The third quarter of 2015 was particularly challenging for investors, driven by a broad-based correction in global equity markets. In addition, fixed income markets provided little offset as bond returns were close to flat due to an increase of the yield differential between corporate and government bonds (also referred to as credit spread widening). As a result, balanced portfolios produced negative returns in the quarter.
The weakness in global markets was primarily driven by a deteriorating global economic backdrop, particularly in emerging markets. In China, the equity market started the third quarter in the middle of what was ultimately a 45% correction, albeit only unwinding the strong returns experienced earlier in the year. In mid-August, the ongoing volatility prompted the Chinese central bank to aggressively ease monetary policy, intervene in domestic equity markets and devalue their currency. The currency devaluation startled global market participants as most expected China to favour currency stability given their desire for the Yuan to be included in the International Monetary Fund’s basket of reserve currencies. The devaluation created downward pressure on other emerging market currencies and upward pressure on the U.S. dollar.
While the U.S. dollar strengthened, commodity prices remained firmly under pressure during the quarter. WTI spot oil prices traded to below US$40 per barrel, sparking renewed concerns over the stability of high-cost oil producers in Canada and other oil producing countries. The continued decline in oil prices also prompted further easing of monetary policy from Canada and other oil exporters such as Norway. Copper prices, normally a barometer for global industrial activity, declined further during the third quarter to multi-year lows.
This unstable environment hurt the more cyclical stocks in our portfolios, which we felt were already priced more attractively than the more defensive Telecom, Utility and Pipeline stocks at the start of the quarter. The result of this downward price pressure is that the cyclical stocks we hold have become even cheaper relative to the more defensive areas of the market. While we are disappointed to have underperformed versus our index benchmarks year to date, our experience tells us to be patient with these positions because they have the potential to rebound very strongly when positive sentiment returns.
We have seen some softening in forward-looking survey data in the United States and a downshift in the pace of employment growth. However, we remain optimistic on the overall strength of the U.S. economy. The negative effects of a stronger U.S. dollar on exporters should be more than offset by the positive boost to U.S. consumers from lower oil prices. The housing market continues to exhibit signs of strength, and the labour market improvement – although moderating – continues to be in relatively good shape. In fact, our view remains that the U.S. labour market is likely to tighten over the coming year in response to the encouraging and ongoing decline in the unemployment rate, which should eventually provide upward pressure on wages and inflation.
In Canada, recent economic data has shown some tentative signs of improvement. Following five consecutive monthly contractions the economy returned to growth in July and August. Importantly, some of that growth was driven by a rebound in non-energy exports, which appear to be benefiting from a weaker Canadian dollar. The Canadian labour market also appears to be having a solid year, despite concerns about job shedding in the oil sector, total hours worked is now growing year-to-date at the fastest pace in over a decade. This strength in the labour market helps explain some of the resilience in the Canadian household sector, where consumption has yet to be materially affected by declining oil prices.
Despite the positive signals we are seeing domestically, there continues to be risks to our outlook. Canadian household indebtedness, as a percentage of disposable income, is at new all-time highs. This is an ongoing risk to financial stability in Canada. Given the accompanying decline in Canadian corporate profitability, we continue to monitor the labour market very closely for signs of more broad-based job losses which, for a heavily indebted household sector, could be a cause for concern in the future.
Looking forward, we think ultra-easy monetary policy globally combined with lower oil prices should be tailwinds for the global economy and asset prices. This will benefit our funds, but the ride may continue to be a bumpy one. Ongoing turbulence in capital markets is likely as the global economy adjusts in the aftermath of the commodity supercycle.
Global monetary policy outside of the United States has responded aggressively to offset the pains of this adjustment process, with further easing of monetary policy looking increasingly likely from China, Japan, Europe, and potentially Canada over the next 12 months. However, we are cognisant of the fact that low interest rate policies are also approaching a maximum bound of effectiveness.
To some extent, the market decline this quarter was similar to the decline that occurred in global stock markets during the first quarter of 2011. However, like in 2011, we believe that our patient approach of selecting individual businesses that fit our criteria for purchase and are trading at attractive valuations, given their risks, will deliver investment returns that will outpace fixed income returns over our three year investment horizon.
Canadian Equity Fund
The third quarter was a difficult one for global equity markets and the Canadian market was no different posting a decline of 7.9%. The Canadian Equity Fund declined by 10.6% in the quarter after fees and expenses. While Canada’s economy was officially declared to be in a recession, the more impactful news appeared to be the confirmation that China’s economy was slowing. This resulted in continued commodity price weakness, a 24.5% drop in the Materials sector and a 17.2% decline in Energy stocks. The price of oil, which had recovered to near $60 at the end of June, retreated to a new cycle low in the high $30s before settling at about $45 at the end of the quarter.
The other notable sector decline during the third quarter came in Health Care, where Valeant Pharmaceuticals, which is currently under scrutiny surrounding its drug pricing policy, contributed to a 15.6% drop in the sector.
The Canadian Equity Fund trailed the market as stock selection suffered in several sectors including Financials, Utilities and Consumer Discretionary. Despite being underweight Energy and Materials, stock selection caused these sectors to drag down relative performance as well. Many companies in these sectors that were already trading at very compelling valuations became even cheaper. Teck Resources and First Quantum in Materials and Encana, Calfrac and Baytex in Energy all posted sizable declines. A lack of exposure to the relatively steady Telecom sector also hurt portfolio performance in the declining market environment.
The notable bright spots came in Information Technology, where Constellation Software continued to advance and Open Text rebounded strongly from a decline in the second quarter. As mentioned in last quarter’s report, we added to Open Text following the selloff.
Canadian Dividend Fund
The Canadian Dividend Fund declined by 7.2% in the quarter after fees and expenses. Stocks that helped performance during the quarter included Open Text, Constellation Software and Slate Retail REIT. Similar to the Canadian Equity Fund, stocks that detracted from performance during the quarter were from the energy sector and included Cardinal, Encana and Baytex Energy.
U.S. Equity Fund
The third quarter marked the first time since 2011 that the U.S. equity market displayed any real downward volatility. Since the trough of the global financial crisis in March 2009, U.S. equity markets have completed a mostly uninterrupted climb of nearly 200%. This quarter, turbulence finally hit global markets, negatively impacting stocks, bonds, currencies and commodities world-wide. The S&P 500 declined 6.4% (measured in local currency) during the quarter. However, a strong U.S. dollar boosted returns for Canadian investors resulting in the index increasing 0.5%, measured in Canadian dollars.
Our expectation is that we will tend to perform well during down markets and not as well in robust markets, such as the strong market we have witnessed since 2009. This quarter, most of the companies we own performed largely as expected during the stock market decline we experienced in August and September. The one notable exception was the Energy companies in the U.S. Equity Fund, which weighed heavily on results. Overall, the Fund lagged the index during the quarter, declining 2.6% after fees and expenses versus the S&P 500 return of 0.5% measured in Canadian dollars. Virtually all of the underperformance can be directly attributed to our Energy holdings.
Undeniably, the near-term outlook for the Energy sector is challenging. However, the extreme downward pressure on the Energy companies we own has been irrational in our view, with several being valued at all-time low valuations. Valuation levels are now below both the levels we saw during the Global Financial Crisis and back in the late nineties when oil was $12 per barrel. Our investment decisions in the Energy sector are not made from a top-down view on the outlook for oil prices, but rather the quality and value characteristics of the individual businesses and how they compare with other opportunities presented to us. Historically, each of our holdings has proven themselves capable of dealing with the challenge of volatile oil prices and has sufficient financial strength to persevere through this difficult environment. We added to the Energy holdings in the Fund during the quarter and are now overweight the sector.
International Equity Plus Fund
International equity markets had their largest quarterly decline in four years in the third quarter fueled by the selloff in Chinese equities and general uncertainty surrounding the timing of the potential Fed interest rate increases. The International Equity Plus Fund declined by 2.8% after fees and expenses in the third quarter, performing better than the MSCI EAFE Index which declined by 3.6%. Some of the Fund’s Industrials stocks helped performance in the quarter while stocks in the Consumer sectors detracted from performance during the quarter.
Income Advantage Fund
The Income Advantage Fund declined by 3.5% after fees and expenses during the third quarter of 2015.
The fixed income portion of the Fund had a weak quarter with a small gain of just 0.1%, as credit spreads widened significantly despite interest rates remaining relatively unchanged. This weakness gave us the opportunity to invest in higher yielding BBB bonds.
The preferred share component of the Fund continued to be under pressure as issuers came to market with new issues to take advantage of historic low rates despite ever wider spreads. Although our holdings declined in value with the rest of the market this quarter, we managed to outperform significantly, mostly as a result of being underweight bank preferred share. Although preferred shares look inexpensive now on a historical basis and we have room to add to our positon, the continued aggressive issuance means that we will remain patient and wait for new issues at significant discounts.
The largest detractor from performance in the quarter was the Canadian Dividend stock component of the Fund held through units of the Canadian Dividend Fund.
The asset mix for the Income Advantage Fund at September 30, 2015 was:
Fixed Income Fund
Fixed income investment returns were slightly positive during the third quarter of 2015, as gains from lower market interest rates were offset by an increase credit spreads. Canadian government bond yields were broadly lower during the quarter; however, there was significant volatility across the interest rate curve.
The Fixed Income Fund modestly lagged the FTSE TMX Canada Universe Bond Index during the quarter, returning 0.0% after fees and expenses compared to the Index return of 0.1% during the period. This was primarily due to the Fund’s conservative corporate position focused on high quality, shorter-dated issues during a period of rising market volatility and credit spread widening.
Our medium-term view continues to be that global bond yields will rise very modestly as the U.S. Federal Reserve starts to normalize monetary policy into 2016. However, we acknowledge the increasing uncertainty around this view and as a result have positioned the Fund neutrally in terms of overall interest rate risk.
We had positioned the Fund at the beginning of the third quarter with the lowest exposure to corporate bonds in almost five years. The Fund benefitted from the market volatility and spread widening that occurred over the quarter, and provided us with an opportunity to re-establish credit exposure at more attractive prices. Despite the softness in corporate bond markets, the Fund’s corporate holdings added value during the quarter, largely due to their high quality and strong liquidity.
Our outlook for Canadian capital markets remains cautious. On balance, we continue to expect further interest rate cuts from the Bank of Canada. Our view is that the impact of lower oil prices has yet to fully reverberate through the Canadian economy. The resilience of the labour market will also likely come under some pressure due to declining corporate profitability. Lower household incomes, combined with potential job losses will be exacerbated by a highly indebted Canadian household sector. The Canadian economy, and in particular non-energy exports, will benefit somewhat from a weaker currency. However, this alone will not be enough to offset the hit to household incomes caused by lower oil prices, due to higher unit labour costs in Canada and the corresponding devaluation in currencies of many of Canada’s trading competitors.
In this uncertain interest rate environment, we think it is more prudent to focus on credit markets, where risk-adjusted returns are higher. As a result, we have cautiously been re-establishing some of our corporate overweight that had been reduced over the past five years. Our economic outlook suggests we should be cautious about the speed with which we increase our corporate exposure, as we can envision a scenario where credit spreads could widen further. In this way, we believe we are well-positioned to weather this challenging and increasingly volatile market environment.
Corporate Fixed Income Fund
The Corporate Fixed Income Fund declined by 0.1% after fees and expenses during the quarter as credit spreads widened. As in the Income Advantage Fund, this weakness in corporate bonds allowed us to add to higher yielding BBB bonds. Preferred shares also were weak during the quarter.
Looking ahead, the addition of high yield bonds and the opportunity to buy preferreds at historically low levels bodes well for future returns.
High Yield Bond Fund
As seen in investment grade bonds, high yield credit spreads widened this quarter. The high yield weakness was driven primarily by the resource, chemical and energy sectors which declined more than 10%. The High Yield Bond Fund was positioned in defensive and consumer focused sectors and held up much better than the weakest sectors. We opportunistically added to positions as credit spreads increased and valuations became more attractive. We feel that the High Yield Bond Fund is well positioned for patient investors to take advantage of value opportunities as they arise.
Notice of Change to U.S. Equity Fund sub-advisor
Following a lengthy and detailed review of Sprucegrove Investment Management (“Sprucegrove”), the current sub-advisor of our clients’ U.S. equities, we have decided to replace them as our U.S. equity manager. As a result, management of our clients’ U.S. equity investments will be transitioned to Barrow, Hanley, Mewhinney & Strauss (“Barrow Hanley”) beginning in January of 2016. Barrow Hanley currently manage in excess of CAD$100 billion on behalf of their clients and are among the preeminent value-oriented investment managers in the U.S.
This decision was supported by an extensive evaluation of Sprucegrove, and a number of other leading U.S. and International equity managers, that we conducted in conjunction with investment consulting firm Callan Associates (“Callan”). Callan is among the largest independently owned investment consulting firms in the U.S.
Looking ahead, we are very excited to be able to offer our clients access to Barrow Hanley’s 36 year history of successful value-driven U.S. equity investing, remarkably stable investment team and consistent track record of added value.
Please note that there will be no fee implication for any Leith Wheeler clients as a result of this change. In the same spirit, we will calculate and reimburse all of our clients for any custodial charges and brokerage commission charges that result from this transition and endeavor to minimize any potential capital gains tax implications for our clients with non-registered U.S. equity investments.
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.
