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Quarterly Updates - July 2019

A Volatile Second Quarter For Equity Markets

After a blistering start to the year during the first quarter, stock markets were volatile during the second quarter due to uncertainty surrounding the US-China trade negotiations, as well as slowing global economic growth. Despite a significant selloff in May which saw the S&P500 decline almost 7%, markets managed modest positive returns in the quarter as the US market gained 4.3%, (2.1 in C$ terms), while the Canadian market rose 2.6%.

The volatility began in earnest on Sunday, May 6th, when US President Donald Trump signaled a collapse in the ongoing Chinese trade deal negotiations when he tweeted that the US would apply tariffs to virtually all goods imported from China. While the cause of the rift is still being debated, the surprise announcement immediately sent markets into a tailspin, which eventually resulted in the S&P500 and the technology-driven NASDAQ falling 7% and 11% from their respective highs. Chinese markets were also affected, plummeting 11%. Nearing the end of June, the US and Chinese administrations began to signal that a truce and resumption of trade talks were likely.

In response, markets recovered much of their losses, although we believe it is evident that relations between the US and China will continue to be strained for the indefinite future. Much of this trade and tariff news occurred simultaneously against a backdrop of twelve months of slowing global economic growth. Because economies are more vulnerable to negative shocks during growth slowdowns, this heightened concern that the trade war could cause a global recession. Similar to late 2018, the financial press is once again full of stories about how the next recession is just around the corner.

Due to the weak economic data, central banks around the world, particularly the US Federal Reserve (US Fed) and the Bank of China, are providing accommodative measures to help steady their respective economies. Although the US Fed has not yet cut interest rates, yields on long-term bonds fell substantially during the quarter, signaling that the bond market is predicting that several interests rate cuts are likely in the US. Figure 1 below highlights a peculiar situation whereby the US stock market, the S&P500, is trading near all-time highs, whereas the bond market, the US 10-year Treasury, is seeing a significant flight to safety buying bonds lifts their prices, but lowers their yield. In fact, the month of June saw a record amount of money flow into bond funds.

There are indeed various unmistakable signs of slowing economic growth in the US and abroad, but overall we believe the US economy still looks to be in decent shape. Retail sales, a major factor in the US economy, remain healthy and unemployment remains at multi-decade lows.

Company Spotlight: Interactive Brokers Group

Interactive Brokers is a US-based brokerage firm that operates the largest electronic trading platform in the US (by a number of daily average revenue trades). The company brokers stocks, options, futures, EFPs, futures options, forex, bonds, and funds. While Interactive is lesser known than its competitors such as TD Ameritrade and Charles Schwab, we believe it distinguishes itself with a superior business model and first-rate technology. Interactive’s business is built on a highly sophisticated leading-edge software platform that enables it to offer the lowest cost commission and margin rates. This has led to Interactive having industry-leading organic growth in key metrics such as growth in client accounts, client equity values, and a number of daily trades per client. Interactive’s platform also provides the broadest global reach to investors with access to over 120 markets in 31 countries, as well as seamless access to many different asset classes and currencies.

 

Despite the lower commission rates, Interactive’s business model is the most efficient in the industry. The company’s revenue per employee is double that of its nearest competitor and it also has the highest margins in the industry. Interactive has a very strong balance sheet with almost $6 billion of capital in excess of regulatory requirements, no long-term debt and significant free cash flow due to the low capital intensity of the business model. Essentially, Interactive is a software company operating in the financial industry, while producing software economics.

 

Management is wholly aligned with shareholders as they own 82% of the shares and have been very gradually selling down shares over time to create more liquidity for shareholders. Founder, Chairman, and CEO Thomas Peterffy hold the majority of the company’s shares. Interactive Brokers provides a unique way to participate in the long-term global growth of the electronic brokerage industry.

Cautiously Moving Forward

July will mark the 121st month of the present economic expansion, making it the longest on record since 1854. The US Federal Reserve, which usually faces a barrage of criticism when tightening monetary policy and thus increasing the odds of a recession, just announced that they are finished tightening for the foreseeable future and, in fact, are prepared to lower interest rates if required. Given that employment levels and retail sales are still quite strong in the US and Canada, we believe it is quite possible that the current economic expansion continues for quite some time.

On the other hand, we believe we must also be mindful that the expansion will not last forever. Currently, there exists a fair degree of overvaluation in many segments of the US stock market. That said, overall we remain comfortable with various market segments and stocks due to the large valuation disparity that exists.

We have taken modest profits recently and continue to move forward with a healthy amount of caution. Although we anticipate further volatility in the future, we will be prepared with plenty of dry powder to take advantage of any opportunities.

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