Mackenzie Private Wealth Counsel Q1 216 Review Opportunities in a Challenging Macro Environment Todd Mattina, Chief Economist and Strategist, Mackenzie Asset Allocation Team Following one of the rockiest starts to a new trading year, markets have calmed in large part due to the stabilization of China and the oil markets, as well as subsiding recession risks in the U.S. Three key macroeconomic factors contributed to the market volatility in the first quarter. First, markets were worried about an economic slowdown centered in China and emerging markets. Second, markets questioned the effectiveness of central banks in shoring up sagging economies and asset prices. In particular, Japan s shift to negative interest rates in January raised concerns that central banks are running out of ammunition. At the same time, markets were concerned about possible rate hikes in the U.S., which seemed to be out of sync with tightening financial conditions, the strong U.S. dollar and weaker corporate profits. Finally, markets focused on the spillover effects of an oil supply glut on commodity exporters and credit markets. These concerns form the backdrop for longer run macroeconomic headwinds impacting market returns and risks, including a slowdown in trend economic growth, weak global demand and a legacy of high debt after the 28 financial crisis. In particular, the legacies of high government debt and policy uncertainty have increased vulnerabilities, weighing on global demand by encouraging precautionary savings and lower investment. The pace of deleveraging high debts has been uneven around the world. Corporate borrowers in emerging markets and China have rapidly accumulated high debt burdens just as profitability fell (see chart below). Rapid Emerging Markets Corporate Borrowing Even as Profitability Fell (26 Q1 21 Q2) 11 1 9 8 7 6 4 26 EM Corporate Debt (as % of GDP, left) 27 High EM corporate debt increased by about 4% of GDP since 28 Falling EM corporate profitability even as borrowing rose rapidly Return on Equity (in %, right) 28 29 21 211 212 213 214 21 Source: See Credit, Commodities and Currencies, Jaime Caruana, Bank for International Settlements, February, 216. 21 19 17 1 13 11 9 7 In fact, debt has increased rapidly in many emerging markets. China s private debt at about 2% of GDP is comparable to Japan s domestic debt before its bubble burst in the 199s. 1 Corporate debt in the largest emerging markets has also risen from about 6% to 1% of GDP, as quantitative easing and the cheap U.S. dollar encouraged rapid borrowing. Deleveraging could be painful, since rapid debt increases are often followed by financial stress and repaying debt subtracts from spending on goods and services. In Canada, households have not even started the deleveraging process with the highest debt burdens as a share of disposable income in the G-7 (see chart). Canadian and US Household Debt as a Share of Disposable Income (199 Q4 21 Q3) 2 1 1 1991 1993 CAN USA 199 1997 1999 21 23 2 1 See Red Ink Rising, The Economist, March th 216. 27 29 211 213 21 Source: Canada National Balance Sheet Accounts, Statistics Canada; US household debt to disposable income provided via Bloomberg Intelligence At the same time, supply-side factors are reducing longer run potential growth due to low productivity and population aging.
Q1 216 Review Asset Allocation Recommendations Global central banks have actively tried to boost economic activity with large-scale asset purchases while Japan and the Euro Zone have embraced negative interest rates. There is an increased perception that central banks are running out of ammunition to boost growth and asset prices. While central banks have some remaining tools left in their policy tool-box, such as direct `helicopter drops of money to households, further unconventional actions are likely to have diminishing effectiveness in lifting growth in a durable way. Even if they are successful, these policies could lay the groundwork for future market instability by distorting capital allocation decisions and encouraging higher debt. Few Major Countries Have Both Low Government Debt and Budget Deficits (in % of GDP, 21) Debt as % of GDP 1 13 11 9 7 3 1-1 -3 - -1 DEU Modest fiscal space 1 CAN 2 ITL CHN 3 Budget deficit as % of GDP 7 8 Central banks need to pass the baton to governments. A more sustainable policy solution requires government structural reforms to enhance innovation, competitiveness and strengthen institutions. Government should also take advantage of historically low borrowing costs to front-load infrastructure investments that are needed in any event. Unfortunately, structural reforms are often politically unpopular and take years to bear fruit while few governments have the space to finance much larger borrowing (see chart below). Governments will need to deliver more growth-friendly tax policies and productive infrastructure spending, laying the foundation for sustainable growth and stable markets. In today s environment of relatively rich asset valuations, already low interest rates and slower trend growth, investors face a challenging market landscape. Building better portfolios will be increasingly important to enhance expected returns for a given level of portfolio risk. This includes more deliberate management of asset mix, currency and equity factor exposures, alternatives and active risk. GBR FRA 4 USA Source: IMF World Economic Outlook database, October 21 ZAF RUS 6 JPN Very limited fiscal space IND BRA Alain Bergeron, Mackenzie Asset Allocation Team Lead Asset Allocation Outlook Asset Allocation Equity* Currencies (vs CAD) Equities Fixed Income U.S. Canada Europe U.K. Pacific Emerging Markets USD EUR GBP Underweight Overweight Strong Moderate Slight Neutral Slight Moderate Strong JPY *Refers to local currency index; Emerging is MSCI Emerging Markets. February 29, 216. From an asset mix standpoint, we recommend being slightly underweight stocks and overweight fixed income. This view is driven by stretched equity valuations, especially from our longer term models. For example, our Multi-Asset Class Intrinsic Valuation model, which takes into account interest rates, demographics, productivity, stage of the business cycle and sustainable earnings, suggests that U.S. stocks are about 3% overvalued. Also, growth expectations are slowing, which is not supportive. That said, we are on balance only slightly underweight. This is because other factors are more supportive, such as our risk premium valuation models, or the recent communications from the Fed that suggest it is slowing the pace at which it is removing its monetary stimulus.
Q1 216 Review Within global equities, in local currencies, we see the best opportunity in UK stocks. This is driven by attractive valuations relative to other countries. This can be seen in the following chart that compares the relative valuations of equity markets using three different models (see chart below). Summary of Relative Equity Valuation Models (Weighted standardized scores). -. - Model 1 Model 2 Model 3 In terms of currencies, we have moved to a neutral stance on the Canadian dollar (CAD), taking a large profit after being underweight the loonie for more than 2. years. We believe the Canadian dollar is attractive from a valuation standpoint and this could be seen in our four valuation models (see chart below); however, we also believe that Canada s macroeconomic challenges are not over, which should keep negative pressure on the dollar. Currency Valuation Models (CAD vs. USD) Model 1 Model 2 Model 3 CAD Overvalued CAD Undervalued - U.S. Japan Canada Europe ex UK EM Source: Bloomberg, Datastream, Mackenzie Investments, 216 Q2 U.K. Model 4 Overall -2. - 2. Source: Bloomberg, Datastream, Mackenzie Investments, 216 Q2 We recommend investors combine that position with an underweight of the Pound Sterling (see currency discussion below), as a way to manage the risk of the UK leaving the Eurozone (the Brexit ). We recently became neutral in terms of Canadian equities, as sentiment indicators have stabilized. We also became neutral European equities. We still think they are moderately undervalued, but our sentiment gauge suggests caution (see chart below). Summary of Sentiment Models (Weighted standardized scores) 2. For example, a survey of hiring intentions suggests that they are at the lowest they have been since 28. This survey tends to lead the actual hiring decisions by about a year (see chart below). Given these conflicting forces between valuation and macroeconomic prospects, we believe a neutral stance is the wisest positioning at this point in time. Long-term, we believe the CAD will appreciate. Hiring Intentions and SEPH Non-Farm. Payroll Employment. -. - - EM Europe ex UK Japan Canada U.K. Source: Bloomberg, Datastream, Mackenzie Investments, 216 Q2 U.S. 6 4 3 2 1 - -1 22 24 Employment Intentions (% of firms, adv. 6m, left) SEPH Employment (in s, 12m chg., right) 26 28 21 212 214 216 7 6 4 3 2 1-1 -2-3 -4 - Source: Mackenzie Investments, Thomson Datastream, Capital Economics
Q1 216 Review Developments in the Fixed Income Space We continue to be bearish on the British Pound, and hence recommend that investors hedge a greater amount of the Pound than usual. We initiated that view last quarter, due to a combination of unattractive valuation and negative sentiment. We continue to be bullish on the Japanese Yen, in large part because of its attractive valuation. We recognize that the Bank of Japan remains in easing mode; but given the Yen s significant under-valuation, we have been holding the view that monetary policy will not have the usual downward effects. Policies weakening the Yen have also become unpopular with the domestic electorate. Furthermore, our measures of sentiment also point in the same direction as valuation. That said, the Yen versus the USD already appreciated a fair amount relative to when we entered the position in Q4. As such, we have started reducing the overweight and taking some profits. Steve Locke, Mackenzie Fixed Income Team Lead As 216 began, bond markets continued to play-out some of the flight-toquality themes established last year. First, the rate hike and hawkish tones sounded by the Federal Reserve in December were not embraced by bond markets, and marked a divergence in policy with other major central banks, including the Bank of Canada. US 1 Year Yield 2. 2. Mar. 21 Source: Morningstar Jul. 21 Nov. 21 Mar. 216 US Treasury yields fell sharply throughout January and the front end of the US yield curve priced-out all but a single rate hike from the Fed over the next two years. This stood in contrast to the Fed governor s own median projection of four hikes in 216. US Federal Reserve Dot Plot. 4. 4. 3. 3. 2. 2.. 21 216 217 Longer Run Source: Federal Reserve
Market-based measures of inflation expectations also fell in sympathy with energy and commodity prices. Most developed economies have experienced declining headline inflation rates over the past year, although in many cases core inflation rates are higher because they exclude energy and food prices. To start the year corporate credit spreads continued on a widening trend reflecting concerns with potentially lower global growth rates. Most investment grade corporate issuers saw at least 1 basis points added to this relative cost of their debts. For commodity-linked companies yield spreads expanded by an even greater amount. Energy Default Rates Have Spiked (BofA Merrill Lynch HY Bond Index Default Rates) The market stabilized during February as the promise and potential for more accommodation by the ECB combined with speculation that the Fed would back-down from more rate hikes in the near term. Citi Economic Surprises: US 2-2 -4-6 16 12 Overall Energy -8 Mar. 21 Source: Bloomberg Jul. 21 Nov. 21 Mar. 216 8 4 211 Source: Bloomberg 212 213 214 21 216 The energy sector, which along with materials is a significant component of the high yield market, began to see a rising default rate. Credit markets only remained open for higher quality issuers. Economic data in the US remained reasonably good into March and the ECB delivered with a strong package of measures. These included: 1) lowering the Eurosystem main refinancing rate by to %; 2) lowering the marginal lending rate to.2%; 3) lowering the rate on deposits at the ECB to -.4%; 4) expanding asset purchases (QE) to 8 billion per month; ) allowing the QE to also include non-bank corporate bonds; and, 6) a new longer-term refinancing operation for banks (TLTRO II). Corporate bonds have since responded with a narrowing of yield spreads, reversing much of the volatility experienced in January and February. During the quarter we added to investment grade corporate bond exposure to take advantage of opportunities. Our allocations to high yield bonds and loans remain below maximum and we are selectively adding to exposure at these wider spread levels. Our portfolio durations are neutral and overall we expect that yield curves will remain in a low range. For Advisor Use Only. No portion of this communication may be reproduced or distributed to the public. The content of this commentary (including facts, views, opinions, recommendations, descriptions of or references to, products or securities) is not to be used or construed as investment advice, as an offer to sell or the solicitation of an offer to buy, or an endorsement, recommendation or sponsorship of any entity or security cited. Although we endeavour to ensure its accuracy and completeness, we assume no responsibility for any reliance upon it. This document includes forward-looking information that is based on forecasts of future events as of March 31, 216. Mackenzie Investments will not necessarily update the information to reflect changes after that date. Forward-looking statements are not guarantees of future performance and risks and uncertainties often cause actual results to differ materially from forward-looking information or expectations. Some of these risks are changes to or volatility in the economy, politics, securities markets, interest rates, currency exchange rates, business competition, capital markets, technology, laws, or when catastrophic events occur. Do not place undue reliance on forward-looking information. In addition, any statement about companies is not an endorsement or recommendation to buy or sell any security. 244 4/16