Q3 REVIEW AND OUTLOOK
CENTRAL BANKS TO THE R ESCUE?
NO DEN YING E CONOMIC R EALITIES
DON’T IGNOR E FALLING YIELD CURVES
PRICING RECESSION RISK: MARKETS GONE TOO FAR, TOO SOON?
WHAT COULD SPAR K A R EVERSAL OF P OSITIONING?
2 REVIEW AND OUTLOOKQ3
Our late-cycle roadmap continues to play out, and many indicators are pointing to higher odds of an outright recession on the horizon. However, it also appears that an increasing number of market participants are positioning for this outcome. Knowing that markets like to “climb a wall of worry”, could this conservatism prove a potential driver for a risk-on rally in equities broadly, at the expense of bonds and other rate-sensitive securities? The first step in such a reversal would be for the world’s largest economies to escape stall speed.
OVERVIEWOVERVIEW
VIEW PMAM VS. CONSENSUS
R I S KMacro risk rose sharply in August as global growth continued to slow and trade wars escalated. The U.S. Federal Reserve’s lack of enthusiasm about lowering rates also hampered risk markets, causing global rates to collapse and yield curves to invert. Much of this reversed toward the end of the quarter, although we expect this reprieve to be temporary.
H I G H E R
MACROECONOMICS
G LO B A L R E A L G D PGlobal growth expectations continue to grind lower. China’s economic growth keeps decelerating as the leadership adds small but focused stimulus. Germany is likely starting into, or is already in, recession.
LO W E R
U. S . R E A L G D P The labour market remains tight and is showing some signs of concern. Confidence is off peaks, but still robust. Growth expectations have fallen below 2% as capital spending falls on lagging corporate confidence.
S A M E
C A N A D I A N R E A L G D P The Bank of Canada continues to reiterate its cautious stance but has held tight for now on an expected rate cut. It remains concerned about oil-sensitive parts of the economy and the highly indebted consumer’s ability to weather higher rates.
LO W E R
U. S . I N F L AT I O N U.S. inflation is just below target, and the risks appear balanced in both directions.
S A M E
EQUITY RETURNS
U. S . E Q U I T I E S U.S. equity return expectations in the high single-digits might be possible for the year if the Federal Reserve keeps giving the market what it wants – aggressive cuts – and if China trade talks improve further.
S A M E
E U R O P E A N E Q U I T I E S Falling purchasing manager indices (PMIs) and weaker global trade continue to drag down the prospects for European equities. European Central Bank stimulus is not likely to help without substantial fiscal stimulus as well.
B E A R I S H
C A N A D I A N E Q U I T I E S Return expectations are high, given the many risks and few positive drivers. An inverted yield curve and tighter lending standards will weigh on the key financial industry in due time.
B E A R I S H
BOND YIELDS
T R E A S U R I E S ( U. S . 1 0 - Y R )U.S. rates across all tenures fell dramatically in the quarter. We expect rates to rebound a bit from the extreme levels, and eventually fall again as the cycle ends.
S A M E
I N V E S T M E N T- G R A D E C O R P O R AT E B O N D SCorporate bonds do not perform as well in this phase of the economic cycle. The current makeup of this group is the lowest quality it has ever been, with yields artificially driven down by the chase for yield.
H I G H E R
H I G H - Y I E L D C O R P O R AT E B O N D SThe high correlation of corporate spreads to the CBOE Volatility Index (VIX) suggests yields should widen over time, although a lack of product may distort market pricing in the near term.
H I G H E R
OTHER
W T I C R U D E O I LOPEC cuts and backwardation are providing near-term support to the oil price, but the threat of higher U.S. shale production as prices rise keeps oil prices trapped in a trading range. However, an unexpected and sustained disruption to supply could be very bullish for oil in the near term.
S A M E
E P S G R O W T H ( S & P 5 0 0 ) As the economic cycle model turns negative and the Institute for Supply Management manufacturing PMI falls under 50, we expect earnings growth to turn outright negative.
LO W E R
P / E ( S & P 5 0 0 ) Expectations of lower multiples seem justified as risk aversion rises and earnings growth falls, although falling global rates may help offset some of this.
S A M E
PMAM refers to Picton Mahoney Asset Management. PMAM view is relative to the Bloomberg Consensus Estimate for each category. As at September 30, 2019.
PICTON MAHONEY HOUSE VIEW
4 REVIEW AND OUTLOOKQ3
NO DENYING ECONOMIC REALITIES
5REVIEW AND OUTLOOKQ3
Two years ago, we introduced a “late cycle” roadmap as a guide to how the economic cycle might progress and how capital markets could respond to the various stages of deceleration. Figure 1 shows a summary of our roadmap.
A quick review: once the output gap closed in the U.S. (and actual GDP began to exceed potential GDP), it could only be a matter of time before the U.S. Federal Reserve (the “Fed”) became more aggressive in tightening monetary policy. It would eventually become too aggressive, and the bond market would invert the yield curve as a sign that a policy mistake had been made. Eventually, a stalling economy would lead central banks to reverse policy and cut interest rates.
The stock market’s mini-crash in the fourth quarter of 2018 led the Fed to pause any further interest rate hikes, and then begin a new interest rate cutting cycle. When new monetary easing cycles begin, the big debate is whether central banks have reversed policy in time to prevent the economy from falling into recession. We are now on the cusp of a resolution of this debate – for better or for worse.
After recovering their losses in the fourth quarter of 2018, equity markets have been largely range-bound, with plenty of fits and starts around key economic datapoints and geopolitical event risks (U.S.-China trade war, Brexit, Middle East tensions, etc.). However, the performance in equity markets has been largely focused in “defensive” yield names and secular growth sectors/themes. These all benefit from falling interest rates, which have collapsed as bond markets have soared around the world.
The extent of interest rate declines around the world is staggering when one considers that Greece recently issued 13-week bills with a negative interest rate. Greek ten-year bond yields have fallen from around 35% in 2011 – in the depths of another debt crisis for the country – to below 2%. The chase for yield has been relentless, and European quantitative easing has exacerbated it by removing a significant supply of the bonds available for purchase in public markets. Meanwhile, the more economically sensitive areas in stock markets have
underperformed significantly, with certain sectors, such as Energy, being “left for dead.”
Our own economic cycle model (which combines various types of leading indicator data) has seen a meaningful increase in the odds of a recession. Various market-based indicators are suggesting the same thing. The September Institute for Supply Management (ISM) manufacturing survey and its component PMI reading of 47.3 highlights this point best. When this reading is below 50, it implies that economic contraction is on the horizon. It also implies that a cycle of deteriorating earnings growth is imminent (Figure 2).
Although it is usually considered a lagging indicator, a rising unemployment rate has typically been the last straw for the economic cycle, and in the past it has generally confirmed that the transition from a bull market to a bear market for risk assets is underway. The labour market has been running hot for two years now, but there are now signs it is beginning to run out of steam.
OUTPUT GAPCLOSES
INCREASINGINFLATION
YIELD CURVEINVERTS
S&P 500 PEAK
RECESSION
CENTRAL BANK
TIGHTENING
FIGURE 1: PMAM LATE CYCLE ROADMAP
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Source: Bloomberg, L.P., and PMAM Research. As at September 2019.
FIGURE 2: FALLING ISM SUGGESTS S&P 500 INDEX EARNINGS GROWTH IS AT RISK
ISM Manufacturing PMI (rhs)S&P 500 Index Earning Growth (lhs)
6 REVIEW AND OUTLOOKQ3
In our last quarterly review and outlook, we suggested that deteriorating continuing claims may be the proverbial “canary in the coal mine,” but we have also observed that aggregate hours worked in the U.S. have recently shown negative growth for the first time since the last recession (Figure 3).
Workers in the U.S. have enjoyed a very robust employment backdrop, with plenty of jobs to go around. Figure 4 shows the number of job openings in the U.S. far exceeding the peak of the last cycle, but it appears that this measure could also be rolling over after its strong run.
The ISM survey also reports on the number of industries reporting growth in employment. As Figure 5 shows, only four of the surveyed industries were reporting job growth as at September. This is as low as it was in January 2016. Lower levels are normally associated with recession.
Employment levels can affect consumer confidence. Figure 6 shows the difference between consumers’ future expectations versus their present situation. It is generally a concern when consumers are more confident in their current situation than in what they believe may happen in the future. Even with what appears to still be a solid jobs backdrop, consumers appear quite concerned about what lies ahead. This kind of concern tends to precede recessions.FIGURE 4: U.S. JOB OPENINGS: A GOOD NEWS STORY MAY
BE ENDING SOON?
FIGURE 6: WARNING SIGN? CONSUMERS MORE CONFIDENT ABOUT TODAY THAN THE FUTURE
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U.S. Job Openings
FIGURE 5: VERY FEW INDUSTRIES REPORTING JOB GROWTHFIGURE 3: STALLING LABOUR FUNDAMENTALS: AVERAGE HOURS WORKED DECLINING
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U.S. Aggregate Private Weekly Hours Y/Y%Recession
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Conference Board Consumer Confidence: Expectations - Present Situation
Recession
7REVIEW AND OUTLOOKQ3
In previous quarterly reviews, we highlighted the unmistakable slowdown across many economies in leading indicators such as PMIs and their equivalents. Even in China, leading indicators were decelerating long before trade tensions kicked off in earnest. The important point to note was that the U.S. has effectively been playing catch-up to trends already in place globally. In some cases, we have seen modest improvements, but these trends are largely intact and have further affected business sentiment. In Germany, the IFO Business Expectations survey also plummeted to new cycle-lows, implying a recession in Germany this year (Figure 7).
The ongoing trade war between the U.S. and China is having a negative impact on exports and global trade (Figure 8). The less publicized trade war between Japan and Korea is also affecting global trade at the margin. Corporate confidence has been shaken since the trade wars heated up. This has translated into a slowdown of capital expenditures in the U.S. and overseas.
FIGURE 7: GERMAN BUSINESS CONFIDENCE SIGNALLING RECESSION?
Source: Bloomberg, L.P., and PMAM Research. As at September 2019.
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FIGURE 8: GLOBAL TRADE VOLUMES DECLINING SHARPLY SINCE ONSET OF TRADE WAR
Source: Bloomberg, L.P., and PMAM Research. As at September 2019.
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REST OF WORLD IN VARIOUS STAGES OF DECLINE
CPB Merchandise: World Trade Volume Index (Y/Y%)
8 REVIEW AND OUTLOOKQ3
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We have previously written about how to interpret the shape and pace of change in the term structure of interest rates, especially in the context of our late cycle roadmap. A related interpretation is offered by the Federal Reserve Bank of New York, which has created a recession indicator model based on the three-month T-bill vs. the ten-year Treasury curve. As of August, the model points to a 38% chance of recession within the next 12 months (Figure 9). This 38% level is commensurate with levels reached at the start of the last three recessions.
CENTRAL BANKS TO THE RESCUE?
Against this backdrop of deteriorating economic expectations, the Fed remains stubbornly hawkish. While it has cut interest rates by 25 basis points twice in the past three months, its so-called Fed “dot plot” (the aggregate forecast of Fed governors for future interest rates) remains well above what has been discounted in interest rate futures markets.
The Fed’s position is confounding markets and remains a source of disagreement even within the Fed. This disagreement is reflected in the vertical scatter of “dots” in each timeframe. Importantly, the “median dot” (as shown by the blue line Figure 10) seems to indicate that the Fed sees much higher future interest rates than the market expects.
The European Central Bank (ECB) recently decided to restart its bond-buying program, but there has been some controversy about this decision. It appears Mario Draghi, the departing head of the ECB, may have ignored
DON’T IGNORE INVERTING YIELD CURVES
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FIGURE 9: RECESSION PROBABILITY IS RISING BASED ON YIELD CURVE MODELS
NY Fed Recession Probability Model
Source: Bloomberg, L.P., and PMAM Research. As at September 2019.
Median Fed projection implies no more rate cuts, while market still expects two more
FIGURE 10: THE FED’S EXPECTATIONS MORE HAWKISH THAN THE MARKET’S
Fed Funds FuturesFederal Open Market Committee Dots Median
9REVIEW AND OUTLOOKQ3
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the advice of the bank’s monetary policy committee, which advised against resuming the bond purchases. There is no certainty that incoming ECB head Christine Lagarde will continue this policy when she takes over in November. With many European government bonds already having negative yields, it seems that the ECB has already used up most of its monetary policy bullets. There have been rumblings about fiscal stimulus measures that might be enacted by one of Europe’s stronger member states, such as Germany, but so far there hasn’t been much follow-through.
In China, the central authority has made it very clear that it is not prepared to engage in another “floodgate” of monetary and style stimulus like the one that occurred in 2016, when global trade was last under pressure. Despite deteriorating economic fundamentals, this restraint, plus the willingness to engage in a trade war with the U.S., signals that China is playing a long game, and might be willing to forego shorter-term stimulus measures, making sacrifices for gains that will accrue over longer timeframes.
HOW ARE INVESTORS POSITIONED?
Evidence has mounted that the probability of a global recession is increasing. However, it appears that many market participants have already become increasingly positioned for this late cycle/recessionary environment. A recent global fund manager survey by Bank of America Merrill Lynch (BAML) shows that an increasing percentage of professional investors expect a recession in the next 12 months: the number is now at 34% of respondents, the highest level since the last recession. BAML’s survey also notes that professional managers are employing higher levels of cash and protection, with 33% of respondents reporting employing equity put option strategies on a three-month horizon.
According to Hedge Fund Research Institute (HFRI) data, hedge funds are also positioned very defensively, with average beta (sensitivity) to equities lately continuing to probe very low levels (Figure 11).
Beta (1 Month Rolling)
Source: Bloomberg, L.P., and PMAM Research. As at September 2019.
FIGURE 11: EQUITY HEDGE FUNDS APPEAR VERY CONSERVATIVELY POSITIONED
10 REVIEW AND OUTLOOKQ3
Relative Performance of Rate Sensitivities, Defensives and Gold vs. Cyclicals and Resources
2015 2016 2017 2018 2019
Source: Bloomberg, L.P., and PMAM Research. As at September 30, 2019.
Source: Bloomberg, L.P., and PMAM Research. As at September 2019.
In spite of their low yields, bonds continue to attract vast sums of money. Last quarter alone, $160 billion of new money flowed into global bond funds, on a rolling 13-week (three-month) basis. Year-to-date, global bond inflows of $325 billion stack up significantly against equity fund outflows of $204 billion. Falling interest rates have, in turn, continued to drive the outperformance of rate-sensitive/defensive equities, compared with more economically sensitive equities (Figure 12).
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FIGURE 12: RATE-SENSITIVE/DEFENSIVE STOCKS LEADING THE CHARGE
FIGURE 13: TWO TAKES ON THE SAME STORY: ONE MORE VOLATILE THAN THE OTHER
FIGURE 14: COMPLACENCY? IMPLIED VOLATILITY DISCONNECTED FROM GEOPOLITICAL RISK
Both groups of stocks seem to be baking in at least a partial recession scenario. Figure 13 highlights that the rolling 30-day realized volatility in cyclical stocks has increased significantly compared with rate-sensitive volatility over the past year. Each group seems to be a similar “bet” on the weakening trajectory of the global economy.
Given the strong trends in bonds and rate-sensitive/growth stocks, it is probably fair to assume that interest rate sensitivity is currently a key concern the positioning of many portfolios. In fact, we believe positions in interest rate-sensitive and secular/thematic growth stocks in portfolios are becoming alarmingly crowded. Evidence to support this can be seen in the serious disconnect between the broad concern for economic policy risk and investors’ willingness to hedge equity risk as reflected by VIX, the so-called “fear index”.
In the past we have mentioned strategies in which managers sell short volatility, presumably to capture the “spread” between the implied volatility (VIX) and what is realized in the market, the latter often being lower than the former. Lower yields may be emboldening volatility short sellers to take on extra risks in order to boost returns. However, a sudden negative change in the economic landscape that causes volatility in stock markets could wreak havoc on this strategy. In other words, the evisceration of certain “short vol” strategies in early 2018 may have been a warm-up act for what could follow if the environment suddenly changes (Figure 14).
Cyclicals Rate SensitiveS&P 500 Index
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Global Economic Policy Uncertainty IndexCBOE VIX Index
SHORT VOL TRADE HAS CREATED THIS GAP
20d Average Cumulative Total ReturnRecession
11REVIEW AND OUTLOOKQ3
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With many recessionary signals well integrated into market expectations, is it plausible that an end-of-cycle stock market correction could be more muted this time around, given investors’ already conservative positioning? Is it also plausible that if recession is avoided, and the economy shows signs of acceleration, this conservative positioning will have to change drastically, benefiting more cyclical exposures at the expense of interest rate sensitive holdings? We think the answer is “yes” in both cases.
There are already some modest signs that economic growth rates could be stabilizing. One of these is the recent and somewhat sustained improvement in Citigroup’s U.S. Economic Surprise Index. Perhaps general market expectations for economic growth had been too low (Figure 15).
Perhaps an underappreciated driver of economic reacceleration might be the dramatic declines in long-term interest rates, combined with monetary policy easing, that
WHAT COULD SPARK A REVERSAL OF POSITIONING?
FIGURE 15: SURPRISE! WERE EXPECTATIONS FOR U.S. ECONOMY TOO LOW?
Source: Bloomberg, L.P., and PMAM Research. As at September 30, 2019.
12 REVIEW AND OUTLOOKQ3
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have occurred around the world this year. Falling interest rates already seem to be benefiting housing markets, with resale activity, homebuilder sentiment and refinancing activity in the U.S. all improving, after falling in 2018 (Figures16–18).
Other recent developments might also contribute to a more positive near-term economic backdrop. President Trump has given in to a “mini-deal” on trade, which hopefully will lead to a pickup in global trade and a more constructive process to resolve remaining trade issues. The Fed seems to be embarking on some form of quantitative easing to address stresses in the short-term funding markets. Even Brexit negotiations seem to be moving forward, which could bring some relief to the European outlook.
MBA Refinancing Index (rhs)
Source: Bloomberg, L.P., and PMAM Research. As at September 2019.
FIGURE 16: EXISTING HOME SALES ACTIVITY PICKING UP AFTER FALLING IN 2018
FIGURE 17: HOMEBUILDER SENTIMENT RISING
U.S. Home Mortgage 30 Year Fixed National Avg (lhs)
FIGURE 18: MORTGAGE REFINANCING ACTIVITY RESPONDING TO LOWER RATES
Source: Bloomberg, L.P., and PMAM Research. As at August 2019.
Mill
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13REVIEW AND OUTLOOKQ3
Source: Bloomberg, L.P., and PMAM Research. As at September 2019.
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We believe that the most critical issue for investors to consider in the near term is whether easing monetary policy, combined with improving geopolitical issues (especially regarding trade), will be strong enough to extend the cycle – or whether it will all be too little, too late, to avoid some sort of economic recession. Using previous cycles as a guide, we are tracking key economic variables and how they performed around the Fed’s resumption of rate cuts over the last 35 years. Our goal is to understand whether these variables are now performing more in line with a mid-cycle slowdown (which is generally positive for risk assets) or with a lead-up to a recessionary environment (which is generally not positive for risk assets). We identified three pre-recessionary easing periods (2007, 2000, 1989) and three mid-cycle easing periods (1984, 1995, 1998). Comparing current data to these periods should help to discern whether recent easing measures will prove too little, too late, to avoid recession in the U.S.
As Figures 19 and 20 show, some of these indicators show very stark divergences between the paths to recession and to mid-cycle slowdown. History would suggest we probably won’t have to wait long to get substantive clues as to which path the markets are taking.
FIGURE 19: CHANGE IN CONSUMER CONFIDENCE – PRESENT SITUATION
FIGURE 20: CHANGE IN CONTINUING JOBLESS CLAIMS AROUND FIRST FED CUTS
Recessionary
Recessionary
14 REVIEW AND OUTLOOKQ3
Our best assessment is that the probability of recession continues to increase. However, many market participants are increasingly positioned for recession, meaning the pay-off for being correct may be less rewarding (at least on a relative basis) than expected. The potentially more explosive outcome would be that a soft landing for the economy occurs instead, leading to a positive shock for more cyclical themes in stock markets and a negative shock for bonds and more interest rate-sensitive stocks.
In the meantime, until the weight of evidence changes, we would consider pro-cyclical moves as short term in nature, and well within the context of a longer topping process that ultimately results in a traditional bear market. Should the evidence play toward a soft landing over the next few months or quarters, we are prepared to become more aggressive with cyclicality in our portfolios.
IN CONCLUSIONIN CONCLUSION
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SECTOR OUTLOOKS
CONSUMER DISCRETIONARY
Consumer Discretionary stocks remain range-bound after bouncing off their December 2018 lows earlier this year. Fears of an economic downturn continue to weigh on cyclical names, and although Fed rate cuts in the U.S. may provide a short-term lift for the markets and the sector, the material risk of a global downturn remains. Accordingly, our slightly overweight position in the sector skews toward more defensive names, complemented by smaller weightings in cheap, cyclical stocks with still-strong fundamentals that continue to perform at a high level.
For example, we added to our position in Restaurant Brands International Inc. (TSX:QSR), which we view as more defensive in nature, with its increasingly delevered balance sheet, significant opportunities for unit growth and accelerating free cash-flow potential. New management appears to be highly focused on driving organic growth across all banners – as opposed to cost cutting – which marks a positive change from previous leadership.
BRP Inc. (TSX:DOO) is a more cyclical stock that is delivering exceptional results and market share gains, benefiting from disruption of its key competitor, Polaris Industries Inc. We believe that the stock has over-corrected and should benefit from multiple expansion.
INDUSTRIALS
We remain weighted toward more defensive names in the industrials space. Growth declaration at the margin, peak cycle concerns and the ongoing dispute between the U.S. and China are still cause for uncertainty. Negative sentiment continues to weigh on perceived lower-quality or cyclical names (e.g., construction firms, equipment dealers, trucking). That said, demand indicators and manufacturing indices are showing signs
of levelling out, and capital goods orders and freight volumes have already moderated quite a bit. We continue to favour companies with a history of compounding, idiosyncratic growth angles and/or opportunities to improve return on invested capital. Waste Connections Inc. (TSX:WCN) remains a preferred name; its management team continues to deliver solid growth, impeccable execution and continued accretive M&A. We are also positive on Canadian Pacific Railway Ltd. (TSX:CP), given its industry-leading growth profile and its track record of improving expense management through the disciplined implementation of precision scheduled railroading. We also remain bullish on Air Canada (TSX:AC), based on its free cash flow-generating potential and its valuation disconnect relative to peers.
MATERIALS
Despite the outperformance posted by gold equities over the past quarter, we are becoming increasingly cautious on gold’s near-term prospects. From a commodity standpoint, gold’s net long speculative position is close to the all-time-high in 2016, due to U.S.-China trade friction and late-cycle concerns. That said, given this bullish positioning, any positive macro news could trigger a large unwinding of the sector. We continue to hold on to our core precious metal holdings, such as Agnico Eagle Mines Ltd. (TSX:AEM) and Franco-Nevada Corp. (TSX:FNV).
We remain cautious on industrial metals, given late-cycle concerns and macro headline risks. Some of the physical market indicators suggest that conditions are not as bad as commodity prices seem to be indicating. That said, absent a trade settlement between China and U.S. and a reacceleration in global manufacturing activity, it’s difficult for us to see any sustained rebound in industrial metal prices. Our longer-term outlook for copper, however, is quite positive, and we expect to build positions when global economic expectations stabilize and begin to accelerate.
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We are seeing some green shoots for construction materials such as oriented-strand board and lumber; strong U.S. housing market data in recent months suggest the sector may be turning a corner. Meanwhile, capacity curtailment in B.C. should help shore up some of the excess supply in the market.
HEALTH CARE
Health care sector underperformance is expected to continue into year-end as numerous fundamentals continue to take a back seat to political concerns. The best-performing subsectors in the third quarter were medical technology (up 5%) and labs (up 7%), while the worst were managed care organizations (down 8%) and companies in the dental space (down 10%). Issues such as presidential election rhetoric, unclear health care reform policies and drug pricing issues continue to pressure sector performance.
Two significant issues are weighing on the managed care sector especially, and neither one will likely be resolved in 2019. The dismantling of the Affordable Care Act (ACA or “Obamacare”) is being appealed before the Federal Fifth Circuit Appeals Court. The hearing was held in July, and a decision is expected imminently. If the court allows the lower court decision to stand (i.e., repealing Obamacare), the defendants could appeal to the Supreme Court (SCOTUS), and a likely stay would maintain the status quo, pending a final resolution sometime in 2020. Although the Trump administration joined the repeal party, recently, it appears that the administration may seek a stay to keep the health law operational for the foreseeable future, including trying to delay a potential SCOTUS hearing on the ACA until after the 2020 presidential election. The Medicare-for-all proposals from some Democratic presidential candidates are also weighing on the sector. President Trump recently indicated that he is going to issue an executive order on the Medicare system titled “Protecting Medicare from Socialist Destruction,” with the focus likely on protecting the Medicare program from any Medicare-for-all plan.
Drug pricing overhangs continue to persist, and the lack of any explicit resolution (through an executive order, after the Democratic primary or the outcome of the election) is keeping investors on the sidelines. It also appears that the bipartisan Senate drug pricing bill could slip into next year, prolonging the lack of visibility. The administration recently talked about drug importation, rather than the more controversial International Pricing Index (IPI) reference pricing. In July, Health and Human Service (HHS) released a preliminary plan to create two new pathways to import drugs, which was limited in scope. HHS has yet to publish a Notice of Proposed Rulemaking.
CONSUMER STAPLES
While the environment remains turbulent, a defensive rotation into Consumer Staples continued in the quarter, and the sector outperformed the broad market index by about 400 basis points (in both Canada and the U.S.). We remain overweight in the sector, because we see steady growth and good execution for large and mega-cap players.
In particular, a strong inflation backdrop boosts Canadian grocers, which supports our overweight in Empire Company Limited (TSX:EMP/A), a company that is exhibiting strong top-line growth and stealing market share from competitors, while aggressively cutting costs to get margins more in line with peers.
In addition, in the U.S., we remain long on Walmart Inc. (NYSE:WMT), which is consistently taking share away from competitors, through best-in-class merchandising and pricing, while aggressively pursuing cost cutting to fund its e-commerce operations. Walmart stands to benefit in a market downturn as consumer purchasing shifts from conventional grocery stores to discount banners. We also have a long position in Coca-Cola Co. (NYSE:KO): its channel diversification (with products spread out between food retailers, food services and convenience stores), limited label penetration and dominant market share create a competitive moat that provides the company with best-in-class pricing power that it can use to consistently drive organic growth that outperforms peers.
INFORMATION TECHNOLOGY
The MSCI World Information Technology Index and the S&P/TSX Composite Information Technology Sector Index generated 2% and 3% returns in the third quarter, respectively. The leading subsectors were tech hardware and semiconductors, with investors discounting current weakness in more economically sensitive stocks in anticipation of a recovery due to inventory drawdowns and the potential resolution of the U.S.-China trade dispute. The weak subsectors were communications equipment and IT services. In communications equipment, industry bellwether Cisco Systems , Inc. (NASDAQ: CSCO) noted macro shifts and order weakness across both enterprises and service providers.
Software also underperformed the IT indices, due to valuation compression and a shift of sentiment away from secular high-growth stories. Elsewhere, regulatory scrutiny continues to weigh on Internet leaders such as Amazon.com Inc. (NASDAQ:AMZN) and Facebook, Inc. (NASDAQ:FB). Overall, we
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enter the fourth quarter cautiously optimistic on the sector. Our favorite themes include: 1) service provider network densification ahead of 5G deployment; 2) expansionary business model transformations; and 3) the broadening appeal of online subscription models.
In Canada, we like Descartes Systems Group Inc (TSX:DSGX) for its exposure to increasing global trade complexity and e-commerce/omnichannel retailing. As a Saas logistics and supply chain management solution provider, the company continues to see operating leverage as it scales up and benefits from network effects inherent in the company’s global logistics network. The company is seeing faster revenue growth as its revenue mix shifts towards capacity matching solutions (attained through its MacroPoint acquisition) and e-commerce and omnichannel retailing (order fulfillment and routing solutions), with more companies turning to Descartes to deal with increased global trade complexity (tariffs, sanctions, customs data).
Internationally, we like Marvell Technology Group Ltd. (NASDAQ:MRVL), which has broad exposure to the 5G infrastructure buildout, due to its initial design wins at Samsung Electronics Co., Ltd. Samsung can potentially gain market share against Huawei Culture Co., Ltd., and Marvell also has content opportunities in other infrastructure players such as Nokia Corporation (NYSE:NOK) and Ericsson (NASDAQ:ERIC). MRVL’s storage business has stabilized, and it is shipping below end-market demand levels, while some new design wins could offset the headwind of the ongoing shift from hard drives to solid state drives in notebooks. Wired networking remains sluggish, as confirmed by Cisco’s comments, but could be nearing trough levels. Some optionality could come from the company’s ARM server chip, which is currently being tested by Microsoft Corporation (NASDAQ:MSFT).
FINANCIALS
We remain somewhat cautious on the outlook for the Canadian Financials and prefer exposure to a select number of positive change stories, including Element Fleet Management Corp (TSX:EFN), Intact Financial Corporation (TSX:IFC), Brookfield Asset Management Inc. (TSX:BAM/A) and TMX Group Ltd. (TSX:X).
For the bank group, the third quarter was another volatile quarter, with some interesting takeaways. It was the third quarter in a row we have witnessed the majority of the group miss earnings estimates, with growth in the key Canadian retail banking segment slowing to 3.5% year-to-date. This is down from 9% and 10% growth posted in 2018 and 2017, respectively.
Lower-than-expected earnings for the group were largely driven by weakness in Canadian retail banking, with revenue growth continuing to slow into the low single-digits. Additionally, credit losses continued to normalize, with loans losses up 20% from the previous year, providing a headwind to earnings growth in the core retail domestic segment.
Credit is an area that is increasingly receiving attention; we again saw loan losses increase across the group, largely driven by idiosyncratic events and some general weakness in the commercial and consumer credit books as the credit cycle progresses. We expect the focus on credit to remain a major theme, because the near-decade-long tailwind provided by a benign credit environment threatens to become an increasing headwind for earnings growth. We are not expecting large loan losses in the near term, but do believe that weaker financial conditions will begin to manifest themselves in a normalization of the credit cycle, and this will hamper earnings and dividend growth for the bank group in 2020–2021. Other big-picture themes we have been focused on continue to play out: consumer loan growth remains muted, near multi-decade lows, while lower rates (coupled with a flatter yield curve) in Canada and the U.S. continue to take a bite out of the margin expansion thesis that drove performance in Financials in previous years.
We continue to highlight the inherent value in core deposit franchises (especially as financial conditions tighten) and how they can become key differentiators for the group; we believe this trend will continue to develop. In our view, funding costs will dictate risk appetite as we progress through the cycle. Those who lack strong stable deposit franchises are forced farther out along the risk curve to support earnings growth, compared with peers who benefit from a significant funding advantage. We believe that this behaviour increases a bank’s beta to the credit cycle, and continue to be cautious about these lower-quality names. We have seen this behaviour manifest itself recently in acquisitions/growth of higher-risk assets and out-of-footprint expansion. Although valuations for the bank group are approaching more attractive levels, we have a more tempered outlook on earnings per share growth prospects. We believe that a selective approach is more important than ever in the banking group, and that the dispersion of returns is set to increase in a more meaningful way. Our core Canadian bank holdings include Royal Bank of Canada (TSX:RY) and The Toronto-Dominion Bank (TSX:TD).
In the insurance space, we continue to favour Sun Life Financial Inc. (TSX:SLF); we believe its strong free cash-flow generation, conservative balance sheet and capital strength are clear differentiators. We are also positive on Intact Financial Corporation (TSX:IFC), as we believe signs of positive change are set to become increasingly evident in its personal auto
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and U.S. specialty lines businesses, and we like its defensive characteristics in the Canadian Financials space.
ENERGYA sudden eruption of geopolitical events in Iraq and Saudi Arabia threatened at their peak to develop into the greatest sustained production outage in the history of petroleum. However, these events have subsided, and the catalysts for a sustained outage are now actually fewer than before. In Saudi Arabia, for example, there are now U.S. troops on the ground for the first time in years, and they have brought anti-missile equipment with them. The odds of Iran pulling off another successful attack under the guise of plausible deniability are now much lower as a result.
In the absence of active material geopolitical catalysts, we go straight back to an extremely bearish supply/demand scenario for global oil markets, where >3 million barrels per day of non-OPEC production (heavily weighted toward 1H20) will come onstream at a time when global demand will likely be flat, given the cyclical weakness in emerging markets (which consume a majority of the world’s oil) and structural problems with oil demand ( oil products are too dirty/expensive compared with substitutes such as natural gas and liqufied petroleum gas). We expect a sharp decline in the price of oil to the $40/bbl level sometime in the next three to six months, at which point OPEC will likely act and again engage in emergency cuts to shore up prices. If OPEC fails to do so, the price could crash to levels last seen in the first quarter of 2016, when WTI touched a low of $20/bbl.
We are positioned defensively as a result, and we are focused on downstream names, such as Parkland Fuel Corporation (TSX:PKI), which have zero oil production and will benefit from a falling oil price.
COMMUNICATION SERVICES
This mature and relatively quiet space was hit by a number of interesting developments in the quarter. Following up on the decision of carriers to embrace unlimited data plans, the Canadian Radio-television and Telecommunications Commission (CRTC) came out with an order banning three-year equipment installment plans (EIP), which would have helped carriers lower the monthly burden on consumers by a third. Then came a CRTC decision that set final rates for aggregate wholesale high-speed access services that were lower than the interim rates. The new rates are to be
applied retroactively and will result in charges of upwards of $300,000,000 for the carriers. This forced the carriers to seek relief in the Federal Court of Appeal, which has granted an interim stay on the decision. The CRTC has also hinted at the possibility of allowing mobile virtual network operators in Canada, which would boost competition significantly. All this regulatory noise, combined with softer growth expectations and the current higher valuations, is enough to dampen our enthusiasm about the sector. Our preference in the space continues to be Shaw Communications Inc. ( TSX: SJR.B), which has done an excellent job of executing its wireless growth strategy, and can grow at the expense of the incumbents. It also has upside from stabilization in its wireline operations.
UTILITIES
It was a stellar quarter for Canadian Utilities; the sector returned 10%, compared with 2.5% for the TSX Composite. In our view, much of this outperformance was a result of a significant move down in bond yields (Canadian ten-years declined 11 basis points, and U.S. ten-years declined about 33 basis points). Looking at growth, we don’t see much of divergence in growth rates among large-cap utilities; guidance for most U.S. and Canadian utilities indicates growth rates of about 5–7%. We continue to maintain an overweight in Brookfield Infrastructure Partners LP (TSX: BIP-U), which has the potential to generate outsized earnings growth compared with its peers as the effects of cash deployment start to flow through to earnings. Also, we view BIP -U as a company that is assembling a portfolio of assets that will be hard to replicate. Given this developing scarcity value, we view the current valuation of about 12x P/FFO (forward) as attractive.
REAL ESTATE
Declining bond yields during the quarter benefited the REIT sector, which returned 8.2%, compared with 2.5% for the S&P/TSX Composite Index. The sector continues to be bifurcated, with investors bidding up multi-family, industrial and downtown Toronto office REITs and remaining lukewarm on retail REITs. Our focus name in the sector remains Colliers International Group Inc. (TSX: CIGI). This asset-light, roll-up business is benefiting from the tailwind of growing institutional allocations to real estate, which is creating the need for global real estate brokers that are large and sophisticated enough to properly service this market. We continue to hold Allied Properties REIT (TSX: AP-U). This office REIT has a significant presence in downtown Toronto, where vacancy rates are in the low single-digits, well below those in other major cities around the world.
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This material has been published by Picton Mahoney Asset Management (“PMAM”) as at September 30, 2019. It is provided as a general source of information, is subject to change without notification and should not be construed as investment advice. This material should not be relied upon for any investment decision and is not a recommendation, solicitation or offering of any security in any jurisdiction. The information contained in this material has been obtained from sources believed reliable, however, the accuracy and/or completeness of the information is not guaranteed by PMAM, nor does PMAM assume any responsibility or liability whatsoever. All investments involve risk and may lose value.
This material may contain “forward-looking information” that is not purely historical in nature. These forward-looking statements are based upon the reasonable beliefs of PMAM as of the date they are made. PMAM assumes no duty, and does not undertake, to update any forward-looking statement. Forward-looking statements are not guarantees of future performance, are subject to numerous assumptions, and involve inherent risks and uncertainties about general economic factors which change over time. There is no guarantee that any forward-looking statements will come to pass. We caution you not to place undue reliance on these statements as a number of important factors could cause actual events or results to differ materially from those expressed or implied in any forward-looking statement made.
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