While the S&P/TSX Composite Index staged a major comeback at the start of 2019 and is up approximately 15 per cent year-to-date, it’s relatively unchanged from where it was one year ago. Since the beginning of 2018, the S&P/TSX Index has repeatedly stalled around the mid-16,000 level. In the current environment, active portfolio management including sector rotation, stock selection and country and industry exposure diversification have become increasingly important for investors to employ in order achieve attractive returns.
In a recent interview with The Globe and Mail, Kurt Reiman, BlackRock’s chief investment strategist for Canada, shared his market expectations and thoughts on how investors may want to position their portfolios for the second half of 2019. Here are excerpts, with an expanded version available to subscribers online at tgam.ca/inside-the-market.
With North American equity markets at or near record levels, what is your outlook for the months ahead?
Equities still have more upside from here. Earnings estimates for the next 12 months seem pretty reasonable, maybe they are a little bit optimistic but not too bad. Canadian earnings have been holding up remarkably well relative to other regional markets. When you look at measures of valuation, the market doesn’t appear overly stretched.
When you are in this environment where geopolitical and especially trade tensions are the predominant driver of the macro environment, it makes sense to alter your geographic equity allocations to markets that are less affected and away from markets that are more affected. For example, we retain our overweight in the U.S. and that is reflecting that fact that U.S. economic growth, even though it’s slowing, is the best in the developed world. The U.S. equity market is heavily weighted towards sectors that have what I would call structural growth dynamics, like technology and health care. The U.S. equity market over all has shown that it is able to consistently deliver a higher return on equity and valuations are not stretched. We have reduced our exposure to emerging markets, we have brought that down from an overweight to neutral, and we have lowered our allocation to Japanese equities from a neutral to underweight and we have brought Asia, ex-Japan, also from a neutral to an underweight.
[Our] view is that markets have priced in too much optimism with regard to China’s efforts to stimulate its own economy. In a best case [scenario], we expect China’s economy to stabilize but at a weaker level, and this will have a material impact not just on the emerging market complex but also on some of the developed countries in the periphery of China.
Also, we reiterate our preference for taking a minimum-volatility approach, or to have a minimum-volatility screen for our equities to keep the portfolio from not moving around too much. For Canadian investors, if they were to take a minimum-volatility approach, they would end up diminishing the share of their portfolio that is focused on financial, energy and materials, some of these cyclical and value-oriented parts of the market, and [taking] higher allocations in some of the more defensive sectors. We think that is a reasonable approach because value-oriented companies don’t typically perform well during periods when investors are thinking that either the economy is going to be slowing or heading into a recession. In fact, that’s when value performs the worst. Value performs the best when you are coming out of a recession, when you are starting to recover.
Importantly is to stress that for the second half of the year, I don’t think returns will be as good as they were in the first half. I still think investors are going to be rewarded for gaining exposures to equities, but it’s really important [to be tactical] about which markets and the weightings.
What are your expectations for the second quarter earnings season?
When it comes to the second-quarter earnings, what I am going to be focused on is what companies tell us about the impact of the increase in tariffs, how that is changing [management’s] thoughts around global supply chains, global value chains, and how they are thinking about their own capital spending plans. Some of the weakness today in growth is coming from business sentiment and business investment. So I want to see what CEOs are saying about their own visibility on their runway for future growth because what they are also going to be thinking about is that they have a pretty strong domestic consumer because of the tight labour market and wage growth – I think that is something that is maybe a bit underappreciated. Lastly, I would be curious to know what companies are reporting with regard to whether they are taking a hit on margins as a result of having to pay higher tariffs or are they passing it on to consumers. We will be thinking about what effects tariffs will have on either profit margins or consumer price inflation.
Should investors be taking profits ahead of second-quarter earnings announcements as management outlooks may be cautious?
No, I don’t think I would be necessarily taking profits here. I would still be looking to investing with an eye towards the next six to 12 months.
Our message is that protectionism and geopolitics are going to drive macro outcomes and that’s going to potentially drive some volatility in markets but because we have central bank monetary policy support, this is likely extending the economic cycle relative to what it might otherwise be. Financial conditions are easier as a result. Earnings growth is holding up and the markets are not particularly expensive here. I would be favouring holding an overweight to equities.
One idea – it’s been a great year for bond investors, 6 per cent or so returns in government bonds and maybe 8-per-cent returns if you went into investment-grade or high-yield bonds. Those are great numbers for a bond investor. Where I may be thinking about taking a little bit of risk out of the portfolio is more on the long end of the government bond market where yields are quite low. For investors who may be making more changes to their portfolios than others, something to think about is shortening the maturity profile of their government bond holdings and considering if they want to take the proceeds and raise cash or if they need income, investing in investment-grade bonds. If they are willing to take risk, perhaps even looking into emerging market debt.
When your 10-year Canadian government bond is only three basis points higher than the two-year and it’s only giving you a yield of 1.6 per cent today, it may make sense to think about what risk that poses for the portfolio if in fact instead of interest rates continuing to fall, rather they move a bit higher.
From a valuation perspective, how much potential upside do North American stock markets have?
When I have said the equity market looks fair, I have been speaking about the U.S., which is effectively in line with its five-year average [on a price-to-12-month forward earnings basis]. Canada, on the other hand, is almost 10 per cent below its five-year average. The energy [sector] is 50 per cent below its five-year average.
Returns over the next year or so are not necessarily going to come from multiple expansion but rather from earnings and dividend growth. Looking out over the next year, earnings growth is [forecast to be] in the mid- to- high single digits for both the U.S. and Canada.
Are the sector laggards, such as energy that has lagged the performance of the S&P/TSX composite index year-to-date, value traps?
Broadly speaking, value managers have just been through an extended period of underperformance.
I think it’s probably safe to say that, with oil prices at the higher end of their recent range but probably range bound, energy represents something of an opportunity – but I would probably be selective here. I would be careful with some of the companies that are just in the business of production and maybe think more about the companies that are involved in the pipeline or mid-stream energy companies or companies that are integrated and have broader operations. I think there are opportunities within energy. There are always opportunities within the value space.
In June, gold rallied to a six-year high. What is your outlook for this subsector?
I think there are pluses and minuses around gold. For sure, the geopolitical risk equation is driving gold prices higher. There has been a revision of economic forecasts and central banks have stepped in and said if they need to they are going to respond and that’s pushing down interest rates at a time when inflation expectations are moving lower. That means that real yields are falling and whenever real yields fall, gold prices tend to rise. Gold doesn’t provide any income. It is your store of value or safe-haven asset, so when your income-producing vehicles like government bonds start yielding less in inflation-adjusted terms, gold starts to do better as an asset.
Do we think that interest rates are going to continue to move down? I think in some geographies – maybe in Europe where they have committed to an aggressive easing campaign and they are likely to deliver – you could see further downward movement in real yields, I think that is reasonable, but we are probably pretty near the cycle lows. Gold does have that optionality on it if geopolitical tensions more broadly or U.S.-China tensions should get worse.
You believe the Bank of Canada will keep rates on hold for the balance of this year, is that correct? Also, when there is a rate change announced, what direction will it be – up or down?
Yes, it is. I think that the path of least resistance is probably another rate cut over the next year. If inflation is a little bit above their target and growth is good are they going to rush to raise rates? Probably not. On the other hand, if business investment or sentiment around capital spending plans should turn down and it happens amidst a decline in commodity prices, I think that would probably be enough to get the Bank to cut rates, but I don’t see that right now.
Right now, our forward-leading indicator for Canadian [economic] growth seems pretty solid at around 1.75 per cent over the next 12 months, and that’s been moving higher since the beginning of the year. Canadian [economic] data has been sequentially surprising to the upside. Cheap currency, fading effects of NAFTA uncertainty, stable commodity prices, quite possibly also the growing appeal of technology within Canada, I think that will be an increasingly relevant topic to think about. I don’t mean semiconductors, servers and cloud, but I mean green tech, clean tech, resources tech, AI [artificial intelligence] and machine learning, robotics and e-commerce. There is a lot there that we can look to as future support to growth.
When we last spoke in the fourth quarter of 2018, you believed the Canadian dollar would be range bound with some bias to strengthening relative to the U.S. dollar – a fairly accurate forecast with the Canadian dollar locked around the mid-70-cent level.
I feel like a broken record and I don't mean to be. It has been moving in the range that I thought was reasonable between 75 and 78 cents and I don't have any reason to change that. I still think that this level is keeping the Canadian economy competitive and is not an impairment to growth.
Lastly, a significant proportion of people’s wealth is in their homes. What is your outlook for is this asset class – real estate?
One policy added to another and another is not linear in the effect that it has on housing. Foreign buyer taxes, other macroprudential policies for insured home buyers, the net effect of rising short-term rates and the impact it has on five-year fixed mortgages, over time these things accumulate, but they don’t accumulate in a linear fashion. It starts to make buying a home for people who are marginal buyers pretty difficult. I don’t know if we have really seen that much change – all the macroprudential policies are still there. Five-year fixed-rate mortgages may come down some because the five-year government of Canada bond yield has fallen so much this year but you still have those higher hurdle rates with stress tests on uninsured mortgages to contend with and the foreign buyer tax in certain regional markets. I think all of these effects remove the broader housing contagion risk to the Canadian economy, which I think in the long run is healthy.
Jennifer Dowty