Quarterly Updates - April 2019

Financial markets surged during the first quarter of 2019

It was one of the strongest starts to a year in decades and the best quarter since 2009, when markets were recovering from the bear market of 2008/09.

What a difference three months makes. You may recall from our last quarterly letter that at the end of 2018, markets were in substantial disarray. Pessimism if not outright panic had gripped the markets and fears of an economic recession in the US and around the world had become prevalent. By December 24th 2018, the S&P500 had declined by 15% during the month of December alone. By the end of 2018, stocks had fallen in most major markets around the world by 20% or more, a magnitude that traditionally marks bear market territory.

In hindsight, although there were a number of concerns churning in the global financial markets (e.g., Italian Financial Crisis, Brexit, China/US trade disputes), we believe there were two primary explanations for last year’s selloff. First, the US economy which had received stimulus in the form of tax cuts, was coming off its growth surge and was slowing. At the same time, the US Federal Reserve (the Fed) was tightening monetary policy by raising interest rates and shrinking its balance sheet (quantitative tightening). The combination of these two forces was akin to an elastic band stretching wider and wider towards a breaking point, and it was happening while asset valuations were stretched to near record levels. In December, after the Fed raised rates for the fourth time in 2018, the breaking point was reached and markets had a minor panic. This reaction strongly suggested that investors were worried that the Fed had gone too far and was about to cause a recession by excessively tightening monetary conditions.

What changed during the first quarter of 2019 was that the Fed orchestrated an historic “pivot” by sending unmistakable signals to the financial markets that it will hold off on further interest rate hikes and stop shrinking its balance sheet. There are two possible explanations for the Fed’s actions. The charitable explanation would be that it recognized it was tightening too quickly and adapted to a dynamic situation as it unfolded. A more cynical read would hold that the Fed “blinked” and once again came to the rescue of financial markets. Either way, markets have rejoiced and recovered a substantial amount of the losses experienced in the latter half of 2018.

Unfortunately, investors collectively became spooked by the market volatility last year and liquidated investments at the height of the panic and at the lows of the markets. As Figure 1 shows, when stocks went on sale during the fourth quarter, many investors collectively decided to forgo this attractive buying opportunity and instead opted to reduce their exposure to stocks. In short, and as is often the case with the investing public, they sold at the lows and therefore failed to participate in this year’s recovery.

We have seen this dynamic play out countless times in the past and if nothing else, it shows the value of having a long term investment horizon and the ability to act in a contrarian fashion.

We are proceeding with cautious optimism

During this most recent period of heightened volatility, we took advantage of the situation by being a selective, but meaningful buyer of stocks. We added to existing holdings and we initiated three new positions: Bank of Nova Scotia, Vanguard FTSE Emerging Markets ETF, and Birchcliff Energy.

We had no special insight as to the likelihood of a recession other than pointing out that various signals for an impending economic downturn seemed to be absent. This is in stark contrast to 2008, when signs of excess in the US economy were more evident.

The simple reason that we were buyers of stocks during the selloff is that valuations became more attractive and in the Balanced Equity Fund, we had substantial dry powder to take advantage of the opportunities to buy stocks at reasonably attractive levels.

Fast forward three months to today and the environment seems to have improved markedly. As mentioned earlier, stocks, particularly in the US have recovered a large portion of the losses registered in the latter part of 2018. Although this has benefitted portfolios thus far in 2019, it also means we are not finding as many attractive opportunities as we did three months ago. There are still however, several reasons at the margin that keep us in the cautiously optimistic camp, even after such a large move in a short period of time.

First, although the equity market environment has improved since late 2018, there exists a fair degree of concern about an impending recession. Rarely does a day pass by without the occurrence of a front-page news article commenting on the likelihood of the economy slowing or sliding into a recession. More recently, there has been a barrage of commentary about a popular recession signal emanating from an “inverted yield curve” – a situation that occurs when short term interest rates are higher than longer term interest rates. This is often, but not always a harbinger of an economic downturn.

At Focus, we have followed markets and the economy for decades and have yet to come across anyone who can predict a recession with a high degree of success. This time last year, there was rarely a mention of recession, and buoyant markets reflected that lack of concern. When stocks are reflecting no or little risks, we become nervous. This year, the aforementioned recession concerns mean that there is a healthy amount of skepticism in many areas of the market and many stocks are trading at more reasonable valuations. This is particularly true for companies in economically sensitive sectors such as banking, insurance, energy, autos and housing.

Another development that may further improve market sentiment centres on China, admittedly an area we do not spend much time analyzing. Regardless of one’s personal views about China, the country now represents a meaningful portion of global growth. Last year, growth in the Chinese economy was decelerating at a worrying pace. Trade tariffs threatened by the Trump Administration caused further concern for the world’s growth engine. As a result, sentiment towards China has never been worse in recent memory. Nonetheless, China has proven in the past to be capable of stimulating its economy even in tough times and we believe we may already be seeing early signs of reaccelerating growth. Furthermore, it seems that a resolution to the trade tensions between the US and China is progressing towards a tentative deal. Chinese stocks have responded positively to these early signals as have other emerging markets. If China recovers, the prospects for global growth could also receive a boost.

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