Smart Money

The Return of Volatility – Equities began the year by extending their 2017 gains. But, in late January, accumulating uncertainties and rapidly rising yields eventually pushed equity volatility up and drove prices down. Nearly all major stock and bond categories finished the period in negative territory. Following an unprecedented streak of 19 consecutive months without a 5% correction for the S&P 500, the US equity benchmark fell nearly 10% in just 10 trading days in February. A brief recovery in stocks in the latter part of February was interrupted again in March by concerns over a potential trade war between the US and China.

In March, the Federal Reserve raised rates for a sixth time since the end of 2005. Nevertheless, developed-market sovereign bond yields have remained stubbornly low until recently. As inflation began surfacing in US consumer reports, yields started to climb. The 10-year US Treasury Yield hit 2.95% in March, a level it hasn’t reached in almost 3-years, which followed the original “taper tantrum” sell-off.

Displacing Deflation from Investors’ Mindset – Inflation trends have been declining for the better part of three decades. However, the millennial year marked the flatlining of the core consumer price index. As a result, central bankers have become obsessed with raising the level of inflation beyond the 2% trend rate experienced since the turn of the century. The great financial crisis of 2009 served to intensify the fixation.

High inflation can be harmful to an economy when it is not accompanied by rising wages. Equally, low inflation can hamper corporate pricing power which restrains earnings. Accordingly, the Federal Reserve attempts to boost the long-run growth rate by exercising control over inflation, as it is transparent and linked to the health of the economy. The problem is that inflation cannot be measured by an increase in the price of one product or service, or even several products or services. Rising costs are not spread evenly between businesses and industries, which contributes to the absence of inflation in government data.

Since the early 1980s, inflation has slowed in developed economies for a variety of reasons including demographics, technological advances, M2 money supply declines and higher corporate concentration. Further, given the swath of retirees over the next decade as well as the likely displacement of jobs due to robotics and artificial intelligence, runaway inflation is an unlikely concern in the foreseeable future. It is no wonder inflation fears have become so subdued. As a result, relative to financial assets, hard assets and commodities have only been this cheap twice in the past 50 years – 1970-1972 and 1998- 2000.

So, why are we doubtful about the disregard for an inflation surprise?

• Over the last few quarters, corporate earnings reports have stated concerns about tight labor markets and emerging inflationary pressures. This is a decisive shift from the deflationary tones of 2015 and 2016. Management strategy discussions frequently involve methods to pass on price increases from materials and labour.
• China is contributing to global inflation due to increasing factory prices. Historically, China exported deflationary forces to the world with lower labour costs. Looking forward, the country is also set to deliver on right-sizing industrial capacity in sectors that were previously oversupplied; such as aluminum, coal and steel.
• A wide range of reflation-markets and related-indicators have been breaking from long-term patterns. After declining over 60% from peak-to-trough from 2014 to 2016, oil prices stabilized and are now up over 100% from the January 2016 low. Oil is a key input not only for transportation but also feed stock and plastics.
• On 02-Feb-18, the Bureau of Labor Statistics reported a 2.9% increase in average hourly earnings.

With government data now picking up the inflationary signals, bond yields quickly moved higher causing a bond sell-off. The impact was also felt in equity markets, given the potential shock higher costs would have on corporate profits. As such, investors should remain nimble and cognizant of inflation’s impact on both asset classes.

As April approaches, the on-ice focus of most professional hockey players remains on their upcoming playoff push. In the player advisory world, the April tax deadlines are our version of a playoff push. Many fail to consider the complexity involved in filing taxes for a professional athlete. While some complain of federal and provincial filing requirements, an NHL athlete often has a filing requirement in each jurisdiction in which they play. This means a typical NHL player can file upwards of fifteen tax returns! Check the link below to learn some quick facts about how an NHL athlete files their taxes.

Global markets had mixed returns for the month ending 22-Mar-18. The TSX lead the way with a 1.6% gain spurred by commodities.  The S&P 500 index was up 0.5% while the MSCI fared worse with a 1.4% loss as Asian markets experienced weakness.  Korean automobile manufacturers were particularly impacted on trade war worries, while Japanese equities experienced Yen strength as a headwind during the month.  On the commodity front, Oil reversed a 2.5% slide to gain 5.1% on the back of strong inventory data, while gold strengthened by 1%.  As stock market volatility increased, the price of gold climbed.  Gold is notoriously known as a safety asset.  Accordingly, it tends to rise when there is a meaningful slump in the market. Investors often take shelter in non-yield-bearing gold as a buffer against risk.  The US 10-year Treasury Yield appreciated 5bps, bouncing back over 2.90%.

Trade wars have been a constant theme weighing on markets in 2018.  On 1-Mar-18, Trump announced a 25% tariff on steel imports and a 10% tariff on aluminum to help shore-up weakening domestic  industries.  Though Trump walked-back part of these measures as they relate to Canada and Mexico, pending final NAFTA negotiations, some have hinted at the move being a direct message to China.  Chinese steel production has been curtailed dramatically for environmental reasons.  This has contributed to steel exports into the US falling from 400K metric tons/month in 2014 to 60K.  However, many are looking beyond this announcement to potential follow-on effects, including the announcement of an estimated US$50Bn in tariffs against China over intellectual property violations.  The amount was based on estimates of economic damage caused by China through the theft of US technology and intellectual property. China has not yet made any counter-announcements, but they have hinted at retaliation.  China is not the only country affected by the tariffs either, as leaders from other countries such as those in Europe have also hinted at retaliatory measures.  Inflation, which has already shown signs of strength, is a notable consequence of trade wars.

We have previously commented on increased market liquidity (QE-driven) and its positive affect on markets.  With the Fed embarking on a QE unwind and potential impacts of USD repatriation starting to take hold, signs of USD shortages are beginning to show.  This can be seen in the US LIBOR-OIS spread, or the differential between the rate banks charge to each other to lend (LIBOR) vs. the overnight risk-free rate (OIS).  With the majority of loans priced off LIBOR, a rising rate may reveal reduced USD liquidity. In turn, the willingness for banks  to lend into the market may be diminished.  The 55bps spread hit on 21-Mar-18 reflects the highest spread seen since the Global Financial Crisis in 2007, which is material, though the cause can only be approximated.  Either way, it is something to monitor as any liquidity shortage could have pronounced implications on asset prices and credit risk/borrowing capacity in general.

During this period, market participants were reminded that the stock market and the economy are not the same thing. The US Labor Department’s January jobs report showed that 200,000 new jobs were added in the first month of 2018.  Meanwhile, the historic rise in global equities came to an abrupt halt.  An unprecedented streak of 19 consecutive months without a 5% correction was finally broken.   Following the Labor Department’s report, which also showed that wage growth jumped 2.9% year-over-year, global benchmarks fell over 7% during the next six trading days. The fear that wage growth will lead to higher inflation, and higher inflation will lead to the US Federal Reserve raising rates more quickly resulted in the S&P 500 giving back all of 2018’s gains as it entered a correction. A correction, which is a 10% pullback from a market peak, occurred on 26-Jan-18.  Market corrections typically occur every other year, on average.  However, the last correction for the S&P 500 was almost two years ago. Interestingly, the correction occurred less than a week after investors poured record amounts into exchange-traded funds in January.

Despite raising rates five times since late 2015, developed-market sovereign bond yields have remained stubbornly low until recently. As inflation began showing up in US consumer reports, yields started its ascent. Adding fuel to the inflation narrative, US President Donald Trump unveiled his $1.7 trillion infrastructure spending plan that will take place over the next 10-years and the US dollar depreciated nearly 15% against a basket of its key trading partners. As a result, the 10-year US Treasury Yield hit 2.92%, a level it hasn’t reached in almost 3-years, which followed the original “taper tantrum” sell-off. More significant perhaps, the equity market correction was not accompanied by rising bond prices – bonds did not act as the “hedge” that many strategies and allocation models assume.

Over the course of the last few years, many investors have abandoned traditional hedging strategies as the cost of insurance made it difficult to outperform a constantly rising benchmark. Rather, many investors tried to exploit the rising trend by selling volatility or buying inverse volatility strategies through exchange traded funds/notes (XIV Index). As a result, participants were caught off-guard and on the opposite end of the violent unwind that ensued in February. The sell-off resulted in the largest single-day point drop (not largest percentage drop) for the Dow Jones Industrial Average and wiped out nearly six years’ worth of gains for the XIV Index. More concerning for long-term investors is the outcome for these rules-based or “smart-beta” strategies, which include styles like risk parity. These strategies incorporate volatility to define the allocation of capital to different assets and rely on liquidity.  A dangerous feedback loop may arise as the underlying securities can’t provide the liquidity promised by the exchange traded notes/funds as investors stampede out of the strategies.

The NHL trade deadline has grown to become one of the most exciting days of the NHL season. While teams in the playoff race look to bulk-up for a late season push, teams waving their white flags seek to unload salary and acquire young assets. What many on the outside fail to consider is the immediate lifestyle changes faced by the players who are traded. To assist with this change, check out our Traded Player Checklist below!

This weekend, the NHL’s best players will gather in Tampa, Florida for the 63rd NHL All-Star Game. The fan-frenzied weekend will end with the popular 3-on-3 tournament, displaying teams from each of the four divisions all competing for a $1 million prize. As the 44 selected players prepare for the exciting event, check out our infographic providing some interesting numbers surrounding the annual All-Star Game.

A Synchronized Global Recovery – Global equities experienced a near-perfect backdrop of steady global growth, low inflation and continued accommodative monetary policy in 2017, leading to strong performance. For the year, all major equity categories and sectors ended the year with double-digit gains; shaking off nuclear threats, populist uprisings and a stalled Trump Administration agenda.

Commodities closed higher on the year, led by gains in crude oil, with WTI rising 12.5%. Precious metals and copper also posted gains, while agricultural commodities were mixed. The US dollar index, which compares the greenback to a basket of global currencies, slid about 10% last year after rising for nearly three years.

Despite fears of US Federal Reserve tightening and fiscal reform leading to higher growth, most US bond indexes closed the year higher. The US yield curve, which has historically been an important indicator of recessions by inverting prior to the previous seven recessions, flattened by about 100 basis points.

Approaching Levels of Significance – The equity bull market is now deep into its ninth year, the second-longest on record. The third (and perhaps final) phase of the bull market kicked off in 2016 as global economic momentum strengthened to include more sectors and countries. The improvements were broad based as nearly every major global economy expanded in 2017. Lower corporate taxes in the US and a continuing rally in commodities bolstered the outlook for 2018.

Strategist forecast S&P 500 earnings to be between $139-$150 per share, an approximate 10.3% increase from 2017 forecasts. Similarly, the earnings multiple has increased, to nearly 18x the next four quarters’ expected earnings.  The long-term average multiple is 16.5x; moreover, the multiple was 17.1x one-year ago.  Statistically, a 10% setback is plausible if the Price-to-Earnings multiple backs up to 16.5x, even with a $150 earnings figure. However, at this point it appears that any pullback will be merely corrective as the emergence of a recession in 2018 is doubtful.

The ISM Manufacturing Index is often used as a guide for the business cycle.  In the US, the ISM is currently experiencing the third-longest expansion in history and its reading is at the second-most elevated level in the last thirty years. Meanwhile, the Conference Board Leading Economic Indicator Index continues to increase while the US Treasury curve remains upward sloping – despite recent flattening. Given the strong economic backdrop and the need for governments to “inflate-away” their debt, we believe commodity-linked equities, including precious metals and agriculture, will outperform.  Additionally, this sector is exhibiting favourable valuations.

Volatility may be resurrected in 2018. Possible triggers for spontaneous instability include;

• Failure for capital expenditures and hiring/wage increases to underpin growth.
• Excessive debt levels.
• Accelerated interest rate increases.
• Defiance to the “America First” rhetoric.

The first signs of erraticism may surface in the currency markets. A surge in the US Dollar index is likely in the near-term as tax repatriation increases demand. However, net-investment positions may trigger a USD sell-off while many countries are already seeking alternatives to the dollar system. China and Russia continue to stockpile physical gold while hinting at problems with the Eurodollar system. Meanwhile, the two countries are negotiating with Saudi Arabia for a Yuan-backed oil contract.

In the near-term, bonds are somewhat attractively priced. Originally, economic growth forecasts caused prices to slide and yields to rise. More recently, yields rose when the U.S. Senate reached a short-term compromise to end the government shutdown. The 10-year bond now sports its highest rate in over one year. Longer term, we do not anticipate traditional fixed income to benefit the portfolio from a total return perspective. Yields remain near historic lows and an increase in supply will pressure prices. Deflationary pressures have been prominent recently, as millions of baby boomers leave the workforce; but, a recent IMF research report anticipates that population aging will become very inflationary due higher health care costs. Nevertheless, bonds provide a reliable stream of income, uncorrelated performance and low-cost portfolio insurance.