Entries from July 2017 ↓

Overrated

DOUG By Guest Blogger Doug Rowat

Avoid home-country bias. This has become the now familiar and constantly repeated refrain of Canadian portfolio managers, especially after the oil shocks of 2014 and 2015. The continuous warning: don’t overweight Canada, fear our market and be aware of all its dangerous shortcomings. And we’ve all seen THE stat: Canadian equities make up only 4% of the world’s market cap. And the argument: our market is concentrated and overly dependent on commodities.

So, it’s become the ultimate blasphemy for a portfolio manager to take a heavily overweighted position to Canadian equities, prompting finger wags and harsh reprimands. Take none other than investment giant JP Morgan, which argues that investors “suffer” from home-country bias, never acknowledging that they may actually benefit. Frequently, the experts also cite the crippling fear of investing globally as the source of the bias.

Well, we don’t live in fear. In fact, we actually maintain a global portfolio for our clients with about two-thirds of our equity weighting focused outside Canada. (Hey, we get global investing—we even know what EAFE stands for.) However, most of our client portfolios still have a 21% weighting to Canadian equities—many, many times Canada’s meagre weighting on the global equity-market stage. But we don’t believe our clients are “suffering” because of this. Yet we still feel the judgmental eye of all the portfolio managers who have accepted the home-country-bias argument as gospel. How dare these cowboys at Turner Investments adopt such a reckless Canadian equity overweight?

Well, we dare. And here’s why:

1. There’s no compelling evidence suggesting that Canadian equities are any more volatile than global equities. Looking at standard deviation, a measure of risk, Canadian equities have been about equal in volatility to global stocks throughout most periods including the financial crisis. In fact, overall, their volatility has been slightly lower.

Standard Deviation: Canadian Equities no more Volatile than Global Equities

Source: Bloomberg. Chart measures 6-month rolling standard of the S&P/TSX Composite and the MSCI World Index. Standard deviation measures the amount of variation or dispersion within a particular index or security. In other words, it measures risk.

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2. We use a capped Canadian market ETF, so we significantly reduce concentration risk. Recall that Nortel reached a peak of 35% of the Canadian market back in 2000. Such a dominant—and risky—weighting doesn’t occur with a capped ETF.

4. Holding Canada at roughly one third of our equity weighting is still significantly lower than the average Canadian investor. According to Morningstar data, the typical Canadian investor weights almost two-thirds of their equities towards Canada. THAT is a substantial wager.

5. Currency is simplified. Most Canadians, naturally, utilize Canadian dollars, so holding Canadian equities in Canadian dollars is practical and reduces currency risk. Forecasting markets is hard enough, never mind currency direction. There are also tax benefits to holding Canadian equities such as the dividend tax credit.

6. We’re active portfolio managers. We get paid to overweight areas that we favour and underweight areas that we don’t. Right now we like Canada.

And there’s a lot to like. We recognize that the Canadian market has underperformed this year, but we have renewed confidence in our economy. Our annualized GDP growth rate is well above 3%, eclipsing virtually all other developed nations. And our impressive growth has not gone unnoticed: the IMF earlier this week stated that it expects Canada’s GDP growth rate this year to outstrip all other G7 nations. Our banks are enormously profitable and consistently raising dividends. The US economy is doing well and the US is, of course, our largest trading partner. And finally, our market valuations are reasonable with Canada trading at a meaningful discount to the US.

The S&P/TSX Composite was the only major stock market in the world that failed to advance in the first six months of 2017. We view this as an anomaly given our brighter economic outlook and the impressive profitability of the Canadian banks—the largest component of our market. We think a ‘catch up’ trade is possible in the second half.

There is some merit to the home-country-bias argument. We don’t, after all, want to sacrifice diversification simply to wave the flag. We’re also not blind to the fact that the energy sector hasn’t exactly been shooting the lights out. But all the anxiety that’s been layered on Canadian investors if they dare to have a portfolio with more than a 4% weighting to Canada is ridiculous.

We have a great country. Invest in it.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.

What now?

Six months ago nobody thought Canada would raise rates in 2017. Six weeks ago nobody expected rates could rise twice by the end of the year. But one prime rate hike, two rounds of mortgage increases, one Bank of Canada move and a boffo economic report later, here we are.

Current market odds of a second rate hike – in October – are running close to 80%. And, shockingly, there’s now a four-in-ten chance they could be jacked one more time before this pivotal year is out. The very thought of this was enough to send the dollar skidding higher by most of a cent, over the eighty mark.

And, wow, look at Mr. Bond…

The yield on five-year Canada bonds – the benchmark used for pricing fixed-rate mortgages – is in heat. From a low of half a point a year ago (when the geniuses here said rates could never rise), it has risen by more than 300%, and is likely on its way higher. This means you can pretty much count on more hikes in mortgage rates, which are already closing in on 3% and may well be 4% by next summer.

What happened?

The big news Friday was the economy. After being in a funk last year, the GDP’s gone ballistic. It’s growing at the fastest rate in 17 years – since way back when people were lining up to buy Nortel and busy creating Millennials. The 4.6% growth rate in May wipes the floor with the 1.2% rate of US expansion. This is the seventh month in a row the economy has swelled, which is the best stretch in seven years. Combine that with better job and trade stats, and the mighty Land of the Beaver rocks.

Of course, not everything is cool. While oil, manufacturing and retailing were romping, housing was limping. Real estate and rental leasing fell for the first time in six months and the activity of real estate agents plunged 6.3%.

This is consistent with the fading street price of housing that this pathetic blog has been detailing with gruesome, horrifying yet addictive regularity lately. The official price of a detached home may have fallen in the GTA by about 16% since April, but that’s not taking into account the vast number of transactions which aren’t closing in a domino game of crashed deals. Stats in the months to come will show what agents are seeing daily.

Like Uri Kogan. His weekly report on sales and listings in a demand area of north Toronto is a snapshot of seller despair. There are 76 active listings in his area of focus (Steeles/Centre/Yonge/Dufferin) and last week there were 0 sales. Zero. The most recent accepted offer was made 20 days ago. Prior to that, only five houses sold in July. This is how a serious price correction starts – when buyers lose their motivation and simply disappear.

Well, a better economy’s a good thing, of course. I told you a couple of months back to tactically increase your Canadian portfolio weighting. Now you know why. You were also advised a year ago to pick up preferred shares when they were, like me, cheap and irresistible. Because these give a great dividend and also rise right along with interest rates, prefs have jumped about 15% in value in a year while paying you cash flow to own them. How sweet is that?

But robust growth for Canada will also guarantee a little more inflation and consistently rising interest rates. The bank prime of 2.95% will certainly be 3.2% and possibly almost 3.5% by year’s end. Secured HELOCs will rise to the 3.5% level. Fixed-rate, five-year mortgages will be similarly prised, putting them a full point higher than a year ago. Yeah, money’s still cheap, but every day more people wake up to the understanding (a) we will never again see 2% loans and (b) Justin can’t save you.

Things to do next week: lock up your variable rate mortgage. Get some preferreds. Drop your selling price. Start a neighbourhood realtor support group. Adopt a dog. You may need someone to lick you this winter.