The Investment Committee of the Portfolio Advisory Group meets regularly to formally discuss markets, sector allocation and investment recommendations. Below is a brief synopsis of our current views. For specific investment strategy relating to your investment portfolio, please contact us.
Equities: Dear Santa Claus, I hope you and Mrs. Claus and the elves are doing well at the North Pole. Thank you for bringing great equity returns for boys and girls last year. I’ve behaved very well this year. I enjoyed last year’s gift so much that I wish you could bring the same again this year. My twelve year old sister doesn’t believe that you really exist (maybe it’s because she asked for bonds last year!), and she says that you’re really just this bearded man living in Washington named Ben Bernanke. If this is true, then I’m a little worried because when I asked my dad about Mr. Bernanke, he said that he was planning to retire soon from his current job. The last time I saw you at the mall, you did look pretty old so maybe my dad is right. That’s okay, everyone has to retire sometime, even you I guess. Will the new Santa be just as nice as you? My dad says that your replacement is no Grinch, but will probably be less generous than you have been, and that boys and girls should expect some “tapering” in their stockings. I hope “tapering” isn’t a code word for a lump of coal! My dad says that it’s something no one has received before, but that there’s no need to be afraid because there will likely be other good things in our stockings such as improved job growth and better corporate profits. That’s it for now Santa. I’m going to leave extra cookies for you this year! XOXO P.S. Please don’t be as mean to my bondowning sister as you were this year. Also, I’ve heard a rumour that your friend Santa Draghi in Europe is starting to feel more generous; the boys and girls there sure need it!
Fixed income: U.S. data last week continued to look stronger but, consistent with our expectations, bond markets are taking it in stride. It makes sense to us that this would be occurring for two reasons: (1) Markets are starting to price in inevitable tapering, whether it be as early as this month (34% probability according to a recent survey) or early in 2014; (2) To avoid another spike in rates that could derail US housing, any tapering action will likely be accompanied by other monetary policy directives/actions intended to contain yields (e.g. a change in unemployment target guidance). This seems to be calming market expectations regarding how quickly short‐term interest rates should, or will, rise. With this context in mind, it didn’t surprise us to see that the US 10‐year held in and even rallied 2bps after Friday’s a non‐farm payrolls data – that came in a good deal stronger than consensus (see below). Although we do believe bond yields will rise, it now seems increasingly likely that the rise in rates will be more gradual as the Fed seemingly engineers a more settled path to rate normalization. Nevertheless, the Fed remains in uncharted waters here – risks for fixed income will continue to linger as we enter 2014.
Preferreds: The preferred share market was given an early Christmas gift last week as three new rate reset issues came to market and were well received by both retail and institutional investors. As we head into year end those preferred shares with a low reset spread (<2.00%) and the non‐investment grade sector have been facing price pressures due to investors focusing on tax loss selling strategies. Looking into the new year, even with bond yields expected to move higher, albeit at a more gradual pace, the preferred share market is poised for a potential rebound due to the large amount ($8.3 Billion) of expected redemptions that are likely to take place throughout 2014.
Capital Markets: Bring on the tapering! Recent momentum suggests U.S. economy is ready to handle it. The Fed has been eager to start tapering its quantitative easing program for a few months now. Ongoing improvements in employment and more recent improvements in consumer sentiment and housing (see below) suggests that conditions are now right for the Fed to start reducing its stimulus program. Bluntly said, this emergency source of stimulus has achieved its stated objective of kick‐starting the economy and is no longer warranted.
For much of 2013, equity markets have greeted good economic news with nervousness that the Fed would begin unwinding its record bond buying program. As we witnessed with last Friday’s November jobs report, markets are slowly transitioning to accepting positive economic news more constructively. As the U.S. economic pace accelerates, we expect equities to remain the preferred asset class. Investors should circle 2:00pm on Dec 18 (Fed’s next FOMC statement) on their calendars as this could present one of the few days of volatility in the near‐term. We think investors should continue to buy equities on any weakness, and more importantly, should be developing plans to deploy cash earmarked for the equity market.
The Canadian bank group reported Q4/13 earnings growth of 6% YoY, a touch below Street expectations. Domestic personal and commercial banking remained healthy with an 11% YoY improvement, while wealth management was the best performing segment, up 19% YoY based on strong AUM growth. Capital markets (‐13% YoY) were a drag for most banks, while the U.S. and International segment was relatively flat (except for TD’s strong U.S. operations). Current Street 2014 estimates point to an average 6% earnings growth ahead, with TD, RY, and BNS expected to grow earnings at the fastest rate.
WTI crude oil prices have rebounded from the low‐US$90s as North American refinery utilization has rebounded and the southern leg of TransCanada’s Keystone XL pipeline (Cushing, Oklahoma to the Gulf Coast) is set to open in early 2014. This 700,000 bbl/day capacity should help alleviate the inventory glut at Cushing where WTI prices are set.
Strong recent U.S. data confirms that the economy has approached “escape velocity” and has proven to be resilient in the face of higher mortgage rates, a government shutdown, and tax increases in early 2013. The much anticipated November jobs report delivered a second consecutive month of 200+k new jobs (203k vs. 185k est) while the unemployment rate declined to the lowest level in five years (7.0% vs. 7.2% est and 7.3% last month). Remarkably, the drop in unemployment rate was accompanied by an increase in the labour force articipation rate. Following strong October residential building permits, new home sales also rebounded (444k vs. 429k est) reflecting consumer adjustment to higher mortgage rates. November auto sales (16.3M vs. 15.8M est and 15.2M last month) were the strongest since mid‐2007 reflecting a rebound in consumer confidence (82.5 vs. 76 est and 75.1 last month) after the government shutdown in October. Finally, manufacturing and non‐manufacturing surveys remain in positive territory.
Third quarter GDP accelerated to +2.7% (vs. 3.6% for U.S.) while November housing starts (192k vs. 195k est) continue to point to a soft landing scenario. Geopolitical: A budget deal well before the deadline? This would indeed by a gift to investors if Congress passes it.
U.S. Congressional Republican and Democrat negotiators have struck a compromise budget deal that would fund the government for the next two years. Although there are detractors on both sides, the deal will be tabled to the full House and Senate later this week, ahead of a January 15, 2014 deadline. So far, Republican leaders Eric Cantor and John Boehner have come out in support of the budget deal, as has President Obama. Progress on this file would leave the debt ceiling (due to be reached in February) as one of the few remaining near‐term risks for capital markets.
Please note that this will be the final edition of Here’s What We’re Thinking for 2013.
Best wishes for the Holiday Season and a healthy and prosperous 2014!
Portfolio Advisory Group
In contrast with last week’s quieter, U.S. holiday-shortened week, the first week of December was a comparatively active one in the markets featuring Q4F13 Canadian bank earnings and a number of important economic data points. All major Canadian banks save for Laurentian reported Q4F13 earnings. CIBC, Royal Bank, and Canadian Western Bank exceeded consensus earnings expectations, while TD and BMO (adjusted for a security gain) missed. BNS and National Bank results were in line. CWB, NA, BMO, and TD increased their dividends. NA’s dividend increase was higher than expected and TD’s was unanticipated. Two banks – TD and NA — announced 2:1 stock splits while CM unexpectedly refrained from doing so. One final and somewhat surprising bank-related development was RBC’s announcement that CEO Gordon Nixon would be retiring effective August 2014, and the appointment of Dave McKay as his successor. For the week through Thursday’s close the S&P/TSX Bank Index declined 3.2%, while the TSX declined 1.5%. U.S. economic releases during the week were generally positive. Most notably the November change in nonfarm payrolls increased sequentially to 203k, exceeding expectations of 185k, and the unemployment rate declined to 7.0%, lower than the consensus estimate of 7.2% and October’s 7.3%, despite an increase in the labor force participation rate. Q3F13 U.S. GDP was stronger than expected at +3.6% annualized (estimate +3.1%), and the same was true of consumer confidence (University of Michigan December preliminary reading 82.5 versus 76.0 estimate), the November ISM Manufacturing index (57.3 versus 55.1 estimate) and auto sales (16.31M November SAAR versus 15.8M estimate). At the time of writing the S&P500 was down a modest 0.2% over the week after a strong Friday rebound, as U.S. 10-year Treasury yields increased approximately 11 bps to 2.86%. On the commodities front, WTI advanced 5% over the week to US$97.46 following TransCanada’s Dec. 3 announcement it would open the southern portion of its Keystone pipeline in January 2014 to transport crude from Cushing OK to the Texas coast, helping to alleviate a key bottleneck.
The Dow and S&P 500 continued their longest losing streak this year as investors take a breather following strong quarterly earnings. The Dow declined 263 pts. to close at 15,823 and the S&P 500 lost 20 pts. to close at 1,785. In comparison, the TSX fell over four sessions with the index shedding 195 pts. to close at 13,200.
• Equities. Himalaya Jain, Director, Portfolio Advisory Group wrote: “We recently released our 2014 outlook and expect equities to outperform fixed income again next year. With further evidence that the U.S. economic recovery is accelerating and Europe and China are gradually improving, increasing risk appetite should result in further rotation into equities and out of bonds. Based on current valuation, we expect 2014 Canadian and U.S. equity returns to be in the 7%-10% range.”
• Fixed Income. Andrew Mystic, Director, Portfolio Advisory Group wrote: “The US data this week continued to look stronger but, consistent with our expectations, bond markets are taking the data in better stride. It makes sense to us that this would be occurring for two reasons: (1) Markets seem to be expecting that the impact of seasonal hiring and government shutdowns are likely going to leave the Fed holding off on tapering until Q1/14, when they can get a cleaner read of the data (2) To avoid another spike in rates that could further derail US housing, any tapering action will likely be accompanied by other monetary policy directives/actions intended to contain rates (e.g. a change in unemployment target guidance or other monetary policy action). This seems to be calming market expectations regarding how quickly rates should, or will, unwind. With this context in mind, it didn’t surprise us to see that the US 10-year held in and even rallied 2bps on the back of Friday’s a non-farm payrolls print – a print that came in a good deal stronger than consensus expectations (203k vs. 185k). Scotia economics is not forecasting that the US 10-year will reach 3.40% by Q4/14. Although we do believe rates will rise, it now seems increasingly likely that the rise in rates will be more gradual as the Fed seemingly engineers a more settled path to rate normalization. Nevertheless, the Fed remains in uncharted waters here – risks will continue to abound.”
US Federal Reserve meeting minutes released this week displayed a bias to reducing economic stimulus sooner rather than later assuming improvement in the job market. That, in itself, was not news but the fact that the markets seemed to take it in stride suggests traders are warming to the tapering idea. Further proof came when labour numbers were released Thursday that showed applications for unemployment benefits in the U.S. had dropped by 21,000 to 323,000. Economists had estimated 335,000 applications so the number surprised on the upside. This could easily have led to handwringing as recently as a few weeks ago as good jobs data is a key measure for the early withdrawal of stimulus. Good US economic data was also contained in retail sales numbers which came in higher-than-anticipated Wednesday as they climbed to a seasonally-adjusted 0.4%; surpassing expectations of.1%. Overall, retail sales are up 3.9% year-over-year. Meantime, inflation remains muted as US consumer prices fell 0.1% in October; the first drop since April. Compared to a year ago, consumer prices as measured by the consumer-price index were up 1% – the smallest 12-month increase since October 2009. Separately but notably, China announced revisions to its one-child rule allowing married couples to have two children if at least one spouse is an only child.
After breaching the 16,000 point mark for the first time Monday, the Dow closed above it Thursday by adding 48 pts. for the four-day period and settling at 16,009. The Dow has now set 40 all-time highs in 2013. The S&P 500 also breached a new record Monday – 1,800 points – but failed to stay above it finishing Thursday at 1,795. The Nasdaq fell for the four days dropping 16 points to close at 3,969 while the TSX shed 7 points ending at 13,475
• Equities. Himalaya Jain, Director, Portfolio Advisory Group wrote: “From a big picture perspective, markets will remain focused on Fed tapering (timing and pace). Wednesday’s release of Fed minutes (from the Oct 30 FOMC meeting) suggested that consistent improvement in economic data would warrant tapering QE “in coming months.” In our opinion, this is nothing new… the Fed will taper when the economic data justifies it. The next important barometers will be the release of Oct housing starts data (Nov 26) and non-farm payrolls (Dec 6). Equity markets are likely to remain capped for now and still vulnerable to a modest pullback.”
• Fixed Income. Andrew Mystic, Director, Portfolio Advisory Group wrote: “We continue to see merit in our broader macro view, namely that rates will likely rise but that the pace of that rise will likely be more steady and incremental, with smaller bouts of data dependent volatility. Our view is predicated on (1) the fact that the Fed is now likely to have greater continuity with the general tone of a Bernanke led Fed. The probability of this outcome increased markedly this week as Janet Yellen’s confirmation was referred to the Senate (2) any asset paring will likely be met with other accommodative action, whether that be a change in forward guidance or other market operations (3) broader macro growth although tepid, seems likely poised to gain some traction in 2014 (4) the more recently dovish BoC tone will continue to figure prominently in market sentiment. Although key risks remain, particularly in relation US political developments, bond market tone seems increasingly likely to remain range bound but with a modest upward rate bias in the near term. As well, the front end of both US and Canadian curves have been demonstrating more buoyancy which we believe will continue for the foreseeable future.”
The S&P 500 briefly breached the 1,800 level Monday setting a new record high.
The S&P 500 bull market started in March 2009 (low of 677) and is now sporting a total gain of 165%. In terms of return and duration (now at 56 months), the ongoing S&P 500 bull cycle is above the historical mean of 140% gain and 46 months. Although return and duration are already above average, the extent of P/E expansion remains moderate compared to previous similar cycles.
Since 2009, the S&P 500 trailing P/E multiple has rebounded 5.9 points (to 16.5x) versus an average gain of 13.5 points in previous similar markets. Hence, the main difference currently lies in how fast earnings have improved throughout the recovery. S&P 500 trailing earnings have rebounded 82% to US$102. Stumbling earnings and pricey valuations have historically contributed to end bull markets. Looking out to 2014, neither appears restrictive and the S&P 500 run could continue.