Global capital markets responded to a series of positive developments during the quarter that suggest we are in the midst of a synchronized global economic recovery. Global economic growth during the third quarter was the strongest since mid-2010, and the composition of this growth is improving with global capital expenditure now expanding at the fastest pace in six years.
Looking ahead, the outlook is further buoyed by the prospect of additional fiscal stimulus in several developed market economies, including the U.S., Japan and Germany. In the U.S. particularly, the prospect of additional fiscal easing in the form of large tax cuts is unusual given where we are in the economic cycle, specifically when the labour market is already operating at near full employment.
In this environment where monetary policy remains accommodative and with a potential easing of fiscal policy, global equity and credit markets continued to perform well during the quarter. While foreign equity returns were robust, for Canadian-based investors these gains were more modest after adjusting for the impact of a strengthening Canadian dollar. Canadian equity markets turned in a positive result, with Energy stocks leading the way following higher oil prices. Higher commodity prices helped the Materials’ stocks in our Canadian and International equity portfolios, which both outperformed their respective benchmarks. Relative results in the U.S. portfolio were hurt by an underweight in the expensive Information Technology sector, which was the best performing sector in the S&P 500.
Returns on Canadian fixed income portfolios were negative during the quarter, as an improving economic outlook and a more hawkish Bank of Canada worked together to increase bond yields. Of particular note during the quarter was the Bank of Canada’s decision to deliver a second rate hike in early September. The central bank will likely feel vindicated in its decision to raise interest rates, now that core inflation has started to edge higher towards their 2% target. The cumulative effect of this path for rate hikes has been a doubling in the five-year government bond yield from its trough in May 2017.
Canadian Equity Fund
After a weak second quarter, the TSX Composite returned to positive territory in the third quarter, increasing 3.7%. The Energy sector led the way, up 6.6% as oil prices moved higher and finished the quarter above US$50 per barrel. Following two rate hikes by the Bank of Canada, the Financials sector was among the top performers, increasing 4.5%, while some of the interest-sensitive sectors or “bond proxies” such as Utilities (-1.9%) and Real Estate (-1.0%) declined.
The Canadian Equity Fund outperformed the Index over the third quarter, advancing 4.2% after fees and expenses, due to strong performance from its holdings in Industrials and Consumer Staples.
In the Industrials sector, Fund performance was helped by Toromont Industries (TSX:TIH, Financial) and Finning International (FTT, Financial). Toromont Industries was among the best performers in the Fund, up 20.3%. In August, the company announced that it would be purchasing Hewitt Group, the Caterpillar dealer in Quebec, Western Labrador and the Maritimes. This is a great acquisition for Toromont, giving the company a strong geographical footprint, covering Manitoba to Newfoundland, and provides further opportunities for growth and cost synergies. Shares of Finning rose 13.0% over the quarter, as the company reported solid second quarter results. Revenues were up 21% year-over-year, boosted by strong new equipment sales and product support revenues.
After a weak start to the year due to concerns around NAFTA renegotiations, Saputo (TSX:SAP, Financial) rose 5.1% over the third quarter, outperforming the TSX Consumer Staples sector (-2.7%). Saputo has diversified operations across Canada, the US, Australia, and Argentina, which will help to mitigate any potential change in trade rules. Saputo has been performing well with solid volume growth across its business segments and strong earnings.
Energy was the top performing sector over the quarter, as stronger oil prices pushed the sector higher. This helped a number of our holdings, including Canadian Natural Resources (+12.4%) and Mullen Group (+7.2%).
The weakest performer in the Fund was one of our smaller holdings, A&W Revenue Royalties (-3.5%), which fell despite reporting positive same stores sales growth as results improved in Alberta and Saskatchewan.
Canadian Dividend Fund
The Canadian Dividend Fund returned 4.1% after fees and expenses in the third quarter, due to strong performance from its holdings in Industrials and Consumer Staples.
Similar to the Canadian Equity Fund, Canadian Natural Resources and Mullen Group were top performing holdings while the weakest performer in the Dividend Fund A&W Revenue Royalties.
U.S. Equity Fund
The Canadian dollar continued to strengthen into the third quarter versus the U.S. dollar, resulting in a modest 0.5% return for the S&P 500 in Canadian dollars. In US dollar terms, the market was up by a respectable 4.5%. Sectors more geared to better economic growth and higher interest rates outperformed, including Financials, Materials, and Energy. While Energy is still the worst-performing sector in 2017, energy stocks bounced back sharply during the third quarter as oil prices rose. The biggest winners during both the quarter and year-to-date periods have been Information Technology stocks. The stocks driving the outperformance are the “FAANG” stocks (Facebook, Amazon, Apple, Netflix, and Google (Alphabet)), along with other high-flying technology and cloud- focused companies.
The U.S. Equity Fund modestly lagged the S&P 500 during the third quarter, declining 0.2% after fees and expenses, but maintained its lead over the last year and since Barrow Hanley took over the management of the Fund in January 2016.
While our underweight in Information Technology detracted from relative performance, fund holdings (including Versum Materials +15.0% and Michrochip Technology +12.4%) performed strongly. Among the Fund’s Energy stocks, top performers included Kosmos Energy (+19.4%) and BP (+8.4%).Industrials stocks Spirit AeroSystems Holdings (+29.2%) and Owens Corning (+11.5%) also helped fund performance Detractors from Fund performance included Cardinal Health (-16.8%) and TEVA Pharmaceutical Industries’ (-48.8%).
International Equity Plus Fund
Global equity markets were volatile but performed well in the third quarter of 2017 due to improving global economic conditions. The International Equity Plus Fund returned 1.6% after fees and expenses in the third quarter of 2017, outperforming the MSCI EAFE index which advanced by 1.4% in the same period. The top contributing sectors to Fund performance included the Financial and Energy sectors, while the Consumer Staples, Utilities and Telecommunications sectors were the weakest during the quarter.
The country weightings of the International Equity Plus Fund at September 30, 2017 were:
Balanced Fund
The Balanced Fund advanced by 1.0% in the third quarter of 2017 after fees and expenses. The asset mix for the Fund at September 30, 2017 was:
Unrestricted Diversified Fund
The Unrestricted Diversified Fund advanced by 1.2% in the third quarter of 2017 after fees and expenses.
The asset mix for the Fund at September 30, 2017 was:
Income Advantage Fund
The Income Advantage Fund increased 1.3% after fees and expenses in the third quarter, as strong returns from the Fund’s Canadian dividend equity and preferred share holdings helped boost results. In the last 12 months, the Fund has returned 6.6% after fees and expenses.
The fixed income portion of the Fund fell by 0.7% over the quarter. Fixed income returns were negative as two successive rate hikes from the Bank of Canada pushed short-term bond yields higher, though this was partly offset by the Fund’s overweight in investment grade corporate bonds, which saw modest appreciation. The preferred share component of the Fund was up 2.2% and the Canadian dividend holdings rose by 4.5% during the quarter.
The asset mix for the Income Advantage Fund at September 30, 2017 was:
Core Bond Fund
Fixed income returns were negative during the quarter due to the interest rate increases by the Bank of Canada pushing short-term bond yields higher. This was partly offset by a modest decline in the yield differential over government bonds in both provincial and investment-grade corporate bonds.
The Core Bond Fund declined 1.9% after fees and expenses, similar to the FTSE TMX Canada Universe Bond Index which declined by 1.8% during the quarter.
Corporate credit spreads were relatively stable in the third quarter. We modestly added to corporate bonds during the quarter, primarily through the new Maple issuance from Apple Inc. and also BHP Billiton Finance Ltd. In provincial government bonds, we shifted the Fund further underweight as these bonds remain expensive based on current valuations. Most of this shift was through a reduction in Ontario provincial bonds, although we also trimmed exposures in some of our larger overweight in Alberta and Manitoba following their relative outperformance.
The outlook for the Canadian economy remains relatively optimistic, although we expect some moderation from the exceptionally strong growth experienced in the first half of 2017. We expect continued growth and a slow rise in core inflation measures towards target to keep the Bank of Canada on a tightening bias.
However, we remain particularly mindful of the impact of higher interest rates on a highly indebted household sector and housing markets in Toronto and Vancouver. In addition, we believe current valuations on corporate and provincial bonds warrant caution as we draw towards the later stages of the credit cycle.
Corporate Advantage Fund
The Corporate Advantage Fund declined by 0.4% after fees and expenses during the third quarter, as strong returns from the Fund’s preferred share holdings helped boost results. In the last 12 months, the Fund has returned 1.9% after fees and expenses.
The asset mix of the Corporate Advantage Fund at September 30, 2017 was:
High Yield Bond Fund
The high yield market realized positive returns in the third quarter. The market saw a large volume of new issuance in September, but had no trouble absorbing the new supply as the market continues to have a strong appetite for additional yield. The High Yield Bond Fund returns were driven by modest credit spread tightening and the higher coupon income associated with the asset class. The CAD hedged units of the High Yield Fund returned 1.6% while the unhedged units declined 2.1% both after fees and expenses during the quarter.
The strongest performers in the portfolio came from the energy and commodity sectors. Metals and mining companies benefitted from higher commodity prices during the quarter, including Teck Resources (+8.0%) and First Quantum Minerals (+4.6%). The energy sector led the Index in the third quarter as oil prices increased. Unit Corporation (+6.4%), an oil and gas drilling company, was the strongest performer in the sector.
We remain positive on high yield debt over the longer term, although valuations based on spreads are at the tighter end of their historical range. Forward expectations of default rates (a measure of market stress) based on spread valuations continue to run at very low levels as U.S. economic data continues its positive momentum. Relative to investment-grade bonds and equity markets, high yield still offers favourable return potential. In a rising interest rate environment, high yield bonds have historically performed well due to their shorter duration and higher coupons.
The High Yield Bond Fund remains conservatively positioned, with the expectation that returns over the rest of the year will continue to be generated from the high coupon income.
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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.
