In managing money for clients, we like to say we are paid to be paranoid, as we continually evaluate the prospects and valuation of our investments. In doing so, we scour financial results, filter news reports, ask questions, and investigate concerns and opportunities. As one common line goes "Not understanding what you own is like playing poker without looking at your cards".
Our decisions in 2018 have made client portfolios more conservative. We took profits in companies that we considered overvalued and/or economically sensitive. In turn, we purchased more attractively valued companies that should perform well in the future on a total return basis, even amidst a potentially slowing economy in the near future.
Canadian and U.S. Equity Markets
Although the United States economy is quite strong, and the Canadian economy is in full stride, stock markets in both countries already reflect this. Markets have also experienced more fluctuation this year as they assess the future impact of various economic policies currently underway. Central banks are raising interest rates as a form of monetary tightening to get back to more normal levels, which serves to slow the economy by making it more expensive to borrow. The United States government has enacted tax cuts that should stimulate the economy as a form of fiscal stimulus and is expected to last another year or so. But in our view, the market has already priced this into expectations.
This fiscal stimulus will eventually fade. As the United States Federal Reserve continues to reduce its $4 trillion balance sheet and the effects of higher interest rates filter into both the United States and Canadian economies, the probability of an economic slowdown rises. The uncertainty about when this might happen,
combined with a rising yield curve (see my colleague Cory Lang's article), is what we believe has limited stock market gains year- to-date. As liquidity conditions tighten and asset purchase programs are phased out, countries with strained finances may struggle and add further uncertainty to global markets that are more integrated than in the past.
There will always be debate on the impact of policies and the state of the economy, but as bottom up investors, we care most about the fundamentals of the businesses we own. We invest in companies we expect to own for a decade. Even if the market shut down for 10 years, we'd be happy to hold these companies. We purchase high quality dividend paying companies and invest in corporate bonds aiming to achieve a real return for our clients (positive return after inflation). We ensure that the investments we make, which cross many sectors, are in public securities allowing us to include hard assets like real estate and infrastructure without sacrificing liquidity. Value, quality, dividend growth, and patience are the cornerstones to our investment philosophy. This is particularly important when considering the investment objectives of our clients, especially on the topic of retirement.
In our opinion, the biggest risk for clients is not having enough money saved for retirement. If you own shares in great businesses, you should be rewarded with attractive returns that outpace inflation. Owning high quality companies that pay growing dividends raise the probability that clients' will meet their retirement objectives.
When it comes to financial markets, complacency is to be avoided. And when you're at the tail end of a near-decade long expansion, it pays to be even more vigilant. The current economic backdrop of respectable GDP growth, record low unemployment, and full stock market valuations should be looked at with a critical eye
Here at BCV Asset Management, one of the indicators we regularly watch is the Treasury yield curve. The importance of this curve should not be underestimated, as any change in the curve has ripple effects throughout financial markets, and it can be a relatively good signal of where the economy and the markets are headed in the future. The Treasury yield curve graphically represents United States government bond yields relative to various maturities. The absolute level (high vs. low), the shape (steep vs. flat), and the change in the shape are all relevant factors when analyzing the curve.
Where are we now, and what might the curve be indicating7
Interest rates have been historically low for some time now, but this is changing. With a tight labor market and inflation expectations rising, interest rates are moving higher in general. The Federal Reserve has been raising interest rates rapidly, and many forecasters anticipate two more rate hikes in 2018, with the potential for more in 2019.
What about the current shape of the yield curve7 Two-year treasuries currently yield around 2.55% with the ten-year at
2.90%, so the curve is retaining its normal character of lower short-term rates and higher long-term rates. However, there has been recent concern around the changing shape of the yield curve. More specifically, the curve is becoming flatter which could potentially lead to an inverted curve, where short term rates exceed long term rates. This is commonly observed by taking the difference between the 2 and 10-year treasuries, which is currently 0.35% or 35 basis points. When looked at historically, this spread has proven to be a good predictor of recessions when the spread turns negative. As the chart below shows, recessions (shaded areas) tend to follow periods where the 2-10 spread has become negative. The chart also demonstrates that over the longer term, the spread has drifted lower (with some volatility along the way) from a peak of around 2.88% in 2011to 0.33% at the end of June 2018.
How does all this fit into what we are doing at BCV? We are watching indicators like these not to predict when a recession will happen, but to consider the effects it will have on our portfolios and what strategy is most appropriate going forward. Considering the rising rates and flattening nature of the yield curve, being defensive in our portfolios is a prudent approach. With this in mind, investing in high-quality companies that grow their dividends over time is a sound investment strategy. By its very nature our dividend growth strategy assumes a certain level of defensiveness which allows us to weather a downturn that may be signaled by a shifting yield curve.
" Protectionism" is the economic policy of restricting imports through tariff s and other means to shield domestic business and workers from foreign competition. The opposite economic theory is an open economy focused on free trade; where companies compete globally based on quality and price of their goods produced or services created. In every country there is usually a blend of some protectionist policies while allowing other industries to compete globally. For example, Canada has tended to protect its dairy industry, which operates with tariff barriers to foreign competition, while allowing many other industries no such favoritism. In the US, imported light trucks face a 25% duty, While many other products have no tariffs.
It is generally accepted that protectionism raises prices for consumer s while increasing the profitability of the protected industries. However, the benefits of free trade are not evenly distributed and hence the political climate in the United States has shifted to a more protectionist stance.
The current United States administration is determined to rework all its trading relationships with its major trading partners. The United States director of Trade and Industrial Policy, Peter Navarro, has long held protectionist views and is attempting to repatriate many multinational global supply chains to reduce the United States trade deficit. It is part of what President Trump calls the 'American First' agenda of reindustrialization and it is causing quite a lot of dislocation. Whether the administration is successful remains to be seen, but the renegotiation of The North American Free Trade Agreement ("NAFTA") has effectively stalled with Canada and Mexico, as steel and aluminum tariffs are now in place. The United States is now threatening tariffs on imported German cars and has recently implemented another round of tariffs on $34 billion of Chinese goods. Uncertainty abounds as countries are attempting to respond in-kind by either escalating or retreating from these tariff measures by the United States.
There is an aggregate economic loss when companies are less efficient due to nationalistic, political objectives. Since the United States has a large domestic economy that is less dependent on trade than its trading partners, it stands to lose less in the zero-sum game of a trade war. This trade war rhetoric is unlikely to dissipate in the near term as trading patterns develop over time and will unwind slowly. Looking at the United States' largest trading partners in 2017. according to the United States Census Bureau, Canada should be viewed favorably as it is the largest market for United States exports and yet has the smallest trade deficit of the top five trading partners. In fact, 65% of the total United States trade deficit is with China, which should be the most difficult to change. See table below comparing total trade in goods (not including services) and the United States trade deficit.
There is probably a solution to be found between Canada and the United States, as trade is roughly balanced. Canada's dependence on trade with the United States is significant, as such, we will be motivated to find a solution. However, we'll likely have to alter our negotiating position somewhat and make concessions in a revised NAFTA. It is difficult to be confident about the other four countries resolving these issues, for if the United States maintains their policy of reducing trade deficits with its trading partners, those countries will resist these changes. Expect things to get worse before eventually improving. Trade patterns take time to adjust and so this narrative will be with us for a while.
Investing has its uncertainties, and they are always changing. There may be a small benefit to all this global trade uncertainty. Global trade friction is not positive for corporate profits generally, but it may provide an offset by slowing down the rising interest rate cycle that has been a risk factor for global markets. At BCV we cannot predict the future macroeconomic environment and as such will continue to emphasize owning solid interest-bearing bonds and quality companies that can continue to raise their dividends in swaying economic environments. Doing so points to long term investment success whether this trade war deteriorates or unexpectedly ends.
First Quarter 2018:
Brookfield Asset Management Inc.: 15 cents (14 cents)*
Bank of Montreal: 93 cents (90 cents)
Brookfield Property Partners LP: 31.5 cents (29.5 cents)*
Canadian National Railway Company: 45.5 cents (41.25 cents)
Canadian Western Bank: 25 cents (24 cents)
Enbridge Inc.: 67.1cents (61cents)
Intact Financial Corporation: 70 cents (64 cents)
Magna International Inc.: 33 cents (27.5 cents)*
Manulife Financial Corporation: 22 cents (20.5 cents)
National Bank of Canada: 60 cents (58 cents)
Suncor Energy Inc.: 36 cents (32 cents)
TELUS Corporation: 50.5 cents (49.25 cents)
Second Quarter 2018:
BCE Inc.: 75.5 cents (71.75 cents)
Bank of Nova Scotia: 82 cents (79 cents)
Canadian Imperial Bank of Commerce: 133 cents (130 cents)
Canadian Natural Resources Ltd.: 33.5 cents ( 27.5 cents)
Power Financial Corporation: 43.3 cents (41.25 cents)
Royal Bank of Canada: 94 cents (91cents)
Stantec Inc.: 13.75 cents (12.5 cents)
Sun Life Financial Inc.: 47.5 cents (45.5 cents)
Toronto-Dominion Bank: 67 cents (60 cents)
TransCanada Corporation: 69 cents (62.5 cents)
Third Quarter 2018 (pending):
Algonquin Power & Utilities Corporation: 12.82 cents (11.65 cents)*
National Bank of Canada: 62 cents (60 cents)
TELUS Corporation: 52.5 cents (50.5 cents)
* Dividend paid in USD.
First Quarter 2018:
AT&T Inc.: 50 cents (49 cents)
Analog Devices Inc.: 48 cents (45 cents)
Home Depot Inc.: 103 cents (89 cents)
Johnson Controls International plc: 26 cents (25 cents)
VISA Inc.: 21cents (19.5 cents)
Second Quarter 2018:
Apple Inc.: 73 cents (63 cents)
International Business Machines Corporation: 157 cents (150 cents)
Johnson & Johnson: 90 cents (84 cents)
Qualcomm Inc.: 62 cents (57 cents)
United Health Group Inc.: 90 cents (75 cents)
Third Quarter 2018 (pending):
FedEx Corporation: 65 cents (50 cents)
* Dividend paid in USD.