Week Ending: September 13th, 2019 | Published: September 17th, 2019
The about-face for sentiment continues as more olive branches were extended from both sides in the U.S.-China trade war. Adding to the fray was better-than-expected economic data from the U.S. consumer: weekly jobless claims plunged; retail sales were solid; and, consumer sentiment improved. Stimulus came from the ECB with more monetary stimulus set to come next week from the U.S Federal Reserve (Fed). All of this, plus the reversal in bond yields, sent global equity markets higher with the S&P/TSX making, and U.S. equity benchmarks flirting, with new all-time highs. As a highly cyclical and technology-light index, the TSX is the poster child for a violent rotation that’s happening beneath the surface of advancing indices. The sharp reversal in bond yields and the whisper of a “growth-might-be-around-the-corner-if-we-can-get-a-trade-truce” narrative has lit a fire under beaten-up energy and lagging bank share prices. The losers are the defensive darlings – the traditional yield proxies (utilities and real estate), plus gold companies, but also the secular growth stories in technology. The tale of the tape is stark: Shopify fell 10.4% (but was up 186% YTD to the end of August), while bank stocks were up between 4% and 5% on the week, going a long way to closing the (rare) underperformance gap with the broad TSX.
Given the developments over the past month, we continue to ask the question, “What, if anything, has actually changed?” The move for bond yields makes sense to us; the move higher for equities less so. Equities are forward-looking and, as such, they’re pricing in what is perceived to be better days ahead. Our concern is twofold: better days are just a hope at the moment, subject to great uncertainty; the upside (should those hopes come to fruition) we believe is limited by the fundamentals, namely earnings growth. The shoe has yet to drop on a ratcheting down of 2020 earnings growth estimates, that at ~10% remain too high, even if a “mini trade deal” is struck. Any temporary deal will not remove the uncertainty for long-term corporate investment decisions and there is already damage done -- global supply chains are being rearranged and no deal is likely to cover technology firms with national security implications. As for central banks, Mario Draghi’s aggressive plea for fiscal stimulus is an admission of the fruitlessness of progressively further negative interest rates to fix a confidence problem. For corporations, access to capital and its associated cost is not the issue, it’s rather how to deploy it. Buybacks are slowing and, with all the uncertainty, companies seem reluctant to invest in plants and equipment.
Given that we see fundamentals driving the global economy and corporate earnings expectations as much the same as they were a month ago (and risks to both remaining high), we believe the bond market selloff and lofty equity levels make for an attractive time to move slightly defensive within the broader context of a mature business cycle. To clarify, we suggest only a slight move (as further small gains from equities over the next six months are expected). On a risk-adjusted basis, the math justifies a slight underweight to stocks in favour of bonds. For most balanced portfolios, we see this as between a 2% to 3% shift out of equities into fixed income.
Chart of the Week: Sharp Reversal in Bond Yields Knocks 1/3 Off YTD Return
North American bond yields continued their sharp reversal higher on the back of easing trade tensions, firm U.S. inflation and retail sales. The move in yields also likely reflects some profit-taking on the part of bond investors who have been handsomely rewarded throughout 2019. The FTSE Canada Universe Index has lost 2.95% in three weeks. It had been up a whopping 9.5% YTD in mid-August when yields bottomed out (the Canada 10-year hit 1.09% – not enough to beat the Sept. 29, 2016 record of 0.95%). The yield increase is the largest weekly move since 2017 and the largest weekly decline for the index in nearly three years. Canadian bond yields had been plummeting since last year’s fourth quarter and we’ve argued that yields had broken from fundamentals – most notably firm inflation and economic conditions not suggestive of a recession. This is precisely the kind of snapback we’ve been concerned would surprise conservative investors. At this juncture, we believe yields will likely remain volatile, but expect two- and ten-year bond yields will ultimately finish the year around current levels.
The week in review
The European Central Bank (ECB) cut interest rates further into negative territory and delivered a wide range of stimulus measures aimed at addressing slowing growth and below-target inflation. Quantitative easing is back after just an 11-month hiatus, with an asset purchase program of €20 billion/month starting on November 1 and continuing for as long as needed. A two-tiered system of reserve remuneration was introduced in an attempt to relieve European banks suffering from lower deposit rates. Forward guidance was changed to a more open-ended approach focused on economic conditions rather than the calendar-based guidance previously provided.
U.S. consumer prices (Aug.) rose 0.1% m/m (in line with expectations) resulting in a slight drop in the annual pace of inflation to 1.7% y/y from 1.8% in the prior month. Core inflation rose 0.3% m/m (versus +0.2% expected) for a third straight month, lifting the yearly rate to 2.4% y/y from 2.2% previously. The impact of tariffs is beginning to show up in inflation data.
U.S. retail sales (Aug.) rose 0.4% m/m (versus +0.2% expected) as households show little impact from the ongoing trade war. Core sales (ex-autos and gas) rose 0.1% m/m, while the control group rose 0.3% m/m after a 0.9% jump in the prior month.
U.S. NFIB Small Business Optimism Index (Aug.) fell 1.6 to 103.1. University of Michigan Consumer Sentiment Index rose to 92.0 in its preliminary September reading, up from 89.8 in August (versus 90.8 expected), breaking a three-month downtrend.
Chinese trade data illustrates the impact of the trade war: exports fell 1.0% y/y, with exports to the U.S. plunging 16% y/y. Imports fell 5.6% y/y – a worrying sign of weak domestic demand; within the data, imports from the U.S. nosedived 22% y/y.
Chinese credit growth bounced back more than expected, suggesting that policy efforts to boost bank lending are gaining momentum. Aggregate financing (Aug.) was 1.98 trillion yuan, compared to 1.01 trillion prior and versus 1.6 trillion expected.
The week ahead
Canadian inflation and retail sales
U.S. and Canadian housing data
U.S. industrial production
U.S., Japan and U.K. monetary policy announcements
U.S. and Chinese trade officials to meet