Investors surveying the financial headlines on the second Thursday in February could have been forgiven for adopting the crash position. Markets around the world spent the first month and a half of 2016 zigzagging up and down over troubling news out of China and worries about losses in the banking sector.
And while things have been calmer since then, the markets have yet to get volatility out of their systems. “When we look at the world, there’s plenty of things to worry about, so we would anticipate there could be episodes of higher volatility in the second half or even next year,” cautions Bruce Cooper, chief investment officer at TD Asset Management. He points to high levels of global debt, low liquidity in markets, political events affecting trade and structural imbalances in some emerging economies.
Combine all of that with stubbornly slow economic growth, and now looks like a time for investors to play some defence. Equities as an asset class are not hugely in favour right now, with Goldman Sachs downgrading them to Neutral in May and advising investors to overweight cash in their portfolios. But cash today yields almost nothing, and fixed income yields low or even negative interest rates. There are few safe havens. Fill the bulk of your portfolio with a combination of high-rated bonds (weighted toward corporate, rather than government, debt) and high-quality, dividend-paying equities, and you likely won’t take a hit. More risk-tolerant investors, meanwhile, may find some bargains amid the volatility, particularly in emerging markets.
The markets have rallied since mid-February, from a combination of expanding valuations and returning confidence. “It’s going to be critical for earnings growth to kick in in order to sustain the bull market from here and to be able to push stocks higher,” says Sarah Riopelle, vice-president and senior portfolio manager at RBC Global Asset Management. Many companies posted negative year-over-year changes in both revenue and earnings growth in the first quarter. Some of that is the result of the commodity price slump, but excise its effects, and “earnings growth was somewhere in the low single digits in Canada and the United States,” says Cooper, whose firm is predicting mid-single-digit returns for equities. “The challenging thing for investors is we’re in this environment of muted returns, but it’s accompanied by the risk of higher volatility,” Cooper says. “So it’s a bit of a roller-coaster ride.”
Domestically, the Bank of Canada’s April 2016 Monetary Policy Report projected real GDP growth of 1.7% in 2016, rising to 2.3% the following year. The loonie’s flight trajectory will play a major role in whether those predictions are realized. The Canadian dollar has been very volatile so far this year, jumping from a low of 68¢ (U.S.) on Jan. 20 to a short-lived 80¢ on April 29.
Nonetheless, the Canadian market has been one of the best performing globally year-to-date, alongside the less mature and more risky likes of Brazil, Mexico and Argentina. That’s partly a result of the recovery in energy and materials stocks, as valuations adjust to new commodity price levels. Investors who were underweight on the Canadian market because of negative outlooks on the Canadian dollar, oil and other commodities are returning, says Lesley Marks, senior vice-president and chief investment officer, Fundamental Canadian Equities, at BMO Asset Management. The spot price for Brent Crude has recovered from a mid-January low of US$27.19 to just above the US$50 mark.
But the big driver of gains on the S&P/TSX Composite index has been another commodity that has returned from a price nadir: gold. “Something like nine out of the 10 top-performing stocks in the S&P/TSX are gold or silver companies, and I think almost all of them don’t have positive earnings or EBITDA,” says Marks. The sector is further along the cyclical timeline than oil, because its own price fall happened five years ago instead of two. The highest-cost gold production has come offline—albeit more slowly than oil and gas output has done, because shutting down a rig is a speedier operation than shuttering a mine—leading to a more balanced supply-demand picture. Though there has already been an upswing, investors might find opportunities in cost-conscious miners.
Another group of companies doing well are the banks. Firms in Canada’s financial sector are under less pressure than their counterparts in, say, Europe or Japan, where negative interest rates are out in force. Canada is still a long way away from instituting such a policy—although Bank of Canada governor Stephen Poloz has suggested he’s open to the idea. In addition to earnings, investors should watch for the impact of the currently strong Canadian housing market and the banks’ strategic positioning against the disruptive force of financial technology, says Marks.
Across the border, the growth outlook appears more positive, notwithstanding the anemic 0.5% GDP increase the American economy posted for the first quarter. The Federal Reserve made the psychologically important decision to hike interest rates last December, and recent remarks from Fed chairwoman Janet Yellen telegraphed the possibility of another hike in the summer. But Cooper says it’s unlikely the institution will make further aggressive increases. Barring an overzealous tightening, most predictions put growth above 2%. (Goldman Sachs has it at 2.2%, while the IMF dropped its call to 2.4% in April.)
Still, don’t go rushing into U.S. equities just yet. The Fed is still the only major global central bank raising interest rates, which creates headwinds for U.S. companies that international competitors don’t face. And there are the fundamentals to consider. “U.S. stocks are probably among the more overvalued companies on a global scale,” says Luc de la Durantaye, managing director of asset allocation and currency management at CIBC Asset Management.
Plus, the U.S. will go through an event likely to affect markets and economies everywhere: the presidential election in November. “In an election year, the market typically peaks and trends downward” six months before the voting date, noted Savita Subramanian, Bank of America Merrill Lynch’s head of U.S. equity & quantitative strategy, in a May interview with Bloomberg TV. Fundamental disagreements over tax and regulatory policy among the candidates mean U.S. companies are likely to face an altered operating environment (or at least the expectation of such), regardless of the election outcome.
And de la Durantaye points out that the one topic on which the candidates do seem to align is not positive for the world economy. “The political line is a bit more anti-trade,” he says. Presumptive Republican nominee Donald Trump has talked about imposing a 45% tariff on Chinese imports, while Democratic front-runner Hillary Clinton has backed away from the Trans-Pacific Partnership, a treaty she helped negotiate as secretary of state. “If that rhetoric continues to heat up over the summer, that’s going to create some degree of uncertainty as to whether the U.S. would become a bit more closed or introduce trade friction with its trading partners,” de la Durantaye says. Any such move would negatively affect economies that rely heavily on exporting to the U.S., or on trade in general, a list that includes Japan and Korea, and probably Canada.
Europe and Japan
Other established markets carry their own baggage. In Europe, economic stagnation and unhappiness at the influx of refugees is fuelling opposition to pan-continental institutions and agreements. “We want to monitor to make sure there’s not going to be a resurgence of anti-euro sentiment, which would be negative to European assets and the euro as a currency,” says de la Durantaye. The most immediate and tangible signal might be the June 23 referendum on the United Kingdom’s potential departure from the European Union, or Brexit.
The London-based National Institute of Economic and Social Research, a non-partisan think-tank, said in May that the economy of a European Union–free U.K. could be as much as 3.2% smaller by 2030. Opinion polls suggest a majority of voters will opt to stay, but the post-referendum negotiations between the U.K. government and the E.U. could still sour market sentiment. (Punters not shy of alternative investments might want to note that London bookie Ladbrokes was offering one-to-five odds on “remain,” a considerably better return than most markets.)
Other established markets might face the consequences of untested monetary policy implemented by policy-makers looking to stimulate their economies. “Central banks are contemplating ever-more-exotic policy options,” says TD’s Cooper, pointing to the growing interest in “helicopter money.” Under this hypothetical policy, governments transfer money directly to taxpayers to encourage spending, a handout funded by issuing bonds with a coupon of zero and no maturity date, which central banks buy. There’s no laboratory in which helicopter money can be tested, notes Cooper, so any central bank that tries it can’t predict the economic outcome. The European Central Bank and Bank of Japan have both been cited as potential users of the mechanism, though the latter has ruled it out for the time being. Even if Canada doesn’t start dropping payloads of cash itself—something Cooper says he does not foresee in the next three years, at least—the ripple effect of a central bank explicitly targeting higher inflation and adopting formerly verboten measures to get it would be felt on these shores in the form of increased global volatility.
While there remain pockets of strength, emerging markets are not likely to provide a salve to weakness in their developed counterparts. China in particular remains a source of worry among investors and economists alike. Long a major contributor to global growth, it has a significant impact on capital markets—the January equities scare was caused by fears about a Chinese slowdown. Its government has put a stimulus package in place and is continuing its much-vaunted transition from infrastructure to consumer spending, but a lack of trustworthy economic data and corporate reporting continues to scare investors.
Volatility has been the byword for the Chinese stock market in the recent past, not least because the government has a habit of intervening in the form of lockdowns and corporate actions whenever the Shanghai index dives. Debt levels in China and other emerging economies have also risen significantly in the recent past. Combine that with weak commodity prices, flat global trade and the governance risk associated with companies in many of these countries, and safety-minded investors are perhaps best served by limiting their exposure to the grouping at this time. The more adventurous might find opportunities in areas like emerging market credit—Mexico, for example, offers bond yields in the middle single digits while boasting relatively low levels of corporate, consumer and government debt.
Cooper says risk management is key in times like these. “I don’t see that the risk-reward today is outrageously attractive, so you may as well have conservative positioning,” he says. If the markets go down, you’ll be positioned to take advantage. “If they don’t, and you’ve got a portfolio of high-value, dividend-paying equities and investment-grade bonds and a bit of gold, you’ll be fine.”