Calmer heads prevail as economic numbers continue to improve.
The third quarter started off well with gains in both stocks and bonds. Worries over higher interest rates took a back seat to improving economic fundamentals both at home and abroad.
In Canada, the S&P/TSX Composite Index rose by 3.2%, led by strong gains in gold companies, consumer staples and financials. Gold rallied by more than 7.3% on expectations that the low interest rate environment may fuel future inflation. I don’t expect that this gold rally is sustainable given that there are no meaningful signs of inflation on the horizon.
U.S. and global equities also showed strong gains, with the S&P 500 rallying 5% in U.S. dollar terms, while the MSCI EAFE gained 5.3%. For Canadian investors, a falling U.S. dollar muted those gains. Investors celebrated stronger than expected economic growth, improving job numbers, benign inflation and strong consumer demand. Many were also encouraged by comments made by Ben Bernanke, the Chairman of the U.S. Federal Reserve reinforcing that tapering does not mean tightening. He reiterated that while bond buying would slow or stop, interest rates would not move higher until certain employment and inflation thresholds were breached. Given the current outlook, it may be many months before that happens.
In Europe, investors rejoiced on news that the troubled region had finally emerged from recession. While this is positive news, there is still much uncertainty about the pace of economic growth. With the austerity measures and debt controls that are in place, it is highly unlikely that we will see a return to the spectacular pace of growth experienced before the global credit crisis. Still, there is no denying the region is in much better shape than it was a year ago, and is definitely on the right path.
As we enter into the dog days of summer, my investment outlook remains consistent. I favour equities over fixed income. While I don’t expect that we will see big jumps in bond yields, I expect that we will see higher levels of volatility as investors speculate on when the Fed will begin raising rates.
While it may be tempting to sell all your bond holdings in this environment, I would strongly advise against that. Fixed income, even in a heightened risk environment can be a cornerstone of any portfolio. You will want to focus on shortening duration and increasing yield, while monitoring your overall risk exposure. Some good ways to do this include short-term bonds, floating rate notes, and global bonds.
Within equities, I favour the U.S. over Canada and Europe because it offers stronger fundamentals. Corporate profitability remains strong. There may be some opportunities in Europe, but I would not recommend the region as a core holding. Instead, I would suggest you consider gaining exposure through a high quality, actively managed global equity fund that can provide exposure to the region. Investors with higher risk appetites may want to consider a European equity fund, but remember it can be volatile.
Canadian equities remain a concern. Our market is heavily focused on commodities which are expected to be under pressure for the near to mid-term. Another worry is the affect a slowdown in the housing market will have on our banks. Fortunately signs are pointing to a soft landing in housing, but still the risk remains. I would avoid index funds, and instead look for a high quality, actively managed fund that looks much different than the S&P/TSX Composite Index.