The spectre of rising geopolitical tensions in Ukraine and Gaza cast a shadow over an otherwise positive week in the markets. News that a passenger jet was tragically shot down in Eastern Ukraine Thursday may prove to be a turning point in the conflict that’s already ensnared Russia, Ukraine, the US and its allies. Equally concerning is the ground offensive Israel launched into Gaza on the same day to neutralize Hamas militants after ten days of bombardment. In both instances, the fear lies in an escalation of the conflicts and the prospect of them broadening beyond the region. Until Thursday, the markets had put in a good showing thanks to encouraging US corporate earnings, good news from China and supportive words from the Fed. In her semi-annual report to Congress, Fed chief Janet Yellen reiterated her belief that “a high degree of monetary policy accommodation remains appropriate”. Turning to US corporate earnings, more than 50 companies in the S&P 500 reported through Thursday with many surpassing the expected 4.8% rise in profits. Solid earnings helped divert attention from disappointing US retail sales and an underwhelming housing report which showed new home construction falling well short of expectations. In Canada, the BoC released its regularly scheduled interest rate policy statement and there was, as expected, no change in interest rates – still 1% since 2010. But there was a change in outlook with growth expectations reduced for this year and next. Farther afield there was good news out of China which reported a slight acceleration in Q2 growth as GDP grew to 7.5% compared to 7.4% in Q1. The increase is credited to recent stimulus efforts and points to a potential bottoming in Chinese growth. Finally, the BRICS nations – Brazil, Russia, India, China and South Africa – announced the creation of a development bank to assist in infrastructure work and emergency financing similar to the IMF.
Stocks lose momentum
Stocks lost momentum over the four-day period and ended mixed. The Dow rose 33 pts. to finish at 16,976, the S&P 500 fell 9 pts. to close at 1,958 and the Nasdaq shed 52 pts. to settle at 4,363. The TSX gained 79 pts. to end at 15,204.
Banks and lifecos most hospitable space within traditional yield sectors, bonds have an eventful week
Equities. Himalaya Jain, Director, Portfolio Advisory Group wrote “As Canadian bank stock hit new highs, we are being asked more frequently whether they are overvalued. While valuation multiples have increased, we don’t consider forward P/E multiples to be excessive at this point. Sentiment on the bank sector has improved to reflect expectations of a soft landing in the Canadian housing market and consistent earnings growth. Funds flow from other traditional dividend-growth sectors may also be fueling the rise in the banks. Street sentiment on the telco sector has been souring due to fear of increased competition, pipeline/utilities trade at valuations well above historical averages, and the REIT sector remains vulnerable to higher interest rates. This leaves the banks and lifecos as the most hospitable space within the traditional yield sectors. While banks may yet have further upside, lifecos look relatively more attractive based on valuation. In addition to higher bond yields, another potential catalyst over the next 12 months for the lifecos is a resumption of dividend growth.”
Fixed Income. Andy Mystic, Director, Portfolio Advisory Group wrote “Despite being relatively lackluster early on, it did prove to be an event filled week with comments from Fed Chair Yellen, the Bank of Canada rate decision and a heightening of geo-political risks to close out the week. During her semi-annual testimony to Congress Fed Chair Yellen continued to signal an expectation for low interest rates, noting that the US economic recovery is not yet complete with still too many Americans unemployed. Sticking to her recent tone she further noted that “a high degree of monetary policy accommodation remains appropriate.” The Bank of Canada this week pushed out its economic capacity expectations suggesting that the Canadian economy would not reach fully capacity until the mid-part of 2016 – three months later than previously forecast. The Bank retained a neutral interest rate bias but with Canadian CPI having printed Friday at 2.4% y/y (vs. exp. 2.3% y/y) – inflationary concerns will likely be coming increasingly into focus. Although we traded in relatively subdued fashion through most of the week, the shooting down of a Malaysian Airlines Boeing 777 over eastern Ukraine saw bonds rally firmly Thursday – with the event seemingly signaling a further deterioration in Western-Russian relations. . Despite the geo-political risks, our broader views on the US and Canadian economies remain largely intact. Despite the rally seen in bonds, investors still aren’t being sufficiently compensated for extending term, in our view. With inflation and most US data gathering momentum, we continue to highlight the risks of a Fed that that could turn hawkish, supporting the need to remain defensive. In the short term though, geo-political risks could hold rates in at lower than expected levels.”
Europe’s debt woes jumped back into the headlines this week trumping other economic, geopolitical and corporate developments. Word that one of Portugal’s biggest-listed banks had delayed coupon payments on some short-term debt securities spooked global financial markets Thursday. The fall-out was most pronounced across the euro-zone – particularly the banking sector – but ripples travelled as far as North America where fidgety traders hit the sell button. That was in stark contrast to the previous day when sentiment was running high after the US Federal Reserve released minutes from its latest policy meeting. The minutes confirmed the bank’s accommodative stance as there was no mention of an interest rate rise which emboldened traders. What was in the minutes was agreement among officials to end the central bank’s bond buying in October – something that had already been expected and largely factored into the markets. The Q2 US earnings season – not Portuguese bank debt – was expected to dominate the narrative at the start of the week with expectations for a 4.8% rise in corporate profits versus a 2.1% climb in Q1. Finally, a range of geopolitical tensions continue to percolate in the background. In the Mid-East, Israel and Palestinians in Gaza are exchanging missile fire while the Iraq situation remains fluid and unpredictable. Meantime, the Ukraine government remains engaged in a day-to-day conflict to oust pro-Russian separatists from its soil.
Stocks fall from peaks
North American benchmarks came off their record highs with the Dow shedding 153 pts. over the four-day period to end Thursday at 16,915, the S&P 500 slipped 21pts. to end at 1,964 and the Nasdaq gave back 89 pts. to close at 4,396. The TSX dropped 100 pts. to settle at 15,114.
Preferreds trending higher as expected, rising risks to long-term bonds
Preferreds. Tara Quinn, Director, Portfolio Advisory Group wrote “The preferred share market continues to trend higher as the supply vs. demand theme we expected at the beginning of the year continues to affect preferred share performance. The recent reset redemptions have helped the performance of existing resets as money is being reinvested into good quality securities. As this time we still view rate reset preferred shares as offering an attractive yield versus corporate bonds. Bank perpetuals are trading with a negative yield to call and should be avoided at this time. We would also encourage investors to consider reducing exposure to non-bank perpetuals as there are risks that 30-year bond yields could drift higher from current levels causing prices to fall.”
Fixed Income. Andy Mystic, Director, Portfolio Advisory Group wrote “With inflation beginning to rise, the US economy continuing to gain traction, and markets seemingly becoming complacent (volatility currently at pre-crisis lows) we see some rising risks to bonds. That being said, the technical buying that would likely materialize with a US 10-year Treasury yield in the 3.0-3.25% range, make it difficult to envision US rates moving materially above that level with any great authority in the near-term. With risks beginning to become more pronounced, but rate and spread levels still relatively low, there remains very little incentive to assume risk. As a result, we continue to believe that investors should remain short duration (i.e. durations typically of three to four years or lower). With credit spreads continuing to approach historical tightness (IG five year currently at 55.2bps vs. low of 29.7bps) security selection will become increasingly important. At the front end, GICs still provide the best relative value (one to five years). Within the investment grade space defensive investors should migrate towards better rated credit (e.g. BBB to A). We would suggest that investors limit or reduce exposure to high yield (HY) product which continues to grind up to historical highs. In addition to the diminishing risk/reward proposition of HY, investors remain vulnerable to extension risk as a sufficient sell off in HY could drive duration term extension. Although the HY carry trade could potentially continue for some time yet, the relative attractiveness of the HY space is clearly diminishing – particularly as markets seemingly become complacent and volatility remains subdued. Investors are simply no longer being paid sufficiently for HY risk, in our view.”
Fresh signs of global growth emerged this week enabling many stock benchmarks to reach new highs. The most notable sign came Thursday in the form of monthly US jobs numbers which were released a day early due to the American Independence Day holiday. The jobs numbers painted a picture of robust hiring south of the border for the month of June. Non-farm payrolls increased a seasonally adjusted 288,000 versus a projected payrolls rise of 215,000. Also notable were upward revisions to payroll numbers in April and May and an unemployment rate that fell to 6.1%; beating estimates it would stay unchanged at 6.3%. Sentiment was further boosted by news out of China Tuesday that showed June factory activity expanding at the fastest pace since December. The bump in factory activity follows encouraging data coming from exports, industrial production and retail sales. The prospect of stronger growth coming from the world’s two largest economies buoyed traders who have been looking for reasons to add to their holdings amid the benchmarks’ record runs. Geopolitical conflicts in Iraq and Ukraine also remained relatively contained this week, which was also viewed as a plus. Finally, the ECB left its main interest rate unchanged at 0.15% and continues to charge a fee of 0.1% on bank deposits above a certain level to try to spur growth.
Stocks set new records
New records were set north and south of the border this week as all but one major benchmark punched through previous highs. In Canada, the TSX added 115 pts. over the four-day period covered in this report to end at 15,207. In the US, the Dow and S&P 500 notched new highs with the blue chips rising 216 pts. to close at 17,068 and the broader S&P 500 adding 25 pts. to finish at 1,985. The Nasdaq – the only benchmark not in record territory – is at a 14-year high after adding 87 pts. through Thursday to end at 4,485.
We’re not expecting second half performance to match the first half
Equities. Himalaya Jain, Director, Portfolio Advisory Group wrote “While we continue to recommend an overweight stance in equities, and expect moderate equity gains over the next one to two years, the S&P/TSX Composite and S&P500 appear technically overbought in the near-term. Recent acceleration in the US job market and other key economic barometers, particularly after a dismal start to the year, bode well for corporate earnings growth ahead. We think equity markets have generally responded appropriately to improving economic trends, albeit with more vigor than we initially expected. At the beginning of this year, we had expected 7%-10% upside for the S&P500 and 7%-12% for the S&P/TSX Composite for 2014. Halfway into the year, returns for these two markets are already within our expectations for the whole year. While full year returns could exceed our original expectations (depending on how events unfold), we’re reluctant to reset our outlook at this point, and suggest that second half returns are likely to be modest relative to the first half. Aside from geopolitical issues, the key risk to our outlook is the Fed being pressured to raise interest rates sooner than the current consensus which is calling for a mid-2015 timeframe. We continue to recommend holding higher than average cash balances, with an aim of deploying this cash during instances of market volatility.”
Preferreds. Tara Quinn, Director, Portfolio Advisory Group wrote “The preferred share market continues to trend higher as the supply versus demand theme we expected at the beginning of the year continues to affect preferred share performance. The recent reset redemptions have helped the performance of existing resets as money is being reinvested into good quality securities. As this time we still view rate reset preferred share as offering an attractive yield versus corporate bonds. Bank perpetuals are trading with a negative yield to call and should be avoided at this time. ”
After starting the week at or near record levels it was going to take something special to keep stocks moving higher. That something special never happened. In fact, the news – economically and politically – was so-so at best which sent most benchmarks incrementally lower. The revised US GDP figure for Q1 stole the spotlight as it contracted more dramatically than previously thought. It fell at a seasonally adjusted annual rate of 2.9% versus estimates of a 1% decline. The slip – although greater than expected – was largely shrugged off by traders who wrote off the weather-ravaged quarter long ago. Meantime, a read on durable goods orders for May disappointed as it showed a 1% decline while personal spending only rose a scant 0.2% in the same month. Alternatively, housing numbers were good with new home sales easily beating estimates – 504,000 compared to a predicted 435,000 – and house prices rising across the board in 20 US cities by 10.8%. Elsewhere, a flash read on Chinese manufacturing activity came in at a seven month high of 50.8, up from 49.4 last month. Reads above 50 signal expansion which should please Beijing as it has introduced a number of mini-stimulus programs to try to boost economic growth. Turning to Europe, the German Ifo Institute’s gauge of business sentiment fell to 109.7 from 110.4 in May with geopolitical tensions in Ukraine and Iraq blamed for the downgrade. In Iraq, the situation remains fluid with insurgents continuing to gain ground amidst diplomatic and military efforts to bring calm to the country.
Positive first half
With just two trading days left before we reach the halfway mark 2014, the Dow is up 1.63% year-to-date, the S&P 500 has risen 5.89%, the Nasdaq has gained 4.85% and the TSX is ahead 10.35%. For the four days covered in this report, the Dow fell 99 pts. to close at 16,846, the S&P 500 gave back 5 pts. to end at 1,957 and the Nasdaq finished 9 pts. higher to settle at 4,379. The TSX fell 78 pts. to close out Thursday at 15,030.
Recent forecast by Fed increases outlook for short-term interest rates
Equities. Himalaya Jain, Director, Portfolio Advisory Group wrote “Despite an improving economic trend, the Federal Reserve chose to maintain the status quo on short-term interest rates thereby keeping monetary policy very accommodative. Separately, however, the latest forecast by Fed governors increased the outlook for short-term rates for 2015 and 2016. Based on the survey, short-term interest rates are expected to reach 1.13% by the end of 2015 (previous average forecast was calling for 1%) and 2.50% by the end of 2016 (up from 2.25% previously). While an imminent increase in rates is unlikely, we expect market volatility to increase from historically low current levels once the Fed starts to communicate the need for higher rates. We would look to such volatility as an opportunity to deploy excess cash in portfolios.”
Fixed Income. Anthony Salvatore, Associate, Portfolio Advisory Group wrote “Bonds ended the day lower on Monday after economic data out of the US printed above consensus forecasts. The Market US manufacturing PMI for the month of June printed at a 57.5 level print on expectations of a 56.0 level print while US existing home sales during the month of May increased 4.9% on the back of a 1.9% advance. Bonds rallied Tuesday after a news headline that Syrian warplanes hit targets in western Iraq spurred safe-haven buying and short covering. Bond yields rallied to the tune of 0.01-0.06% in both the US and Canada after Syrian warplanes carried out airstrikes in western Iraq, stepping up the military role of the US adversary in helping Baghdad’s Shiite-dominated government fight Sunni insurgents. Bonds extended their advance on Wednesday after the final US GDP print for Q1 showed the economy contracted more-than-expected. Q1 US GDP came in at -2.9% on the back of a -1.8% consensus expectation. Bonds continued to trade higher for a fourth straight day on Thursday after US economic data came in mixed. Ongoing geopolitical tensions in Iraq also continue help keep a lid on treasury yields. Initial jobless claims and personal income printed largely in-line with expectations while personal spending printed softer-than-forecast.”