2014 continues to provide strong returns for both bond and stock investors. At the start of the year, most investors expected low returns from bonds. However, the broad bond market is up almost 5% this year, and long bond portfolios are up over 9%. Alongside these impressive returns, our Canadian Equity and U.S. Equity Funds are both up very strongly as well. How is it that both asset classes are returning such positive returns at the same time?
The bond market has been re-assessing the timing and speed of interest rate increases after becoming too concerned in the summer of 2013 that the Federal Reserve (“the Fed”) would move quickly to raise rates once its quantitative easing program is finished. This caused a sell-off in bonds last year and a sharp rise in yields, which has proven to be premature. The economy has continued to improve, and interest rate increases are inevitable, but there is little concern about increasing inflation at the present time. Rate increases will be slow and gradual, and low short term rates are again anchoring lower bond yields. This has been positive news for stocks, which are relatively more attractive alongside very low bond yields, and as a result price-to-earnings multiples have expanded this year.
In the second quarter, emerging markets rebounded and led the developed markets globally, which in turn provided a boost for the Energy and Materials sectors in Canada. As a result, Canadian stocks continued to rise in the second quarter, with the TSX Composite Index again delivering returns above 6%, matching the return earned in the first quarter. U.S. and International stocks provided a more modest, albeit slightly positive return. Since the start of the year, our U.S. Equity Fund continued to outperform the market, returning 9.6% after fees and expenses, which has been the strongest source of value added for our balanced portfolios thus far in 2014.
As discussed earlier, bond yields continued their move lower in the second quarter, reversing the increase in 2013 and giving the bond market significant capital gains year to date. We expect bond yields to stay in a fairly narrow trading range until the Federal Reserve gets closer to increasing interest rates. We continue to plan for the first move towards higher rates to occur in the second half of 2015. While most economic forecasters are expecting the overall economy to grow in the 3- 3.5% range over the next 12 months, our base case expectation is more cautious at 2-2.5%. Higher levels of growth would require a significant increase in new homes sales and capital expenditures from current levels. Any disappointment in growth over the next 12 months would most likely put downward pressure on bond yields to the lower end of their current trading range. The additional yield of corporate bonds over government bonds has continued to decline. We would not be surprised to see this trend continue until short term interest rates return to more normal levels.
While we still expect returns for our stocks to exceed bond returns by a healthy 4-5% margin over the next few years, both asset classes offer somewhat compressed returns due to higher valuations since the beginning of the year. Unlike the last several years, the earnings yield on stocks is no longer highly compelling relative to the yield offered on corporate bonds, which justifies only a modest overweight to stocks. In our Balanced Fund, we have taken opportunities to trim our overweighting in stocks slightly, taking some profits over the last six months.
Canadian Equity Fund
The Canadian stock market has enjoyed healthy returns over the past several years. However, it is worth noting that on June 18, 2014, the TSX Composite Price Index finally regained its previous record close set six years earlier in June 2008. So despite the prevailing sentiment that the current bull market might be long in the tooth, the reality is that we have only just recovered from the market decline of 2008 and 2009.
The TSX Composite Index continued its strong performance in the second quarter of 2014, rising 6.4%. Global equity market performance was also generally robust, as investors gained confidence in the U.S. economy and a European recovery, while fears of an emerging markets meltdown faded. Faced with very low interest rates and supportive economic news, investors continued to view equity assets as attractive and pushed prices higher.
Our Canadian Equity Fund delivered a solid performance in the second quarter, gaining 5.6% after fees and expenses. Continuing from their strong first quarter, oil and gas stocks led the way with large gains from several holdings including NuVista Energy (TSX:NVA) and Cardinal Energy (TSX:CJ). A new addition to our Fund, PrairieSky Royalty Ltd. (TSX:PSK), topped the list of individual stock performers, gaining 39% from the company’s initial public offering (“IPO”) at the end of May. For the Energy sector overall, however, stock selection was a slight drag on performance in the second quarter.
Stock selection also hurt performance in the Industrials and Consumer Discretionary sectors, as Finning International (TSX:FTT), Hudson’s Bay (TSX:HBC) and Bombardier Recreational Products (TSX:DOO) declined in otherwise strong sectors. While less of a factor than in many recent quarters, gold stocks, of which you own none, generally outperformed the base metals, fertilizer and lumber stocks in your portfolio.
Having no Health Care or Telecommunications companies helped relative performance, as those groups were the worst performers amongst the TSX sectors. Finally, Saputo’s () strong performance in the otherwise weak Consumer Staples sector added significantly to performance.
In summary, Our Canadian Equity Fund has enjoyed a strong first half of 2014. Despite this performance, we believe that prospective returns remain attractive over a three-year investment time horizon.
