The first quarter provided very attractive returns for investors, as balanced funds performed well. The Canadian stock market led the way with a 6% return as the Materials sector rebounded from a weak 2013. The S&P500, in Canadian dollars, almost matched the S&P/TSX Composite with a return of 5.8% and the EAFE index, in Canadian dollars, was not far behind returning 4.6%. Bond yields retraced some of their 2013 increases in January, giving bond investors close to 3% returns for the quarter.
Over the past 12 months, bond markets have primarily been driven by expectations for the anticipated path towards interest rate normalization. On March 19, new Federal Reserve Bank chair Janet Yellen provided further clarity as to how that path could evolve. Her comments indicated that the current bond purchase program should end sometime this Fall. This was somewhat earlier than previous expectations that the program would end closer to December. In addition, during the press conference she explained that a reasonable expectation for the gap between the end of bond buying and the beginning of interest rate hikes should be approximately six months.
So where do we go from here? Assuming the Federal Reserve begins to hike interest rates in mid- 2015, we would expect this tightening cycle to be somewhat slower and end at a somewhat lower level than previous tightening cycles. The U.S. economy continues to struggle from the residual impact of debt deleveraging and labour market conditions that point to the challenges from having people unemployed for a long time and part time workers becoming more prevalent. With inflation remaining low, we expect a normal level of short term rates should be 3% and that this normalization process could take as long as three years.
In terms of bond markets, the most likely scenario will be a gradual increase in rates, but with longer term interest rates increasing much less than shorter term interest rates. Despite a gradual improvement in the economy, we do not expect to be in the position where borrowers can withstand a significant increase to the real cost of funds. In addition, the net borrowing of the U.S. government will have declined to the point that we expect the reduced bond buying by the Fed will be more than offset by purchases from households and foreigners.
In an environment of interest rate normalization, we expect stock markets to perform reasonably well. That being said, an environment of increasing interest rates will most likely put pressure on price earnings multiples for some companies, especially those that have been valued as “fixed income surrogates”. Our main strength when managing equities for our clients is stock-picking, rather than forecasting the broad markets, and we continue to evaluate each company on its own merits. In some markets, such as the United States, we have found it more challenging to find as many bargain companies, but overall we continue to find value and believe it will become more of a stock picker’s market.
Many of the investments in our U.S. Equity Fund are best-in-class companies with long established records of industry leading performance. In our view, the portfolio is well positioned for the inevitable economic and stock market vacillations to come and we view the portfolio risk as modest. Notably, in the last couple of weeks several high profile equities, such as Facebook (FB), Tesla (TSLA), LinkedIn (LNKD) and Amazon (AMZN) sold off sharply. We have no idea as to whether or not this will continue, but it is important to recognize that we do not own such names, either due to unestablished business performance or lofty valuations.
Our Canadian Equity Fund is similarly well positioned, with companies trading at valuations that we believe understate their true prospects. For example, Aimia (TSX:AIM), the brand loyalty business that runs Aeroplan, is a company whose value is not fully appreciated by the market today. The program has been reset and enhanced, two key credit card partners are in place, and risks have been reduced due to a more solid “runway” going forward with Air Canada.
We believe a balanced approach will continue to be rewarding for long-term investors.
Canadian Equity Fund
The TSX Composite Index began 2014 positively, rising 6.1% during the first quarter. Global equity market performances were mixed, with improving economic data out of the U.S. and Europe offset by weaker than expected growth in emerging markets and uncertainties surrounding the political state of affairs in Russia/Ukraine. Despite these market concerns, markets continue to move in a positive direction.
Our Canadian Equity Fund delivered a solid performance in the first quarter, gaining 6.0% after fees and expenses. While the performance was broadly based, with 25% of the companies in the portfolio gaining more than 10% in the quarter, stock selection in the Energy sector was particularly strong.
In terms of sector exposures, our Fund’s underweight position in the Telecommunications sector and overweight position in the Utilities sector helped relative performance in the quarter. Conversely, our fund’s overweight position in Industrials and underweight position in the Materials sector hurt performance. Our Canadian Equity Fund’s lack of exposure to gold stocks hurt performance in the first quarter, as the TSX Gold & Precious Metals sub-index rose 13.3% on a sharp bounce in gold bullion prices. After an abysmal performance in 2013, a relief rally in gold could have been expected, but we continue to believe that gold stocks are expensive and find better value elsewhere in our investment universe.
In summary, our Canadian Equity Fund had a good start to 2014. Despite its strong performance in 2013, we believe that returns from our fund should outpace fixed income alternatives over a three year investment time horizon.