Q1 2020 INVESTMENT REVIEW AND OUTLOOK - EXTENDING THE CYCLE - Picton Mahoney
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Q1 2020 INVESTMENT REVIEW AND OUTLOOK
EXTENDING THE CYCLE
RECESSION RISKS GREEN SHOOTS STRENGTH IN STOCK “ALL CLEAR” (BUT WORLD RECOVERY
ABATING MARKETS & OTHER FOR HOW LONG)? CRITICAL FOR CANADA’S
RISK ASSETS FUTURE PROSPECTSOVERVIEW
Risk assets enjoyed a buoyant 2019 as several headwinds
dissipated and new tailwinds began to emerge. Much of
the gains in stock markets, in particular, were the result
of valuations expanding back to where they were prior
to the large price declines in the fourth quarter of 2018.
The next upward leg in stock prices should be more
earnings-driven, as a result of expanding tailwinds from
monetary policy easing around the world aided by better
geopolitical trade dynamics. For the first two-thirds of
2019, secular growth and/or interest rate-sensitive stocks
outperformed, but more economically sensitive sectors
picked up performance in the latter stages of the year. We
expect this cyclical theme to continue as leading indicators
improve around the world in 2020.
2 Q1 2020 INVESTMENT REVIEW AND OUTLOOKPICTON MAHONEY HOUSE VIEW
VIEW PMAM VS. CONSENSUS
R IS K
Q4 saw the resolution of several key risks that hung over 2019: The U.S.-China trade dispute took a step
towards resolution, as did uncertainty over Brexit, while leading indicators showed some signs of bottoming, HIGHER
especially in Europe. Defensively positioned investors embraced these developments by buying riskier assets
and sectors, while selling safe-haven government bonds.
MACROECONOMICS
GLOBA L R EA L GD P
Global economic growth can continue to glide around the 3% level if the nascent recovery in Europe proves SAME
sustainable, U.S.-China trade relations continue to improve, and central banks remain accommodative.
U. S . R EA L GD P
Lack of productivity and falling labour market growth are consistent with expected growth rates in the mid 1% SAME
range, assuming both corporate and consumer confidence can remain intact.
CA NA D I A N R EA L G D P
Cracks are showing up in Canada as the Bank of Canada sits on its hands: a sharp rise in unemployment, falling LOWER
small business confidence and rising consumer delinquency rates.
U. S . INF L ATI ON
SAME
U.S. inflation is just below target, and the risks appear balanced in both directions.
EQUITY RETURNS
U. S . EQU I TIES
Moderate U.S. equities return expectations are possible if confidence and employment remain intact and China SAME
trade talks improve further.
EU R OPEA N EQU ITI E S
Rising leading indicators should provide some fuel for European equities at least temporarily.
BUL L ISH
CA NA D I A N EQU ITI E S
Return expectations are high, given the many risks and few positive drivers. An inverted yield curve and tighter BEARISH
lending standards will weigh on the key financial industry in due time.
BOND YIELDS
TR EA S U R I ES ( U. S . 10 - Y R )
U.S. rates rose dramatically in the quarter, rebounding from extreme levels seen in Q3, and are now at a fair SAME
level, balancing lower growth expectations with potential for sustained inflation.
I NV ES TM ENT-GR A D E C O R P O R AT E B O N D S
Corporate bonds are about as tight as can be. The current make-up of this group is the lowest quality it has ever HIGHER
been, with yields artificially driven down by the chase for income product.
H IGH -Y I EL D COR P O RAT E B O N D S
Lack of product keeps this group well bid with spreads very tight, although the lower-quality segments are HIGHER
showing some signs of risk aversion.
OTHER
W TI CR U D E OIL
Barring any sustained disruption resulting from geopolitical risks, oversupply is expected to once again plague LOWER
the oil market in Q1 of 2020, as lacklustre petroleum demand remains a persistent concern.
EPS GR OW TH ( S & P 5 0 0 )
LOWER
Earnings growth expectations for Q1 are too aggressive given the lacklustre economic backdrop.
P/E ( S & P 50 0 )
Much of 2019’s equity gains were driven by multiple expansion, and at these levels there is not much room to SAME
go higher.
PMAM refers to Picton Mahoney Asset Management. PMAM view is relative to the Bloomberg Consensus Estimate for each category. As at December 2019.RECESSION RISK ABATING 4 Q1 2020 INVESTMENT REVIEW AND OUTLOOK
Once the U.S. Federal Reserve (the “Fed”) begins FIGURE 1: CONSUMPTION-RELATED MEASURES FOLLOWING FIRST
a monetary policy easing process, one of INTEREST RATE CUTS (UNEMPLOYMENT RATE)
two things can happen: a mid-cycle economic Change in Unemployment Rate Around First Fed Cuts
reacceleration or a recession. Put another way, Current Change
Cycle Recessionary
in Unemployment Rate Around First Fed Cuts Mid-Cycle
the Fed’s interest rate cuts are either “in time” or
44
are “too little, too late” to save the economic cycle.
In late 2018 markets sent the message to the 33
Fed that its aggressive tightening of monetary
policy was a mistake. Investors became keenly 22
focused on flattening and potentially inverting
yield curves as a classic harbinger of recession 11
and vented their concerns by aggressively
selling equities in portfolios. To its credit, the 00
Fed realized its mistake and not only abruptly
ended any further rate hikes in early 2019 but -1
-1
-18 -16 -14 -12 -10 -8 -6 -4 -2 0 2 4
also began cutting interest rates as the year -18 -16 -14 -12 -10 -8 -6 -4 -2 0 2 4 66 88 10
10 12
12 14 16
14 16 18
18
progressed to support the U.S. (and ultimately Source: Bloomberg, L.P., and PMAM Research. As at November 2019.
Current Cycle Recessionary Mid-Cycle
the global) economy.
In our past few quarterly outlooks, we discussed
the importance of tracking how a variety of FIGURE 2: U.S. CONSUMPTION-RELATED MEASURES FOLLOWING
economic measures compare to similar points FIRST INTEREST RATE CUTS (CONSUMER CONFIDENCE
in past monetary easing cycles. We believed Change in Consumer Confidence – Present Situation Around First Fed Cuts
this simple analysis could provide evidence of Current Cycle Recessionary Mid-Cycle
whether the Fed’s monetary policy easing was
20
20
“in time” or “too late” this time around. We have 10
10
largely focused on employment and consumer 00
confidence measures, which tend to show large -10
-10
differences depending on whether a recession -20
-20
-30
-30
has been averted or not. It’s apparent that
-40
-40
the more time that passes since the first Fed -50
-50
interest rate cut in 2019, the more it appears that -60
-60
recession has been averted and an economic -70
-70
stabilizing and reacceleration process is at -80
-80
-90
-90
hand (Figure 1 & 2). -18 -16 -14 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18
-18 -16 -14 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18
A recent report from respected research house Current Cycle
Source: Bloomberg, L.P., and PMAM Research. As at December 2019.
Recessionary Mid-Cycle
Bank Credit Analyst (BCA) notes: “Major debt
imbalances that often precede U.S. recessions
are absent, the rebound in housing starts and
homebuilding confidence is inconsistent with
a restrictive monetary policy stance, and
pipeline inflationary pressures are absent.”
We would add that a number of headwinds
that were responsible for stoking recessionary
fears are abating and should become at least
modest tailwinds that support global economic
expansion in 2020. These include the positive
economic impacts from recent U.S. monetary
policy easing, Chinese monetary and fiscal
stimulus and an easing of global trade tensions.
Q1 2020 INVESTMENT REVIEW AND OUTLOOK 5GREEN
SHOOTS
The Fed reversed policy and cut interest rates 75 FIGURE 3: HOMEBUILDER SENTIMENT ROBUST
basis points (bps) in 2019, while also distancing National Association of Home Builders Market Index
itself from prior quantitative tightening (QT) 90
90
measures and moving to a new form of
quantitative easing (QE) to deal with unintended 80
80
pressures that had developed in short-term
70
70
funding markets. Not only that, but at the most
recent Federal Open Market Committee (FOMC) 60
60
meeting in December, Fed Chair Jerome Powell
also suggested that the Fed would not raise 50
50
interest rates until it saw a “significant move up 40
40
in inflation that’s also persistent.” With inflation
expectations continually running below the 30
30
Fed’s 2% inflation target, this would suggest
20
20
that the risk of any Fed tightening has been
pushed out significantly into the future. In other 10
10
words, not only is Fed monetary policy now
accommodative, it should remain this way for 00
1985 1990 1995 2000 2005 2010 2015 2020
some time to come. 1985 1990 1995 2000 2005 2010 2015 2020
Source: Bloomberg, L.P., and PMAM Research. As at December 2019.
The U.S. economy should respond accordingly.
Already, the most interest rate-sensitive areas
of the U.S. economy are suggesting that FIGURE 4: CHINA STIMULUS SHOULD LEAD REBOUND IN ACTIVITY
trends should improve. As Figure 3 shows,
Li Ke Qiang Index (GDP Proxy)
homebuilder sentiment measures have recently China Credit Impulse (12M Change, 3M Lead, RHS)
30
30 2525
recovered to a new cycle high.
2020
25
25
1515
CHINA TO CONTRIBUTE TO IMPROVING
20
20
GLOBAL GROWTH 1010
Chinese policy-makers have been very patient 15
15 5 5
in managing the economic slowdown that
0 0
their country has been experiencing. While the 10
10
Chinese economy is growing at its weakest -5-5
pace in nearly three decades, and deflationary 55
pressures are building, policy-makers have -10
-10
stuck to their structural reform agenda.
00 -15
-15
It seems apparent that another massive
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
stimulus package like that which occurred in
2008/2009 or 2015/2016 is simply not in the Source: Bloomberg, L.P., and PMAM Research. As at December 2019.
6 Q1 2020 INVESTMENT REVIEW AND OUTLOOKcards. However, the dangers of excessive deleveraging can recently been raising the possibility of increased government
not be dismissed either, and it appears that policy-makers spending to boost the economy. Estimates suggest that
are finally responding with at least some stimulus. Chinese there is enough fiscal stimulus firepower available under the
officials have cut their bank reserve requirement ratio by existing rules to add approximately 0.6% to eurozone GDP.
400 bps, have cut taxes, have increased bond issuances
to fund infrastructure projects and have boosted capital
spending at state-owned enterprises. Another important SOME EASING OF GLOBAL TRADE TENSIONS IS
future positive for growth is that Chinese inventories have ANOTHER PLUS
been de-stocked. As Figure 4 shows, the recent stimulus
measures in China should start improving the economy, It seems reasonable to conclude that business confidence
while inventory re-stocking should provide an additional and economic leading indicators had been at least
boost on top of these measures. partially eroded by heightened political uncertainty and
weak global manufacturing and trade. We believe that at
least some of these previous headwinds (especially global
SIGNS OF LIFE IN EUROPE trade) should flip to tailwinds with the signing of the first
stage of an economic trade deal with China.
Europe has continued to be a weak link in the global economy
over the past few years. However, the past few months have The Institute for Supply Management (ISM) Manufacturing
offered some signs of hope for Europe, not the least of Index has been in a steep decline that began even before
which is a sharp rebound in growth expectations in the ZEW trade tensions picked up in earnest last spring. This
(Zentrum für Europäische Wirtschaftsforschung or Leibniz index fell well below 50, suggesting manufacturing is in
Centre for European Economic Research) broad eurozone contraction (Figure 6). However, with stimulus measures
survey (Figure 5). increasing and trade tensions abating, we believe that this
measure is stabilizing and that the worst parts of the decline
Europe should benefit from the Chinese stimulus initiatives are more than likely over. After struggling through 2019
just discussed, given that there are strong links between with increasing uncertainty as to the rules of engagement
Chinese producer prices (which should respond to increased on global trade, CEOs should be encouraged by the
stimulus measures) and European growth and inflation. announcement of a broader-than-expected first-stage trade
Europe is also in a position to deliver its own fiscal stimulus deal between the U.S. and China (and maybe even because
programs under its rules-based governing framework. of the final passage of the new Canada – United States –
Even the generally frugal government of Germany has Mexico Agreement (CUSMA)).
FIGURE 5: LEIBNIZ CENTRE FOR EUROPEAN ECONOMIC FIGURE 6: MANUFACTURING ACTIVITY: HUNTING FOR
RESEARCH) BROAD EUROZONE SURVEY A BOTTOM
ZEW Eurozone Expectation of Economic Growth ISM Manufacturing New Orders ISM Manufacturing PMI
80
80
70
70
60
60 65
65
40
40 60
60
20
20 55
55
00 50
50
-20
-20 45
45
-40
-40 40
40
-60
-60
35
35
30
30
-80
-80
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: Bloomberg, L.P., and PMAM Research. As at December 2019. Source: Bloomberg,
2003 2004 2005 2006 2007L.P.,
2008 and
2009 PMAM
2010 2011Research. As 2015
2012 2013 2014 at December 2019.
2016 2017 2018 2019
Q1 2020 INVESTMENT REVIEW AND OUTLOOK 7FIGURE 7: SMALL BUSINESS CONFIDENT ENOUGH TO RAISE COMPENSATION
NFIB Small Business Compensation Plans Index
30
30
25
25
20
20
15
15
10
10
5
5
0
0
-5
-5
2004
2004 2005
2005 2006 2007 2008
2007 2008 2009
2009 2010
2010 2011
2011 2012
2012 2013
2013 2014
2014 2015
2015 2016
2016 2017
2017 2018
2018 2019
2019
Source: Bloomberg, L.P., and PMAM Research. As at December 2019.
This improved sentiment is certainly evident in surveys of to a retracement in global capital spending (Figure 8). The
U.S. small businesses that suggest a rebound in intentions so-called “Round 1” potential resolution to the trade war
to boost compensation for their employees (Figure 7). should be enough of a sentiment boost to help global capital
spending stabilize and improve. New orders combined with
China and the U.S. represent 40% of the global economy inventory replenishment should help reverse a negative
and 60% of the increase in global GDP. It’s little wonder trend in overall industrial production.
then that the tit-for-tat tariffs enacted in 2019 contributed
FIGURE 8: NEW ORDERS FOR DURABLE AND CAPITAL GOODS FINDING A BOTTOM?
U.S. Manufacturers’ New Orders
15
15 Durable Goods New Orders ex TransportationY/Y%
Capital Goods New Orders Nondefense Ex Aircrafts Y/Y%
10
10
5
0
-5
-10
-10
-15
-15
2013 2014 2015
2015 2016
2016 2017 2018 2019
2019
Source: Bloomberg, L.P., and PMAM Research. As at December 2019.
8 Q1 2020 INVESTMENT REVIEW AND OUTLOOKEXPECT STRENGTH
IN STOCK MARKETS AND OTHER
RISK ASSETS TO CONTINUE
Stock markets rallied sharply in 2019 as price/earnings Based on the past three mid-cycle soft landings that followed
(P/E) multiples expanded following the sharp sell-off in the beginning of interest rate-cutting cycles (September
equities in the fourth quarter of 2018. Later-cycle economic 1984, June 1995, August 1998), this would suggest targets for
reacceleration following Fed interest rate cuts are the S&P 500 Index in the 3,550 range for this year. It is worth
generally characterized by both continued expansion in noting that over the past two years we have referenced the
P/E multiples for stock markets (Figure 9) and rising similarities between this market environment and that which
earnings. This is a bullish combination that should repeat occurred in 1998/1999. If markets were to continue tracking
this cycle as improving economic expectations and rising the movements from that cycle, it would suggest a peak
earnings combine with modest increases in P/E ratios to target closer to 4,010. Adding possible fuel to this rally is the
drive stocks higher. fact that global central bank liquidity in aggregate has spiked
higher recently (perhaps thanks to the Fed’s stealth QE).
FIGURE 9: CHANGE IN S&P 500 INDEX P/E RATIO
1998-08-30 1995-06-30 1984-09-28 2019-07-31
10
10
88
66
44
22
00
-2
-2
-4
-4
-18 -16 -14 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18
-18 -16 -14 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18
36037 34880 30953 43677
Source: Bloomberg, L.P., and PMAM Research. As at December 2019.
Q1 2020 INVESTMENT REVIEW AND OUTLOOK 9“ALL CLEAR”
(BUT FOR HOW LONG?)
While we believe the current environment is supportive for said for the ensuing bear market that followed once the
risk assets and expect equities to rally this year, we do not tightening process resumed.
believe that this is the start of a new multi-year economic
cycle and bull market. The output gap in the U.S. remains However, following the latest FOMC meeting in December,
closed and yield curves are still quite flat, suggesting that investors were left with the impression that the Fed’s bar
this environment still resembles something later-cycle in for raising rates again is set quite high. The Fed suggested
nature (Figure 10). that the relationship between low unemployment and
inflation, as demonstrated by the Phillips Curve, is muted
and the classic wage-price spiral of inflation is not kicking
FIGURE 10: YIELD CURVES NOT SIGNALLING A NEW CYCLE
HAS BEGUN in, even with tightness in labour markets. The hurdle to
NBER Recession
raise interest rates is now quite high, given global growth
Federal Fund Futures (18M/3M) risks and persistently low inflation. Another way of looking
10YR/2YR Yield Curve at this is that the Fed is willing to let inflation run hotter
3% even should it materialize sooner than expected. Moreover,
as is usually the case, we expect the Fed to remove itself
2% from election-year economic developments. The Fed should
be out of the way in 2020. This is supported by the Fed’s
1% consensus on future interest rates (the so-called “dot plot”)
showing that the next action that policy-makers expect to
0% take is still a rate increase, but not until sometime in 2021.
-1%
While we are going to assume that the Fed is out of the
picture for the next year, we also believe it will be difficult
-2%
for it to resist raising rates following the U.S. election
if the economy is chugging along and equity prices are
-3%
setting new highs. This is when caution will be much more
1990 1995 2000 2005 2010 2015
warranted. The analysis below (Figure 11) from investment
Source: Bloomberg, L.P., and PMAM Research. As at December 2019.
strategist Barry Bannister at Stifel Financial suggests that
equity markets have become more vulnerable over time to
The traditional 60% equity/40% bond balanced portfolio rate increases that barely approach the Fed’s estimate of the
has enjoyed its best performance since 1998, and asset neutral rate of short-term interest rates (the rate at which
valuations are elevated, while correlations across monetary policy is neither restrictive or accommodative). If
traditional asset classes are high. This type of later-cycle this is the case, then even a few interest rate hikes will again
environment can be quite profitable for portfolios, but become a problem for stock markets and the economy. We
also becomes more fraught with risk, especially as the expect stock market volatility to emerge later this year as
eventual possibility of a renewed central bank tightening investors begin to price in a post-election environment in
cycle begins to be priced into markets. For instance, which the Fed is no longer as accommodative. This volatility
while 1999 was an amazing year for equities once it could be exacerbated if the U.S. Democratic party embraces
became clear that the Fed had eased in time (inflating the much more socialistic policies and then appears headed for
technology bubble along the way), the same could not be a presidential election win in November.
10 Q1 2020 INVESTMENT REVIEW AND OUTLOOKFIGURE 11: FED FUNDS VS. NEUTRAL RATE
Effective Fed Funds Rate Neutral Interest Rate
12
10
8
6
4
2
0
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
2019
Source: Bloomberg, L.P., and PMAM Research. As at December 2019.
CREDIT TRENDS WILL AGAIN BECOME IMPORTANT concerned recently about spread widening in the riskier
TO MONITOR AS THIS YEAR PROGRESSES end of the credit spectrum, where we noticed that
corporate spreads in the low-rated CCC bonds had begun
widening quite aggressively (Figure 12). Some of this
In the past, credit markets have often acted as a “canary widening was more sector-specific and related to more
in the coal mine,” warning that something was amiss in risky energy companies’ ability to repay their debt. These
the economy. Currently, signals from credit markets concerns have dissipated again, but we believe these
remain quite benign, with various credit spread measures riskier credit markets will be worth watching for warning
remaining at low (i.e., optimistic) levels. We did become signs as the year progresses.
FIGURE 12: CANARY IN THE OIL WELL?
Credit Suisse High Yield Index CCC Yield
22
20
18
16
Yield (%)
14
12
10
8
6
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
Source: Bloomberg, L.P., and PMAM Research. As at December 2019.
Q1 2020 INVESTMENT REVIEW AND OUTLOOK 11WORLD RECOVERY
IS NOW MORE CRITICAL FOR
CANADA’S FUTURE PROSPECTS
Canada has enjoyed significant trade and economic benefits term rates, and falling longer-term rates began to sniff
given its proximity to and special trading relationship with out trouble ahead.
the U.S. The strength of the U.S. economy will always be
important to Canada, but some troubling developments on Unexpectedly, November saw Canada’s job market weaker for
our home front now make better U.S. (and global) economic a second straight month, with the biggest drop in employment
strength even more critical. and largest one-month jump in the unemployment rate
(from 5.5% to 5.9%) since 2009. Canadian retail sales also
As previously discussed, flattening or inverting of the disappointed, falling 1.2% month-on-month versus expectations
yield curve generally suggests that the bond market is of a 0.5% increase. Meanwhile, personal bankruptcies and debt
becoming concerned about the prospects for a country’s restructurings are also their highest in a decade, jumping 13%
economic growth. While the U.S. curve has flattened over year-on-year in October, according to the Office of the
time, Canada’s curve is even more concerning (Figure 13). Superintendent of Bankruptcy. This sets up a test of the Bank
Part of this may be because the Bank of Canada sat on the of Canada’s resolve in holding off from lowering interest rates,
sidelines through 2019, while the Fed (and most other and certainly casts doubt on the Bank of Canada’s ability to
central banks) loosened policy. They didn’t lower short- chart its own course of avoiding monetary stimulus at this time.
FIGURE 13: THE CANADIAN YIELD CURVE IS FLATTER THAN THE U.S. CURVE
Sovereign Yield Curve
U.S. Canada
2.3
2.2
2.2
2.1
2.1
2.0
2.0
1.9
1.9
1.8
1.8
1.7
1.7
1.6
1.5
3M
3M 6M 1Y 2Y
6M 1Y 2Y 3Y
3Y 4Y
4Y 5Y
5Y 6Y
6Y 7Y
7Y 8Y
8Y 9Y 10Y
9Y 10Y 20Y
20Y 30Y
30Y
Source: Bloomberg, L.P., and PMAM Research. As at December 2019.
12 Q1 2020 INVESTMENT REVIEW AND OUTLOOKThe Bank of Canada is in a difficult FIGURE 14: POST-GFC PRIVATE SECTOR BALANCE
position. Years of household debt Private Sector Balance as a Share of GDP
accumulation have made many 12 USA Canada
Canadians much more vulnerable
to economic weakness than in the 10
past. Goldman Sachs has recently
8
sounded the alarm regarding
Canada’s private sector financial 6
imbalances (Figure 14 & 15). They
liken the current Canadian private 4
sector environment to that in the 2
U.S. following the tech wreck in
the early 2000s, suggesting that “a 0
large retrenchment in a dominant
sector (Oil & Gas in Canada) has -2
been offset by an expansion of the -4
household deficit on the back of
lower interest rates and a housing -6
boom…”. 1985 1990 1995 2000 2005 2010 2015
Source: Goldman Sachs Research. As at Q2 2019.
FIGURE 15: MOST MAJOR ECONOMIES AN EXAMPLE TO CANADA
Latest Private Sector Balance (% of GDP) vs. Average since 1985 The Bank of Canada may be caught
Latest Long-term Average in a struggle of trying to reign in
14
14 elevated levels of household debt
12
even as the economy is slowing. This
12
may be an important reason why the
10
10 Bank of Canada has not followed the
lead of the U.S. and many other
88
countries by injecting renewed
66 monetary stimulus into the economy.
Perhaps the Bank are hoping that a
44
reacceleration in the global economy
22 will drag the Canadian economy
along with it, while tighter monetary
00
policy will discourage private sector
-2
-2 debt levels from increasing to even
more alarming levels. Perhaps this
-4
-4
delicate balancing act will work out,
-6
-6 but if it doesn’t, it would suggest that
y the Canadian economy may be much
an
UK
ly
A
ce
lia
da
n
n
nd
ain
de
pa
US
Ita
m
an
more vulnerable to a global downtrend
ra
na
la
r
Sp
Ja
e
Ge
Fr
er
st
Ca
Sw
Au
than in the past.
itz
Sw
Source: Goldman Sachs Research. As at Q2 2019.
Q1 2020 INVESTMENT REVIEW AND OUTLOOK 13IN CONCLUSION
Based on the most recent evidence, 2020 should be a
solid year for equities, especially those that are more
economically sensitive. We believe that the Fed realized
its policy error and changed course in time to extend the
economic cycle. Its stimulus should be aided by stimulus
measures in other parts of the world (especially China)
and by trade headwinds becoming at least modest
tailwinds for global growth. As the year progresses, we
will pay close attention to whether too much good news
becomes a harbinger of the resumption of an unwelcome
interest rate-hiking process that brings the end of this
economic cycle back into view.
14 Q1 2020 INVESTMENT REVIEW AND OUTLOOKSECTOR
OUTLOOKS
INDUSTRIALS see inventory restocking compounding real demand growth,
potentially driving non-precious metal and bulk commodity
We are focusing more on cyclical names in the industrials prices higher.
space. Persistent low interest rates, signs of a trade deal and
what appears to be a soft landing are all reasons for optimism
heading into 2020. Demand indicators and manufacturing INFORMATION TECHNOLOGY
indices are showing signs of levelling out, and capital goods
orders and freight volumes are poised to inflect over the The MSCI World Information Technology Index and the
next year. Rails and equipment names are our areas of focus. S&P/TSX Composite Information Technology Sector Index
generated 11% and 10.6% returns, respectively, in the fourth
We still continue to favour companies with a history of quarter, as at December 16. Leading subsectors were tech
compounding, idiosyncratic growth angles and/or opportunities hardware and semiconductors, as investors discounted
to improve return on invested capital. current weakness in more economically sensitive stocks
in anticipation of a recovery due to inventory drawdowns
and the pending resolution of the U.S.-China trade dispute.
MATERIALS Weak subsectors were communications equipment and
IT services. Within communications equipment, industry
We have turned neutral on gold’s near-term outlook, as (1) bellwethers continued to note broader macroeconomic
the Fed’s rate-cutting cycle has likely come to an end; (2) weakness across both enterprises and service providers.
China and the U.S. have reached a phase-one deal, sending Software rebounded from Q3 and performed in line with
some relief to the global trade spat; and (3) the election in the technology sector indices in Q4. Overall, we enter 2020
the U.K. has also provided more certainty on the Brexit optimistic on the technology sector, and our favorite themes
outcome. The global macro risk, in our view, is subsiding, include: 1) public cloud migration and the diversification of
and will likely spark a risk-on move in the value-driven software deployment across broad business segments; 2) the
cyclical stocks (e.g., non-precious metal mining stocks). We beginning deployments of 5G networks; and 3) the anticipated
have been paring our long position in precious metal equities upturn in semiconductor equipment and memory cycles.
since late September, and are more focused on “self-help”
stories that add value despite the commodity price volatility. In Canada, we continue to like names which have robust, global
infrastructure that contribute to revenue growth and scale.
We have turned more bullish on industrial metals and bulk
commodities, as we believe the détente between the U.S. and Internationally, we are focused on the shift to unified
China on the trade front could ignite an inventory restocking communications-as-a-service (UCaaS). UCaaS is essentially
cycle. Based on our on-the-ground research in China in mid- replacing PBX systems, which are the traditional internal
November, feedstock and finished goods inventories for a lot company phone networks that run on copper wires. As PBX
of the downstream producers in the country were sitting at a systems reach their end of life, the market is increasingly
low level (copper fabricators, steel mills, manufacturers, etc.). transitioning to UCaaS systems, due to an improved customer
If global industrial activity begins to pick up again, we could experience, better manageability, and lower cost. The total
Q1 2020 INVESTMENT REVIEW AND OUTLOOK 15potential market size of $50B is only about 10% penetrated by to weigh on the group. However, early signs of a U.S. trade
cloud platforms. deal with China reignited hope in late November and early
December that a global downturn could be avoided, lifting
cyclical names. We remain slightly overweight in the sector
HEALTH CARE and have added smaller weightings in cheap, cyclical stocks
that show some positive fundamental change to our core
Year-to-date (YTD), the Health Care sector (19.6%) has
holdings of higher-quality, more defensive positions.
underperformed the S&P 500 Index (29.8%), as numerous
fundamentals continued to take a back seat to political concerns.
However, quarter-to-date, the sector has been outperforming the CONSUMER STAPLES
market (13.19% vs. 7.68% for S&P 500). After three quarters
of significant underperformance due to presidential election Both the Canadian and U.S. Staples indices flatlined in Q4
rhetoric and unclear health care reform policies, the managed after very strong YTD performance. As concerns about an
care subsector has been the best performer (33.1% vs. economic slowdown have turned into bullish sentiment as
13.19% for the health care sector) this quarter. The reversal we move into 2020, the defensive rotation that benefited
in performance was largely due to a reduction in extreme Consumer Staples in 2019 has also stalled. In Canada
headwinds from Medicare-for-All health care proposals that specifically, we have taken a more neutral stance on grocers.
would, if implemented, significantly change the health care Grocers’ valuations hit their peak in October, spurred on
structure in the U.S. Senator Warren (one of the Democratic by defensive rotation and healthy fundamentals. However,
presidential candidates) pivoted away from Medicare for All, increased competition throughout the country could be a
leaving Senator Sanders as the sole proponent of universal headwind. This coupled with a cyclical rotation, has led to
health care coverage. Drug price overhang continues to recent sell-offs for the group.
persist, and lacking any explicit resolution (through an
executive order, policy from Health and Human Services As in Canada, U.S. staples showed meagre performance
(HHS) or action by Congress is keeping investors on the in Q4. However, compelling stories still remain. Most
sidelines. Several pricing solutions have been proposed by significantly, the spread of African swine fever (ASF) in China
the House, by the HHS, by Medicare and Medicaid Services, is leading to unprecedented loss of hogs (~25% of the world’s
with no consensus among them, and none have been finalized. hogs) and leading to inflation in pork as well as chicken and
Odds remain against any broad bipartisan agreement on drug beef as consumers in Asia look for substitutes. We have
pricing next year. The pharmaceutical and biotechnology been positive on protein processors because of this. Coupled
subsectors have underperformed YTD, but recent mergers with the U.S. signing of a phase-one of the trade deal with
and acquisitions in the biotechnology subsector have resulted China, we can expect both pricing and volume tailwinds for
in outperformance in the quarter. The best-performing the sector. Given the unprecedented nature of ASF, protein
subsectors for year were medical technology (up ~32%) and processors in the U.S. remain a compelling investment
labs (up ~31%); they have been safe havens in a turbulent opportunity.
environment. Health care performance in 2020 could be
more positive, as valuations are more reasonable following
a year of underperformance, and investors have a better FINANCIALS
understanding that aggressive policies are unlikely to succeed
in a divided government in an election year. In addition, with We remain selective with our Canadian Financials exposure
only one potential presidential candidate promoting Medicare and prefer a select number of positive change stories facing
for All, the severe headwind for the managed care subsector structural growth.
has abated. As for drug pricing, it will remain a topic on the
We are marginally more positive in our view on the Canadian
presidential campaign trail, but we continue to believe that any
banks after a tough year for the group in 2019, underperforming
change will be more evolutionary than revolutionary.
the S&P/TSX Financials Index by 600 bps and the TSX by 700
bps. Earnings-per-share growth for the group decelerated to
CONSUMER DISCRETIONARY 3% from 13% and 11% in 2017 and 2018, respectively, and marks
the slowest growth for the group since 2010. The deceleration
Consumer Discretionary stocks were largely range bound in earnings growth was driven by a continued deceleration in
to end 2019, as fears of an economic slowdown continued volumes and higher loan losses as the credit cycle continued
16 Q1 2020 INVESTMENT REVIEW AND OUTLOOKto normalize. Credit is an area that is increasingly receiving a REAL ESTATE
lot of attention, and we expect this to remain a major theme
as the near-decade-long tailwind provided by a benign credit REITs were the darling of the defensive group, and that meant
environment becomes an increasing headwind for earnings that they were the worst affected in Q4, which was marked by
growth. We are not expecting large loan losses in the near rising yields. We believe the space is bifurcated, with names
term, but do believe that weaker financial conditions will begin that have positive tailwinds and growth prospects bidding
to manifest themselves in a normalization of the credit cycle, very well (apartment and industrial) and stories facing
and this will hamper earnings and dividend growth for the headwinds (retail) trading at lower than historical average.
bank group in 2020–2021. With recession fears fading, we believe commercial real
estate brokers should trade at a much tighter discount to
the broader market, and that should provide investors with
We continue to look to scale and strength in core deposit
both earnings growth and a potential valuation rerate. In our
franchises as the key differentiators for the group and believe
view, we are still in the early stages of this consolidation, and
this will only get more important. In our view, scale and funding
some brokers are well positioned to capitalize on this trend.
costs dictate risk appetite as we progress through the cycle.
Those who lack scale and valuable lower cost deposits are
forced further out the risk curve to support earnings growth.
We believe that this behaviour increases a bank’s beta to the
ENERGY
credit cycle, and continue to be cautious on lower-quality Oil faces enormous seasonal cyclical and structural downward
names. We have seen this behaviour manifest itself recently pressure as we go into Q1. The Aramco attacks turned out to
in acquisitions/growth of higher-risk assets and out-of- be a non-event, as did civilian uprisings in Iran and Iraq. In
footprint expansion. Although valuations for the bank group addition, as a result of new marine fuel regulations that kick
are approaching more attractive levels, we have a more in globally on January 1, high-sulphur oil will face additional
tempered outlook on earnings-per-share growth prospects. demand headwinds that are permanent.
We believe that a selective approach is more important than
ever in the banking group, and that the dispersion of returns Canadian energy, by virtue of being amongst the highest-cost
is set to increase in a more meaningful way. forms of production and the highest by sulphur content, is
looking forward to the edge of a precipice. Within exploration
and production and midstream, continue to favour the
COMMUNICATION SERVICES highest-quality names. Q1 is a time for capital preservation,
and the best way to do that is to hold cash.
Investors continue to be in a wait-and-watch mode as the
sector remains in a state of flux from an internal stand Natural gas has a relatively better outlook than oil. Since a
point - a transition towards unlimited, higher intensity with quarter of North American gas is associated production from
regards to competition and a move away from subsidies oil wells, and with LNG exports at barely 7% of the market,
towards EIP – and an external standpoint – with regulators the continent is immune from even the worst supply-demand
still contemplating MVNO (mobile virtual network operator) fundamentals currently ravaging the global gas market.
and the shape that it will take (quasi-facilities-based or not).
The sector’s relatively high valuations make the stocks more
(negatively) correlated with interest rate movements, and
that is exactly what we saw this quarter. Our view on the
sector remains lukewarm owing to a combination of the
factors discussed above.
UTILITIES
Similar growth prospects (5%–7% EPS growth) and relatively
high valuations make this another less interesting sector
from our standpoint; and as a result we continue to remain
underweight in the sector.
Q1 2020 INVESTMENT REVIEW AND OUTLOOK 17HEAD OFFICE This material has been published by Picton Mahoney Asset Management (“PMAM”)
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