OB Report
September 2018
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Markets Rise Despite Trump and Trade Tensions

Murray Leith By Murray Leith CFA, Executive Vice President & Director, Investment Research
Article 1

After a volatile and disappointing start to the year, North American stocks rose steadily over the summer. From mid-April to mid-August, the major Canadian and U.S. equity benchmarks appreciated roughly 7% and 11%, respectively. The Odlum Brown Model Portfolio benefited from the rising tide and is up more than 12% from a year ago.

The longer-term returns have been extremely satisfying as well, with the Model yielding compound annual returns of 14.1% and 11.3%, respectively, over the past five and 10 years. Barring a correction in the near term, the 10-year return figure will improve even more as we cycle through the tenth anniversary of the 2008/09 Financial Crisis. Indeed, the post-crisis ride has been remarkable, as highlighted in the chart below, which compares the performance of the Model with the Canadian S&P/TSX Total Return Index and the U.S. S&P 500 Total Return Index ($CDN).

Table1

With the global economy strong, corporate profit growth robust, inflationary pressures moderate and interest rates still relatively low, it’s not surprising that investors are generally upbeat regarding the outlook for the economy and the stock market. It is human nature to extrapolate trends, and most of the time it’s reasonable to do so; the past is normally a good predictor of the future. It’s the turning points in the economy that can catch investors off guard, as investor sentiment tends to be too pessimistic during recessions and too optimistic late in the economic cycle.

It’s our job to contemplate where we are in the economic cycle and to assess whether equity market risks are consistent with the potential rewards. It’s easiest to be confidently optimistic during the depth of an economic recession, when corporate profits, investor sentiment and equity valuations are depressed. At that time, these elements have much more room to rise than to fall. The converse is also true late in the economic cycle, when the risk and return equation is not nearly as favourable and the odds of a setback in the economy, corporate profits, investor sentiment and valuation multiples are higher.

Table 2

While there is no doubt that we are in the latter part of the economic cycle, with higher risks and lower prospective returns, we don’t believe it’s time to make any significant changes to portfolios. In fact, the goal is never to make a dramatic, recession-driven call to significantly reduce stock market exposure, but rather to always assess whether our Model is focused on the stocks and sectors with the best risk and return characteristics. The key is to not get carried away with the crowd when sentiment gets unjustifiably euphoric, as was the case with technology and resource stocks in 1999 and 2008, respectively. At this juncture, we believe most stocks and sectors are reasonably and appropriately valued relative to each other and the economic outlook. Furthermore, the risk and reward equation for stocks remains favourable compared to alternative asset classes, in our opinion. The media headlines are full of things to worry about, but risks are ever-present at all points in the economic cycle, and we don’t believe today’s risks are extraordinary.

One risk that elicits the most questions is U.S. President Donald Trump’s position on trade and whether a trade war could undermine the global economy and stock market. While we could certainly imagine the media citing Trump and trade should a stock market correction occur in the near term, we think the worries about trade tensions are overblown. Our reasoning is several-fold.

First, recent trade tariffs announced by the U.S., China and other countries are very small relative to the size of the global economy. Moreover, not all tariffs will be collected, as many companies will redirect trade through other countries to avoid payment. Tariffs that are paid are not a dead-weight loss either; they are merely taxes that will be collected and redistributed by governments.

Trump could certainly escalate the trade tensions, but it would take much bigger and broader tariffs, combined with commensurate retaliation from other countries, to make a meaningful dent in global trade. Also, it’s quite possible that Trump’s bark will prove bigger than his bite. Behaving like a bully is his signature negotiating tactic – act crazy at first, and win concessions while moderating later.

While increased protectionism will no doubt undermine global growth, the trade tensions to date are not significant enough to make us overly concerned. We already live in a growth-constrained world due to high levels of debt and slower-growing populations; social unrest and trade tensions merely reinforce the slow-growth reality. Our Model has been positioned accordingly for a long time. We are broadly diversified with a good balance of businesses with higher long-term growth potential, cyclical recovery prospects and defensive characteristics.

If trade tensions intensify, our U.S. holdings will likely do better than our Canadian positions, since the U.S. has less to lose in a trade war compared to countries like Canada. Consequently, our economy, dollar and stock market would be expected to suffer comparatively. On the other hand, Canadian stocks stand to outperform the U.S. if trade tensions moderate. Either way, we are well hedged with roughly a 50/50 split between Canadian and U.S. investments.

Enjoy the fall and try to ignore Trump’s tweets.



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