Second Quarter Wrap-up
The first half of the year for equity markets was a bit of a roller coaster ride with highs and lows and a fairly steep correction in the first quarter. With all the volatility, the end result though is that markets ended up pretty close to where they started the year. The MSCI World Equity Price Index in local currency was up 0.2% at mid-year. This after being up over 5% YTD in late January and down over 4% in late March for a max drawdown of close to 10%. In the U.S., we did have an official correction (decline greater than 10%) as the S&P 500 declined 10.1% from January to early April. The max drawdown for the TSX Composite was 8.4%. The wild ride has eased of late, and with two quarters behind us, the TSX Composite is up 0.4% and the S&P 500 Index is up 1.7%. We continue to see the most strength in the technology sector, with the NASDAQ rising 8.8% YTD. Internationally, the MSCI EAFE Index and MSCI Emerging Markets Index are down 0.2% and 3.5%, respectively, in Canadian dollars. To the last point, the Chinese stock market has suffered with all the trade war issues, with the Hang Seng Index down 3.2% in local currency.
In credit markets, here too returns have been muted - if not negative - due to rising interest rates putting pressure on bond prices, particularly long-dated government bonds. Our FTSE TMX Canadian Universe Bond Index is up 0.6% after two quarters, and in the U.S., the Bloomberg Barclays US Aggregate Bond Index is down 1.6%. Taken together there is a slight decline here, which has not been the norm over the past many years if not decades. Bond markets in the U.S. have underperformed as their interest rates and inflation are rising at a faster pace than here at home. There are many who have proclaimed the end of the generational secular bull market in bonds, and that a new secular bear market has begun. This may or may not be the case, but what is crystal clear is that inflation and interest rates are rising, and from a portfolio management perspective, a more tactical and active approach is required in this space than in the past.
For commodities, we have seen resurgence in the energy space with WTI Crude prices rising over 20% this year as the supply and demand metrics have become more balanced from what was an over-supply issue (not lack of demand) and bear market for oil prices in the 2014-2017 period. WTI prices finished the second quarter at approximately $74USD/barrel. Gold continues to stay somewhat depressed and unable to get back to peak levels seen in 2011 and 2012. It has been mostly remained range bound between $1100USD and $1350USD, currently sitting around $1250USD.
Lastly, in currency markets, our Loonie has struggled this year along with a more lackluster economy in relation to the U.S. With growth not as strong and less inflationary and interest pressures, our dollar has fallen over 4% to the greenback this year, and down about 2% against the Euro and Pound.
Milestone strategy and outlook
Throughout the Q1 correction, and if you have been reading these missives over the past few months you would know, we had been steadfast in our belief that this was a healthy and standard correction from overbought and overly high sentiment levels, particularly for the US. We have published multiple posts on distinct areas that we believe are important to consider, mostly positive in nature. In hindsight, the correction was somewhat 'textbook' within a longer-term bull market. We still believe the secular bull market in equities is alive and well as the fundamental backdrop continues to be favorable and the tailwinds outweigh the headwinds by our measure, and downside volatility should be viewed as an opportunity, at least as long as the positive core thesis we have had remains intact.
Let's review what that thesis is, look a bit more closely at earnings this quarter and for 2018, as well as where we stand on interest rates and inflation, and then finish with the health of credit markets which could simply be adding to the tailwinds of potential further upside.
Going back over two years now, we postulated that we had shifted from the first leg of the current secular bull market to the second leg of what we believe will likely have three. This was a shift from an interest-rate driven bull market that ended in 2015 to an earnings-driven bull market that began in the second quarter of 2016. We still believe this to be the case today and earnings growth is certainly currently backing up that thesis. The key difference between these two is that that first leg was driven by interest rates declining and expanding the price-earnings multiples (valuations) of equities, whereas now we actually have rising interest rates, and thus it is the earnings portion that is keeping valuations in check, if not contracting multiples. Contrary to some belief, equity multiples do not need to expand for a bull market to occur. At this point in the cycle, it is important for earnings growth to stay positive for markets to continue their upward trajectory. That being said, as this portion of the cycle progresses we typically experience more volatility and this has definitely been the case this year.
So to reiterate our positive core fundamental thesis that we have written about in past missives, despite all the fears out there with regards to trade wars, upcoming elections, Europe continuity, slowing global growth and a flattening yield, what is important to stay focused on is that the equity market is most closely correlated to the direction of earnings. In fact, the correlation of the S&P 500 and the direction of earnings is over 93%. We expect earnings growth (operating earnings per share) in the U.S. to be over 20% throughout 2018. The first quarter resulted in over 26% earnings growth and we expect Q2 to be in the low 20% range.
Now, the direction of earnings is primarily driven by economic activity, which we believe remains in an uptrend, and seems to be accelerating as exhibited by the NFIB Small Business Optimism Index in recent months. The latest reading was the sixth largest in the history of the survey going back to the early 1980s, and May's reading was the second highest ever. “Small business owners continue to report astounding optimism as they celebrate strong sales, the creation of jobs, and more profits,” said NFIB President and CEO Juanita Duggan. “The first six months of the year have been very good to small business thanks to tax cuts, regulatory reform, and policies that help them grow.” In past cycles, this index has been a lengthy leading indicator, peaking a median 40 months prior to a recession. In addition, consumer confidence remains near historically high levels, and this is typically a good sign of future consumer spending which make up the bulk of U.S. GDP. Dear readers, this is not how cycles end.
In turn, positive economic activity is driven by the availability of money/credit and a positively sloped yield curve. The recent flattening of the U.S. 2-year and 10-year yield curve to 30 basis points is certainly a pause for concern, but something to monitor, not necessarily to outright fear. We have shown in past commentary that the past seven cycles, when the yield curve does invert, a recession hasn't occurred for median of 19 months following the inversion, so this is not an immediate concern. The following chart shows the details on the prior cycles.
Source: Bloomberg Finance L.P., Canaccord Genuity Corp.
Further, the slope of the yield curve and the availability of credit are determined by U.S. Fed policy (Bank of Canada policy here). Interest rates have no doubt been rising of late but what is of primary importance is the real Fed Funds Rate. The preferred inflation reading that is watched most closely by the Fed is the personal consumption expenditures price index, otherwise known as the PCE Deflator. This is still currently at around zero (minus 0.3% as of May). This is far below levels that have occurred prior to past recessions. When we look at the long-term chart of this we don't see any recession danger until this get to above a level of 2% (see chart below).
Source: Canaccord Genuity Corp., Ned Davis Research Inc.
There are some in the media who have countered that you can't use that reading this time as we have come off an interest rate floor of zero and was held there by the Fed for years. However, we balance this reading by also looking at the National Financial Conditions Index (NFCI) which is an important measure of stress on the financial system. There are three sub-indices the NFCI, which are risk, credit and leverage. All past recessions have been preceded by these indices rising to above average levels. As shown in the next chart, there are currently no signs of stress at the current time which all three well below average stress levels.
Source: Canaccord Genuity Corp., Ned Davis Research Inc.
And lastly, Fed policy is primarily driven by core inflation, which we discussed to some extent above. While rising and becoming more of a concern, the core PCE Deflator remains in the middle of the range over the past twenty years, allowing the Fed to stay "neutral" (see chart below). It is currently at a level of 2%, which is in line with the Fed's longer-term target of 2%. Again, not an immediate concern, but something we will continue to monitor.
Source: Canaccord Genuity Corp., Ned Davis Research Inc.
We wanted to detail this core thesis again to encapsulate our current stance and outlook.
To finish off our comments this quarter, we want to bring to your attention another factor that is contributing to or adding fuel to the bull market in U.S. equities. We have stated previously that recessions are usually born from serious cracks in the credit markets, but we continue to see a robust market. Even the repatriation feature of the recent U.S. tax cut has done nothing to shrink the demand for credit from investors led by U.S. public pensions. This is the large institutional money. The public credit market grew in the first half of this year at an annualized rate of 3.9%. This is a strong number and is even more impressive considering the amount of money that companies repatriated and the shift to private credit by borrowers. We continue to see impressive numbers every week where public pensions are bringing in fresh new tax revenues (after raising taxes to boost pension contributions) and allocating it aggressively to address underfunding and add to the credit boom. This demand for credit from pensions and insurers will result in even more mergers and acquisitions in the equity space, designed to boost shareholder value. These fresh new cash flows and aggressive investments should help the credit-led equity bull market persist for quite some time.
As always, we continue to monitor our long-term leading indicators for recession risk, as well as some of the risks that could put a ceiling on equity markets, like escalating trade wars, accelerating near-term inflation and Fed policy mistakes. However, we remain positive in our intermediate to longer-term outlook based on the core drivers that we still see in place today.
Here is our Milestone Market Report on economic data, capital markets, commodities and currencies through June 29th, 2018: (click image for PDF version)