August was another strong month for investors, as most market indices ended the month in positive territory. The notable exception was the MSCI EAFE Index, which was lower by 0.4% in Canadian dollar terms as Asian Pacific markets, specifically Japan were lower.
Bond markets were also largely higher as the combination of accommodative central banks and increasing geopolitical uncertainty pushed yields lower. In Canada, the yield on the benchmark Government of Canada ten year bond fell from 2.16% to 1.99%. This spurred a rally across all segments of the bond market, with government bonds and long term bonds leading the way.
Canadian equities continued to roll along, gaining 2.09% in August, bringing the year-to-date gain to more than 16%. The bulk of this rally has come from impressive showings from many energy, materials, and consumer focused names. Positive economic news has certainly helped to provide a tailwind to stocks, as the Canadian economy roared back to life, with GDP growing at an impressive 3.1% in the second quarter. This was well above expectations, with many economists looking for a more muted 2.5% rise.
U.S. equities also continued to roar along, with the S&P 500 adding another 4% in August, bringing the year-to-date returns to nearly 10% in U.S. dollar terms. Factor in the strengthening U.S. dollar, and the return is more in the 12.5% range for Canadian investors.
As we enter into what has historically been the most volatile period of the year for the markets, I remain cautious. There are a number of reasons for this. First is one of valuation. Equities remain fully valued, and should there be any sort of a stutter with either revenue or earnings, a downturn is likely. Another reason for concern stems from the increasing geopolitical pressures that are bubbling in a number of areas including Ukraine, Syria and Gaza. If we see a meaningful escalation in any of these conflicts, many investors may head for the exits, embracing the traditional safe havens of gold and government bonds.
A third reason for my concern is that by all accounts, many investors have become rather complacent. Market volatility is now at levels that are below what we saw in 2007 and 2008. Any increase in volatility could leave some investors concerned, causing them to sell out of their equity holdings and run for the exits.
Still, looking at the risk reward balance, I continue to favour equities over fixed income, particularly for the medium to long term. There is little doubt that rates will begin moving higher in the future, which will act as a major headwind for fixed income investments. Equities, while fully valued still offer a more compelling risk-reward tradeoff than do bonds.
While the conditions may be ripe for a market correction, I believe that for investors with at least a medium to long-term time horizon that it would be ill-advised to try to time any such correction. The longer-term damage of being wrong can more than outweigh the short-term pain of remaining fully invested. However, if you have a time horizon of three years or less, it may be wise to protect your capital by moving to a more defensive position.