National Post (Latest Edition) - Financial Post Magazine - - CONTENTS - by Andy Hol­loway

In­vestors al­ways hear that a slow­down in China or a U.S. Fed­eral Re­serve rate hike will af­fect the Cana­dian mar­ket, but how such macro- eco­nomic events play out is more im­por­tant to un­der­stand.

In­vestors did not have an easy time of it in 2015. From oil’s prices lump de­spite ris­ing and omni present ten­sion sin the Mid­dle East and Rus­sia’s in­va­sion of Ukraine to a pos­si­ble exit by Greece from the eu­ro­zone and tech­ni­cal re­ces­sions in Canada and Ja­pan, stock and bond mar­kets rode wave after wave of volatil­ity and many in­vestors ended up in the red. How bad was it? Cash out per­formed most as­set classes for the first time since the 1990s.

Un­for­tu­nately, 2016 didn’t start off any bet­ter. In the first few trad­ing days of Jan­uary, con­ta­gion from China’s lat­est stock-mar­ket tum­ble swiped out US $4 tril­lion in eq­uity value world­wide. The S&P/ TSX Com­pos­ite In­dex, mean­while, fell into a bear mar­ket, hav­ing dropped 20% since its Septem­ber 2014 high. Fur­ther out on the hori­zon loom as many as four rate hikes by the U.S. Fed­eral Re­serve, con­tin­u­ing its trend to­ward tight er mone­tary pol­icy as the Amer­i­can econ­omy re cov­ers, even if few other economies are show­ing any­thing more than weak signs of life.

“Per­sis­tent weak global growth is in­ten­si­fy­ing ,” says Bruce Cooper, TD As­set Man­age­ment’ s chief in­vest­ment of­fi­cer, chalk­ing that up to ag­ing de­mo­graph­ics in both the de­vel­oped world and China as well as high lev­els of debt, whether that’s gov­ern­ment, cor­po­rate or con­sumer, in many parts of the world. Both fac­tors lead to weaker ag­gre­gate de­mand, which leads to slower eco­nomic growth and, ul­ti­mately, poorer in­vest­ment re­turns—some­thing in­vestors are go­ing to have to get used to un­less some­thing hap­pens to turn things around.

In the mean­time, head­lines scream that one event or an­other will weigh down on port­fo­lios. But that’s a lit­tle sim­plis­tic. “The mar­ket doesn’t tell you why it did some­thing,” says David Kaufman, pres­i­dent of West court Cap­i­tal Corp ., a Toronto-based port­fo­lio man­ager spe­cial­iz­ing in tra­di­tional and al­ter­na­tive in­vest­ment .“One macro af­fects an­other, and the world keeps spin­ning so it makes it dif­fi­cult to fig­ure out things that are af­fected by mul­ti­ple fac­tors.” Nev­er­the­less, he says, more clients are ask­ing him how events in the U.S ., China and other places af­fect their in­vest­ments here at home.

“Much of a port­fo­lio’ s per­for­mance in the long term is driven more by macro-eco­nomic fac­tors and less by stock-spe­cific fac­tors ,” says Pramod Udi­aver, co-founder and CEO of In­vi­sor In­vest­ment Man­age­ment Inc. in Oak vi l le, Ont .“And why? Be­cause the global econ­omy is so well in­te­grated these days, which a lot of peo­ple don’ t re­ally ap­pre­ci­ate when they think about in­vest­ments .”

That lack of ap­pre­ci­a­tion maybe be­cause the ef­fects are not of­ten di­rect ones, and some­times it’s just the per­cep­tion that they should change things. But that doesn’ t make the many less real, and there a num­ber of big macro-eco­nomic fac­tors that have and will con­tinue to play a role .“In­vest­ment se­cu­ri­ties are val­ued based on ex­pected fu­ture per­for­mance, not on how a com­pany is do­ing at a given point in time ,” U di av er adds .“And the fu­ture per­for­mance is largely de­pen­dent on these larger macro fac­tors.” Most of which, for now, seem to be head­winds as op­posed to tail winds.


China, for ex­am­ple, once fuel led the global econ­omy and stock mar­kets, espe­cially in Canada. The Chi­nese econ­omy for years has been in­vest­ment-driven, which re­quires a lot of nat­u­ral re­sources to build. Re­sources

such as oil, wood, potash and many met­als like nickel and cop­per that Cana­dian com­pa­nies sup­ply in abun­dance were needed. But two things in China are oc­cur­ring that make it more of a drag on global growth and, hence, in­vestor port­fo­lios here at home. The coun­try’ s GDP growth is slow­ing from the 8-10% range to 7% or less —and, keep in mind, those are gov­ern­ment num­bers, which may over state ac­tual growth — and it is try­ing to tran­si­tion its econ­omy to one driven by con­sump­tion as op­posed to in­vest­ment .“Clearly, they can’ t sus­tain the 10% growth num­ber and mar­kets need to un­der­stand that and then ad­just our val­u­a­tions ,” U di av er says.

China is the world’ s sec­ond-largest econ­omy, re­spon­si­ble for about 20% of global GDP, and it’ s Canada’ s sec­ond-largest trad­ing part­ner, so any slow­down is go­ing to cause prob­lems. “China is not caus­ing this low-growth world, but with China slow­ing now, it’s ex­ac­er­bat­ing the low-growth world ,” TD’s Cooper says .“It af­fects Cana­di­ans, of course, be­cause China is a big con­sumer of com­modi­ties .” And, as ev­ery­one knows, com­modi­ties are still about 30% of the Toronto Stock Ex­change, although that’ s down quite a bit from just a few short years ago. As China’s growth de­clines, they have less need for oil and other re­sources that Canada pro­duces, which means the prices of those com­modi­ties drops. As a re­sult, there’ s less de­mand for the Cana­dian dol­lar, which also de­pre­ci­ates. Live by the petr o-cur­rency, die by the petro-cur­rency.

An­other com­pli­ca­tion is that even China’s lower-growth pro­file as­sumes that its eco­nomic tran­si­tion goes well, which isn’t a given even in a gov­ern­ment-led econ­omy. State-owned en­ter­prises are a big part of the econ­omy and act in many cases like em­ploy­ment agen­cies, Cooper says. For ex­am­ple, it has many steel com­pa­nies that should closed own since they are high-cost pro­duc­ers in a lower-de­mand en­vi­ron­ment. Clos­ing them makes sense if China re­ally is try­ing to be driven by con­sumer de­sires, but it can’t since it would throw thou­sands out of work and, there­fore, hurt


de­mand for goods and ser­vices.

Kaufman of­fers one caveat: if you think China will grow, and it still is, in­vest­ing in Europe and Canada isn’ t as crazy as it seems now given that these are two of the least-liked mar­kets .“Even if they were to keep growth in-house and have a mas­sive trad­ing deficit, they still need water, they still need potash, they still need oil, all the things that a thriv­ing ur­ban econ­omy re­quires that they don’ t have in their mas­sive ge­og­ra­phy ,” he says.


It would be wel­come news to the oil ind us- try if China does keep grow­ing, even if more mod­est ly. The orig­i­nal rea­son be­hind oil’ s prices lump was ex­cess sup­ply caused by the ex­plo­sion ins hale oil from the U.S. and the ad­di­tion of about one mil­lion bar­rels a day from Iraq last year .“De­mand was pretty good, but not good enough to over­come sup­ply growth ,” Cooper says.

En­ergy com­pa­nies, espe­cially in Canada and the U.S ., re­sponded by slash­ing their cap­i­tal ex­pen­di­ture bud­get sand work forces, which will cur tail pro­duc­tion growth in the com­ing years. That would nor­mally sta­bi­lize prices and even re­verse the down­ward trend, espe­cially since ten­sions are still sim­mer­ing in the Mid­dle East. But Cooper won­ders whether the slump in oil prices that re­newed in late De­cem­ber and con­tin­ued through the first week of Jan­uary was more to do with slow­ing de­mand and less about ex­cess sup­ply. If true, that would pro long the en­ergy in­dus­try’ s agony and that of its in­vestors.

The Cana­dian mar­ket, as men­tioned, has a high and di­rect cor­re­la­tion with en­ergy prices and there is a domino ef­fect on all the re­lated busi­nesses that ser­vice that sec­tor, which in­cludes the banks, per­haps the last big bas­tion of strength on the TSX. “The banks will ex­pe­ri­ence a knock-on ef­fect even though the di­rect af­fect is small,” says Beth Hamil­ton-Keen, chair of the board of gov­er­nor sat CFA In­sti­tute and di­rec­tor of in­vest­ment coun­selling at M aw er In­vest­ment Man­age­ment Ltd. in Toronto .“For ex­am­ple, TD has 1% ex­po­sure to oil and gas lend­ing —but the re­sult­ing job losses and de­faults by in­di­vid­u­als will in­crease that sec­ondary and ter­tiary ef­fects ,” She adds that also means the loonie will stay weak, as will the cur­ren­cies of other coun­tries that are heav­ily tied to oil.

As a re­sult, Cana­dian in­vestor port­fo­lios will con­tinue to be hit. The S&P/TSX60 in­dex, for ex­am­ple, con­sists of quite a few blue-chip com­pa­nies and doesn’ t have a lot of ex­po­sure to oil or other com­modi­ties. If the drop in oil im­pacted only en­ergy com­pa­nies and their in­vestors, the 60 should fare bet­ter. And it has, to a cer­tain ex­tent. The Com­pos­ite in­dex has ac­tu­ally dropped over the past five years, while the 60 is slightly up. But that’s dur­ing what has ar­guably been the great­est bull mar­ket ever .“If you be­lieve this mas­sive bull mar­ket was an in­di­ca­tor of eco­nomic strength in a post-cri­sis world, then you’d have to be­lieve Canada would have done well dur­ing that pe­riod of time ,” Kaufman says. But, as has be­come all too clear, it didn’t.


One econ­omy that has strength­ened dur­ing the post-fi­nan­cial-cri­sis world has been the U.S., some­what aided, of course, by three rounds of quan­ti­ta­tive eas­ing and in­ter­est rates that were slashed to near zero by the U.S. Fed­eral Re­serve. But the Fed, after dither­ing for sev­eral quar­ters, fi­nally raised in­ter­est rates by a quar­ter point in De­cem­ber to 0.5%, sig­nalling its faith that the U.S. econ­omy was on an even keel. Some key data points such as em­ploy­ment, hous­ing and con­sumer spend­ing all in­di­cate a rea­son­ably healthy U.S. “Any in­ter­est rate in­crease is a pos­i­tive thing,” In­vi­sor CEO Udi­aver says. “It’s a good thing for the econ­omy, be­cause rates are only in­creased when there is a longer-term ex­pec­ta­tion that the econ­omy is go­ing to do well .”

It’ s no sur­prise then that the S&P500 has been one of the stronger in­dexes over the past five years, but even that in­dex strug­gled through 2015 and early 2016. That could be be­cause in­vestors be­lieve growth rates will con­tinue to be lower for longer, which should nat­u­rally trans­late into low in­ter­est rates for the fore­see­able fu­ture. The Fed in­di­cated that it ex­pects to raise rates four times dur­ing 2016, while the mar­ket seems to be pric­ing in two. TD’s Cooper, how­ever, is more pes­simistic. He be­lieves the Fed will ei­ther not raise rates at all or be con­tent with one hike. “We think growth is go­ing to be dis­ap­point­ing, and if growth is dis­ap­point­ing, rates are not go­ing to go up,” he says. “And you see that at both the short end, cen­tral bank ad­min­is­tered rates, as well as out the yield curve .” Cooper points out that 10-year Trea­sury yields ac­tu­ally de­clined after the Fed raised rates in De­cem­ber. Why? Be­cause the U.S. econ­omy is oper­at­ing at or near full ca­pac­ity so there’s lit­tle ex­tra growth to be had.

Again, that isn’t good for eq­ui­ties. The link be­tween growth and eq­uity is re­ally through earn­ings. Earn­ings growth in the U.S. has mostly been very good for the past six years, ex­clud­ing 2015, but Cooper ex­pect sit will be pretty tepid from here on. “Part of the rea­son is that with low growth, com­pa­nies are hav­ing trou­ble grow­ing rev­enue and they’ ve al­ready cut costs a lot and mar­gins are close to all-time highs ,” he says. “If your rev­enues aren’ t grow­ing and you’ ve al­ready done all the cost cut­ting you can, you wouldn’ t ex­pect earn­ings to grow much .”

If rates do keep ris­ing in the U.S. —a


rate cut is more likely in Canada—Hamil­ton-Keens ays cer­tain sec­tors such as in­sur­ance should do bet­ter than oth­ers, de­pend­ing on the num­ber and size of those hikes. But, she adds, in­vestors should have a bal­anced port­fo­lio that has bet son both sides of the rate equa­tion as well as bonds for bal­last.

The last hike by the Fed didn’t cause much of a stir, but that’s be­cause it was well-sig­nalled and fac­tored in. “The more im­por­tant thing for in­vestors in Canada will be the trend, the con­sis­tency and mag­ni­tude of rates in the fu­ture ,” Hamil­ton-Keen says. Fur­ther hike sin the U.S. rate could lead to a strength­en­ing green back and an in­di­ca­tion that the U.S. is a safe haven—a po­si­tion oc­cu­pied by Canada dur­ing the fis­cal cri­sis— so in­vestors will flood into the coun­try.

But hik­ing rates also hurts the earn­ings of U.S. com­pa­nies that de­rive a big por­tion of their rev­enues from for­eign coun­tries, espe­cially if their costs are in dol­lars while their rev­enues are in weaker cur­ren­cies. The cost of cap­i­tal also rises. Sim­i­larly, how­ever, Cana­dian com­pa­nies that get the bulk of their rev­enue from the U.S. while their costs are borne at home should do bet­ter. Man­u­fac­tur­ing, for ex­am­ple, should ben­e­fit, though it hasn’ t to this point be­cause other coun­tries’ cur­ren­cies are also de­pre­ci­at­ing again­st­the U.S. dol­lar.

But at the port­fo­lio level, Hamil­ton-Keen notes that any hold­ings in­vestors have in U.S. or international eq­ui­ties prob­a­bly have a dif­fer­ent re­turn pro­file than a home-bi­ased port­fo­lio since cur­rency gains could ac­count for up to two-thirds of re­turns .“Those gains do not nec­es­sar­ily rep­re­sent the un­der­ly­ing profitabil­ity of the com­pany, but the spread dif­fer­en­tial, which can be ahead wind if you have a port­fo­lio heav­ily weighted in Cana­dian eq­ui­ties ,” she says.

All of which is why in­vestors pay so much at­ten­tion to any hints of what the Fed and other cen­tral banks might do. The im­pact of their ac­tion son in­vestor port­fo­lios, as Hamil ton-Keen sug­gests, may “well be blown out of pro­por­tion ,” but the per­cep­tion of macro-eco­nomic events can have just as strong ef­fect on mar­kets as re­al­ity can. At some point, in­vestors may re­al­ize that all the zero in­ter­est rate poli­cies and tril­lions spent on quan­ti­ta­tive eas­ing haven’t done a whole lot to spur growth in any case. “Growth is still kind of crappy ,” Cooper points out .“One risk is that the mar­ket loses con­fi­dence in cen­tral banks’ abil­i­ties to en­gi­neer a re­cov­ery .”


Un­like the U.S ., Canada’ s cen­tral bank has not taken more rate cuts off the ta­ble. The econ­omy flirted with re­ces­sion in 2015 and re­mains weak, while the dol­lar has dropped 15% over the past year or so, which isn’t sur­pris­ing when you con­sider the over hang from com­modi­ties and nat­u­ral re­sources. “A slight in­crease in U.S. in­ter­est rates might weaken the Cana­dian dol­lar a lit­tle bit, but how much more is a big ques­tion ,” U di av er says .“We think it will float around the cur­rent lev­els for a bit. We will prob­a­bly not see a ma­jor change in in­ter­est rates. We might ac­tu­ally see a fur­ther re­duc­tion or neg­a­tive rates as the Bank of Canada gov­er­nor has in­di­cated .”

Of course, the BoC’s of­fi­cial rate is only 0.5% after it cut rates twice last year, so it doesn’t have much room left. It also in­di­cated in Jan­uary that it was con­tent for the Cana­dian dol­lar to re­main weak. That may be good for some, but it doesn’ t ex­actly es­tab­lish con­fi­dence that the econ­omy has a chance of re­bound­ing this year, and some ar­eas and sec­tors are al­ready suf­fer­ing.

Hous­ing, for ex­am­ple, is weak­en­ing in Al­berta, but it’ s strong in Toronto and Van­cou­ver, where de­mand re­mains strong and there are space con­straints. Any at­tempt to cool off the lat­ter two mar­kets would al­most cer­tainly mean dis­as­ter for strug­gling mar­kets like Al­berta’s, although the fed­eral gov­ern­ment has made some steps in the past few years to rein the mar­ket. But it’s mort­gage rates that re­main key and, de­spite the Bank of Canada’s po­si­tion on rates, RBC raised some of its rates in Jan­uary. For ex­am­ple, the five-year fixed rate rose to 3.04% from 2.94%. Is that enough to tip the scales? Prob­a­bly not, even if all the other fi­nan­cial in­sti­tu­tions fol­low suit. But a rate change of some sig­nif­i­cance over­time could be the trig­ger for some hous­ing mar­ket pain.

“A col­lapse in hous­ing comes from des­per­a­tion so what’s that des­per­a­tion go­ing to look like? It’ s go­ing to comes from ei­ther rates go­ing up and there­fore peo­ple can’ t af­ford their mort­gages, and when do you get to the point where they walk away ,” Ha mil­ton-Keen says .“Other fac­tors could be the ceas­ing of lend­ing, weak eco­nomic po­si­tion .” There is, how­ever, a sav­ing grace: for­eign in­vestors con­tinue top low money into this coun­try’ s real es­tate.

An­other pos­i­tive for in­vestors is that many be­lieve val­u­a­tions are some­where in the range off air, so in­vestors should be able to ride out the ex­pected bouts of volatil­ity if they can tune out some of the noise, pick high-qual­ity com­pa­nies with strong bal­ance sheets and cash flows, along with some ex­po­sure to the U.S. dol­lar through ei­ther eq­ui­ties or bonds, and some fixed in­come.

“We tell our clients that these are walls of worry and walls of worry are of­ten good for mar­kets, be­cause there is a lot of cau­tion be­ing ex­er­cised by in­vestors ,” U di av er says. “But from the past, we know that mar­kets of­ten climb these walls of worry. What’ s not good for the mar­ket is a state of eu­pho­ria and we don’t think we are any­where near close to that.”

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