The article below is Aon's latest quarterly investment outlook for Canadian markets.
Interest rate cuts are supporting equities, but bonds continue to send a different message on the global economic outlook ahead.
The pick-up in bond market volatility could last. Two opposite worlds look possible – one advancing a zero/negative rate world further and a different one that could ultimately pose some upside risks to yields. Canada will not escape this trend.
Credit market stresses are surfacing . Our caution on credit stays.
US corporate profits have stopped growing, and Canadian profits look to have peaked. A marked recovery in profits looks unlikely given margin pressures that are now coming through. Even though triggers for large market falls are few today, rebalancing and trimming into market strength is entirely appropriate.
The continued struggle for value stocks to keep up is setting up room for a strong rebound when the right conditions arrive, but we do not expect this to be seen quite yet.
There is a growing view that ESG factors are mattering more for portfolio-building. We expect viewpoints to shift over time as awareness builds and choices on integrating ESG more effectively into portfolios improve.
Bonds diverge markedly from equities
The highlight of the last quarter was the very sharp roll-over in global bond yields, and Canada was no exception. Though central bank rate cuts around the world were the trigger, behind this lay worries that the global economic slowdown was not abating. We had noted in July 2019 that global manufacturing and trade were facing outright decline, and this was readily observable over the summer. In a strong quarter for bonds, global yields fell sharply through July/August, with a respite in September. Corporate bonds also did well, though returns came mainly from falling US treasury yields. Strikingly, bond market worries over economic growth did not bother US and Canadian equities (see chart above), arguably because central bank easing promised easy liquidity conditions. Commodities fell, reflecting worries over slowing demand. The Canadian dollar was on the weaker side against the dollar, but firmer against the Euro, which boosted US equity market returns in CAD, but depressed EAFE returns in CAD. The re-election of Justin Trudeau, but losing his majority, does not impact our main investment thesis that we continue through a transition environment.
Expect bonds to turn more volatile
Uncertainty is increasing in fixed income markets. There is a widespread view that at current interest rates, central banks are running out of monetary policy room to react to any further worsening in global economic conditions. Policy emphasis will have to shift towards looser fiscal policy to provide economic support, especially in a sharp downturn.
However, such a shift is easier said than done and comes with catches. Fiscal room is not large either. Government debt is now far higher in most countries, including the US, than a decade ago. Large scale debt-financed government spending would mean bigger US treasury bond issuance, but what if such supply is not absorbed at such high bond prices (low yields)? To take a more extreme course, if higher US government spending is financed by new money from the US Federal Reserve (instead of US government debt), this could pressure bond markets even more because it implies a loss of Federal Reserve bank independence, which would increase inflation uncertainty and take yields higher.
Equally, an opposite path is plausible. If such policy shifts do not come, or fail, we could be heading in the opposite direction, towards still lower interest rates and yields, following Europe and Japan into negative nominal yields. This keeps the ‘lower for even longer’ trend in yields intact! Canadian fixed income markets will not be an exception to these global forces, given the close linkage to US and global markets.
The point is this. As these sharply opposing risks focus bondholders’ minds, it seems more likely to lead to greater volatility. We are all used to lower bond market volatility as interest rates have gone ever lower, including in Canada, but now higher volatility looks likely for a time even though the ultimate direction of yields will remain unclear. What should be done? Such strongly opposite paths for bond yields make it high risk to act on a specific view. Maintaining a high level of liability hedging is a way to cope with this uncertainty.
An important question that holders of corporate bonds should consider is whether credit risk in the market is being adequately compensated. One of the trends to allow for is the changing mix of credit quality in market benchmarks. In the US and Canadian investment grade corporate bond indices, a key development over several years has been the shrinking proportion of the higher-grade bonds. One way to show this is to look at the behaviour of the AA rated proportion of the index versus the lowest rung – graded BBB. As the table below shows, the AA universe has become a rather lower proportion of the index relative to the BBB universe, signalling quality deterioration within the index.
The growing supply of lower rated bonds relative to higher rated ones should arguably be reflected in a higher risk premium for BBB bonds relative to AA graded bonds. This is especially so since a potential downgrade of BBB bonds moves them out of the high grade to the high yield universe, a transition which typically leads to significant price changes.
Yet, when we look at the way current credit markets are compensating AA bond holders relative to BBB in the U.S., there is no marked change over time. More attractive pricing points for BBB’s versus AA’s (stress points of February 2016 and December 2018) have not been sustained (see chart above). Our cautious view reflects this unattractive pricing, especially if investment grade bonds are held passively.
By contrast, price differentiation is happening in sub-investment grade. In July we noted how CCC bonds were pricing better versus B rated high yield bonds. The leveraged loan market is also making clear its greater wariness of risks. In the important US loan universe, downgrades are up sharply, and the number of issues trading at large price discounts (10% or more) has been rising. As these price adjustments are at an early stage, our negative view on sub-investment grade is also unchanged.
The profits slowdown
Yet another US quarterly earnings season is on us. Given the consensus that the economy has slowed down significantly in 2019, a key question for equity markets, and here the US is the undoubted global pacesetter, is whether earnings (corporate profits) are sufficiently resilient to support the market or take it higher, sustainably. If the economic slowdown continues or deepens going into 2020, can profits hold up? In the past year, the economic slowdown has clearly impacted profits already. Earnings expectations have been downgraded substantially, so that for calendar 2019, it is now touch and go whether S&P 500 profits grow at all. This means that the large gain in the S&P 500 year to date has come entirely from the market becoming more expensive. For Canadian equity markets the story is more optimistic, but not by much. Earnings growth for 2019 is expected to be 4.8%, this is still half of what was expected at the start of 2019. The same message holds for Canada as the US, that much of the gains this year has come from the market becoming more expensive.
Analysts are still optimistic for 2020 and the latest consensus forecast for growth in earnings per share of some 10% in the US, and around 7% for Canada. If stronger sales growth now comes through and cost pressures subside, a strong recovery in profits is possible, but this looks unlikely. Even if the economic slowdown ends, one key difficulty is that profit margins are still at very high levels – S&P 500 margins, while a little lower this year, are still well above levels ever seen before, Canadian margins are equally extended. Margin drivers are now weakening. This is a complex area, but one drag is already observable from the trade conflict itself; the reversal of globalisation (higher tariffs, less benefit from cost-offshoring etc), is pushing costs higher. Margin pressure makes a strong recovery in profits less likely since it impacts profits beyond just the effect of the economic slowdown on business sales.
A further warning sign emerges from the US national accounts measure of corporate profits. This data (referred to as NIPA – national income and product accounts) shows that broad corporate profits in the US (including unincorporated businesses) have been flat for a few years. The contrast with S&P 500 profits, which have substantially outgrown the national profits series, is startling (see chart).
It is true that these are different measures, but also accurate to say that the cycles in both have been similar and that national profits cycles have generally led S&P 500 profits. If past patterns were to repeat, the national series is pointing to a prolonged slowdown in S&P 500 profits. This, too, is pointing to greater difficulty in market gains being sustained.
Contradiction beneath the bull market
Under the surface of the longest bull market ever lies a contradiction. For most of the period, investors have sought the safety of defensive segments of the market. ‘Value’ stocks, the cheaper segment of the market has lagged badly, while expensive so-called ‘growth’ stocks have carried on outperforming. This is a characteristic of a defensive investor mind-set, reflecting a preference for those stocks already expensive on a relative basis because their profits and margins seem more secure. However, the premium paid on this group of stocks is now at a two-decade high versus the cheaper – ‘value’ end of the market. However, extreme though this valuation picture is, it could linger so long as the economic environment stays uncertain. Into a sharp downturn or other outbreak of strong risk aversion, the chances of a major rotation towards value are now rising, as cheaper stocks will then appear more defensive than highly priced stocks. In short, value will come back, but later, when economic and broad market conditions change significantly.
Treading with caution in equities
Our wariness on equities remains. While no immediate triggers are in place for large and sustained market falls, our ‘transition market’ characterisation of an upward creep in volatility with higher risks of market upsets remains accurate. Weaker earnings and high valuations alongside soft economic conditions are not supportive of further sustained market gains, even as interest rates stay low or fall further. This is therefore a time when bouts of market strength offer scope to rebalance down or de-risk by trimming exposures. Given Canadian equities exposure to the global markets, we continue to prefer US equities to Canadian equities.
Looking for shelter in a market storm
We have never been in a market environment quite like this given the large impact of such low interest rates and central banks in driving markets. This makes it difficult to answer the question of what appropriate diversifiers could be in a sustained and large market downturn. Recommendations that draw on behaviour in past market cycles may not be appropriate this time. However, our analysis suggests that some traditional diversifiers will still protect capital in a large market downturn. Sovereign bonds will still do this job, notwithstanding the risks to yields from policy shifts that we noted on p.2. Gold (exposure held through funds), already doing well thanks to such low interest rates, looks worthwhile as a diversifier too. More conventionally, private real estate and infrastructure, though not immune, are not too badly placed given their more income-driven return profile. Finally, absolute return strategies (alternative risk premium or macro strategies) that benefit from rising market volatility and have less directional dependence on equity and credit markets, should also protect capital.
There is an evolving view that ESG factors are mattering more for building portfolios, a break with the not too distant past when this area was regarded as only marginally relevant. Some elements of ESG – to do with corporate governance, for example, have always mattered. In 2019, it is the E (environment) issue that is becoming more of a focus in building portfolios – related to the effects of climate change, pollution, land use and waste disposal, to take just some topics of focus and the increasing effects of regulation in these areas on companies. To date, this has been more impacting in Europe than in the US. The information flow that would lead to an accurate assessment of E risks to portfolios is still only at a nascent stage. Over time, risks are likely to be better understood, and information flow and disclosure will improve. As regulatory impact becomes more central to corporate life, so will the incentives to adequately measure impact beyond that of narrow financial reporting.
There are several routes to a more effective integration of ESG issues into portfolios ranging from those which build some broad awareness, to those which look to build resilience and defences against risks, all the way to those which actively seek new return opportunities being created or look for measurable impact in terms of responsible investment goals. There is a place for all these approaches. Responsible investing viewpoints and implementation approaches will evolve along this spectrum over time.
Market data source Factset
The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.
1 Indices cannot be invested in directly. Unmanaged index returns assume reinvestment of any and all distributions and do not reflect fees or expenses. Please see appendix for index definitions. Past performance is no guarantee of future results
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Appendix: Index Definitions
S&P 500 Index – The market-cap-weighted index includes 500 leading companies and captures approximately 80% of available market capitalization.
Russell 2000 Index - The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set.
MSCI EAFE Index $ - The MSCI EAFE Index is designed to measure the performance of the large and mid-cap segments of developed European Australasian and Far East Markets. The index covers approximately 85% of the free float-adjusted market capitalization and is measured in USD dollar terms.
MSCI EAFE Index (Hedged) - The MSCI EAFE hedged Index is designed to measure the performance of the large and mid-cap segments of developed European Australasian and Far East Markets. The index covers approximately 85% of the free float-adjusted market capitalization and is measured in hedged dollar terms.
MSCI Emerging Markets Index – The MSCI Emerging Markets Index captures large and mid-cap representation across Emerging Markets (EM) countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country and is measured in USD terms.
Bloomberg Barclays Capital Aggregate Index - The Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
HFRI: The Hedge Fund Research, Inc. Monthly Indices (HFRI) are fund-weighted (equal-weighted) indices. Unlike asset-weighting, the equal-weighting of indices presents a more general picture of performance of the hedge fund industry. Any bias towards the larger funds potentially created by alternative weightings is greatly reduced, especially for strategies that encompass a small number of funds. All single-manager HFRI Index constituents are included in the HFRI Fund Weighted Composite, which accounts for over 2000 funds listed on the internal HFR Database.
CBOE VIX Index: Tracks the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options.
ML MOVE Index - The Merrill lynch Option Volatility Estimate (MOVE) Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options which are weighted on the 2, 5, 10, and 30 year contracts
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