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Q4 2019 - A very good decade of performance!

Financial letter
Richard Morin

Richard Morin

Update :
Update :
February 4, 2020

Happy New Year 2020!

The Archer Wealth Management team wishes all of our clients, partners and friends a great year in 2020!

All good things come to those who wait!

An excellent 2019 for the stock markets (22.9% and 24.9% respectively for the Canadian and American stock markets) marks the end of a very good decade (6.9% and 16.0% annualized respectively). The risks of a global recession seem to have faded, the U.S. Federal Reserve has cut rates three times and corporate profits are holding up for the time being. The markets have responded: stock market indexes ended the year and the decade at record levels.

Asset classes Returns in $C
  4th quarter 2019 10 years old
Bonds[1] -0,9% 6,9% 4,3%
- Canadian women[2] 3,2% 22,9% 6,9%
- Americans[3] 6,8% 24,9% 16,0%
- International (EAEE)[4] 5,9% 15,9% 7,8%
- Emerging markets[5] 9,3% 11,7% 5,8%
Real estate investments (REITs)[6]. -1,5% 21,8% 11,3%

The strong performance of the Canadian economy, rising oil and resource prices, and a narrowing of the interest rate differential with the U.S. have made the Canadian dollar the best performing currency among developed economies in 2019, up 5% against the U.S. dollar. The appreciation of our currency has somewhat undermined global portfolio returns for Canadian investors in 2019 and for the decade.

Canadian bonds have also generated excellent returns in 2019 (6.9%) as well as for the decade (4.3% annualized). This result is explained by the continuous decline in long-term interest rates, not only over the last decade but for almost 40 years now, which pushes up the value of a bond portfolio. Yet there was no shortage of experts over the past 10 years predicting that an inexorable rise in interest rates to "normal" levels would decimate the bond portfolio, and advising investors to seek refuge in short-term bonds. Those who listened to them had to settle for an annual return of 2.4% before fees.

Very few people predicted such returns in the wake of the 2008-2009 financial crisis. At the dawn of the 1920s, making predictions about the economy or financial markets is equally risky. Will the longest economic expansion in modern history end in 2020? Did the stock market overextend itself in 2019 and will it suffer a correction? Will long-term interest rates begin a sustained rise? No one can answer these questions and therefore no one should bet their retirement capital on any of these scenarios.

It is in large part because Archer never makes predictions (and therefore never makes wrong predictions!) that our clients earn better returns: 1.3% annually better than the average Canadian fund[7].

All good things come to those who wait!

Canadian stocks: " crash

The Canadian stock market is very concentrated: 4 major sectors (financials, energy, materials and industrials) account for more than 70% of the market capitalization. These 4 sectors all had returns between 16% and 24%, so that the Canadian stock market generated 22.9% over the year. The relatively strong performance of the Canadian economy, rising oil and materials prices, and a strengthening residential sector explain this performance.

Technology stocks - led by Shopify - may have risen 63%, but they simply don't weigh enough in the index (5.7%) to have a major impact.

The same is true for cannabis stocks. The drop of up to 60% in some of these stocks (a " crash"?) hardly deserves a footnote since they represent only 0.5% of the index.

Sector Yiels
S&P / TSX Composite (in CAD) S&P 500 (in USD)
Energy 16.2% 11.8%
Materials 22.1% 24.6%
Industrial values 23.6% 29.3%
Consumer discretionary 13.1% 27.9%
Consumer Staples 12.8% 27.6%
Healthcare (including cannabis) -11.4% 20.8%
Finance 16.9% 32.1%
Information Technology 63.5% 50.3%
Communication services 8.2% 32.7%
Utilities 31.6% 26.4%

U.S. equities: still in tech

Unlike the Canadian stock market, technology stocks are the leading sector in the US stock market: they represent 24% of the S&P500 index, with more than half of that for the FAANGMs (Facebook, Apple, Amazon, Netflix, Google/Alphabet and Microsoft). The sector's 50.3% performance in 2019 (in USD and including dividends) explains a good part of the S&P500's 31.5% performance.

The other major sectors of the U.S. stock market did not do too badly either, except for the health care sector, which performed "only" by 20.8%. Despite the slowdown in production, the industrial sector also had an excellent performance of 29.3%. Energy was the only negative with a performance of 11.8%.

A one-year performance of 31.5% may seem high. However, it follows a sharp decline in the last quarter of 2018, so the increase since September 30, 2018 is 13.7%.

In fact, the roller coaster ride of the last 5 quarters perfectly illustrates what separates investors who make good long-term returns from those - and there are unfortunately many - who are doomed to make mediocre returns. Indeed, the reason the stock markets fell sharply in the last quarter of 2018 is that many investors sold to "protect" their capital. So they sold at the bottom of the market - at the end of 2018 - and missed out on the great returns of the first quarter of 2019, or worse if they still haven't reinvested.

The following table illustrates the impact on the equity portfolio of whoever would have missed the first quarter 2019 returns.

Cost market timing chart

International equities: Europe beats Japan

International equities in the developed world could not keep pace with US equities but still returned 15.9% (in CAD) in 2019. The (symbolic) interest rate cut and quantitative easing by the European Central Bank, as well as relative optimism in thesecond half of the year, explains why European equities did better than Japanese equities, which were hurt by the Trump trade war. UK equities also underperformed, probably due to the uncertainty caused by Brexit.

Not surprisingly, Hong Kong, struggling with riots since last summer and also a collateral victim of the trade war, as well as Spain, struggling with political instability, have performed poorly in 2019. However, they weigh too little in the index to affect our returns in any noticeable way.

Emerging markets: a great decade followed by a bad one

Results in emerging markets were more mixed, with a return of 11.7% in CAD. Several of the major components of the index, such as China, Taiwan, Brazil and Russia, did well with returns ranging from 17% to 43%. However, South Korea, India, South Africa, as well as Southeast Asian and Middle Eastern countries pulled the average down.

In contrast to the 2000s, emerging markets have significantly underperformed developed markets over the past decade - 3.7% annually for the MSCI Emerging Market Index versus 9.5% for the MSCI World Index. Perhaps expectations - and stock prices - were too high at the start of the decade.

Chinese equities in particular have underperformed despite robust economic growth over the past 10 years.

India and South Africa are two other countries that have disappointed the high expectations of investors. There is a growing realization that India, with its large infrastructure deficit, fragile financial sector and ultra-nationalist Modi government, may be a giant with feet of clay rather than the Asian tiger it was thought to be. As for South Africa, its dismal economic performance in recent years leaves little room for profit growth and stock market returns.

Despite this, emerging markets continue to deserve their place in investors' portfolios. They account for a quarter of global market capitalization and generate 60% of global economic growth[8]. 8] Although more volatile, their cumulative stock market returns since the early 2000s are significantly higher than those of developed markets. This is also expected to be the case over the next decade.

Bonds: Rates remain very low

Despite a negative performance in the last quarter (-0.9%), Canadian bonds still generated an excellent return of 6.9% for the year.

After reaching a low of 1.1% in August, when the market perceived a high risk of recession, the rate on 10-year Government of Canada bonds stabilized at around 1.6% at the end of the year. Given the optimism in the stock market, one would have expected a stronger rally in 10-year rates. After all, these bonds are mainly used as an insurance policy in the balanced portfolio.

The paradox of an optimistic stock market that coexists with such low bond rates is undoubtedly explained by the excess liquidity in the markets. We have already mentioned that the aging of the world's population is leading to a situation where savings exceed investment opportunities. In such a context, all asset classes are pushed up: stocks, bonds and real estate.

The strong performance of the Canadian economy has led to a narrowing of the Canada-U.S. credit spread, which calls into question the appropriateness of maintaining U.S. bonds in the portfolio.

Real Estate Investment Trusts (REITs): a great decade

The environment was favorable for income trusts in 2019: a healthy Canadian economy and a general decline in long-term interest rates. Their return for the year was 21.8% despite a slight decline in the last quarter. Their annual return of 11.3% over the past decade has been significantly higher than equities, which is not surprising since they are sensitive to changes in long-term interest rates.

It is unlikely that the environment will be as favourable for REITs over the next decade. By various measures, Canada is one of the most overvalued countries for real estate. Furthermore, it is difficult to see a scenario where interest rates continue to fall, except in the event of a recession. It would therefore be prudent to revise our return expectations for REITs over the next decade.

[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
[7 ] 5.6% annualized since the firm's launch in February 2017 vs. 4.3% for the average "Canadian Neutral Balanced" fund. Sources: Fundata and Archer
8] International Monetary Fund, IMF Data Mapper