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Bank of Canada shocks markets by cutting rates… No material change to investment outlook
When we did our last review of the ETF Recommended List in December, the thing that had everybody’s attention was the precipitous drop in oil prices and the effect it was expected to have on the Canadian economy. At that time, oil was trading in the $66 range, and has since continued its decline, touching a low of $44.45 at the end of January. It has since gained a bit of ground and shown some signs of stabilizing, closing February 28 at just under $50.
Clearly this drop has spooked many, including the Bank of Canada Governor Stephen Poloz who cut the Bank’s key overnight lending rate by 25 basis points in January. He said this was an insurance policy against the potential fallout from economic slowdown expected thanks to lower oil. While that may be the official line, many market participants saw this more as a way to lower the value of the Canadian dollar in an effort to boost sagging exports.
While this move was surprising, it really hasn’t done much to change my investment outlook. I still favour equities over fixed income. Within equities, I favour the U.S. over Canada or Europe.
Where my outlook has changed slightly is that I have improved my short term outlook on fixed income to NEUTRAL from UNDERWEIGHT. However, this is only a temporary change in stance and will move to UNDERWEIGHT again as we are able to gain more clarity around the economic and interest rate picture.
I had been favouring short term and higher yielding bonds because I was worried that a higher, more index like duration stance would hurt returns with flat or rising rates. Now, with downward pressure on rates, taking more duration risk in the short term may be justified. This is only for the very near term, and a more defensive positioning will be warranted soon.
Within the equity space, even with the higher valuation levels, I continue to favour the U.S. over the other regions. It is not so much a case that the U.S. is a great place to invest, but more the other regions are facing headwinds.
In Canada, oil will likely be the key driver of the markets, with spillover to the financials, particularly the banks who are expected to struggle under the weight of lower interest revenues, less merger & acquisition activity, and potentially higher loan loss reserves. Combined, energy and financials make up half the index, so without a material rebound in the oil price, it will be difficult for the TSX to generate outsized gains. Further, I expect that volatility will continue to be on the upswing.
In Europe, with the recent Greece crisis kicked further down the road, the focus can again return to the underperforming economies. The European Central Bank continues to talk about stimulus packages, and eventually one will stick. Valuations are the most attractive of any of the developed markets, but until there is a sustained recovery, I expect higher levels of volatility. For those with an above average appetite for risk, you may want to consider adding to Europe, but it is a risky play right now.
Asia continues to struggle, with China posting its slowest growth rates in decades. The central bank stepped in, cutting interest rates in an effort to spur the economy. China is a key driver not only to Asia, but also Europe and the emerging markets. As long as China continues to struggle, so too will those regions. As with Europe, I expect things will turn around in the medium term, but am expecting higher than normal volatility while things work through.
Additions
BMO MSCI EAFE Index (C$ Hedged) ETF (TSX: ZDM) – This ETF is designed to replicate the performance, net of fees of the MSCI EAFE Index, with 100% of the currency exposure hedged back to Canadian dollars. The MSCI EAFE Index is the pre-eminent benchmark of international equities, investing in approximately 1,000 large and mid-cap stocks in developed markets around the world, excluding Canada and the U.S. It covers approximately 85% of the outstanding, free float adjusted market cap. I am adding this ETF to replace the iShares MSCI EAFE Index (C$ Hedged) ETF (TSX: CPD). ZDM provides virtually identical investment exposure, but does so at a lower cost, without sacrificing liquidity. The maximum management fee of ZDM is 20 basis points, which is 30 bps lower than XIN. One key difference is XIN invests in the U.S. traded iShares MSCI EAFE Index (NYSE: EFA) which fully replicates the index, while ZDM may use a sampling methodology. A downside to the sampling methodology is there may be a higher tracking error. This higher tracking error is more than made up for with slightly higher returns and a lower cost. Based on those factors, I believe this switch will be beneficial to investors.
Deletions
iShares S&P/TSX Canadian Preferred Share Index ETF (TSX: CPD) – With the Bank of Canada cutting its overnight lending rate, the outlook for the preferred share market in Canada turned somewhat negative. To understand why this is the case, we need to look at the makeup of the S&P/TSX Preferred Share Index, which this ETF seeks to replicate. Approximately two thirds of the index is fixed reset preferred shares, 30% is in perpetual preferred shares, and the rest a mix of floating rate and retractable preferreds.
With fixed reset preferreds, they pay a set dividend for a set time, usually five years. After this initial period, the dividend is reset at a new level that is based on a formula that often uses the Government of Canada five year bond yield as its benchmark. With the recent rate cut, the yield on the Canada five year has taken a fall, currently hovering around 91 basis points (March 4), down substantially from the end of the year. If we do see additional cuts as many expect, yields are likely to fall even further.
Investors now fear that the dividends on the fixed resets will be set at much lower levels, making them much less appealing from a yield standpoint. With the ETF very concentrated in fixed resets, I am not comfortable with the near term risk, and will be avoiding this ETF until we get a clearer direction on rates, and the new dividend levels. Investors looking to invest in preferreds may want to consider individual issues or some of the more actively managed preferred share mutual funds rather than this in the near term.
iShares MSCI EAFE Index (C$ Hedged) ETF (TSX: XIN) – I removed this from the Recommended List because I believe that ZDM provides a lower cost way to access the same investment exposure. The maximum management fee for XIN is 50 basis points, while ZDM is 0.20%. In a case where two investments offer a similar risk reward profile, I believe the lower cost option is the best choice.
ETFs of Note
iShares Canadian Short Term Bond Index Tactical Bond ETF (TSX: XSB) – With the Bank of Canada likely to cut their key overnight lending rate lower at least one more time, the near term outlook for fixed income investments has improved dramatically from just a few months ago. While the expectation of a cut has largely been built into the price of shorter term bonds, there is still some potential for a little rally if it does happen. While some of the longer dated issues may benefit more from the rate cut, I continue to be defensive and am favouring shorter duration issues. This ETF focuses exclusively on Canadian investment grade bonds that have a maturity of less than five years. It has a duration of 2.79 years, which is significantly lower than the 7.56 year duration of the broader Canadian market. This remains my top pick for shorter term bond exposure.
PowerShares Tactical Bond ETF (TSX: PTB) – I had originally recommended this as an alternative to the iShares Canadian Universe Bond Index ETF (TSX: XBB) because I believed the tactical approach would allow it to outpace XBB in a rising yield environment. I liked that it is a hybrid between an active and passive strategy, investing in a mix of fixed income ETFs offered through PowerShares and other ETF providers. Invesco’s Global Asset Allocation team examines the economic and market environment, and will tactically position the underlying holdings to best position the portfolio for their outlook. Now that the yield environment has changed, and they are expected to move slightly lower, I would once again favour XBB over this offering for the near term. However, taking a more medium to long term view, I believe PTB to be a solid choice for those looking for a diversified, one ticket fixed income ETF solution.
BMO Low Volatility Canadian Equity (TSX: ZLB) – While I had expected the low volatility strategies to outperform in down markets, I certainly was not expecting the recent stellar performance posted by them of late. This was the best performing Canadian equity ETF over the past three months, gaining 12.1%, handily outpacing the broader market. It invests in stocks that have shown the lowest beta for the past five years, from a universe of the 100 largest, most liquid names that trade in Canada. Because of its focus on low beta, it is concentrated in the more stable consumer names, utilities, and communications, while maintaining a significant underweight in financials, energy and materials. This positioning explains the outperformance, as it was those sectors that were hit hardest. While I have been pleasantly surprised by the recent performance, it is not sustainable, and I expect it to moderate in the coming weeks and months. Given the run up, now is a great time to rebalance your portfolio, and consider taking some money off the table with this, and any other low vol ETFs you may hold.
iShares Core S&P 500 Index (CAD Hedged) ETF (TSX: XSP) – Despite the economic recovery underway south of the border, U.S. equities took a breather, with XSP dropping 3.2% in January and finishing the most recent three months with a modest 0.70% loss. In comparison, the average U.S. equity mutual fund gained 9.1% for the most recent three months. The key reason for this dramatic difference in performance is the fully hedged currency exposure of XSP. With the Canadian dollar continuing its slide against the U.S. greenback, those investments with unhedged U.S. dollar exposure saw an extra boost to their performance thanks to the currency. With the Canadian dollar expected to remain weak, and more downside possible, depending on the Bank of Canada, the fully hedged currency position may continue to act as a headwind. If you still want U.S. equity exposure and are comfortable with unhedged currency exposure, you should take a look at the iShares Core S&P 500 ETF (TSX: XUS). It offers the identical investment exposure, save for the currency hedging policy. While unhedged currency exposure has been a benefit of late, it can also be a detractor should we see the Canadian dollar bounce back. Regardless, XSP and XUS remain my top picks for U.S. equity ETFs for their diversified portfolios and low cost. If there is a market that lends itself to passive investing over active, it is the U.S., and these ETFs are the best way to play the space.
BMO Global Infrastructure ETF (TSX: ZGI) – One of the more compelling investment themes for the past few years has been rebuilding the world’s crumbling infrastructure. This ETF looks to capitalize on that by investing in companies that are involved in the development, ownership, or management of infrastructure assets such as energy, pipelines, bridges, airports and toll roads. It holds approximately 50 names, and not surprisingly, it is heavily concentrated in energy and utilities. It tracks the Dow Jones Brookfield Global Infrastructure North American Index, which means that the majority of the holdings are large, well-capitalized companies. A benefit to this is they tend to generate meaningful dividends for investors. At the end of January, the dividend yield of the underlying holdings was 3%, which is higher than the broader global equity market. It passes some of this along to investors through a regular quarterly dividend, which has been $0.145 per quarter for the past several quarters. I prefer this over the iShares Global Infrastructure ETF (TSX: CIF) because it has shown a more favourable risk reward profile at a lower cost. One concern that I do have is the valuations of the underlying portfolio looking pretty stretched, which may result in a period of underperformance and higher than average volatility. However, investor demand for yield and momentum in the sector may provide support for many of the names in the ETF. Still, the medium term outlook for infrastructure remains strong, and ZGI is a great way to gain exposure. While historic volatility may have been lower than the broader equity markets, I would still treat this as a sector fund and limit exposure in a portfolio according to your risk tolerance.