In the aftermath of the Brexit vote, equity markets across the globe plunged as did the pound sterling, only for equity markets to recover in rather quick order. Over the course of the third quarter we came to the conclusion that Brexit was the signal that confirmed a regime change at the heart of financial markets.
Brexit was a climactic moment in that bond investors relented and drove down long-term bond yields to post-crisis lows. Rather than signal a dramatic economic slowdown, high-yield and corporate bond spreads continued to tighten. Investors in general, witnessing the fall in bond yields, sought yield in the stock market where upwards of 64% of S&P companies had a higher yield than the U.S. 10-year Treasury bond, igniting an equity market rally. Investors seeking yield then sought emerging market debt, which fuelled a currency rebound in developing countries and provided some much-needed financial healing in stressed portfolios to the benefit of commodities generally.
The result is that financial conditions that were extremely tight early in 2016 have completely reversed. They are now as easy as they have been at any time since the crisis. The reason we believe this is a regime change is that several factors are in place to sustain relatively easy financial conditions. The first is that neutral interest rates in the United States have been revised down by the U.S. Federal Reserve Board. The neutral rate is the level of interest rate that neither stimulates nor restricts savings and investment. The second is that the pace of rate increases in the United States will be much slower than originally feared. Thus, the divergent U.S. monetary policy versus the rest of the world, which contibuted to a higher U.S. dollar in 2015 and early 2016, is much alleviated. In addition, politicians are reversing positions on balanced budgets and austerity with the rise in populist parties. This is evident in the U.K. as well as the United States, where both presidential candidates are advocating fiscal policy that would be positive for economic growth.
The net result is that financial conditions have eased considerably with both credit and equity markets open, which is positive for riskier assets, including commodities and energy.
In Canada, energy performed strongly in the third quarter as did information technology, industrials, and health care.
The fund outperformed its benchmark for the quarter. The outperformance is attributable largely to energy, where our leading positions in Encana (ECA, Financial) and Devon Energy (DVN, Financial) were strong performers. Information technology was also strong thanks to names like Alibaba (BABA, Financial) and Samsung (XKRX:005930, Financial), which performed strongly. Alibaba is a core holding in the portfolio.
Health care detracted on account of Bristol-Myers Squibb (BMY, Financial), which failed an important immune oncology study, setting its development plans back and negatively affecting its shares. We maintain our exposure to Bristol-Myers Squibb, confident that the company will recover but acknowledging this will take time.
Being more constructive on riskier assets, we have added risk in equity markets through higher weightings in materials and energy.
We sold our large gold positions based on the fact that the recovery was taking shape and that deflationary fears were receding.
With easier financial conditions and a mild reacceleration in world economic growth, corporate profits are poised to recover after two years of flat-to-declining earnings. If easy monetary policy can be supplemented by fiscal policy in time, markets can expect continued economic growth, even if it is likely to remain sub-par compared to previous cycles. While stronger economic growth in the United States could lead to concerns over a reacceleration of rate rises, we believe the Fed will remain cautious in that it will try to limit tightening financial conditions that might short-circuit a recovery. Inflation might also become a concern, which would be another reason to raise rates more quickly, but we believe this is not a near-term concern.
There is much speculation on the U.S. presidential race, especially in the unlikely but possible event of a Donald Trump victory. A Trump victory would surprise markets and, given the erratic policy proposals or lack thereof, the uncertainty would likely rattle markets at least initially. We believe this likely would be short-lived as Trump is fairly consistent in his desire to use fiscal policy to lower taxes as well as increase infrastructure spending, which would further boost the economy.
In conclusion, we are constructive on riskier assets as financial conditions remain easy, corporate profits are poised to rise, and multiples, while elevated, can creep higher in light of the low level of interest rates, which we believe will remain low.
This commentary is published by CI Investments Inc. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein. This report may contain forward-looking statements about the fund, its future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments. 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, their values change frequently and past performance may not be repeated.
