Our Q3 Investment Report is out – Looking Back on Q3, Looking Forward at Q4, and spotlights on active vs. passive and global infrastructure.
Karl Berger, Cidel Senior Wealth Consultant and Director, was guest host on BNN’s ‘The Street’ last week. In this clip he discusses the Federal Reserve and expected upcoming changes.
An inspiring piece on the Invictus Games plus spotlights on distressed investing, cancer research and why you should question widely held investment maxims.
Click Here: https://cidel.com/newsletters/august-2017/
Cidel’s August Newsletter – A Coda to Summer: Jimmy Buffet, your kid’s sports, and kale salads.
Click Here: https://cidel.com/newsletters/august-2017/
Our Quarterly Report is out – looking back on Q2, what’s on our radar for Q3 and spotlights on our trust services and the Fed’s balance sheet.
Cidel’s June Newsletter – Steves Schwarzman and Jobs, Lefty’s insider trading issues and the myths of working philanthropically.
Click Here: https://cidel.com/newsletters/june-newsletter/
Cidel’s May Newsletter – an interesting range of perspectives on pricing
Click Here: https://cidel.com/newsletters/may-2017/
Gerard Baker, Editor-in-Chief of the Wall Street Journal speaks at a Cidel sponsored RamsayTalks event. Baker discussed America and the world in the age of President Trump.
Cidel’s Q1 Quarterly Report is out: looking back, looking forward, and spotlights on artificial intelligence and the rise of populism.
Our March newsletter looks at Toronto’s rise as a VC hub, Henry VIII’s role in Brexit, and why you see so many puffer jackets.
Cidel has been appointed portfolio sub-advisor for the NexGen Canadian Dividend Fund, by Natixis Global Asset Management Canada. We are looking forward to continue building on our relationship with Natixis and expanding our sub-advisory business in Canada and around the world.
In our February newsletter we feature an interview with a uniquely modest private equity manager, Howard Marks of Oaktree Capital, and a remarkable Canadian medical device that lets blind people see.
Click here: https://cidel.com/newsletters/february-2017/
Our Q4 Quarterly Report is out – our investment team’s quick take on the important stories of the prior quarter and what could impact portfolios looking forward, plus more in-depth analysis of important themes or presentations we think might interest you.
The first Cidel Newsletter of 2017: a look at Uber and AirBnB’s beginnings; an intimate account of mental illness; the magic of thinking long-term when investing; and a timely list of ways to keep your productivity going strong through the new year.
Click Here: http://cidel.com/newsletters/january-newsletter/
Here is a clip from Karl Berger’s (Senior Wealth Consultant and Director) appearance on BNN last week. Markets are reacting to Trump’s victory with expectations of significant economic growth and higher interest rates. In our view, Trump’s victory represents uncertainty. http://www.bnn.ca/video/top-canadian-stocks-no-matter-what-trump-does-or-doesn-t-do~1032234
Our last newsletter of the year: Dalio on Trump, Tiffany’s troubles, and the best books of 2016. See you in 2017!
Click Here: http://cidel.com/newsletters/december-2016/
Click here to watch Rob Spafford on Bloomberg TV’s “The Daily Brief.”
Click here to watch Karl Berger on BNN’s “The Street”, discussing the causes and implications of the U.S. dollar hitting 14-year highs.
We never really expected to write the words “President Trump” in any commentary but that is where we are today. It has been an emotional rollercoaster that has left many clients, friends and family concerned, disheartened and perhaps afraid. It is at moments like this that we have to distance ourselves from the passion of the moment and reframe the issue. Emotional considerations aside, where is the real risk? The bottom line is this: in the aftermath of the Trump victory we have greater uncertainty which will entail lower economic growth rates and higher premiums for risky assets.
During the past few years we have witnessed a continued movement in market prices towards safety, resulting in a considerable sacrifice of potential upside. Corporations have continued to amass record amounts of cash as a cushion against another downturn. Investors have withdrawn money from equities and sought the perceived safety of fixed income. In Switzerland, where I write this commentary, the entire yield curve is negative, meaning investors buying Swiss government bonds in fact pay for the privilege instead of earning from it. Even investing your money for 50 years in Swiss bonds yields nothing. With the election of Trump it is unlikely that any of these situations will change soon.
In general, things never turn out as badly as you fear they might. Even if President Trump wants to enact some of his election promises, he will have to work through Congress to get the bills passed. In the past we have certainly seen many governments and presidents come and go without a dramatic impact on businesses. The problem today is that we can easily envision a number of bleak outcomes. Initially, as with Brexit, we suspect that the markets will stabilize because very little will change in the short run. But leaving aside social and moral judgements, we believe that in this economic environment, the investment risks are somewhat greater – not so much from a legislative perspective but from an economic policy perspective.
For us, the real concern is what will occur in the event that slower US growth slips into a recession? Let’s look at how this could play out over the next few years. First, we expect that at some point during the next year Trump will announce a replacement for Janet Yellen, the current Chair of the Federal Reserve, whose term expires in February 2018. Unless we are pleasantly surprised, her replacement could be someone without the experience or credentials that all Federal Reserve Presidents in recent memory possess. Moreover, Trump has indicated that he would like to reform the Fed, which may well compromise its traditional independence. It is likely that the replacement will be much more beholden to the President and even the Republican Party, which implies a greater focus on inflation and less on the goal of full employment.
Second, if the economy moves into recession, what will be the likely policy response from President Trump? The average decline in interest rates during previous recessions has been about 5%. The Federal Reserve does not have the ability to drop rates further. Previously we would have expected the government to step in and increase spending to stimulate the economy. However, it is more likely that a businessman and Republican will try to restore confidence by cutting spending in a recession, when government revenues are declining. The result would be a more pronounced recession. The result could be a long and particularly nasty economic slowdown. We are not forecasting this outcome; however, the possibility of such a scenario is higher now.
For investors, managing risk though judicious equity selection and geographic exposure will be even more important as uncertainty rises. Investors can not blithely assume that the US economy will be the engine of growth that it once was because the possibility of policy mistakes is higher. Our expectation is that economic growth will continue to disappoint and be revised lower and interest rates as a consequence will remain low. At Cidel, we will re-examine our allocations and individual investments in light of this event, as we continually do, to determine appropriate changes in this new environment.
The US 10-year bond yield climbed almost one quarter of a percent to 1.83% amid increasing expectations that the Fed was on the cusp of a second interest rate hike in the US this cycle and that problems arising from negative interest rates marked a low point for yields-pressured bond markets. This expectation undermined equity markets, with the MSCI World falling 2%. The Canadian Dollar weakened against its US counterpart.
Historically, the healthcare sector has been popular with growth investors, and for good reason. Positive long-term demand trends due to an aging population, combined with significant barriers to entry underpinning the ability to raise prices combine to offer the prospect of above average earnings growth, largely independent from the economic cycle. This combination should have particular appeal in the current environment of moribund growth and weak pricing power, however the sector has been underperforming the broad market significantly. What are the issues frightening investors, and what can we expect going forward?
Two main factors are causing investors to question assumptions around the historical business model of pharmaceutical companies, particularly their ability to raise prices at will: political pressure from government, and commercial pressure from large scale drug purchasers.
The US Government is the largest payer for prescription drugs, so it has a vested interest in the trajectory of drug prices. However, elections create the potential for a change in the balance between the various competing interests. The Republican platform is largely focussed on replacing the Affordable Care Act with some alternative offering patients greater choice and reducing the burden on employers. Hilary Clinton’s goals include improving the Affordable Care Act, and improving Drug Affordability. Proposals to increase affordability include making it easier for generic/biosimilar drugs to get to market, creating a watchdog to ‘respond’ to excessive price hikes in older drugs, and allowing Medicare to directly negotiate for drug prices. While both platforms could result in changes, the ability to pass legislation obviously depends largely on who controls Congress, so if gridlock persists, any radical overhaul is ultimately unlikely. However, due to pre-election uncertainty, it’s no surprise that investors are avoiding the sector until the outcome is known.
Additionally, there are state-level initiatives which create uncertainty in future earnings potential for the pharma sector. Most prominently, Proposition 61 in California proposes mandated best pricing for state employees/retirees. While it seems likely to pass, how drug companies will respond remains to be seen. In our view, any proposal to impose direct Medicare price controls are the most concerning for investors, although the current system has already resulted in concentrated buyers negotiating with drug companies, demanding and receiving considerable economies of scale.
This increasing pressure by drug purchasers (insurance companies and their Pharmacy Benefit Management agents) to reduce net drug prices is the second serious source of pushback to pharma earning potential, and it seems to be intensifying and affecting additional areas. For example in diabetes treatment, Novo Nordisk (a former portfolio holding) recently revealed that an inability to get sufficient pricing on its new drugs to offset negative pricing on older treatments, caused a 50% cut in its medium term growth target. In our opinion, this ongoing pressure from purchasers is a bigger fundamental concern than political headlines.
So where next? The consensus from a recent healthcare conference we attended is that the sector should perform better post-election, although the pricing environment will likely remain tougher for some time. Given that price increases more or less fall 100% to the bottom line, valuations will likely adjust downwards, and it’s not clear that this process is complete. However, while price pressure is a challenge for the industry, the inexorable increase in healthcare costs is a real longer term challenge for government finances, and any ability to reign them in without hampering innovation would be a welcome ‘big picture’ development. In any case, change always creates opportunities, so Cidel – and investors – will be on the lookout.
September saw equity markets close to their all-time highs, with gains in both Canada and the United States. For the third quarter the MSCI was up 5.25%, the TSX was up 5.45% and the S&P 500 was up 4.23%. The bond market was also up by 0.44% for the same period. Despite positive equity market returns, clients and institutions remain concerned as the US election approaches.
The most common question that we get from clients is – what changes we are going to make to portfolios ahead of the US presidential election? With emotions running high many clients feel that preemptively moving to a cash position may be a prudent decision. Stepping away from the emotions associated with the presidential candidates, we can examine this question from the perspective of market timing and market efficiency. The answers provide an interesting insight into markets and returns.
Make no mistake about it, aggressively timing the market does not add any value to investment returns – in fact it is a big detractor to long term performance. Constantly bouncing from cash to a fully invested position only makes money for the brokers. For market timing to be successful, a trader (notice we didn’t use the word investor) must identify the correct moment to exit the market and ALSO identify the correct moment to re-enter the market. In addition, the trade must cover all the commissions and taxes that are associated with the decision. Over long periods of time equity markets tend to rise, so by timing the market you are also swimming against the tide of growth. The likelihood is that all those factors will work against any market timing strategy. So under what conditions would such a strategy be successful if at all?
The answer lies in the arena of market efficiency. At Cidel we believe that markets are semi-efficient, which means that markets incorporate all public information into prices and that if there are gains to be made it is from insights uncovered through detailed proprietary research. Putting this into perspective, ask yourself how many people in the market don’t know that Donald Trump is running for president, and that there is some possibility that he may win. Of course most people know this fact and have been incorporating this possibility into the prices of assets, not only in the US but across the globe (e.g. recent gyrations of the Mexican peso). For any trading strategy to be successful, a trader must have access to information that is not public or, in this case, have an insight into Trump’s presidency that other traders do not possess. So a position on Trump or no Trump based simply on personal opinion is unlikely to yield any edge.
If there is an edge to be gained, it is likely in the form of scenario analysis. By that I am referring to possibilities that the market has not priced in because they are not widely considered. For instance, consider the following possibilities. What if Trump drops out of the running prior to the election date? What if Trump wins a narrow majority in the electoral college but loses the vote? Will the electors vote with the win or will they vote contrary to the pledge? What if Clinton wins by a landslide and the Democrats also win majorities in the House and Senate? By working through these scenarios we can get an idea of what markets are likely to do and how we would respond either by buying or selling a specific stock(s). Scenarios combined with our proprietary equity research give us the opportunity to react quickly if there is an exaggerated market movement, no matter how brief.
Ultimately, it is knowing how to manage the risk/opportunity associated with unexpected news that generates returns, rather than trying to aggressively time an event for which the whole market is prepared.
Arthur Heinmaa, CFA
Click here to watch Chief Investment Officer Arthur Heinmaa on Bloomberg TV.
Global equities produced modest gains in August, with emerging markets continuing to perform well. 10-year bond yields climbed as investors continued to fixate on the outlook for US monetary policy.
When considering what to do with cash not earmarked for internal investment, corporations have two basic options for returning it to shareholders: either to pay a dividend or to repurchase shares in the market. Market analytics firm FactSet notes that US firms bought back $166.3 billion in shares in the first quarter of 2016, an increase of 15.1% over the same period last year. To put this into context, FactSet calculates that this represents a “buyback yield” of 3.3% for the S&P500 index. Should investors care?
The debate over the relative merits of dividends and buybacks can generate surprising levels of passion in the hearts of finance practitioners. Academics would argue that, assuming a company’s share price is fairly valued, there’s no real difference – if company A paid a 10% dividend while company B bought back 10% of their shares, shareholders in company B wanting immediate income could sell 10% of their holdings to have the same amount of cash and proportional interest in the company as their counterparts in company A. Without selling, their percentage interest in the company would have increased by 10%, so while the total value of the company would be unchanged, the value of each holding would be 10% higher. Logistics company Expeditors International described it as the corporate finance equivalent of a Miller Lite (“Tastes Great/Less Filling”) commercial. In the real world, however, there are some more nuanced factors to take into consideration.
When buybacks initially rose to popularity in the 1990s, dividends were taxed at a higher rate than capital gains – a bias that created a clear argument in favour of buybacks. After the tax treatment of dividends was reformed, this argument evaporated, though buybacks didn’t. A popular justification, particularly considering broader market supply and demand for equities, is that ongoing buyback activity creates a natural demand for stock and can act as a tailwind to share prices. Goldman Sachs expects $450 billion in total share repurchases during 2016, creating the largest single source of demand for US equities. However, buybacks invariably dry up in a sharp market downturn. Ideally, a company would buy back stock when its share price is trading at an overly depressed level and stop (or issue stock) when shares are overvalued. Canadian insurer Fairfax Financial is one of the few companies that (tries) to do this.
There are counterarguments, of course. Firstly, many companies buy back substantial amounts of shares to offset incentive shares issued to management, leaving the total number of shares outstanding unchanged while simultaneously downplaying the income statement impact of share options. More broadly, share repurchases can interact with badly designed management incentive schemes to encourage decisions not necessarily in the shareholders best long-term interest, for example aggressively buying back shares rather than investing in a long-term project, or borrowing large sums of money to finance buybacks. While the mathematical justification certainly exists in the current low interest rate environment, the potential for unintended consequences down the road exists as well.
At Cidel, we ultimately have a bias in favour of dividends not least because of their tangible nature, however, a solid understanding of a company’s sustainability and underlying cash flows is the most important basis for sound investment decisions.
Cidel Asset Management Inc. manages the Toron AMI Balanced Strategy.
Toron AMI’s Balanced Portfolio fund is designed for a broad range of investors as a complete
portfolio solution. Investors benefit from access to the firm’s multiple investment strategies in one
balanced investment. Read the Fact Sheet for a full overview of this strategy.
For information about performance, view this summary from the eVestment Database.
Note: Toron AMI and Benchmark performance is gross of applicable management fees.
Over the course of July, equities shrugged off their Brexit inspired swoon, with the MSCI World Index gaining just over 4%, largely upon the perception that central banks would act to offset any economic impact of the UK decision. The Canadian dollar fell modestly against its US counterpart, and the yield on the US 30-year treasury fell 10 basis points.
While it is generally accepted that the various programs of Quantitative Easing (QE) – injecting cash into the economy by buying bonds – carried out by Central Banks have been successful in terms of supporting the economy, it’s also apparent that they haven’t delivered the boost to growth and inflation some of their more enthusiastic advocates hoped for. Likewise, the move to impose negative interest rates seems to some extent to have been counterproductive thus far, due to the negative impact on commercial bank profitability. Obviously believers in the maxim “if at first you don’t succeed”, many opinion leaders are now advocating even more out-of-the-box policies- particularly the concept of ‘helicopter money’.
While it creates a fantastic mental image, helicopter money is actually a metaphor put forward by economist Milton Friedman and popularised in a 2002 speech by Ben Bernanke when he was a Fed Governor. The basic concept is that if the central bank created money and gave it to the government, which in turn used it to invest in infrastructure, say, or cut taxes, the resulting boost to aggregate demand in the economy would stimulate growth. While this sounds in effect the same as QE, there is a crucial difference. In a QE program, the central bank is exchanging one asset (cash) for another (bonds issued by the government). The government still has to repay those bonds, albeit now to the central bank rather than the previous private sector holder. While the mechanics could take several forms, a program of helicopter money would effectively supply fresh cash to the economy but with no corresponding government liability. From the perspective of the private sector, QE leaves their net assets the same but alters the mix; helicopter money on the other hand serves to increase their net assets.
On paper this sounds like a good idea- public spending and a boost to people’s incomes should have a stronger direct economic impact than relying on some spill over from higher asset prices arising from QE. Likewise the absence of incremental government borrowing reduces the risk of upward pressure on interest rates. However as is always the case there are a number of significant potential pitfalls (setting aside questions of the legality of such action). The credibility of central banks lies to a large degree on their independence from the government, and a perception that they are in reality subject to political influence could therefore threaten the effectiveness of future actions. Short term success in stimulating the economy could also take government focus off attempts to enact more difficult longer term reforms. Finally, the achievable boost to demand is debatable if any increase in household income is perceived to be one-off in nature- for this reason spending on infrastructure and so forth is preferable to a one off transfer payment to members of the public.
Overall it is likely that the risks to central bank credibility will prevent a wholehearted adoption of helicopter money. Certainly the Bank of Japan, considered by some the most likely candidate to put it into practice, recently disappointed markets with their failure to do so. That said the temptation is there and will intensify should the current underwhelming growth trends persist. Overall we return to the sentiment expressed in last month’s note- the importance of selectively investing in companies with underlying business characteristics that give them control over their own destinies.
Click here to read a Wealth Professional article on the global appeal of Canadian telecoms, featuring our portfolio manager Rob Spafford.
Click here to read this Canadian Business magazine about investing in a low interest rate environment, featuring our Chief Investment Officer Arthur Heinmaa.
For the quarter ended June 30th, equity markets returns were up slightly from the previous quarter and are now positive for the year. Year to date, the S&P returned 3.28%, the MSCI 0.12%, the TSX 9.8% and bonds 4%. Of course the big news was the result of the Brexit vote and the stunning decision by the citizens of the UK to leave the European Union. This result continues to reverberate across financial markets with equity markets almost recovering their losses following the vote. In contrast however, the global bond markets have not returned to their pre-Brexit levels. This month we will look at what this decline in yields might mean for the economy and investors.
Thirty years ago interest rates stood at over 15% and many people were losing their homes because they were unable to afford the higher mortgage payments due to increasing mortgage rates. Never in their wildest dreams did anyone expect to see today’s 10-year Canadian bond rates at 1% and 30 year bond rates at 1.60%. In the week after the Brexit vote long term (30 year) yields dropped by 0.45%, an amazing move in the bond market, and they remain at those low levels. What is implied by these interest rates?
The first implication of these low rates is that global growth will remain muted. The economy will stumble along, but it is unlikely that we will return to the 3% growth rates of the past. Low interest rates over the past 8 years have encouraged companies and individuals to spend/consume today, essentially bringing forward consumption from the future to today. The direct consequence of that policy is to dampen demand in the future. Anyone who really had an intention to spend or expand has already done so, and hence lower demand lies ahead. Lower demand will translate into anemic growth.
The second implication is that inflation is expected to remain low. Many market observers forecast increasing inflation rates as both the Fed and European Central Bank embarked on quantitative easing and central bank balance sheets expanded. This has not proven to be the case, and indeed the market is now forecasting that the first interest rate increase will now take place no earlier than 2019. Without sufficient demand the economy will fall chronically short of potential, resulting in little or no inflation. Therefore, we shouldn’t expect inflation to push interest rates higher.
The third implication, which is actually more of a question, is why the government is not spending on needed infrastructure projects. Adjusting for inflation, long-term Canadian and US interest rates, i.e. the borrowing cost for the government, are at or below zero. In many other countries interest rates are below zero even before inflation adjustments. It would be reasonable to assume that there should be some infrastructure investments that would produce a benefit that is greater than zero. As most of us would agree, public transportation would be high on the list, as would road repairs. Unfortunately however, there seems to be little will for governments to spend money – even at these low interest rates. Until that changes don’t expect the growth picture to change.
In this low growth environment it is more important than ever to be selective about the securities you purchase because tepid economic growth will not bail out a struggling company, and indeed it will serve to exacerbate the financial implications of corporate mistakes.
Arthur Heinmaa, CFA
CEO, Cidel Asset Management
Chief Investment Officer
Click here to see Karl Berger on Bloomberg TV, discussing investing in global markets.
CEO Craig Rimer is featured in this Wealth Professional article. Click here to read about what sets Cidel apart from the ‘Big Five’ Canadian banks.
In a huge surprise, the UK voted to leave the European Union. This decision immediately reverberated through global financial markets with Sterling dropping over 10% versus the US dollar, dropping to a 31 year low, equity markets declining over 5% and the 30 year bond rising 4%. To put things in perspective, the Dow Jones Industrials were up 500 points in the previous 5 days and are expected to lose 500 points at today’s opening. Where financial markets will settle is still unknown but we wanted to share some of our initial thoughts on this historic day.
1. Is this the beginning of another financial crisis?
This is not another Lehman. The voting results surprised yesterday’s consensus, resulting in dramatic short term moves in the market but this decision in no way undermines the financial system. The banking system today is better capitalized and less leveraged than at any time in recent memory. This vote is not the same as the financial crisis of 2008. Investors should not liquidate their portfolios thinking that we are on the brink of a financial collapse. What we have experienced is a global repricing of financial assets based on the prospects for lower growth in the future.
2. What are the key things to consider?
In our view there are three important features of this vote to consider. First, the vote is clearly a vote against the establishment. Almost universally economists, business leaders and academics supported and campaigned for the remain side. Despite the reasoned, logical arguments put forth by the remain side, voters rejected those arguments and instead sided with the populist anti-immigration anti-Europe leave campaign. Indeed those cheering the results are none other than Donald Trump, Marie Le Pen and Frauke Pettry (Alternative for Germany) all of whom are campaigning as the anti-establishment candidates in their countries.
Second, there was a dramatic split between the young (under 35) and the old (over 60) with the young voting almost 75% in favour of remaining in the EU and an equally large portion of the older population voting to leave. In the abstract this result is disheartening because the younger population will have to live with a decision that they clearly did not want. Only time will tell if this decision lingers in the minds of younger voters when it comes time to make decisions on pensions and healthcare for retirees.
Third, there was a large split in the vote between the large urban areas and the rural areas. London, Edinburgh, Liverpool and Manchester all voted to stay with the bulk of the smaller regions voting to leave. The polarization of voting was remarkable and we think it is an indication of how the smaller regions believe that they have been bypassed in this new era of globalization.
This pattern of voting is not unique to the UK. It is likely that we will see a similar pattern in Spain on June 26th and in the US this fall. This polarization between the young and old, urban and rural and the establishment and populists will only increase political uncertainty in any future election. All of which will make it riskier for corporations to make longer term capital commitments.
3. What are the consequences for the economy?
Overall we should expect lower growth in the future. In times of market turbulence we regularly look at what is happening in the fixed income markets to validate or refute what is happening in equity markets. The US long bond dropped from a yield of 2.56% to 2.39% in the space of a few hours. It might seem like a minor move but in fixed income markets this move is nothing short of remarkable. It is a clear indication that the expectation will be for lower growth and lower rates for a longer period of time.
The reasons for lower growth are straightforward and both are rooted in the uncertainty surrounding the timing, terms and conditions of the UK exiting the euro. Corporations in Europe or doing business in Europe will be more cautious and will delay or slow investment in that region until the terms of business are clear. Given the size of the European economy this will have an impact on the prospects for global growth.
For the individual, particularly in Europe, our suspicion is that they will be more risk averse and accumulate savings rather than spending or investing. This situation will act as a brake on growth and might drive interest rates even lower throughout the European area and the rest of the developed world.
4. Should I adjust my portfolio?
The answer is no. The instinct to run to cash is always powerful in times of uncertainty and it is important to fight that sentiment and stick to a disciplined plan. Rarely do short term emotional decisions work out well. One can’t trade on yesterday’s prices so the decisions must be based on what the prices are today and more importantly what they might be in the future. Hence, the important activity will be to incorporate this new reality into our valuation models and make appropriate changes to holdings and asset allocations if required.
The past 24 hours have been unlike anything we have seen since the UK withdrew from the European Exchange Rate Mechanism (ERM). We will continue to monitor markets and will make changes to your portfolios only if it is warranted by valuation concerns and not emotion.
Please feel free to contact your Cidel Consultant if you have any other questions.
Chief Investment Officer, Asset Management
Charles Lannon was interviewed by the Financial Post. Click here to read about our view on the current bull market, and some of the holdings in our Global Equity mandate.
Portfolio manager Stephen Caldwell gives The Globe and Mail some of his favourite stocks in the healthcare sector. Click here to read.
May saw a rebounding US dollar adding to returns on US assets for Canadian investors. Other international markets made some headway too. The strong US dollar pressured several commodities, although oil worked its way higher. Despite experiencing some volatility, US long bonds ended the month largely unchanged.
US companies are required to file audited financial statements prepared according to Generally Accepted Accounting Practices (GAAP), determined by the Financial Accounting Standard Board (similar requirements exist in other countries). However, companies may also report earnings on a pro forma basis, incorporating adjustments to GAAP earnings to reflect what they would like investors to see as the company’s underlying earnings power. While it is true that investors should be looking forward to a company’s future earnings potential and not focus on short term, ‘one-off’ developments, it would not be cynical to think managements use pro forma earnings to paint the most flattering picture possible, a task made easier by the relative freedom to decide which adjustments to make. Currently the spread between GAAP and pro forma earnings for the S&P 500 is running at 30%, a difference last seen in the third quarter of 2009 when companies were still cleaning up their books after the financial crisis. Combined with the current anaemic level of earnings growth, commentators are increasingly concerned that companies are becoming more aggressive in papering-over deteriorating fundamentals. Likewise the Securities and Exchange Commission (SEC) has made it clear that they intend to question more companies about how they arrive at their pro forma figures, indicating that they will be placing this issue under increased scrutiny. Should investors be concerned?
While a degree of caution makes sense, a review of historical trends and a closer look at the current situation would argue against overreacting. Firstly, 20 companies alone account for in excess of 50% of the pro forma/GAAP spread; secondly, oil and gas impairment charges are, as would be expected, running at high levels. Finally, the spread between pro forma and GAAP estimates hasn’t been a great predictor of future market performance; indeed, the divergence is often greatest around a market bottom, when companies are writing down all sorts of assets in the middle of a recession. However, conclusions drawn from the aggregate picture don’t necessarily hold when looking at individual stocks. It’s always important to be aware of accounting issues, whether or not the market is paying as much attention as it should.
At Toron AMI, our investment process explicitly includes a review of earnings quality and the appropriateness of adjustments included in pro forma numbers. We accept the case that genuine one-off events, such as restructurings, should be considered (although a surprising number of companies exist in a world of rolling restructurings), but we take a highly skeptical view of certain common non-cash adjustments. First, adding back the cost of management stock options as a non-cash expense is debatable because ultimately these options result in dilution to existing shareholders or a cash outflow to buy back shares and offset the dilution. Second, we are cautious about adding back the amortisation of acquired intangible assets because the intangible itself was purchased with shareholder funds; it’s almost like adding back depreciation of fixed assets.
While some degree of pragmatism is ultimately required, we take care to consider any material adjustments in pro forma earnings in our valuation work. By incorporating this discipline into every investment decision we make, together with consideration of management track records and other key factors, we focus our attention only those investments offering a favourable balance of risk and reward.
A rebounding Canadian dollar saw gains on international equities translate into modest losses for the month of April. Commodity prices and related shares did well, although the sustainability of their outperformance is an open question. US 10-year Government bond yields moved modestly higher.
On June 23, British citizens will take to the polls in a referendum over ‘Brexit’ – whether the UK will remain a member of the European Union – a decision with important ramifications for both sides.
Among those favouring Brexit, there is undoubtedly some nostalgia for a bygone age of ‘warm beer and cricket’. However, advocates also point to the costs (both direct and indirect) of EU membership, which have been estimated as high as 11% of GDP. Obviously estimating indirect costs (e.g. those due to ‘excessive’ regulation, etc.) is highly subjective. Particularly concerning for London, a financial hub (financial services are 12% of UK GDP), are EU proposals to introduce a financial transaction tax, among other regulations. Another concern is the impact of immigration from EU states. Although the UK’s ability to attract young, well-educated EU immigrants was a significant factor in the OECD’s reappraisal of the UK’s trend growth rate from 1% to 2%, this favourable view is far from universal – the last general election saw significant defection of traditional blue-collar support from the Labour Party to the Eurosceptic UKIP. Finally, there is a sense that the EU will inexorably move toward ‘ever closer union’, leaving the UK increasingly marginalised; therefore leaving now is perceived as the lesser of two evils.
In the other corner, supporters of the status quo point to Britain’s trade privileges as a member of the sizeable EU market and to the ability of financial firms based in London to operate in EU markets with a ‘single passport’. Proponents also emphasise the benefits of immigration, pointing to studies that EU migrants are net contributors to public finances. Brexit would have an immediate negative impact on the economy, and subsequent growth, they claim, would not offset it. Finally, it might not be as easy for the UK to preserve the current trade benefits with the EU as Brexit advocates assume. The potential for a yes vote is causing concern in Brussels, not least because of its potential to spread to other members.
The demographics of support for the two camps are interesting. ‘Remain’ is most popular with the younger 18-29 year old cohort, whereas ‘Leave’ is the choice among those 50+. Given that different age groups have different propensities to vote this could lead to an outcome quite different from that suggested by polls. Similarly, support for staying in the EU is strongest in the highest socio-economic group, and strongest for leaving in the lowest – a reminder that individual circumstances can cause the day-to-day impact (real or perceived) of events to vary significantly.
Polls currently read neck-and-neck, with marginal gains in favour of exit. Online betting markets, however, are pointing to a decisive vote in favour of remaining in the EU. Should the vote favour Brexit, the UK would have 2 years to negotiate a new relationship with the EU, during which the status quo would continue to apply. If two years pass without agreement, membership will cease unless an extension is agreed upon. Although a leave vote will not result in immediate changes to the UK’s status, the subsequent period of uncertainty could well have a negative impact on the economy and Sterling. While Toron AMI’s global portfolios are currently underweight in the UK market, we have an open mind and are watching closely, ready to take advantage of any opportunities arising over the coming months.
Click here to watch Stephen Caldwell on BNN’s ‘The Business News.’
Looking solely at the returns for the quarter ended March 31st, equity markets hardly changed from the beginning of the year: the S&P returned 0.60%, the MSCI -0.90% , the TSX +4.5% while bonds returned about 1.5%. However the quarter was in fact quite volatile. Equity markets declined over 10% at one point, oil hit a new low at $26.05 and corporate bond yields spiked to levels not seen since 2009. It would have been easy to lose money trying to time the ups and downs of this market. The best results were achieved by resisting the urge to trade.
Media reports and investors focused on the movement in equity markets, but the prevalence of negative interest rates across the globe is an even bigger story. Not long ago, negative interest rates seemed related to concerns over the possibility of a Greek default. However, their persistence, and in some cases their adoption as an explicit monetary policy tool, has real implications. Currently, there is about $7 trillion in bonds which trade at negative yields – not an inconsequential sum. An investor in Switzerland could purchase a 5-year bond for CHF103.50, earn no interest and receive CHF100 in 5 years’ time – in effect locking in an annual interest rate of -0.70%. In other words, investors pay CHF3.50 to guarantee CHF100 in 5 years. This situation is entirely foreign to Canadian and US investors.
In Canada, we view current interest rates as extraordinarily low at 0.70% for a 5-year government bond. However, we are a high-yielding country! Most investors would be surprised to discover that among developed countries, only the US, Greece, Portugal and Iceland offer higher yields; even Spain now yields less than Canada. As a result, Canadians should not be so quick to assume that our interest rates will move higher soon and any further economic weakness and Canada may find itself joining the negative interest rate club. But in the global search for yield, Canada currently offers a compelling investment opportunity – positive yields, especially for European institutional investors, for whom negative interest rates are a fact of life. Rather than charge small depositors a negative interest rate, European banks have partially absorbed the interest cost and raised service fees.
So, what does this situation mean for most investors? First, negative interest turns conventional financial wisdom on its head. For example, although deferring taxes on investments has generally been advisable, in the world of negative rates this is no longer the wisest course of action. In fact, you may want to accelerate your tax payments – a dollar today is worth more than it will be in the future. Shrewd Swiss citizens have attempted to prepay taxes, but the government has now forbidden paying anything but current taxes. This is but a small window into the world of negative interest rates.
Second, and most importantly, investors must consider how this kind of interest rate environment impacts retirement plans. Many simple retirement calculators blithely assume that fixed income returns will work out to their long term averages of about 6% per annum. Given the current interest rate levels (0.70% 5 yr. – 1.40% 10 yr.), those returns are simply unrealistic. Even at today’s interest rates, many investors are losing money after taxes and inflation are taken into account. To achieve higher rates, investors must consider corporate bonds, preferred shares and alternative investments as part of their overall bond allocation. Our team is focussed on finding companies with the ability to increase dividends at rates well above inflation and on constructing preferred portfolios that avoid common mistakes with this asset class, thus reducing potential future problems for our clients.
Negative interest rates, once considered a historic anomaly, have become a common fixture in today’s fixed income markets. We can no longer assume that Canada will follow its own path to higher rates. To be successful, investors have to consider the implications of negative rates to understand how to alter their current portfolio or what action to take if Canadian rates fall, gulp, below zero.
Listen here to an internal interview with Charles Lannon, the head of Toron AMI’s Global Equity strategy. He has just returned from a research trip to Japan and Singapore and in the interview he discusses his trip, including the general mood among business executives, the economy, and the companies he met with.
If you have any questions, do follow up with your relationship manager or contact firstname.lastname@example.org for more information about the Conversation Series.
Disclaimer: Past performance is not an indication of future results. The content contained in this document is for information purposes only. It is not intended as an offer or solicitation for purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any transaction. All individuals should obtain specific professional advice.
With the Republican and Democrat nomination processes drawing to a close, campaigning for the November US election will soon begin in earnest. Given the current frontrunners, it certainly promises to be an interesting few months, to say the least. Should investors care? A theory which was once in vogue described the Presidential Cycle, where pre-election promises and fiscal initiatives designed to bolster voter sentiment led to a stronger market in the election year and the preceding one, while the reversal of those initiatives in the following two years led to weaker returns. Certainly there is some intuitive appeal to the theory. It did seem to hold true for a while, which of course led to its gaining popularity, but as is often the case over a longer period its effectiveness has become less compelling- 2008 was an election year, for example. Whether this is a case of mistaking correlation for causation or a reflection of changes over time in the structure of the US economy is an interesting topic for thought.
Considering the election year specifically, research by Deutsche Bank shows that since 1960, the fourth year of the presidential election cycle has seen the S&P 500 produce a capital return of 6.5%, versus a rise of 7.9% for all years; excluding 2008 the respective figures become 9.1% and 8.8%- a negligible difference. Looking within the year, work by Ned Davis Research shows that stocks tend to struggle during the first half of election years, bottoming on average in May. The timing of a more constructive market environment tends to coincide with emerging clarity as to who the eventual winner will be, regardless of who it is.
Overall, while we do not advocate making investment decisions on any short term or seasonal theme, we think it’s reasonable to expect some pick up in volatility in the run up to the election, especially given the likelihood of some controversial policies being floated. Our base case though is that as in the past once a better picture emerges of who the eventual winner will be, it will be discounted as the outcome and the election will fade as a source of investor uncertainty (no doubt to be replaced by something else!) Of the two most likely candidates, Clinton is generally felt to represent the status quo and as a result be the most ‘market friendly’; Trump on the other hand is a bit more of a loose cannon but the fact of the matter is that any presidential legislation has to make it through Congress; an extended period of gridlock would be the likely result, leaving investors to focus on the broader fundamental picture.
Global equity markets started the New Year on a glum note as December’s optimism turned to disappointment as stocks around the globe sold off in January. By some accounts this was the worst start to the year since the 1930s, although a rebound mid-month pared losses. Government bonds posted gains, due in part to “safe haven” buying. The Canadian dollar hit a low against its US counterpart, dipping below 0.69 before rebounding to just short of 0.72 at the end the month.
Overall, sentiment has turned more negative on the outlook for global growth, but it is always difficult to determine in the short term whether this caused markets to fall or vice versa. Policymakers have been active, with the Bank of Japan adopting negative rates on new deposits and the Fed starting to sound a bit doubtful about their outlook and, by implication, the timing of further rate increases. The VIX index, a closely watched measure of market expectations of near-term volatility embedded in S&P 500 stock index option prices, rose sharply before settling back to the 20 level (about its average level since inception in 1990 – the low to mid-teens level that persisted for much of last year being very much an anomaly).
So what, in reality has changed? The decline in oil prices accelerated back in October of last year, and Chinese shares have been in more or less constant free-fall for the last 6 months. While earnings growth for US companies has ground to a halt, this was expected and doesn’t appear to be worsening.
What appears to be at work is that investors are increasingly considering the broader implications of what until now have commonly been viewed as discrete events. In particular, the ability of companies exposed to commodity prices to service their often considerable debt loads has led to concerns over a looming pick up in defaults, and the exposure of the banking system to losses. More broadly, persistently low inflation and a subdued growth outlook has investors pondering the build-up of corporate debt over the past few years.
While we do expect corporate debt levels to be an issue for 2016, we certainly do not anticipate a debacle like 2008 since there is currently no problem with the enormity of the US mortgage market and the magnifying effect of difficult (or impossible) to value financial instruments. That’s not to say that the market won’t be prone to fits of uncertainty however, and an uptick in loan losses could reasonably be expected to pressure bank lending at the margin. A stabilisation in commodity (particularly oil) prices is, in our view, an obvious catalyst for a more constructive market environment as it will help in assessing the magnitude of whatever credit issues there are; it’s probably not a coincidence that stocks and oil both bottomed on the same day in January.
In conclusion, there probably will be some credit issues and other surprises in store for 2016. However given the strength of bank balance sheets (in the US at least), any problems should be manageable and contained to companies that have painted themselves into a corner through bad financial planning. Toron AMI’s portfolios have limited direct commodity exposure, and those companies with exposure have a solid financial profile. Likewise our emphasis on balance sheet strength and durability of cash flows leads us to invest in companies that are well positioned to take advantage of any opportunities 2016 might bring.
Listen here to last week’s open conference call, where we discussed the Canadian preferred share market. Preferred share returns were down significantly in 2015, listen here to learn about the opportunity this presents.
We welcome your questions and suggestions for next month’s call. Send them in to email@example.com.
Disclaimer: Past performance is not an indication of future results. The content contained in this document is for information purposes only. It is not intended as an offer or solicitation for purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any transaction. All individuals should obtain specific professional advice.