The first quarter of 2015 delivered strong returns for investors across all asset classes. While returns to Canadian equity markets were relatively modest, U.S. and international equity returns were high. In addition, bond markets continued to rally as Canadian bonds were boosted by both the Bank of Canada’s January interest rate cut and the start of quantitative easing – printing money and buying bonds – by the European Central Bank.
The strength of global markets remains largely attributable to the exceptional monetary stimulus provided by global central banks. The first quarter of 2015 was no exception, with the Bank of Canada joining many other central banks in easing monetary policy. However, it was the European Central Bank’s commencement of sovereign asset purchases that arguably had the most significant impact on global capital markets.
Against this backdrop of easing financial conditions and rallying asset prices, the outlook for the global economy over the course of the first quarter developed in a more balanced fashion. The stimulus provided in Europe and the weaker Euro is clearly having a positive impact on consumer confidence and consumption data, most notably in Germany. Global economic surveys are suggesting a synchronized global recovery may be developing. Finally, forward-looking indicators for the U.S. housing market suggest that the recent strength in the sector is accelerating further.
On the other hand, a stronger U.S. Dollar is starting to impact the foreign earnings of multinational U.S. corporations and will likely also have an adverse impact on the trade component of U.S. growth. Other U.S. data, particularly in the manufacturing sector, has also started to moderate somewhat from previously solid levels. Although, it is important to note that this moderation is partly attributable to adverse weather and disruptions to port activity caused by labour disputes. The tempering of U.S. growth, combined with declining inflation as a result of lower energy prices, has also delayed expectations for the start of U.S. interest rate hikes.
Despite these revisions, the U.S. Federal Reserve is still expected to diverge from global monetary policy by raising interest rates in 2015. The impact of divergent central bank policies can most clearly be evidenced in currency markets. The trade-weighted U.S. Dollar appreciated a further 8% during the quarter and 9% against the Canadian Dollar alone. U.S. Dollar strength, in turn, has helped push commodity prices even lower (most notably a further 10% decline in WTI oil prices).
Further abroad, the growth outlook in several Emerging Market countries remains weak, with a risk of recession in Russia and Brazil. Chinese policymakers have acknowledged the slowing growth outlook in their economy, prompting several additional stimulus announcements. Finally, the ongoing risks concerning a potential Greek exit from the European Union and the Euro have the potential to be a major source of market volatility over the coming months.
We continue to be cautious on the outlook for the Canadian economy given the decline in energy prices. The importance of energy capital expenditure (“capex”) to the Canadian economy has risen materially over the past decade and now accounts for 34% of all private non-housing capex in Canada. The reduction in energy capex is likely to have an immediate impact on household income and growth. In contrast, the offsetting benefits resulting from a weaker Canadian Dollar are expected to take significantly longer to materialize as a result of both the declining manufacturing base in Canada and the elevated unit labour costs relative to
Canada’s export competitors. We have already noted negative economic growth in January, and other activity indicators (retail sales, wholesales trade sales, manufacturing) point to continued weakness for the remainder of the quarter. The weakness in retail sales is most pronounced in the oil-producing provinces of Alberta and Saskatchewan.
Looking forward, we remain optimistic that the U.S. economy and their consumers will rebound from a sluggish first quarter, which will provide a further source of growth for the global economy, including Canada. However, we recognize that weaker U.S. data and softening global inflation means that the timing of monetary tightening is now likely to be later in 2015. We also continue to believe that the pace of interest rates hikes will be modest and slower than prior tightening cycles. We expect the Federal Reserve will raise rates at a slightly faster pace than the market is currently anticipating, however. The anticipation of U.S. monetary policy tightening is also likely to be a source of heightened market volatility this year.
The positive news for investors, currently, is that this type of environment creates opportunities in the stock market for long term, patient investors, and we continue to use our bottom-up approach to uncover value opportunities for both equities and bonds in our funds. As energy prices weakened, we added to our favourite names in the quarter which were trading at very attractive valuations. Our expected three year returns for the equities in our clients’ portfolios remain significantly higher than the returns we expect from fixed income, which is reflected in the asset mix of our Balanced Fund.
Canadian Equity Fund
The first three months of 2015 were very similar to the last three months of 2014. Concern about the fallout from lower oil prices and its detrimental effect on the domestic economy negatively affected both companies and individuals. The Bank of Canada, anxious about the doom and gloom psychology that was becoming pervasive, cut interest rates in January to provide some “insurance” against the downside of weakening economic activity.
As a consequence, the TSX Composite Index did not increase as much as other global stock markets in the first quarter but did generate a respectable 2.6% return, boosted again by Health Care (+46%), Information Technology (+8.7%) and Consumer Discretionary (+6.1%) stocks. Our Canadian Equity Fund posted a 0.7% gain after fees and expenses. Stocks that added to performance included Constellation Software (+27.1%), Agrium (+21.9%) and Raging River Exploration (+21.4%).
There were three factors that contributed to our underperformance in the quarter. First, our investment position in Financial Services stocks, particularly banks, was hit hard by concerns about slowing profitability. While earnings growth has slowed, the current sell-off is excessive in our view. The second factor is our position in Materials stocks (Capstone Mining Corp: -40.4%, and Labrador Iron Ore: -26.1%), which fell in price due to concerns about the global economy’s growth path. From a market sentiment perspective, the negativity surrounding base metals is overly bearish. Even a slight improvement in the global economy will translate to higher equity prices. Finally, our lack of exposure to Health Care stocks, in particular Valeant Pharmaceuticals, has also been a drag on our results. Valeant has employed an aggressive, levered acquisition strategy that is enhanced by its tax advantaged structure and is benefiting from the current low interest rate environment. Based on our meetings with management, we are not comfortable with the amount of debt, the rapid pace of acquisitions, and the significant underinvestment in the company’s assets.
We continue to believe that the seeds are being sown for a global economic recovery, which should benefit the Canadian Equity Fund. We remain confident our value-oriented approach to stock selection will lead to attractive returns over a three year out time frame.
Canadian Dividend Fund
The Canadian Dividend Fund advanced by 0.6% after fees and expenses during the first quarter of 2015. Similar to the Canadian Equity Fund, our underweight position in a weak Energy sector helped performance while lack of exposure to Health Care (i.e. Valeant) hurt performance. Stocks that added to performance included Constellation Software, Superior Plus and Brookfield Infrastructure. Stocks that detracted from performance included Labrador Iron Ore, Canadian Western Bank and Bird Construction.
U.S. Equity Fund
The U.S. Equity Fund increased by 8.4% in the first quarter after fees and expenses compared to the S&P 500 return of 10.4%. Companies that helped Fund performance included Gannett (GCI, Financial), Markel (MKL, Financial), Pfizer (PFE, Financial), Carnival (CCL, Financial) and Wells Fargo (WFC, Financial). Companies that detracted from performance during the quarter included Tidewater, Mattel, American Express, Intel and Microsoft.
The strength of the U.S. Dollar was a helpful tailwind in the quarter. In local currency, the U.S. market was up 1.0%; however, a strong U.S. Dollar increased returns in Canadian Dollars by over 9%. The first quarter of 2015 continues a very robust run for the U.S. market. We have two primary messages this quarter: 1) following a nearly 200% rebound since the Financial Crisis, U.S. equity valuations are becoming expensive; and, 2) the U.S. Equity Fund continues to be managed utilizing the same time-tested value approach, emphasizing careful due diligence, a margin of safety and patience.
Although the U.S. economy has outperformed other developed markets over the past few years, the degree of improvement continues to be tepid by historical standards, with mixed economic data. Pockets of strength (found within declining unemployment, resurging new car demand and record corporate profits) contrast other factors, including a lack of meaningful improvement in wages and the negative impact a stronger U.S. Dollar will have on certain U.S. companies with foreign operations. Further, unprecedented monetary influence from the Federal Reserve has had a debatable impact on the U.S. economy. Interest rates are near all-time lows, yet GDP growth has been modest. Remarkably, for the past six years U.S. equity returns have been seemingly impervious to bad news of any sort. The S&P’s last 10% correction (in U.S. Dollars) occurred in the fall of 2011.
The one notable exception to the increasingly, limited opportunity set south of the border is within the Energy sector. In our view, this is the one truly inexpensive part of the U.S. market. The U.S. Equity Fund owns a collection of quality Energy-related companies that possess good long term records, market leadership and prudent balance sheets. Given the recent 50% decline in the price of oil, energy stocks have been under pressure. Energy companies are being valued near historically low levels in a market environment where many stocks are valued closer to historical highs.
As is often the case in investing, important things can be counterintuitive. During the panic conditions of the Financial Crisis, excellent investment opportunities arose and future risk/reward opportunities were very attractive. Today, following six years of outstanding equity performance, valuations have risen sharply in many areas of the U.S. stock market, and consequently future risk/return conditions are far less favorable. Heightened overall valuations suggest that risk is an increasingly important investment consideration in U.S. equities. In this regard, we believe the U.S. Equity Fund has meaningfully lower risk than the S&P 500 benchmark.
International Equity Plus Fund
International Equity Plus Fund advanced by 12.4% after fees and expenses during the first quarter while the MSCI EAFE Index returned a strong 14.7%. Sectors that helped performance included Health Care (special pharmaceutical companies Actavis (ACT, Financial) and Novo Nordisk (NVO, Financial) were top contributors) and Telecommunications (led by China Mobile) (CHL, Financial). Stocks in the Consumer Discretionary sector (Kroton Educacional and Galaxy Entertainment) and the Energy sector (Encana) detracted from performance.
We continue to see strong franchises with excellent prospects trading at attractive prices and are seeing opportunities internationally in Europe, Japan, China and select emerging markets including India.
The country weightings of the International Equity Plus Fund at March 31, 2015 were:
Balanced Fund
The Balanced Fund advanced by 5.0% in the first quarter of 2015 after fees and expenses. The asset mix for the Fund at March 31, 2015 was:
Unrestricted Diversified Fund
The Unrestricted Diversified Fund advanced by 4.8% in the fourth quarter of 2014 after fees and expenses. The asset mix for the Fund at March 31, 2015 was:
Income Advantage Fund
The Income Advantage Fund advanced by 1.9% after fees and expenses in the first quarter of 2015. The fixed income portion of the fund had a strong quarter with a gain of 3.3%, mostly as a result of the surprise Bank of Canada cut in the overnight rate in January. The Fund also benefitted from the addition of some select high yield issues during the quarter as the difference in yields between corporate and government bonds increased.
Preferred shares continued to be under pressure this quarter. We have thought that preferred shares had been expensive for the past year and have been positioned defensively in both the issues and the total amount of preferred shares we hold. This leaves us well prepared to take advantage of the current selloff and we expect to start adding to our holdings in the coming period.
The Dividend component of the Income Advantage Fund held through units of the Canadian Dividend Fund increased slightly during the quarter.
Fixed Income Fund
Global fixed income markets rallied in the first quarter of 2015. The ongoing decline in global bond yields was largely a function of downward pressure on inflation as a result of lower energy prices and continued easing in monetary policy. Canadian fixed income was a notable outperformer compared with most other global bond markets. The outperformance of Canadian bonds, particularly shorter-dated maturities, was the consequence of the largely unexpected reduction in the Bank of Canada’s policy rate in January.
The Fixed Income Fund advanced by 3.9% after fees and expenses during the quarter, lagging the FTSE TMX Canada Universe Bond Index in the quarter which advanced b 4.2%. This was primarily due to the Fund’s higher exposure to shorter term bonds than the market during a period of declining interest rates.
Our central thesis is that the Fed will start raising policy rates in the second half of 2015. We also continue to believe that the pace by which interest rates rise will be highly dependent on the economic data going forward, with a heightened probability of a more modest trajectory than in prior tightening cycles. However, we continue to believe that the pace of rate hikes will be faster than the market is currently anticipating.
We expect the Bank of Canada to ease monetary policy further in 2015, most likely by a further 0.25% reduction in the Overnight Lending Rate. This additional easing is already reflected in Canadian interest rate markets for the end of 2015. Our expectation is that declining energy prices will continue to impact the Canadian economy for several quarters, with the subsequent pace of economic growth likely to remain modest due to the longer-term structural effects of a weak manufacturing base, competitiveness issues and risks arising from household indebtedness.
The difference between corporate bond and government bond yields was mostly unchanged over the quarter, with little differences between corporate sectors. We remain overweight corporate bonds primarily through our overweight exposure to AA-rated senior bank debt. We also remain underweight the telecommunications and retail sectors, two areas where we see less attractive risk-adjusted return opportunities.
Provincial bonds outperformed all other sectors of the bond market in the quarter, with the mid-term provincials returning 4.51%; this compares to 3.97% for mid-term federal bonds and 4.23% for mid-term corporates. The Fixed Income Fund benefited from holding more provincial bonds concentrated in longer-dated maturities than the market generally. By province, the Fund remains overweight Ontario and underweight Quebec, with relatively neutral exposures to other provincial debt. We continue to prefer Ontario to other provinces, as we think Ontario is making progress towards balancing its budget by 2017/2018, and the valuation of Ontario bonds relative to other provinces is attractive at current levels. In addition, we expect Ontario will benefit from the drop in gas prices and the weaker Canadian Dollar, while these factors will be a drag on other provinces.
We think that the downside risks to the Canadian economy have risen during the first quarter of 2015. This is the result of a combination of weak energy prices starting to reverberate through the Canadian economy and a slowdown in the pace of the U.S. economic recovery in some sectors.
Our view going forward is that the normalization of monetary policy in the United States will put upward pressure on yields during the remainder of 2015. However, we continue to maintain a modest short-duration position overall given our expectation that Canadian yields will not come under the same pressure due to headwinds from the Canadian economy.
We continue to see value in high quality corporate bonds at current levels. However, we believe that diligent credit analysis will be crucial over the next year to avoid potential credit pitfalls, as some companies seek to increase leverage to capitalize on this ultra-low interest rate environment.
We expect fixed income returns during the remainder of the year to be more modest than in the first quarter of 2015. Bond markets went through a significant re-pricing to reflect the unanticipated January rate cut by the Bank of Canada, combined with expectations for additional easing. Furthermore, our expectations for additional easing from the Bank of Canada are already largely priced into interest rate markets. In addition, 10-year yields on Canadian government bonds are already at 1.30%, limiting the opportunity of further significant capital gains.
Changes to TFSA limits and RRIF payments
Changes to the TFSA contribution limits and RRIF withdrawal schedule were announced in the recent Federal budget. Canadians are now allowed to contribute an additional $4,500 to their TFSA accounts in 2015 for a total of $10,000. RRIF minimum payments have also been reduced so clients don’t have to withdraw as much each year going forward, beginning this year. If you have already withdrawn the higher minimum amount, you will be allowed to re-contribute the difference back into your RRIF if you wish. If you have not taken your full minimum RRIF payment for 2015, you can adjust the amount taken. Please contact us for more information.
Questions about your portfolio?
If you have questions about your Leith Wheeler portfolio, funds or services, please contact your Portfolio Manager or Karey Irwin at 604-683-3391 or 1-888-292-1122.
FORWARD-LOOKING STATEMENTS
This report may contain forward-looking statements about the Leith Wheeler Funds. Forward-looking statements include statements that predict future events, conditions or results - including strategy, expected performance or prospects, opportunities, risks and possible future actions. Forward-looking statements are based on current expectations and projections about future events and are inherently subject to risks, uncertainties and assumptions about the Funds and economic factors.
Forward-looking statements are not guarantees of future performance, and actual events and results could differ materially from those expressed or implied in the forward-looking statements. These statements require us to make assumptions and are subject to inherent risks and uncertainties. Our predictions and other forward-looking statements may not prove to be accurate, or a number of factors could cause actual events, results, performance, etc. to differ materially from the targets, expectations, estimates or intentions. These factors could include, among others, market and general economic conditions, interest rates, regulation, competition and the risks set out in the Funds’ Simplified Prospectus. Do not place undue reliance on our forward-looking statements. Please note the Funds have no intention of updating any forward-looking statements, whether as a result of new information, future events or otherwise.
Leith Wheeler Investment Counsel Ltd. is the manager and primary investment advisor for the Leith Wheeler Mutual Funds. Leith Wheeler Investment Funds Ltd. is the principal distributor of the Leith Wheeler Mutual Funds. Leith Wheeler Mutual Funds are also distributed through authorized dealers. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed or covered by the Canada Deposit Insurance Corporation, Leith Wheeler, or any other deposit insurer. Fund values change frequently and past performances may not be repeated. The unit value of money market funds may not remain constant.
Additional information about the Leith Wheeler Funds is available in the Funds’ Annual Information Form, Fund Facts, Management Report of Fund Performance and financial statements. You can get a copy of the Simplified Prospectus, and the other documents, at no cost by calling 1-866-292-1122, on our website at http://www.leithwheeler.com or by contacting your dealer. These documents and other information about the Funds, such as information circulars and material contracts, are available at www.sedar.com.
