banking system appears stagnant, with as much as 19% of its banks’ loans deemed non-performing. The European Union’s banking system remains mired with bad loans, which total as much as 10%.
China continued to walk a thin line between removing overcapacity and bad debts from its economy and fostering growth. Credit growth in China accelerated in the quarter, leading the Bank of International Settlements to warn that China risks creating a banking crisis in the next few years if they don’t get their financial house under control.
In the commodity realm, OPEC agreed to modest oil output cuts in the first deal since 2008. OPEC will reduce output to a range of 32.5-33.0 million barrels per day (OPEC estimates current output at 33.24 million bpd). How much each country will produce will be decided at the next formal OPEC meeting in November, when an invitation to decrease output may also be extended to non-OPEC producing countries such as Russia. The possibility of production freezes helped give support to oil prices this quarter, which benefited commodity-producing countries such as Canada.
How Did We Do?
(All performance is expressed in Canadian dollars and net of fees.)
Despite the noise and continued uncertainty, returns were steady, and all the Mawer funds ended the quarter in positive territory.
The Mawer Balanced Fund ended the quarter gaining 3.6%, although it underperformed the benchmark’s 4.4%. The main factor behind this underperformance was the performance of our International equity stocks which lagged their benchmark following a rebound of European banks which are not part of our portfolio (and were a major part of the outperformance seen in Q2). Also contributing to the underperformance was the underweight position of some of the strong performing equity segments. In particular, our cautious position in both Canadian large and small cap equity has been a headwind for the quarter and year to date. Canadian markets have rebounded from what was likely an oversold point in February and have subsequently experienced an upward correction. We still feel there are headwinds for Canada and sufficient uncertainty in general and this has kept us from changing our stance in equity weights. Markets have been overly attentive to central bank programs and we appear to have turned a corner with more central banks looking to slow or unwind stimulus programs. Cash has also been a drag on performance given the strength in equities.
The Canadian Large Cap Equity Fund gained 6.0% outperforming the S&P TSX Composite’s 5.5% this quarter, primarily driven by a combination of sector allocation and security selection. Being underweight in materials (notably gold producers, which was the weakest sector) as well as overweight industrials (notably CN and CP Rail) contributed significantly to this outperformance. Security selection was positive, driven by CCL, Constellation Software, Saputo, and the railway companies.
The New Canada Fund posted a healthy 5.8% this quarter, as the Canadian Small Cap universe saw broad strength across most of its sectors (8 out of 11 represented sectors were up on the quarter). The underperformance in comparison to the BMO Small Cap Index’s 6.4% can be primarily attributed to our overweight in the poorest-performing financials sector combined with our lack of exposure to the metals and mining sub-sector, but the Fund made up for that in security selection where we added about 2% of relative value. This value add came most notably from our holdings in Energy and Real Estate. In Energy, the quarter saw strong performance in service companies, which have lagged year to date, such as Canadian Energy Services & Technology, as well as ZCL Composites and Parkland Fuel Corporation—two companies that have more general industrial end-market drivers than oil & gas. Our largest exploration and production holding, Birchcliff Energy, also was a strong contributor. In Real Estate, we saw strong performance primarily from Altus Group which was up over 30% on a price basis in the quarter.
The International Equity Fund gained 4.6%, underperforming the MSCI EAFE Index’s 7.7%. Our lack of European banks in the International Equity Fund has been a massive relative tailwind this year, though in the third quarter they bounced back somewhat to represent approximately half of the Fund’s relative underperformance compared to the Index. IHS Markit, a leader in global information and analysis, and Tencent, China’s largest and most used internet portal, were our two top contributors; both companies have continued to show organic growth in this low-growth world. LG Household &Healthcare detracted from the Fund’s performance as the Korean government looks to be moving to recoup some lost tax revenue from the Duty-Free sales channel, which has been historically a good distribution network for the company.
The U.S. Equity Fund’s gain of 4.5% underperformed the S&P 500 Index’s 5.1% in the third quarter. The Information Technology sector was the best performer, while Utilities, Telecom and Consumer Staples were among the weakest as investors shifted away from defensive industries. Several of our technology investments also performed well including Qualcomm, Alphabet Inc., Visa, and Mastercard. Qualcomm, a company specializing in wireless innovations, was able to acquire a Netherlands based semiconductor manufacturer, NXP. Our telecom investments, such as ATN International, detracted from overall performance.
The Global Equity Fund gained 4.7%, but underperformed the MSCI World Index’s 6.1%. One of the main sources of this underperformance was the Financials sector. European banks (which we do not own) saw their share prices rebound after a very difficult start to the year while insurance brokers, such as long time holding Aon, underperformed after a year of strong gains. Top contributors included data and analytics providers S&P Global and IHS Markit. Both companies have shown the resiliency of their business models this quarter and delivered above-market returns.
The Global Small Cap Fund gain of 9.9% marginally outperformed the Russell Small Cap Index’s 9.7% this quarter. The positive performance can be credited to contributions from the Technology and Consumer Discretionary sectors. Technology holding NCC Group, a global expert in cyber security, and Hansen Technologies, a billing software provider, were among the fund’s top contributors. Both have been able to deliver growth through acquisitions combined with strong organic growth (highlighting the mission critical nature of their services) which has been well received by the markets.
The Canadian Bond Fund had a positive third quarter ending at 0.9%, although it slightly underperformed compared to the FTSE TMX Canada Universe Bond Index, 1.2%. Adding to our performance were our larger weights in provincial, federal, and infrastructure bonds. Provincial bonds was the biggest contributor due to our ~30% weight. The yield curve was flatter this quarter, predominantly with falling yields for bonds with maturities over six years and modestly rising yields for bonds with maturities five years and under.
The Global Bond Fund’s total returns for the quarter came out positive at 1.2% slightly underperforming the Citi World Government Bond Index’s 1.5%. Currency was the main contributor adding 1.26% over the past three quarters. Within currency, the biggest drivers were the Euro, the U.S. Dollar and the Norwegian Krone. The largest negative contributors for the quarter were the British Pound and the Mexican Peso.
Valuation of both equities and bonds remained a major question mark in this third quarter which was punctuated by uncertainty. Equities look expensive at their current levels when compared to historical multiples. However, equity valuations depend on interest rate levels, and if rates stay lower for longer and don’t revert to the mean, prices may appear more justified. However, in most scenarios, the valuation of equities appears “full-ish.”
Government bonds also seem expensive given current levels of yields and inflation. For government bonds to be fairly valued at these levels, it requires the assumption of deflation (not simply disinflation which is the slowing of the rate of price inflation). This is possible, although it is not our base case scenario. It seems likely that bonds are on the expensive side.
The full implications of Brexit are still unknown and will depend on how negotiations between the U.K. and E.U. take shape. So far, the stance taken by each appear to be taking more of a hard line than we might hope for. The U.K.’s departure also may increase the odds that another member of the union may eventually leave. Even the possibility of this happening could fuel more uncertainty in the markets. In macro terms, the U.K. may be an example of the negative impact that anti-globalization measures could have on economic growth.
The overall level of interest rates, and specifically how long they will stay at low levels, also remains one of the big unknowns. Currently the U.S. is the only major economic player that is considering an increase in the benchmark rate—Japan, Europe, the U.K., and China are all firmly within loose monetary policy mode. Even then, the Fed has seemed tentative at best when it comes to raising rates. An increase before the end of the year or the beginning of 2017, however, does remain possible.
Regardless of whether or not the FOMC raises interest rates before the end of the year, the larger question is whether interest rates as a whole will normalize in the medium-term. Although some investors seem to view interest rate normalization as inevitable, there is a plausible case that they will remain lower for longer.
If rates do stay lower for longer, there may be a number of consequences. Banks, for example, should continue to suffer. Between the new proposed regulations, a flat yield curve, and sluggish growth, banks face unfavourable conditions for generating healthy profits. Another likely consequence is that companies will continue to take on debt. We are already witnessing this trend.
The impact of the low interest rate environment on economic growth is difficult to predict. Theoretically, low interest rates should induce growth in an economy by pulling on the credit lever. Lower interest rates lower the cost of financing, which should lead to higher consumer spending and business investment (as well as potential export growth through a lower exchange rate). Unfortunately, this is not what we’ve seen. Instead, we’ve seen increased savings and limited business investment.
Why the conventional credit lever isn’t working is anyone’s guess. Central bankers would likely argue that banks haven’t been properly incented to lend yet or that we haven’t done enough to encourage credit flow. Critics of these policies would argue that the lower rate environment is scaring consumers, not incentivizing them. Others, such as Ray Dalio from Bridgewater, would argue that we are in the later stages of the long-term debt cycle and that these policies simply will not be effective.
We tend to be skeptical of the argument that “if it’s not working, do more.” If the cost of financing for companies is already around 1%, and they aren’t already investing in capital expenditures, it is hard to imagine why they would suddenly be inspired to do so at 0.5%. Monetary policy is a powerful but limited tool. It is not an economic panacea.
As the faith in monetary policy weakens, there has been a growing chorus for fiscal stimulus. While fiscal stimulus may temporarily increase GDP figures, we remain wary that it, like monetary policy two years ago, is going to be the magic pill that brings us back to growth. Fiscal stimulus comes in many different kinds of forms. Some, like research and development, could create a multiplier effect in the economy. Other forms of fiscal stimulus could make problems worse if they contribute to existing overcapacity in the economy or, at best, have a delayed impact. For example, it isn’t clear how quickly spending on infrastructure in the U.S. will lead to productivity improvement. Sometimes the only cure for economic malaise is to accept the pain and go through it.
As always, when you don’t have the specific answers you’re looking for, it’s prudent to resist the urge to guess or gamble. The most effective way forward, in our opinion, is to stick with the fundamentals: invest in well-managed companies with effective management teams that can be purchased at a discount to their intrinsic value. And stay diversified with a focus on the long term. This strategy buffers both you and your portfolio from the often unstable and unpredictable markets.
Mawer Investment Management Ltd.
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