2019 Quarterly Canadian Investment OutlookJun 3, 2019

 

Franklin Bissett Canadian Equity Outlook

Momentum Moves Markets—But for How Long?

March 9, 2019 marked the 10-year anniversary of the current bull market in Canadian equities. Over a 10-year span marked by low interest rates, tepid economic expansion and a global financial market recovery following the Great Financial Crisis, the strongest-performing sectors were Real Estate, followed by Industrials and Financials. It was also a decade that began and ended with relatively subdued commodity prices. Compared to the intervening years, Energy and Materials were by far the weakest performers.

Overall, we believe equity market excesses over the past few years have in part been driven by investor exuberance surrounding the momentum and potential of specific equities—in other words, the movement of the stocks—rather than the fundamentals and valuation of the underlying businesses. As such, we believe now is an important time to be increasingly discerning.

Gyrations and Dislocations

Let’s put the more recent market movements into context. Despite a market correction through most of the second half of 2018, the equity market rebound in this year’s first quarter propelled the S&P/TSX Composite TRI to a new all-time high on March 18, 2019. The accompanying table includes the resurgence of the bull market through quarter-end as well as the 2018 correction. As you can see by the significant variation in sector returns, dislocations have emerged at the margin. More recent gyrations in the equity markets are reminders of the importance of maintaining a long-term view that cuts through the ebb and flow of short-term financial market sentiment.

Total ReturnsBull Market's First 10-years Annualized (March 9, 2009 to March 9, 2019)
Energy 4.6%
Materials 1.4%
Industrials 18.8%
Consumer Discretionary 15.3%
Consumer Staples 16.0%
Health Care 10.2%
Financial 17.3%
Information Technology 8.7%
Communication Services 15.0%
Utilities 9.7%
Real Estate 19.3%
S&P/TSX Composite TRI 11.0%
Franklin Bissett Canadian Equity Fund ~15.0%

For Companies, Capital Allocation is What Counts

How a company allocates its capital is a critical factor in our long-term investment approach. Free cash flow provides the fundamental building blocks that support a company’s evolution as it reinvests into the business, pursues mergers and acquisitions, and undertakes share buybacks or implements dividend plans. Ultimately, these decisions have great bearing on the long-term outcome. How well is the business positioned to compete and thrive? Will that evolution translate into strong shareholder returns?

Our fundamental research focuses on identifying businesses that we expect will generate high, full-cycle profitability and maintain this level of profitability well into the future. Strong capital allocation is critical to this process.

The strong first-quarter advance in Canadian equities has been followed by somewhat choppier markets as headline events influence day-to-day fluctuations. The increased recent volatility is reflective of an increase in uncertainty globally and unwinding of very easy financial conditions. These conditions are expected to continue driving the increased market volatility. We remain prepared to capitalize on equity market dislocations as opportunities present themselves.

Franklin Bissett Canadian Fixed Income Outlook

Liquidity Chinook Warms Bond Markets

Canadian fixed income markets surged in the first quarter of 2019 on tighter credit spreads and lower benchmark government bond yields. While equity markets appeared to shrug off most of the factors that have continued to exert a drag on economic forecasts—slowing global and corporate earnings growth, geopolitical and trade tensions—fixed income markets took most of their cues from an abrupt policy shift by key developed market central banks.

Central Banks Hang a U-turn

Undoubtedly the biggest story of the quarter was the U.S. Federal Reserve’s (Fed) sharp U-turn from a single-minded focus on monetary tightening, that had prevailed throughout 2018, to an easier policy that left its overnight rate unchanged in recognition of the tougher economic and investing environment. The Bank of Canada (BoC) has also held rates unchanged so far this year; and the European Central Bank has gone even further, extending its rate normalization into the distant future. Though the ultimate effects from previous tightening have yet to be fully realized, it appears that the current round of quantitative tightening may be ending sooner than expected. If so, looser money would support current yields and riskier assets like corporate and high yield bonds.

It’s Still the Economy

By the end of 2018, little doubt remained that a synchronized slowing of global economic growth was well underway, really the first since 2009. Although early reports of first-quarter U.S. economic growth indicated higher-than-expected growth (3.2%), we expect future activity to level out, with trade tensions skewing risks to the down side.

In the Canadian economy, we see few catalysts for a significant break in the moderating trend. Consumer confidence has been shaken by current debt levels, tighter credit conditions and higher debt servicing charges. Business uncertainty has increased. Investment spending is down, notably in the energy sector, and elevated inventory levels are restraining manufacturing activity. The Canadian labour market has proven more resilient than expected, but so far wage pressures are contained. Given Canada’s negative output gap and lacklustre global activity, we expect inflation will remain benign.

What the Inverted Yield Curve is Saying

Yield curves plot the interest rates of bonds having the same credit quality but different maturities. They can reveal a great deal about where the economy is headed, providing a useful road map for central bank monetary policy. In Canada, the yield curve inverted from overnight to 10 years over the first quarter. The move occurred very quickly and in concert with sharp declines in yields globally. Flat-to-inverted yield curves typically signal monetary policy is too tight for the underlying fundamentals. In view of the benign inflationary backdrop and the lag effect from higher policy rates, we expect that the BoC is likely done with rate hikes for the current cycle. The U.S. yield curve is similarly flat, and we expect it to remain so over the next quarter as the Fed and market evaluate incoming data.

Credit Likely to Remain Contained

Although the recent rally in credit spreads reclaimed lost ground from the previous quarter, credit valuations are more fairly valued and remain within historical averages. In the current macroeconomic environment, we expect credit spreads to stay in their current range, but risks are to the down side.

Source: Franklin Templeton Investments, May 2019

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