"An ounce of prevention is worth a pound of cure." Central banks, always wary of economic downturns, have stepped in to ease monetary conditions in the hopes of staving off a recession. After a few years of tightening, we have seen central bankers return to increasing money supply (QE) and decreasing rates. Markets have responded mostly positively although this reliance on outside influence has resulted in heightened market volatility and wild swings in interest rates. In the third quarter, the Government of Canada 10 year bond jumped as high as 1.63% and fell to as low 1.10%. This level of volatility for sovereign bonds is remarkable - although it pales in comparison to the negative rates we are seeing in other parts of the world.
Markets in the third quarter responded cautiously to this environment. The TSX, S&P500 and EAFE indexes were all flat to slightly higher mirroring the results from the second quarter. Politics have dominated the headlines, both in Canada and abroad, with election cycles heating up in North America and Europe. The ongoing Brexit saga, trade war with China, increased instability in the Middle East, and of course, an impeachment inquiry in the US, have both businesses and investors justifiably on edge. This is beginning to appear in some manufacturing data which point to a more cautious business environment. This negativity is offset by a very resilient consumer and a labour market which shows improving wage growth and little signs of weakening.
For investors, this wild rate environment, somewhat a function of global uncertainty, is having outsized impacts. Money is moving into risky asset classes and sectors where investors need to be careful should we see rates reverse direction and climb off historically low levels. A low rate environment encourages risk taking while capital is “cheap”. Performance over the past few years has been pushing into momentum growth stocks, particularly in technology. The valuations on many of these stocks have reached levels that are extremely difficult to justify. “Buying high and selling higher” is a risky proposition and historically has ended badly for many investors.
Other sectors such as real estate, utilities and consumer staples, which pay healthy dividends, have benefitted as well. Investors are treating these securities as “bond proxies” in the absence of better returns from the fixed income asset class. Our concern here would be that utilities and real estate in particular are very sensitive to rates, not just in terms of investor sentiment but also in terms of the value of their real assets which move inversely with rates.
A bubble is always obvious in hindsight but the appearance and timing of said bubbles can be difficult to pinpoint in the present. The impact of ultra-low (and in some cases negative) long term rates will certainly have unintended consequences. Central banks should be, and likely are, wary of this and waiting with bated breath for cooler heads in trade disputes. Another cure for the uncertainty would be a concerted push of fiscal stimulus. Recent weakness in Germany combined with political change there has many believing that this could be the catalyst for a moribund Europe. Meaningful infrastructure investment in North America would also go a long way to improving the world economic outlook.
An 'ounce of prevention' may be worth a pound of cure, but a 'pound of prevention' could equal larger troubles down the road. Not a perfect turn of phrase but all that to say, this ultra low rate environment could create unintended consequences. A small recession now wouldn’t be the worst thing and would allow economies to naturally adjust and continue a positive trajectory. Meanwhile, we will continue our disciplined approach and take profits on companies that have had strong performances, look for opportunities in out of favour sectors and be judicious in terms of re-investing dividends and new cash to portfolios.
Markets in the third quarter responded cautiously to this environment. The TSX, S&P500 and EAFE indexes were all flat to slightly higher mirroring the results from the second quarter. Politics have dominated the headlines, both in Canada and abroad, with election cycles heating up in North America and Europe. The ongoing Brexit saga, trade war with China, increased instability in the Middle East, and of course, an impeachment inquiry in the US, have both businesses and investors justifiably on edge. This is beginning to appear in some manufacturing data which point to a more cautious business environment. This negativity is offset by a very resilient consumer and a labour market which shows improving wage growth and little signs of weakening.
For investors, this wild rate environment, somewhat a function of global uncertainty, is having outsized impacts. Money is moving into risky asset classes and sectors where investors need to be careful should we see rates reverse direction and climb off historically low levels. A low rate environment encourages risk taking while capital is “cheap”. Performance over the past few years has been pushing into momentum growth stocks, particularly in technology. The valuations on many of these stocks have reached levels that are extremely difficult to justify. “Buying high and selling higher” is a risky proposition and historically has ended badly for many investors.
Other sectors such as real estate, utilities and consumer staples, which pay healthy dividends, have benefitted as well. Investors are treating these securities as “bond proxies” in the absence of better returns from the fixed income asset class. Our concern here would be that utilities and real estate in particular are very sensitive to rates, not just in terms of investor sentiment but also in terms of the value of their real assets which move inversely with rates.
A bubble is always obvious in hindsight but the appearance and timing of said bubbles can be difficult to pinpoint in the present. The impact of ultra-low (and in some cases negative) long term rates will certainly have unintended consequences. Central banks should be, and likely are, wary of this and waiting with bated breath for cooler heads in trade disputes. Another cure for the uncertainty would be a concerted push of fiscal stimulus. Recent weakness in Germany combined with political change there has many believing that this could be the catalyst for a moribund Europe. Meaningful infrastructure investment in North America would also go a long way to improving the world economic outlook.
An 'ounce of prevention' may be worth a pound of cure, but a 'pound of prevention' could equal larger troubles down the road. Not a perfect turn of phrase but all that to say, this ultra low rate environment could create unintended consequences. A small recession now wouldn’t be the worst thing and would allow economies to naturally adjust and continue a positive trajectory. Meanwhile, we will continue our disciplined approach and take profits on companies that have had strong performances, look for opportunities in out of favour sectors and be judicious in terms of re-investing dividends and new cash to portfolios.