Portfolio Manager's Commentary Q3 2019
Stock and bond prices both rose in the third quarter, as dovish talk by central bankers was transformed into dovish action. What was the economic backdrop?
30 September 2019
The European economic situation deteriorated in the second quarter. Headline growth dipped slightly in Germany and the UK, and consumption growth in the four largest continental economies - Germany, France, Italy and Spain - ground to a near halt. Ironically, consumption growth was quite healthy in the UK, whose denizens had opportunity galore from the ongoing Brexit political drama to “hunker down” but instead seemed to go about their economic lives normally. Large swings in inventories and net exports, both likely related to the March 31 Brexit deadline that was ultimately extended, accounted for the UK economy’s modest decline in the second quarter.
Unfortunately, because its short term interest rate target has been zero for the last several years, the European Central Bank (ECB) has little ammunition left with which to combat the latest slowdown.
The Canadian economy outside Alberta remained strong. Job creation was exceptionally high in January and then tailed off until July, which was another exceptional month for new jobs. Preliminary indications are that August was also very strong. In contrast, job creation in Alberta over the same period was positive but just barely so, as the constraints on energy sector expansion haven’t yet been removed.
The Bank of Canada kept its target short term interest rate at 1.75%, where it has been since its last October.
The economic lethargy across the Atlantic didn’t at all pervade the US economy. After a noticeable dip in the last part of 2018, as the stock market also declined, US retail sales returned with a bang in this year’s second and third quarters.
Job growth remained positive but slightly slower than in prior years, which is to be expected now that the US is flirting with full employment. The above-average pace of job creation required to lower the unemployment rate from 10% in 2009 to 3.7% today is higher than the US economy needs from here onward.
Despite strong US economic news, the US central bank, the Federal Reserve or “Fed” lowered its target short-term interest rate twice this quarter, in July and September. The reductions weren’t so much a sign the US is headed into a recession as they were “insurance against ongoing risks”, namely the slowdown of global growth and the ongoing trade dispute between the US and China.
Inflation is still well under control - even a bit low for the Fed’s liking - and with plenty of ammunition left in its monetary policy belt, the Fed is in the desirable position in which it can reduce rates if it believes doing so is necessary to extend the business cycle.
Stock prices moved slightly upward in the quarter, adding to the recovery from the drop in the fourth quarter of 2018.
However, the main story in the financial markets was the ongoing bond rally. Because bond prices are inversely related to bond interest rates or “yields”, bond prices in the third quarter continued to rise as bond yields continued to fall. Even after a slight reversal in September, the Universe index of Canadian bonds had a return of more than 1% for the quarter and nearly 8% year to date.
Fortunately for stock investors and for the broad economy, the low interest rates mitigate against the likelihood of a recession. Unfortunately for bond investors, the bonanza of bond returns over the last eleven months portends below-average bond returns in the future. Bond yields are essentially as low as in 2012, even though the North American economy is far healthier now than it was then.
The Compass Portfolio returns for the quarter were roughly 1% across all portfolios. The portfolios’ fixed income portions didn’t fully participate in the bond rally, as they consist of shorter-maturity bonds and not the long-maturity bonds whose prices benefited most from the fall in yields.
Over the first three quarters, the portfolios’ returns range from just under 7% for the most conservative to just under 13% for the most aggressive, which reflect the strong bond and stock returns so far this year.
A prominent theme of the third quarter was the Fed’s two cuts to its interest rate target, taken in light of a strong US economy but deterioration elsewhere globally. Though we think the Fed will successfully fend off any potential economic slowdown, a more important question for investors is what happens if the Fed fails and the US “catches cold” from the slowing European economies and its “trade war” with China. Does a modest prospect of an economic slowdown mean stock investors should change their strategy?
We believe the answer is an emphatic no, for two reasons. First, it’s almost impossible to successfully predict a recession’s beginning and end, let alone the stock market movements that accompanies it. For example, stock prices hit bottom and began to rise well before the recession ended in all but one of the US post-WWII recessions. In most cases, stock prices also began to fall long before the recession began.
Moreover, stocks represent ownership in profit-producing companies, profits which decline during an economic slowdown but recover and then reach new heights as recession inevitably ends. Over time, the shorter-term emotion-driven price movements which garner most headlines become virtually irrelevant, and the longer-term growth of companies’ fundamentals - the ultimate source of stock returns - comes to the fore.
Chief Investment Officer
ATB Investment Management Inc.
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