Manager Commentary - Q3 2019

Turbulence in financial markets resumed in the second quarter of 2019. Global exports and manufacturing showed signs of weakness, and the breakdown in trade negotiations between the U.S. and China in early May concerned investors. Equity funds suffered sharp outflows as global stock markets lost a large proportion of their year-to-date gains.

With declining inflation expectations, longer-term sovereign bond yields hit multi-year lows. The 10-year U.S. Treasury yield finished the quarter near 2.0%. The federal funds target rate was 2.0% lower the last time this level was reached, in November 2016. With increasingly accommodative communications from major global central banks, monetary policy expectations adjusted swiftly. Current market expectations for two U.S. interest-rate cuts during the remainder of the year stand in stark contrast to the three interest-rate increases that were projected in 2019 by the U.S. Federal Reserve (the Fed) prior to last December. Risk assets recovered into the end of the quarter. The increasingly accommodative tone from policymakers and expectations that U.S.-China trade tensions would de-escalate helped to ease investor concerns.

The third quarter of 2019 saw policymakers take increasingly aggressive action to counteract the damaging effects from continued trade tensions. The Fed cut interest rates twice during the quarter, paving the way for central bank interest-rate cuts in developed and emerging countries worldwide. The European Central Bank pushed interest rates further into negative territory. With global manufacturing already in contraction territory and the U.S. announcing tariffs on a further US$300 billion worth of Chinese goods, recession fears escalated. The widely followed 10-year/two-year U.S. Treasury yield curve briefly inverted in August (representing conditions in which the long-term debt instrument had a lower yield than the short-term debt instrument), which exacerbated the negative market sentiment. Emerging markets equities sold off, while longer-term government bond yields continued to decline.

In Europe, volatility increased as there was a greater likelihood of a “no deal” exit for the U.K. from the European Union (EU). U.K. equities and currency initially sold off, but recovered a large proportion of losses toward the end of the quarter. In Italy, the populist coalition government collapsed, giving rise to a new governing coalition between Five Star Movement and the centre-left Democratic Party. Italian bond yields declined sharply as financial markets expect the new government to be far less confrontational with the EU.

Toward the end of the quarter, oil markets were affected by a drone attack on Saudi Arabian oil facilities. The removal of more than half of Saudi oil output caused the biggest single day increase in over a decade for the West Texas Intermediate crude price. Prices remained volatile into quarter-end as investors assessed the Saudi oil facilities’ repair timeline and reconsidered the level of geopolitical risk premium warranted.

The Fund’s asset mix detracted from performance during the period, as an overweight exposure to equities modestly underperformed fixed income. The Fund’s asset allocation remained relatively stable during the period. However, fixed-income allocations were reduced further below benchmark toward the end of the period, as declining yields pushed bond market valuations into overvalued territory. The proceeds from the shift were split between equities and real estate investment trusts (REIT).

Within the Fund’s equity component, high-yielding exposures to Australian equities and U.S. mortgage REITs were among the top performers and contributed to the Fund’s performance. Sector allocation contributed to performance during the second quarter as an overweight exposure to the U.S. financials sector outperformed amid renewed loan demand as mortgage rates fell alongside bond yields.

Within the Fund’s fixed-income component, positions in U.S. high-yield bonds and U.S.-dollar-denominated emerging markets sovereign debt contributed to performance owing to a strong U.S. dollar. Geographic allocation also contributed to the Fund’s fixed-income returns. An underweight exposure to bonds in developed markets outside of North America bolstered returns, as a weak euro and a less-significant yield contraction caused underperformance.

Holdings in global (excluding U.S.) real estate equities detracted from the Fund’s performance. These holdings underperformed in light of their significant underlying Hong Kong exposure, which suffered as a result of disruptive pro-democracy protests following the failed implementation of a Chinese extradition law. An overweight exposure to European, Australasian and Far Eastern (EAFE) equities was another detractor as they underperformed amid escalating trade dispute between the U.S. and China.

A holding in local-currency sovereign bonds in emerging markets performed poorly in the third quarter as the surprisingly poor results for incumbent Argentinian President Mauricio Macri in the primary election sparked a rout in Argentinian asset prices. The Fund’s short-duration (interest-rate sensitivity) fixed-income positioning detracted from performance as long-term bond yields declined throughout the period.

The fund manager added a U.S. mortgage REIT position in June to bolster the Fund’s yield and to position for a steepening yield curve (when long-term bonds are offering higher yields than short-term bonds). New holdings in U.S. investment-grade floating rate loans and U.S. high-yield bonds were added to shorten fixed-income duration and increase credit exposure. A Spanish equity position was purchased in September to capitalize on a high-dividend yield following mediocre year-to-date 2019 performance and to position the Fund for a eurozone economic stabilization. A U.S. short-term investment-grade corporate bond position was added to maintain a short duration and overweight credit positioning while replacing a position in floating rate loans. EAFE small-cap exposure was increased as a means to increase net equity exposure and maintain regional composition as global (excluding U.S.) real estate equities were simultaneously decreased. A U.S. mortgage REIT position was increased in September as the fund manager became increasingly optimistic about the prospect of a steepening U.S. yield curve.

The fund manager eliminated an Australian equity holding from the Fund after it rebounded in 2019 amid a stabilizing housing market. The proceeds were used to fund the purchase of a new Spanish equity position. A short-term global sovereign bond was liquidated as the continued decline in global bonds yields significantly eroded the holding’s risk-return profile. A U.S. investment-grade floating rate loan position was sold in September to facilitate a rotation into short-term fixed-rate corporate bonds. A position in global real estate equities was decreased in June to lower the Fund’s interest-rate risk. A high-dividend U.S. equity holding was trimmed in September to fund the purchase of U.S. financials sector equities.

Equity dividend yields are now much higher than 10-year sovereign bond yields, virtually around the world. This calls for a major transformation in the Fund’s construction. The fund manager has lowered the Fund’s fixed-income exposure to below benchmark, as the global bond market has become unattractive from a valuation standpoint. The Fund’s U.S. investment-grade floating rate notes were sold. While the fund manager still views the asset class’ short duration favourably, with short-term interest rates anchored by central bank policy and further interest-rate cuts likely, short-term U.S. corporate bonds appear to be more appropriate, and were added to the Fund.

The fund manager maintains a favourable outlook for equities, as definitive action from policymakers should help offset the impact of trade tensions and the global manufacturing downturn. Accordingly, the Fund’s overweight equity exposure has been further increased. The fund manager believes that growth and inflationary expectations at the long end of the U.S. yield curve have become overly depressed, causing an unwarranted flattening of the yield curve (when short- and long-term bonds are offering similar yields and the benefit of holding longer-term bonds is diminished). U.S. financials sector equity and mortgage REIT exposure were increased in accordance with the fund manager’s expectation for a re-steepening of the curve, which may bolster net interest margins.

 

Fund and Benchmark Performance as at: September 30, 20181 year3 yearSince (Aug. 2016)
Forstrong Global Strategist Income Fund – Series A3.2%3.0%3.2%
35% MSCI AC World Index1, 65% Bloomberg Barclays Global Aggregate Bond Index (CAD Hedged)7.8%5.6%5.4%

 

Learn more about IA Clarington Forstrong Global Strategist Income Fund

1Source: MSCI Inc. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. The Fund's strategy is to invest primarily through diversified investments in a balanced mix of ETFs ("exchange-traded funds") of multiple global asset classes. The performance data comparison presented is intended to illustrate the Fund’s historical performance as compared with historical performance of widely quoted market indices. There are various important differences that may exist between the Fund and the stated indices that may affect the performance of each. The benchmark is a blend of 35% MSCI AC World Index and 65% Bloomberg Barclays Global Aggregate Bond Index (CAD Hedged). The blended benchmark presented is intended to provide a more realistic representation of the general asset classes in which the Fund invests. MSCI AC World Index is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world. The MSCI ACWI is maintained by Morgan Stanley Capital International, and is comprised of stocks from both developed and emerging markets. Bloomberg Barclays Global Aggregate Bond Index (CAD Hedged) is a measure of global investment grade debt from 24 local currency markets that includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. The Fund's fixed income component can invest in both investment grade and high yield bonds while the benchmark has exposure only to investment grade bonds. The Fund’s geographic and sector exposure may differ from that of the benchmark. The Fund may have different currency risk exposure than the benchmark. The Fund may hold cash while the benchmark does not. Overall, the Fund's bond and equity exposure can differ, because the Fund does not use a fixed ratio similar to the benchmark. It is not possible to invest directly in market indices. The performance comparison is for illustrative purposes only and does not imply future performance.