Portfolio Management Commentary
Quarter Ending December 31, 2014
2015: The Year Ahead
In last month’s Insights & Strategies, we provided a recap of key market events in 2014. In this issue, we turn our focus to the future, providing our outlook for 2015. Overall, we expect North American equities to post another year of gains and outperform bonds, as yields grind higher on stronger economic growth. As such, we continue to recommend an overweight in stocks relative to bonds, with the US stock market being our preferred global equity market. In next month’s report, we will provide a detailed update on our asset allocation recommendations and outline the key factors for our preference of large-cap US equities over Canadian and other international equity markets.
Economic Outlook
Our investment strategy framework begins with our expectations for economic growth. We see the North American and global economy gradually improving in 2015, with the US economy leading the way. The US economy, which represents 22% of global GDP, is forecasted to grow at 3% in 2015, up from 2.3% in 2014. Our US economist is forecasting a more modest 2.75% this year, but nonetheless, we see the US economy improving, helping to drive stronger global growth. Key supports for a stronger US economy include:
• US labour market conditions continue to improve with the US economy adding on average 240,000 jobs per month in 2014, up from the 194,000 average monthly job gains in 2013. In fact, last year’s job gains were the strongest since 1999. We see continued healthy job gains driving the unemployment rate below 5.5% by year-end 2015.
• The manufacturing sector continues to deliver solid gains, with the ISM Manufacturing Index sitting at 55.5, well above the key 50 level. New orders remain robust which bodes well for future production.
• We see continued progress in the US housing sector driven by a stronger labour market, improved consumer balance sheets and low interest rates.
• While we expect capital spending in the energy sector to take a hit in 2015, this should be offset by an increase in capital spending in other areas. With US companies flush with cash and the average age of plant and equipment at 22 years – the oldest since the 1950s – we see overall capital spending ramping up this year. • Finally, lower oil prices are likely to have a positive impact on economic growth
this year. Consumer spending accounts for roughly 70% of US GDP while oil and gas capital spending represents 1% of GDP. Given this, lower energy prices should provide a net benefit to the US economy.
Inside This Issue
2015: The Year Ahead...1 Your Portfolio ...4 Final Thoughts ...6 Patrick A. Choquette, CFP, CIM, FCSI
Portfolio Manager Tel: 604-514-5305 [email protected] Raymond James Ltd. Suite 202 – 19978 72nd Ave Langley, BC V2Y 1R7
Putting it all together, we see the US economy delivering stronger economic growth this year, helping to push global growth higher in 2015.
Canadian Outlook
With our important economic and financial linkages to the US economy, where it goes, so goes the Canadian economy. Given this relationship, the Canadian economy stands to benefit from an accelerating US economy. In particular, we see the potential for higher exports this year, on the back of a stronger US economy and a weaker Canadian dollar. We expect energy-related exports to come under pressure this year, but see other areas, such as machinery and autos offsetting this weakness. Exports rose 6.8% annualized in Q3/14, following a 17.8% increase in Q2/14. We see this trend continuing in 2015, helping to propel the Canadian economy higher. While we see stronger activity for the Canadian economy, we believe it will continue to trail the US, given two significant headwinds:
• Canadians have taken on a significant amount of debt in recent years, as a result of low interest rates and rising home values. Household debt relative to disposable income has increased from 120% in 2004 to 165% today. We expect Canadians to “tighten their belts” as they look to address their high debt loads. If correct, this could weigh on consumer spending and economic growth.
• The second major headwind for Canadian growth is the weak outlook for commodities. With the emerging markets slowing, this is resulting in lower demand for commodities. For example, oil (WTI) has declined precipitously from
US$105/bbl last summer to US$50/bbl today. While we expect oil prices to firm up in H2/15, as global growth picks up, we still see oil trading in a new lower range which should negatively weigh on the energy sector and Canadian corporate profits.
In summary, we believe the Canadian economy will benefit from stronger US growth; however, key headwinds such as high debt loads and weaker commodities will result in slower growth from Canada. We see economic growth closer to 2.5% versus 2.75% for the US in 2015.
Fundamental Outlook
Incorporating our GDP growth expectations into our earnings model, we come up with an S&P/TSX earnings estimate of $900/ share which equates to growth of 6% Y/Y. Our earnings forecast is 5% below the current bottom up consensus estimate of $950/ share, as we see the potential for further negative earnings revisions from the resource sectors. This also helps explain why the earnings trajectories for the S&P/TSX and S&P 500 have diverged in recent quarters, with S&P 500 earnings continuing to power higher, while S&P/TSX earnings have weakened. Our more constructive outlook for US earnings is one factor in our call for the S&P 500 to outperform the S&P/TSX once again in 2015. With the large equity gains since the financial crisis, valuations have expanded markedly with the S&P/TSX currently trading at 18.4x trailing earnings and 1.8x price to book value (P/B). For perspective, at the March 2009 low, the S&P/TSX traded at 10x earnings and 1.2x P/B. Clearly stocks are no longer “cheap” but nor are they extremely “expensive”, in our view. While history suggests the potential for further multiple expansion, this is not our base case for this year. We see upside in 2015 being driven
by corporate earnings growth. Our official S&P/TSX price target is 15,300, which is based on a 17x P/E multiple and our $900/share earnings forecast. Adding in a current 2.8% dividend yield, we see the potential for a total return of 7.5% in 2015 from current levels. While we see further upside in 2015, it will likely come with higher volatility as the US Federal Reserve (Fed) normalizes monetary policy by hiking interest rates in mid-2015. Typically, equities decline in the first few months after the first interest rate hike, but then rebound on average 5%, 12 months following the first Fed hike. This is largely due to the fact that the economy is doing better, which translates into stronger corporate earnings. It is generally not until the third or fourth rate hike that the stock market tends to peak, as investors fully realize that the Fed is intent on slowing down the economy and tackling inflation. Therefore, we see a decent first half followed by potential weakness in H2/15 as the Fed begins to hike rates. The expected first rate hike is in mid-2015 which would coincide with the typically weak summer months. Stocks could come under pressure in the summer/fall period, but by the end of the year, we believe North American (NA) equities will be higher, in line roughly with corporate earnings growth.
Ryan Lewenza, CMT, CFA
Your Portfolio
The fourth quarter of 2014 was constructive for all portfolios.
Besides the slight dip in December, the Fall months provided upside for all portfolio types. This shouldn’t seem as a great surprise if you remember that September tends to establish the yearly lows on a seasonal basis. With the final quarter over, we can now turn our attention to the annual figures for 2014:
Once again it is important to note that these annual figures are model returns and may be different from your actual, reported performance. Factors such as management fees, the timing of deposits and withdrawals, and the inclusion into the program will have an
impact on your personal rate of return. With all that said, 2014 was a decent year. In all cases, the annual return tracked closely to our long-term expectations of the model types.
One important comment must be made on the Choquette Income Builder portfolio. While I believe a 4-6% annualized return is achievable over time, the short-term environment for higher interest rates is inhibited by central bankers’ accommodative monetary policies and falling commodity prices. I have seen expert commentary over the last four years arguing for interest rate hikes, and yet this has not occurred. Maybe 2015 will be the year? Personally, I don’t believe in hunch investing, so I will leave this debate to the so called “experts”. What is important to glean, however, is the impact of longer, lower rates. A case in point is the 10 year Government of Canada compounded yield. Right now it comes in at 1.35%. Believe it or not, you can receive a higher yield on a 1 year GIC. So what does this mean for you? It’s very simple. If you have 70% of your portfolio in fixed income investments, like the Income model, that are yielding 2.0% or less, you will have a hard time generating a 5% return. Mathematically you need the remaining 30% of your assets to produce 12% to meet this goal. Do you need to panic? No. There are two things to remember: Interest rates do not stay low forever, but it may just seem that way. Eventually rates will rise and yields will normalize. You can also change your model. Yes, that’s right, if return expectations are lower than needed for a prolonged period of time, then your portfolio may no longer be suitable for your long-term investment goals. This can happen, and there is nothing wrong with adapting to a changing situation. The caveat here is that you will need to be aware of the “risks” associated with seeking higher returns. A couple of options to ponder are increasing your exposure to dividend paying common equities and adding preferred shares to the portfolio to boost yield. In both instances, you would be taking on more volatility and capital risk, but isn’t it also true that missing your intended target is a risk as well. I encourage all Choquette Income Builder model holders to have a frank discussion with me on what works for their situation. And don’t worry if you are not sure what model you are in, I will make a point to discuss it with you when next we speak.
One final point on fixed income, and I will move on. I have mentioned this before, but I think it is important to reiterate that prices on fixed income investments are inversely related to yields. In other words, if rates go down further you should see the prices of your marketable fixed income securities go up. GICs are not marketable so their prices remain the same. So in this case, you are receiving capital gains in favour of yields. 2014 was a great example of how this relationship added to your returns in fixed income even though yields were dropping. The inverse is also true. If rates rise, then yields pick up, but prices fall. This is what most experts are afraid of. This is also what most of us who remember the high interest rates of the early ‘80s are concerned about. Sure it would be great for your bank account balances, but your real estate values would be smashed as lending rates skyrocketed. But such a scenario is very unlikely. Central bankers are far more aware of the impact of credit cycles, inflation is benign, and debt loads, both sovereign and consumer, are by magnitudes greater than during the late ‘70s and early ‘80s. Keep in mind, the economy unravels when the speed of higher rates is indigestible by the market participants. Bankers and governments know this very well and they also know that the consumer has the biggest input in the GDP equation. If you clip his wings too aggressively, he tends to crash at takeoff.
During the final quarter we made some meaningful changes in the month of December. For starters, we reduced our overall position numbers. Instead of 25 individual securities, we are closer to 15 in most portfolios. Why? It’s rather simple. As you are aware, I am not afraid to trade positions in and out of the portfolio based on such reasons as risk management, relative strength ranking, and asset allocation. Less positions means I can focus more attention on the individual names in the portfolio. It also provides me leverage to research better strategies. There is another reason as well. I’ve reduced numbers to add diversity. Yes, I know this sounds absurd, but there is a sound rationale behind the changes. Portfolios can be diversified by style. In other words, you can have both passive and active components in portfolio construction to blend approaches and thereby accomplish better risk-adjusted rates of return. For example, instead of owning stocks that are in the S&P TSX 60, you could buy a proxy for the TSX 60 (passive), and add stocks based on specific criteria (active), to receive the best of both approaches. This strategy has found its way into the portfolios through the inclusion of the following market proxies: XIU (TSX60), IVV (S&P500), and XIN (MSCI). In the case of Canada and the US, individual securities are overlaid as active considerations. All proxies have specific active trading rules to ensure risk management and adherence to current market conditions.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual funds. Please read the prospectus carefully before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.
This Quarterly Market Comment has been prepared by Patrick Choquette and expresses the opinions of the author and not necessarily those of Raymond James Ltd., (RJL). Statistics and factual data and other information are from sources RJL believes to be reliable but their accuracy cannot be guaranteed. The performance outlined in the report is net of fees. The client account performance may vary from the model portfolio due to several factors, including the timing of contributions and dates invested in model. The performance reported is that of the account that represents the model, not a composite. Performance calculation for the models may be different than the index used as a reference point. The index performance reported reflects price gains returns only (not total returns) and in their local currency. It is for information purposes only and is not to be construed as an offer or solicitation for the sale or purchase of securities. This Quarterly Market Comment is intended for distribution only in those jurisdictions where RJL and the author are registered. Securities-related products and services are offered through Raymond James Ltd., Member-Canadian Investor Protection Fund.
Another interesting move for the portfolios was the adoption of the XBB (Canadian Broad Bond Index) for the entire fixed income component. Given the current market for interest rates in Canada, I thought it was prudent to consolidate the positions into a liquid, actively traded ETF, with a medium duration and a concentration in higher credit quality issues that represented the larger bond universe. The effect of this change was positive for all portfolios as the duration increased -- meaning price sensitivity to interest rate changes. If you remember from before, lower interest rates mean higher bond prices, and this is exactly what happened. Also, we had a knock-on effect as weak equity performance in the beginning of the year drove assets into fixed income investments pushing prices higher. This is known as a “flight to safety” trade. The addition of the XBB to the Choquette Maximum Growth model occurred for tactical reasons. So far it has proved to be a profitable move to counteract the increasing volatility of the equity markets and to act as a ballast against downside deviation.
There were other transactions in December which had the added effect of rebalancing the asset allocations of all three models. Presently, the allocations are as follows:
Choquette Income Builder
5% Cash, 65% Fixed income, 10% Canadian equity, 10% US equity, 10% International equity Choquette Moderate Capital
5% Cash, 35% Fixed income, 20% Canadian equity, 20% US equity, 20% International equity Choquette Maximum Growth
5% Cash, 15% Fixed income, 30% Canadian equity, 30% US equity, 20% International equity
Once again your individual account may vary from the above figures because of withdrawals and deposits. It is important to note that the ETF versions of the same models hold identical asset allocations. As a refresher, ETF models are designed for accounts with smaller asset sizes where individual equities would represent either micro-sized positions or fractional units. Instead of excluding them from the program, I created portfolios based on an actively managed ETF strategy which attempts to mimic the holdings in the regular models, but as market proxies to add efficiency. Look to see their performance figures in the next quarterly commentary.
Final Thoughts
Firstly, I wish to thank you for your business and trust over the past year. You are an excellent bunch of people to work for! Your encouragement, poise, and commitment have ensured a profitable relationship. Secondly, my energy in 2015 will be directed towards further gains in your portfolios, but never in isolation to identifiable risks that exist in investing. I think it would be a good time to remind you that I can, and will, reduce the risk of your portfolios by selling positions when prudent analysis deems it necessary. You have given me discretionary ability, and I take that very seriously, that in unfavourable market conditions, we can hold large positions in cash to preserve capital and await better investment opportunities. I do not mention this because I believe it is time to make this decision, I mention this to assure you that I am not handicapped as your portfolio manager and can do what is in your best interests at the appropriate time. In fact I am in the camp that 2015 should be another positive year for the markets. If not, I am not afraid to sit some of it out on the sidelines.
