The first half of the year was profitable, with most investors seeing modest gains. Canadian equities led the way with the S&P/TSX Composite Index gaining nearly 13%, handily outpacing most other developed markets. This was in large part to an impressive rebound in the energy and materials sectors.
With Russia reclaiming the Crimean Peninsula from the Ukraine and renewed tensions in Iraq, oil and gold rebounded sharply on a flight to safety trade and concerns over a disruption in the flow of oil. Still, there are a few reasons to be concerned about Canadian equities. Valuations, while not hugely overvalued are an area of worry as we could see a correction to bring valuations back in line with historical norms.
Another area of worry are the banks, all of which are heavily tied to the rising personal debt levels of Canadians. If there is any meaningful economic slowdown, loan losses will rise, eating at their profit margins. They are also heavily exposed to the housing sector which continues to show pockets of extreme valuation and irrationality, particularly in Toronto and Vancouver. While I don’t expect a housing slowdown anywhere near what was experienced in the U.S., any slowdown will affect earnings of the banks.
The Bank of Canada is in a very tricky position. On one hand, they would like to be able to start moving rates higher to help stem the growth in personal debt and slow the red-hot housing market. Unfortunately the economy doesn’t appear to be strong enough to easily absorb the effect of the higher rates. Further, any increase will likely drive the dollar higher, creating an additional drag on our exports. I expect that they will have little choice but to keep rates on hold until the U.S. Federal Reserve starts moving higher, which is not expected to happen until early to mid-2015.
Except for China, all other major equity markets were firmly in positive territory. The S&P 500 was higher by 7.4% in the first half, while international equities, represented by the MSCI EAFE Index gained 6.8%. China has struggled as the economy continues to be weighed down by the housing market, which has been contracting for a couple of years. In a recent survey by Bloomberg, economists expect that GDP growth in China will be 7.4% in 2014, the lowest level in 24 years. This will act as a significant headwind in the near to medium term, and is likely to cause some spill over to other emerging markets and the commodity sectors.
European markets were modestly higher, with the MSCI Europe gaining 6.2% in the first half and has risen more than 31% over the past year. Despite these impressive gains, the Eurozone economy appears to have stalled. To address this, the European Central Bank took aggressive action, pushing short-term interest rates into negative territory for the first time in history. It is expected this will result in modest improvement in the economy. It is also expected to spur a liquidity driven equity rally, similar to what North America has experienced. While I’m not convinced the ECB’s action is the cure to all of Europe’s woes, it should help.
While the European Central Bank is just ramping up their latest round of economic stimulus, the U.S. Federal Reserve continues to wind theirs down, despite lackluster growth numbers. Growth has been so disappointing that the Fed has slashed their forecasted GDP growth rate for 2014 from 2.9% to between 2.1% and 2.3%. Still, they believe that they can begin to start nudging rates higher sometime in 2015.
Another worry I have with the equity markets is investor complacency. I have noticed that whenever volatility reaches low levels, it is quite often followed by a meaningful market correction. Looking at recent volatility levels, they are now at or below the levels we experienced in 2007 and 2008. I am in no way suggesting that we will see a drop as significant at what we did then, but I still expect a meaningful correction in the near to medium term. If history is any guide, I would expect this to happen as we move into the fall.
Fixed income was positive as the yield on the benchmark Government of Canada ten-year bond dropped from 2.77% at the end of December to 2.24% at the end of June. Not surprisingly, it was the longer dated bonds that benefitted most, with the DEX Long Bond Index gaining more than 8%, nearly doubling the 4.3% rise in the DEX Universe Bond Index.
Looking ahead, I don’t foresee any catalyst that will drive yields significantly higher in the latter half of the year. It is even possible that we may see a further drop, causing a modest rally. However, taking a medium to long-term view, there is little doubt the pressure on rates will be higher.
Another area of concern is with high yield bonds. Over the past few months spreads have fallen to extremely low levels by historical standards. Investors in their quest for yield have pushed prices up and yields down, causing valuation concerns. I expect that we will see spreads widen to more normal levels, muting overall gains in the near to medium term. I would urge you to take profits and rebalance your high yield holdings, to help reduce your overall risk exposure.
Bottom Line
As we enter into the second half of the year, my investment outlook looks a lot like it has for most of the past year. I continue to favour equities over fixed income. Within equities, I am focusing on high quality, large cap names. I prefer North America, but believe there may be some opportunities in Europe in the near term. I am still somewhat concerned about Asia, particularly China. I am also concerned that there may be a modest correction as we enter the fall, although nobody can say if or when such a selloff will happen.
Within the fixed income space, I remain defensive, and favour higher yielding corporate bonds over government bonds. While I had been rather bullish on high yield, valuation levels have caused me to temper my enthusiasm. I would strongly suggest that you take profits in your high yield holdings. Within the more traditional fixed income space, I am expecting flat to low single digit gains for the balance of the year.