2020 Canadian Investment Outlook

Back to Easy (Money) Street

Tom O’Gorman
Director of Fixed Income,
Franklin Bissett Investment Management

Darcy Briggs
SVP, Portfolio Manager,
Franklin Bissett Investment Management


Central banks cut and cut again

The second half of 2019 marked a new global monetary easing cycle by the world’s central banks. Earlier in the year, cumulative global central bank liquidity was set to contract for the first time since the 2008 great financial crisis (GFC); but as evidence mounted of collateral damage in global trade and investment spending from ongoing trade wars and economic data continued to deteriorate, so-called “insurance” cuts transformed into an outright easing cycle.

By the end of the third quarter, global central banks had cut interest rates a cumulative 2,800 basis points (bps)―mostly in emerging markets―including the much-anticipated 50 bps of cuts from the US Federal Reserve (Fed), its first in a decade.

At the end of October, the Fed cut rates yet again to 1.75% and implemented a comprehensive liquidity program to address issues in the overnight lending (repo) market.

Bank of Canada bucks the trend

Despite weak data trends, the Bank of Canada (BoC) has remained a hawkish outlier by comparison, leaving rates unchanged at 1.75%, the highest policy rate globally.

The BoC’s comparatively benign view projects Canada’s economy will grow below potential, with 1.5% real Gross Domestic Product (GDP) grow this year and 1.7% in 2020. In addition, the BoC noted consumer spending and a pickup in housing activity as areas of resilience, while the much-touted rotation to investment and exports has remained elusive. Markets have essentially priced a neutral, data-dependent BoC remaining on the sidelines for the remainder of the year.

Negative yields, oo-la-la!

Globally, inflation expectations have fallen significantly, taking yields down with them as investors have marked down global growth prospects on another breakdown in US-China trade negotiations and announcement of additional tariffs.

Negative-yielding debt spiked to US$17 trillion by the end of August before retreating to approximately $14.7 trillion at the start of October. That’s nearly 25% of the world’s outstanding investment-grade debt.

Notably, European yields have moved sharply lower, with yield curves for Germany, France, Switzerland and the Netherlands sinking deeper into negative territory in response to very weak manufacturing data. Reflation expectations have increased recently, however, since the European Central Bank’s (ECB) third-quarter announcement of a new monetary easing program, response to the Fed’s new asset purchase program and expectations of a China-US trade deal.

The UK yield curve has also shifted lower on global data and interest rate trends and of course, Brexit. The deadline for the UK’s impending exit from the European Union was extended to January 2020 after the UK parliament failed to reach an agreement and called a general election .

Canada’s ace in the hole: positive yields

For investors staring into the abyss of negative yields, positive-yielding fixed income investments in North America (US and Canada), the UK and Australia have been a beacon of light. The fact that the US fixed income market, which dominates the global fixed income market, is also one of the highest-yielding developed markets, adds support to market prices worldwide. Foreign purchases of US Treasuries are the largest since 2012 and a sharp change from 2018.

Canada comes in a close second, although a much smaller market. We expect that high demand for positive-yielding instruments from both domestic and international investors will continue to support bond prices in the United States and Canada, should conditions turn less bond friendly.

In the coming year, we expect yield curves to steepen as investors start to revise growth and inflation expectations as a result of easier monetary policy. Significantly reduced policy uncertainty would aid the process. Even if this occurs, more policy action will likely be needed to steepen the yield curve given current levels of longer-dated interest rates.

The election effect

October’s federal election returned the incumbent Liberal party to Parliament but as a minority government. Prime Minister Trudeau has stated repeatedly that he would run a government with deficits and invest in the economy. In the bigger picture, escalating deficits will require more bonds to be issued by the BoC. For the time being, global investors in search of yield are covering large government deficits. As a result, we expect foreign holdings of Canadian government debt will continue to increase.

Currently this is not a problem; but perception and sentiment are fickle. If the view of outsized deficits turns negative, rising interest rates could lead to a significant increase in government funding costs.

But that is for another day.

"We expect that high demand for positive-yielding instruments from both domestic and international investors will continue to support bond prices in the United States and Canada, should conditions turn less bond friendly.”

Corporate credit: where do we go from here?

With the year drawing to a close amid soft Canadian economic data and elevated global geopolitical policy uncertainty, the Canadian corporate credit market continues to move sideways. Corporate credit spreads have tightened overall, slowing to a glacial pace over the second half of the year and bringing levels to slightly tighter than the post-GFC levels.

As indicated in the chart below, spread as a percent of yield was only 46% at the end of October, is also at the post-crisis average, but in our view it still represents an attractive relative value proposition compared to government bonds and pre-2008 spread levels.

Source: Bloomberg, Franklin Templeton Investments: For the period from October 1, 2002 – October 31, 2019

"…we are methodically adding hedges to protect against potential spread widening in the future and taking advantage of our access to non-Canadian markets to diversify risk where appropriate.”

We acknowledge the credit cycle is well advanced. While fundamentals remain reasonable, many credits are closing in on full valuation.

The global technical backdrop is also pushing spreads tighter as investors move down credit quality in search of yield in the global yield desert. Reduced market liquidity due to many factors, including reduced dealer inventories, can lead to sharp increases in market volatility.

Against this backdrop, we continue to take a moderately cautious stance, preferring higher-quality credits and upgrading as opportunities to cull fully valued credits emerge. Additionally, we will methodically continue to add hedges to protect against potential future spread widening and continue to take advantage of our ability to access to non-Canadian markets to diversify risk where it is appropriate to do so.

Conversely, when volatility events arise, investors can expect us to take advantage of market weakness to gain or add to exposures in issuers we like on a fundamental basis. In this way, we add value for the future.

Hindsight and 2020

Buoyed by trade deal optimism and renewed central bank liquidity, many asset markets are priced for a positive outcome on the trade front; but beneath the surface, soft global macro trends remain, Canada included. Given this backdrop, the jury is out with the fixed income market as it takes a “wait and see” approach to current developments.

Trade agreements would remove a significant impediment, becoming an important catalyst that could foster a new global growth cycle. Fingerprints of the effects of the curent trade dispute are evident all over global data. Trade growth and capital investment have sharply slowed, and Canada is not immune as as lack of visibility on policy, both domestically and internationally, weighs on activity. We expect this situation to continue outside any clarity on policy direction.

US economic growth has remained relatively resilient in the face of the global slowdown, but recent data have shown increasing softness in manufacturing and trade.

In contrast, Canadian growth is still experiencing a slight reflexive rebound near term. We expect a softer employment market will bring the BoC back into play in early 2020. While monetary policy can cushion the negative consequences of policy uncertainty somewhat, it cannot solve them.

 

The Canadian Equity Bull Charges On

Garey J. Aitken
Chief Investment Officer,
Franklin Bissett Investment Management

Tim Caulfield
Director of Equity Research,
Franklin Bissett Investment Management


The current bull market in Canadian equities that began on March 9, 2009 passed its 10-year anniversary and continued to march on in 2019. The S&P/TSX Composite Total Return Index (TRI) reached new all-time highs, returning 198.5% (10.8% annualized) through to October 31, 2019. During this period, we have seen corrections, which we define as a pullback of 10% or more, occur four times: 2011, 2014, 2016, and most recently in the fourth quarter of 2018.

Canadian equities have continued to demonstrate strong performance to date. The broader S&P/TSX Composite TRI returned 18.1% as of October 31, on pace for its strongest performance since 2016. All but two sectors, Energy and Health Care, have posted double-digit returns and all but Health Care have posted positive returns. Despite strong general advances, however, varied returns across the sectors send some conflicting messages around investor confidence and caution, as shown in the accompanying table.

S&P/TSX Composite Index Sector Breakdown

January 1, 2019 to November 30, 2019

Source: Bloomberg, Franklin Templeton Investments

"We have seen the early effects of tariffs and other protectionist polices manifested in reduced economic activity, a prime example being pockets of decline in volumes for North American railroads, including Canadian railroads.”

Low interest rates affect equities worldwide

The persistently low interest-rate environment of the past several years has been a key theme for the global equity market, Canada included. Low interest rates have direct implications for the cost of capital and, in turn, valuations of equities, as well as business economics and overall profitability.

While low interest rates in isolation have increased the attractiveness of equities, they have simultaneously contributed to a shortage of available capital chasing a limited investment opportunity set. The current dynamic is an interesting juxtaposition of accommodative monetary policy, seemingly directed at supporting an uncertain economic future, with tight credit spreads that suggest little concern for default risk.

Sectors send mixed messages

With interest rates edging lower in 2019, interest rate-sensitive sectors such as Utilities and Real Estate have outperformed all sectors except Information Technology. Declining rates notably benefit businesses with long‐duration assets and levered capital structures, as well as yield‐oriented equities. On the other hand, declining rates can, in isolation, have negative offsets for sectors like Financials, that have either a non‐responsive deposit base (banks) or difficult-to-match long‐duration liabilities (insurance companies).

Other highlights to date include:

Overly exuberant IT: For the past few years, we have noticed a clear dynamic in which investors have paid more attention to momentum and potential rather than core fundamentals and valuation. This has been especially evident in pockets of Information Technology, where we have seen aggressive share price moves that have far exceeded likely advances in the real underlying intrinsic value achieved by the businesses. Outperformance in growth sectors like Information Technology is another mixed message we are seeing from the market, coupled with simultaneous advances by more defensive sectors like Utilities and Consumer Staples.

Cannabis highs and lows: One distinct example in 2019 of investor euphoria that captivated the attention of investors (and subsequently fizzled) was the sentiment surrounding many cannabis equities in Canada.

Market capitalization of cannabis equities accounts for less than 2% of the overall S&P/TSX Composite Index; but even at their peak, the “mind share” they carry with investors has always been more meaningful. In the lead-up to Canadian federal legalization of cannabis in 2018, cannabis companies of all kinds were handsomely rewarded for prospects of top-line growth. The excitement carried over into the first part of 2019, although given a lack of results and visibility into future cash flows based on current business models, determining the value of the equities remained extremely difficult. Catalyzed by regulatory concerns and the difficulty in establishing profitable business models, many of these recently high-flying companies are now gravity-bound, trading at substantially lower prices.

Energy reality bites: On the other hand, the Energy sector seems to remain the most out of sync with the current bull market advance. Faced with continued broad industry challenges, as well as unique homegrown issues, Canadian energy faces significant uncertainty. A lack of egress remains at the forefront and the progress of major projects such as the nationalized TransMountain Expansion Project will have great bearing on the fortunes for this sector.

Fog of uncertainty clouds 2020

Despite the strong performance of equity markets, trade and geopolitical tensions remain elevated, with implications for go-forward global growth dynamics. Much of the uncertainty seems directly related to the ongoing trade war between the United States and China, which continues to experience ebbs and flows in trade agreement negotiations. We have seen the early effects of tariffs and other protectionist policies manifested in reduced economic activity; a prime example has been the pockets of declines in volumes for North American railroads, including the Canadian railroads. A successful conclusion to the United States-Mexico-Canada Agreement (USMCA) also remains outstanding and could have further impacts on businesses with specific Canadian exposure.

Many questions, few answers

Without a crystal ball or strong sense of overconfidence to guide the way, we are as uncertain as ever of the near-term trajectory for the markets. Will the 2020 US presidential election bring a meaningful change to that country’s political landscape and related economic dynamics? Will there be a positive resolution to US - China trade negotiations to justify the degree of optimism currently supporting Canadian equities? Will low interest rates continue to support the equity market, or will an increase undo some of the strong gains witnessed to date in the interest-rate-sensitive sectors? Will the move towards passive investing have a greater-than-expected impact on market trends―and if so, will it be for better or for worse? Will the Energy sector escape the seemingly vicious cycle that has plagued the its industries for the past number of years? Was the September 2019 price run-up in the perceived safe haven of gold to a new all-time high of US$1,554 per ounce a harbinger of things to come? Will momentum and potential seemingly continue to matter most to investors, or will fundamentals and valuation return to the fore? Will some unforeseen shock derail the status quo?

"As much as risks and uncertainties cloud the near term, we can be certain that the future will bring threats and opportunities that we “ can capitalize on.”

Sustainable profitability shines through the mist

As always, we are left with more questions than answers, especially in the near term. Certainly, we are mindful of the need to maintain our focus on the long term and the importance of owning businesses possessing the structural advantages that will help them navigate, regardless of the environment.

We believe Franklin Bissett’s fundamentally strong and consistently applied GARP (growth-at-a-reasonable-price) investment style is well suited to the ongoing and changing dynamics we face with Canadian equities. In our view, it is not momentum or potential, but rather fundamentals and valuation―and real growth in the intrinsic value of businesses, driven by advances in sustainable profitability (return on capital relative to cost of capital)―that are critical.

Growth in intrinsic value is typically produced by businesses that possess some form of durable competitive advantage. They maintain appropriate capital structures for the industry in which they operate, and they allocate capital wisely.

As much as risks and uncertainties cloud the near term, we can be certain that the future will bring threats and opportunities that we can capitalize on. We remain ready to take advantage of these dislocations as they present themselves, allowing us to build upon our strong long-term track record of absolute, relative and risk-adjusted returns.

What are the Risks?

All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds adjust to a rise in interest rates, the share price may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging market countries involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Such investments could experience significant price volatility in any given year. High yields reflect the higher credit risk associated with these lower-rated securities and, in some cases, the lower market prices for these instruments. Interest rate movements may affect the share price and yield. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed. Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses.

The information provided is not a complete analysis of every material fact regarding any country, region, or market. Comments, opinions and analyses contained herein are those of the speaker and are for informational purposes only. Because market and economic conditions are subject to change, comments, opinions and analyses are rendered as of December 5, 2018, and may change without notice. The analysis and opinions expressed herein may differ or be contrary to those expressed by other business areas, portfolio managers or investment management teams at Franklin Templeton Investments. Opinions are intended to provide insight on macroeconomic issues and commentary is not intended as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy.