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3rd quarter 2019: A duel to finish

Quarterly review

Richard Morin

Update :
Update :
October 11, 2019

A duel to finish

We are currently witnessing a duel to finish. No, this is not the duel between the House of Representatives and the White House to impeach Donald Trump!

Rather, we are talking about the discordant signals sent by the stock market on the one hand - the U.S. and Canadian stock markets both reached record highs last quarter - and the bond market on the other hand, where rates on government bonds are at historically low levels, even negative. In the long run, the optimism of the stock market is not compatible with the defensive behavior observed on the bond market: one of the two markets is "wrong".

Asset classes Returns in $C
3rd quarter YTD
Bonds[1] 1,2% 7,8%
- Canadian women[2] 2,5% 19,1%
- Americans[3] 2,9% 17,0%
- International (EAEE)[4] 0,1% 9,5%
- Emerging markets[5] -3,0% 2,2%
Real estate investments (REITs)[6]. 7,3% 23,6%

Indeed, such low rates (1.51% on U.S. bonds maturing in 10 years, 1.23% in Canada and -0.59% in Germany at the time of writing) reflect a good deal of investor pessimism, even if demographic factors are at play, as we wrote in a recent post. The signal is even clearer when long-term rates are lower than short-term rates (the famous inverted curve indicating that investors fear a recession).

So, who is right, the stock market which seems to believe that economic growth will continue and corporate profits will continue to grow, or is it the bond market which is right, with a recession towards the end of 2019 or in 2020, accompanied by a bearish stock market?

The answer to this question will probably have to wait a few more months. For now, however, the Archer portfolio continues to generate good returns and its bond portion will help cushion the impact of any market downturn.

Canadian equities: playing it safe

Canadian equities hit a record high in the third quarter and generated a return of 2.5%. Because it is inversely correlated with interest rates, the utilities sector was the best performer, up 9.0% for the quarter (30.3% year-to-date). Investors buy these stocks for the same reasons they buy bonds: they generate current income and offer some protection in an economic downturn and bear market.

Another defensive sector, consumer staples, outperformed in the quarter, up 5.4%.

The cyclical energy and materials sectors continued to underperform, as they have since the beginning of the year. The industrial sector was down 1.8% for the quarter, which is not surprising given the slowdown in this sector in Canada and elsewhere in the world.

Technology stocks did fairly well with a 3.3% gain, but ran out of steam late in the quarter with the correction in Shopify and BlackBerry stocks, down 19.6% and 24.1% respectively in September.

Cannabis stocks all continued to fall with declines of up to 43% during the quarter, with no significant impact on Archer's portfolio performance.

U.S. equities: we still like the interest rate cuts

Once again, the U.S. stock market shrugged off threats to the global economy - trade war, slowdown in Europe and in the U.S. industrial sector - and reached another record high during the quarter. The S&P500 rose 1.2%. Corporate profits continue to be strong and the low bond yields do not offer an attractive alternative.

As in Canada, defensive sectors outperformed, led by utilities (+8.4% in the quarter) followed by real estate (+6.9%) and consumer staples (+5.4%), while cyclical stocks underperformed.

U.S. stock market movements remain largely dictated by interest rate expectations, leading to the paradoxical situation where bad news can drive the stock market higher. Indeed, signs of a slowdown in economic activity increase the likelihood of a rate cut by the Federal Reserve, which makes stocks even more attractive. However, this game cannot go on forever. If the market concludes that a recession is inevitable despite the Fed's efforts, stocks will be hurt. At that point, one will be glad to have kept a good portion of the portfolio in long-term bonds.

International equities: Japan saves the day

International equities in developed countries generated a return of 0.1% in Canadian dollars during the third quarter. Had it not been for the strong performance of the Japanese stock market (+4.5%), the return would have been negative. It seems that the market has finally recognized that Japanese equities are attractive given a price/earnings ratio that is significantly lower than in the U.S. and respectable earnings growth, despite the headwinds resulting from the tensions with Korea and the sales tax increase.

Most European countries offered a positive return in local currency but negative in CAD, as a result of the weakness of the Euro against the dollar.

The Hong Kong stock market fell by 11.7% due to the trade tensions between China and the United States, which are affecting several local companies. The protests in the city had little to do with it. Given Hong Kong's relatively low weight in the index, the impact on our returns is negligible.

Emerging markets: a difficult quarter

It was a tough quarter for emerging markets, which fell 3.0% in Canadian dollar terms.The trade war and slowing growth no doubt explain the drop in appetite for the Chinese stock market, which lost 4.3%. Other countries did worse, such as Saudi Arabia (-9.5%), Thailand (-6.2%) and South Africa (-6.0%). The good performance of Taiwan (+5.1%) and Brazil (+3.7%) limited the decline.

Bonds: roller coaster!

After briefly falling below 1.5% at the end of August, rates on 10-year U.S. bonds have risen to nearly 1.9%...only to fall back to 1.5% at the time of writing!

10-year rates reflect in large part investors' perceptions of the economic outlook. Simply put, when rates fall, it means investors are anticipating a slowdown. When they rise, it's a sign that concern is fading. The roller coaster ride of the past quarter reflects uncertainty about the economic outlook and perceptions that change with each week's statistics.

The 10-year rate was even briefly below the 2-year rate during the quarter (the so-called inverted yield curve); a clear indication that the market anticipates a slowdown and even lower rates in the future. The concern is that the last 5 inverted curve episodes have all been followed by a recession.

Although rates are about 0.3% lower in Canada, their movements closely follow those of U.S. rates.

Even so, bonds contributed a return of 1.2% to the Archer portfolio over the quarter.

Real Estate Investment Trusts (REITs): a class of their own!

Like bonds, REITs benefited from the decline in 10-year rates during the quarter. This makes sense: when bond yields are falling, the steady income generated by REITs is an attractive alternative. Their 7.3% return for the quarter demonstrates once again that REITs are a distinct asset class from equities that contributes to portfolio diversification and performance.

[1] FTSE TMX Canada UniverseXM Bond Index
[2] S&P/TSX Capped Composite Index
[3] S&P 500 Index[4] MSCI EAFE Index
[5] MSCI Emerging Markets Investable Market Index
[6] FTSE Canada All Cap Real Estate Capped 25% Index