Anticipating expansion: How to position for the next phase of global growth
David Taylor, MBA, CFA
Portfolio Manager, Taylor Asset Management Inc.
After a prolonged and unusual recovery, encouraging signals from the U.S. and global economies indicate we may finally be entering an extended period of synchronized global economic expansion.
We believe that, as the expansion unfolds, equities will outperform fixed income, value investing will lead growth investing, and Canadian equities should be over weighted relative to U.S. equities.
Despite our optimism, an economic expansion does not come without risks. Declining correlations within and across equity sectors, along with uncertainty surrounding the Trump administration’s policies, may create an environment where divergences between investor outcomes become especially pronounced. An active approach, in our view, is best suited to such circumstances.
On the cusp of global economic expansion
This economic cycle is proving to be like no other. Historically, economic cycles have averaged seven years – two years of recovery and five years of expansion. This time around, the great recession was so deep that the economic recovery alone has taken almost seven years.
Figure 1: Index of leading indicators for the U.S., 1970 - 2017
Source: Bloomberg Finance LP as of February 24, 2017.
We are only now starting to see early signs of expansion in many global economies, and for the first time in a long time, we are seeing synchronized global growth. Latin America has stabilized, emerging markets have stopped decelerating and Europe is showing growth after six years of hibernation.
Cyclical economic indicators in the U.S., such as light vehicle sales, are above long-term averages. Housing starts have also improved steadily. U.S. home resales surged to a 10-year high in January1. In February, the Conference Board’s consumer confidence index reached its highest level since July 20012. On the employment front, the four-week average of U.S. jobless claims are at their lowest levels since 19733. Taken together, this data bodes well for U.S. gross domestic product growth.
The Purchasing Managers’ Index (PMI) provides a snapshot of the manufacturing sector’s overall strength. A PMI reading above 50 suggests an improvement from the previous period, while a reading below 50 suggests a decline. A reading of 50 means there has been no meaningful change.
In January 2017, the global PMI reached 52.7, reflecting a significant increase in manufacturing activity globally. In developed markets the PMI was even higher, surging to 54.44. Barring any White House-induced shocks to the system, we believe the U.S. and global economies are poised to improve for the foreseeable future.
Investing in the expansion
If we are correct that these are the early days of global economic expansion, we anticipate that, as the expansion unfolds, equities will outperform fixed income and value investing will outperform growth.
- Equities versus fixed income
Global economic expansion will likely result in higher interest rates and higher inflation.
The U.S. Federal Reserve is finally moving further away from its highly accommodative monetary policy and is on track to raise interest rates in 2017. In January, U.S. inflation data saw its largest gain since 20135. Most expect further inflation from the pro-growth policies proposed by President Donald Trump, particularly his infrastructure spending and tax cut plans.
Inflation has also jumped in Canada, with January data showing a 2.1% year-over-year increase – its highest level in more than two years and significantly stronger than December’s rate of 1.5%6. Importantly, many are now finally seeing potential for meaningful inflation in Europe and the U.K.
There has been a substantial inflow of funds into bonds with historically low yields. These investors could be in for a rude awakening: if yields continue to rise, the price of their bonds will decline. In addition, income streams may not keep pace with inflation, especially for government and investment grade bonds. Owning stocks has traditionally been viewed as an important way to keep pace with inflation, as equities are claims on real assets such as land, plants and equipment, which typically appreciate in value as overall prices increase7.
With rising interest rates, higher inflation and global economic improvement, we expect equities to outperform bonds.
- Value versus growth
An extended period of weak economic performance and low returns led investors to seek growth at any price. Because the market was bidding growth stocks to inflated levels, growth stocks outperformed value. This outperformance reached abnormal levels since the equity market bottom in March 2009.
The graph below shows the 10-year rolling return differential between the MSCI World Value Index (net) and the MSCI World Growth Index (net). The area above zero indicates that value investing is outperforming; the area below zero indicates outperformance for growth.
In 2016, w e saw a global reversal of growth’s outperformance. Value investing, as represented by the MSCI World Value Index, returned 8.45% (net) versus the -0.76% (net) returned by the MSCI World Growth Index8. We believe this is not an aberration, but rather the beginning of a new phase where value investing will continue to outpace growth.
We expect value to outperform as we enter the expansion phase of the cycle, since value stocks tend to be late-cycle performers. Their earnings are more cyclical and improve during the second half of the cycle through capital expenditure investing (e.g. industrial products, transportation, energy and materials).
Figure 2: MSCI World Value Index (net) versus MSCI World Growth Index (net) – 10-year rolling return differential
Source: Zephyr StyleADVISOR as of January 31, 2017. Above 0 means value is outperforming growth. Below 0 means growth is outperforming value.
- Canadian equities versus U.S. equities
Cyclical stocks, such as automotive and retail names, tend to rise and fall with the economy. When the economy is performing well, disposable income tends to go up, which increases demand for items such as cars and furniture. Non-cyclical stocks – also known as defensive stocks – tend to be shielded from the direction of the overall economy because the goods or services these companies offer are essential to consumers. Examples include utilities and food producers.
The last six months saw dramatic outperformance of cyclicals versus defensive stocks, both in Canada and around the globe. We expect that Canadian equities, supported by a largely cyclicals-based economy, will continue to outperform U.S. equities.
The current environment is reminiscent of the period beginning in 2004, as markets and the economy recovered from the tech bubble. From January 1, 2004 to June 30, 2008, the S&P/TSX Composite Index had a cumulative return of 94%, while the S&P 500 Index fell by -1.7% (in Canadian dollars)9.
With global economic expansion, we typically see tighter manufacturing capacity utilization, which in turn leads to increased capital expenditures. Adding to plant capacity requires resources, which Canada has in abundance – energy and materials-based companies account for more than 30% of the S&P/TSX Composite Index.
In addition, with rising interest rates in the U.S., we expect the U.S. dollar to lose steam, as it did in the wake of previous instances of monetary tightening by the Federal Reserve. A lower U.S. dollar vis-à-vis other global currencies will benefit commodity prices. All of this bodes well for Canada.
The portfolios we manage have already been rewarded for our shift to Canada and cyclicals, and we believe there is more to come.
Anticipated expansion demands an active approach
We believe that an active approach is required to help capture the potential opportunities that lie ahead.
From a valuation perspective, Canadian and U.S. equities are more expensive than they were over the last year, with P/E ratios currently above historical averages. The post-Trump rally led both indexes to all-time highs in 2017. However, correlations within and across sectors are approaching all-time lows (Figure 4). Because stocks are not moving in tandem, now is not the time for a passive, “own the market” approach. It is fertile ground, however, for experienced stock pickers who can home in on individual opportunities.
Figure 3: S&P 500 stock correlation fell to 20-year lows as of February 9, 2017
Source: Goldman Sachs Global Investment Research, February 9, 2017.
Figure 4: Inter- and intra-sector correlations differ as of February 9, 2017
Source: Goldman Sachs Global Investment Research, February 9, 2017.
We expect that the economic policies proposed by the Trump administration will result in an environment of pronounced winners and losers. For instance, a greater tax on imported goods would be positive news for U.S. manufacturers that compete with foreign companies, but trouble for retailers that import much of their inventory from abroad.
The IA Clarington Focused Canadian Equity Class, IA Clarington Focused Balanced Fund and IA Clarington Focused U.S. Equity Class can help your clients’ portfolios benefit from quality companies that can endure inevitable periods of market turbulence. Our portfolios are concentrated, allowing us to be opportunistic. We also have the flexibility to shift our sector and geographic exposures if we believe conditions are changing.
For more information about IA Clarington Focused Canadian Equity Class, IA Clarington Focused Balanced Fund and IA Clarington Focused U.S. Equity Class, please contact your iA Clarington sales team.
- Accommodative Monetary Policy – A central bank policy that seeks to stimulate economic growth by increasing access to credit through low or reduced interest rates.
- Correlation – Correlation measures how much the performance of two investments move in relation to each other. A high positive correlation means the two investments perform very similar to each other while a high negative correlation means they perform very differently.
- Growth Investing – Growth investing is focused on finding stocks with high earnings growth potential. Investors interested in growth strategies are typically interested in above average capital gains (as opposed to income from dividends).
- Growth Stock – A growth stock is a stock in a corporation that is expected to have above-average growth in earnings. Growth stocks to not typically pay a dividend, but instead reinvest earnings to fuel growth of the company.
- Monetary Tightening – A central bank policy that seeks to dampen inflationary pressures by reducing access to credit through higher interest rates.
- Outperform – An investment outperforms when it generates a higher return than its stated benchmark or index for the same time period.
- Overweight – An overweight position means an investor or investment fund manager is allocating more to an asset class, sector, geographic region or other category than the benchmark weighting.
- Passive Management – Passive management is an investment management style that tracks a particular index, instead of a portfolio of securities handpicked by a portfolio manager. Passively managed investments are not intended to beat index performance, and are instead designed to perform in step with the performance of the delineated index.
- P/E Ratio – An important stock valuation metric that measures the price of a company’s shares relative to per-share earnings.
- Underweight – An underweight position means an investor or investment fund manager is allocating less to an asset class, sector, geographic region or other category than the benchmark weighting.
- Valuation – Valuation refers to the process of measuring how much an investment is worth by analyzing a variety of factors including financial statements, management quality, economic and industry statistics, and many others.
- Value Investing – Value investing is a strategy where investors seek to purchase securities trading below their true (intrinsic) value. Analysts assess the real value of a stock by looking at a company’s characteristics, and if the company is trading below this amount it is considered a value stock. The stock can eventually be sold for a profit when the price reaches the determined true value.
(1) http://www.businessinsider.com/us-existing-home-sales-january-2017-2017-2, Akin Oyedele, www.businessinsider.com, Existing-home sales jump
to a 10-year high. February 22, 2017
(2) http://www.cnbc.com/2017/02/28/feb-consumer-confidence.html, Berkeley Lovelace Jr., www.cnbc.com, Consumer conficence hits 114.8 in February, versus 111 estimate. February 28, 2017
(3) http://www.foxbusiness.com/markets/2017/02/23/u-s-jobless-claims-up-four-week-average-lowest-since-1973.html, www.foxbusiness.com, U.S. jobless claims up, four-week average lowest since 1973
(5) http://www.theglobeandmail.com/report-on-business/economy/consumer-prices-in-us-increase-by-most-since-february-2013/article34026691/, Lucia Mutikani, www.globeandmail.com, U.S. data points to strengthening domestic demand and inflation. February 15, 2017
(6) http://www.theglobeandmail.com/report-on-business/economy/inflation-rate-jumps-to-highest-level-in-more-than-two-years/article34126908/, David Parkinson, www.globeandmail.com, Inflation rate spikes as carbon taxes hit gasoline prices. February 24, 2017
(7) https://www.washingtonpost.com/business/stocks-can-be-your-best-hedge-against-inflation/2011/05/17/AFj9tc8G_story.html?utm_term=.46f24dca7fba. www.washingtonpost.com. Stocks can be your best hedge against inflation. May 21, 2011
(8) Source: Zephyr StyleADVISOR, returns are in Canadian dollars
(9) Source: Zephyr StyleADVISOR, returns are in Canadian dollars
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