Foresight - Summer 2019

Practicing Patience During The Mature Phase of a Bull Market

The current decade-old Bull Market continues to surprise investors with its longevity. We wrote in the Summer 2018 Foresight that we had recently attended the Economic and Financial Outlook hosted by National Bank’s CEO Louis Vachon and Chief Economist Stefane Marion. Their presentations highlighted numerous global themes to monitor as the current Bull Market had recently entered the mature phase of the cycle. Market concerns last year included (with 2019 updates in italics):

· rising global trade tensions: No change to this situation.

· fear that a global trade war will precipitate the next recession: No change .

· stalled NAFTA negotiations: We have a deal, however it hasn’t been ratified by the US Congress and there is a federal election on the horizon in the Fall of 2019.

· rising trade tensions between Canada and the US: Which has been replaced with rising trade tensions between Canada and China.

· rising interest rates in Canada will put a strain on highly indebted Canadian households: There has been relief on this front for Canadian household debt as interest rates have recently retraced, close to present cycle lows. Good news for borrowers, not so for lenders, including bond investors.

· the US stock market was moving towards its 10^th year in this Bull Market: No change, however it is another year older.

The rising trade tensions between Canada and China have a significant dampening effect on the Canadian economy. That said, our trade conflict with China affects only Canada. Whereas, the United States/China escalating trade tensions and tariff sanctions have the potential to push the global economy into recession. As Louis Vachon discussed at this year’s Economic and Financial Outlook, baby boomers are very familiar with a global economy that has two large global powers that are at economic, social and political odds….except the players have changed from the USA and the USSR. However, the USA and USSR annual trade constituted approximately 1% of their respective GDP. The USA and China do more trade every day than the USSR and the USA did in a year, and China/USA trade constitutes approximately 14% of their current respective GDPs. More concerning for investors in US stocks is that approximately 47% of the revenues of the 500 largest companies in the United States are global. With the current White House administration engaged in a combative trade strategy on multiple fronts (China, Europe, Mexico and Canada), there is a further concern that  global trade uncertainty will cause US companies to slow their investment in plant and equipment to support that growth until these global trade relationships settle. This slowing in investment can, in itself, push the global economy towards recession. The question is whether cooler heads will prevail before, or after, the next recession. If the USA and China can come to terms and move forward, this economic cycle may well last for a number of years. If not, a recession in 2019 can certainly inspire political leaders, especially with a US Presidential election in 2020, to get together and make a deal.

Investment Strategy 2019

We witnessed volatility on a month-to-month basis through the last half of 2018 and into the first half of 2019. The following table illustrates the bumpy, albeit positive, returns in most global regions over the previous 12 months. We have added the Government of Canada 1 to 5 Year Bond Ladder to provide a reference point for bond versus stock returns.

Returns and Performance June 2018 to June 2019

					----------------Price change------------
Security	Total  Return	Dividend Yield	12 Month June to June	12 Month High	12 Month Low
TSX 60 (XIU)	4.7%	2.8%	1.9%	4%	-12%
S&P 500 (XSP)	7.1%	1.6%	5.5%	8%	-13%
MSCI Europe (XEH)	4.6%	3.5%	1.1%	4%	-12%
Emerging Markets (XEM)	-0.8%	2.1%	-2.9%	3%	-13%
MSCI All World (XWD)	3.7%	1.7%	2.0%	6%	-11%
Canada  Gov’t 1 to 5 Year Bond Ladder (CLF)	3.2%	2.5%	0.7%	1%	0%

As you can see in the two right-hand columns: huge volatility within the year, and decent end-of-cycle returns in the left column in all regions except Emerging Markets. We also note the comfort gained from dividend yield in churning markets.

This brings us back to the theme of patience in investing during the mature phase of a Bull Market. Once again, we are reminded of the wisdom of Nick Murray, who implores investors not to focus on the “apocalypse-du-jour”, which has many, many faces over the years. Looking back to Stefane Marion’s comments in the summer of 2018, this mature phase which started then should last, on average, 30 months, with a historically-predicted range from the Spring of 2020 through early 2024. Our expectation is that global equity markets will grind higher over the mature phase of this Bull Market; however, investors will have to live with increased volatility on a month-to-month basis. Will the June 2019 G20 Summit produce reconciliation between China and the United States? Will the tensions between Canada and China ease in the coming months, or will our trade with China continue to be negatively impacted by the tensions between the USA and China. With a US Presidential election in 2020, one would expect cooler heads to prevail and a trade deal to be completed to avoid a potential recession and Bear Market in the United States. If cooler heads do not prevail, then we may well enter the recession and Bear Market earlier rather than later.

This would change the timing, but not the discipline, of our strategy of rebalancing your portfolio to maintain your Asset Allocation Plan. As stocks have outperformed bonds over the past six years,

your portfolios periodically have sold down stock positions and deployed the cash to bonds to answer to your Asset Allocation Plan re-balancing. For mature portfolios that are fully deployed today to their Asset Allocation Plan, the next Bear Market is just another phase of the investing cycle,

in which the reverse will occur and portfolios will sell down bonds to their Asset Allocation Plan weighting and stocks will be purchased. The detailed industry sector analysis that we maintain for every portfolio allows us to be more granular in choosing the sector(s) to focus these re-balancings, thus improving the efficacy of the strategy. 

The Current Bond Yield Conundrum for Financial Plans

As mentioned earlier in this edition, global bond yields have retreated within the year to almost cycle lows. At writing, the Government of Canada 10 year bond yield is just under 1.5% and the US 10 year Treasury yield is hovering at 2.0%. With over $12 Trillion of government bonds globally currently returning a negative yield (yes, that is not a typo), Canada and the United States stand out, as bond investors are actually receiving a positive, albeit it small, return. The trouble is that, with bond yields hovering in the 1.5% range in Canada, a balanced portfolio with a 50% weighting in bonds will require stocks to return 8.5% annually to achieve a weighted portfolio return of 5%, or a 10.5% return for stocks to have a weighted portfolio return of 6%.

For those ultra conservative investors with very low volatility tolerances that set up their Financial Plan in the days of 4-5% bond yields, today’s interest rate environment is extremely detrimental and significantly reduces their portfolio’s ability to meet their financial plan’s long term forecast. A conservative portfolio with an 80% fixed income and 20% equity Asset Allocation Plan that assumed bond yields of 5% and long term total stock return of 7% would have a long term weighted portfolio return assumption of 5.4% built into their financial plan. Using today’s bond yield environment, that portfolio would produce a weighted return of 2.6%. To meet the Financial Plan’s long term rate of return of 5.4%, stocks would have to produce a 21% return every year; clearly an unrealistic expectation for stocks.

There is no bullet-proof strategy to ease the negative effect of low bond yields on portfolio returns. One alternative is to increase a portfolio’s asset allocation weighting from bonds to stocks. As we wrote on the front page lead editorial, there is significant asymmetric risk to undertaking this strategy ten+ years into this current Bull Market. The probability of stocks going down is greater than going up. 

A second alternative is to enhance bond yield by buying corporate bonds. Corporate bonds now make up almost half of the US bond market. A large proportion of these corporate bonds are at the minimum investment grade rating of BBB. The significant increase in the size of the corporate bond market with a rating of BBB is a new risk dynamic in the corporate bond market. The risk is that, in an economic downturn, the outlook for the underlying company issuing the bond might be downgraded by rating agencies, resulting in the bond losing its investment grade status. This might then cause pension and mutual fund managers to unload those now-offside bonds, because they are  mandated to hold only investment grade.

A third alternative is to extend the average holding period of the bond portfolio. Although interest rates have remained annoying low (from a lender’s perspective), since the 2009 recession lows, a small swing in low term bond yields results in relatively large swings in the value of the  underlying long term bonds.                      

 As an example, the iShares 20+ Year Treasury Bond ETF (TLT) was $143 per share in July 2016. Over the following 2 ½ years the US Federal Reserve undertook a program of slowly raising interest rates. The result of moving the federal funds rate from 0.5% in  2016 to 2.5% in late 2018 was a 22% decline in the share price of TLT $112/share. A stock market that drops 20% or more is considered to be in a Bear Market!

I am reminded of my young days in Boy Scouts. When we were out hiking in the forest, we were taught to stop periodically, turn around, and take a mental snapshot of where we had just come from. If we unexpectedly ever had to come back that way, this would help us recognize the territory, and appreciate the visual landmarks. The challenge for intelligent investors is to behave like a scout: stop periodically and reflect on where you have come from! The recent low interest environment has us concerned about looking forward - fair enough - but we also need to look backward to gain perspective to see what a strategy has done for us historically.

Lets look at a real client situation. Mary came to us in 1996 and had a Financial Plan done with the conservative 80/20 allocation, as above. The weighted return forecast in the Plan was 5.85% for such an allocation. In 2013, her seventeen year actual annual compound return was 6.64%...despite 80% in bonds! She was happy: a decent return for a conservative portfolio and…ahead of Plan!

That said, she agreed to a slight change in Plan in 2013 to 70% in bonds. In 2013, her bond return was 3.78%. In the ensuing years 2014-18, her bond returns were 1.91%, 5.39%, 1.07%, 1.37% and 1.71%. Rolled forward those five years, her annual return for the five year period 2013-18 was 4.65% and her 22 year annual compound return was 6.23%, down only 0.41% from 2013, despite the 1-2% range of returns from her 70% bond portfolio for most of that five year period.

The lesson…?

Taking the present market trend and forecasting it out indefinitely into the future is a perilous strategy, whether done today or twenty years ago! Forecasting today’s interest rates to remain stubbornly low far out into the future may seem the easy call, given they have remained persistently low throughout this economic cycle post the recession of 2008/2009. The US economy hasn’t seen an inflationary impact from the trillions of dollars printed by the US Federal Reserve in their Quantitative Easing Programs post 2009… at least not yet! Nor has the US experienced the wage inflation one would expect, given the robust job growth and low unemployment numbers enjoyed over the last number of years. There is a group of analysists that believe inflation, not deflation, is the next threat to this economic cycle. Inflation-hedged real rate of return bonds and floating rate bonds may well have their day sooner rather than later… and bond yields returning to 4-5% may still happen in our life times!

In the meantime, although the current bond yield environment has bonds unable to “pull their own weight” from the portfolio return perspective, bonds do continue to provide important diversification and volatility dampening to the equity side of the portfolio. Bonds also provide portfolio cash flow through semi-annual coupon payments and maturing bond ladders if funds are needed, so that an investor never needs to sell stocks at an inopportune time, like the bottom of a Bear Market. If funds are not needed, this cash flow can sit at-the-ready for the market correction. If the stock market does fall drastically at some point, investors will be hugging their bonds...and seeking the wisdom to embrace the fallen stock market and buy low!

For now “two outa three ain’t bad”!