Inside this Issue Q3/14 Update 1 Current Asset Class Weighting 4 Asset Class Descriptions 5
Q3/14 Update Equities have posted very strong returns since the 2009 lows, with the S&P 500 Index (S&P 500) and S&P/TSX Composite Index (S&P/TSX) up 192% and 98%, respectively, on a price basis. Given the strong gains some believe that the market top is near, with some forecasting weak equity returns in the years ahead. While the equity markets could be susceptible to near-term weakness, especially in light of the fact that the US Federal Reserve (Fed) is ending its asset purchases in October, the longer term outlook remains supportive for equities. As such, we maintain our overweight recommendation in stocks relative to bonds. Below we outline our current asset allocation calls, which include our preference for stocks over bonds, developed market equities over emerging market equities, corporate bonds over governments, and government bonds over cash. Overweight Equities The strong equity gains since 2009 have been driven by a combination of improving fundamentals and accommodative central bank policies. The Fed has implemented three rounds of quantitative easing (QE) since 2008, with the Feds balance sheet more than tripling from roughly US$800 bln at the start of the financial crisis to US$4.6 tln currently. The Feds policies and expanding balance sheet have been very supportive to the equity markets. As evidence of this we note that the correlation with the S&P 500 and the Feds expanding balance sheet has been a very high 0.97 since 2009. With the Fed expected to end QE in October this does remove a support for the equity market, but provided the US economy continues to improve, the stock market should be able to withstand the normalization of Fed policy. In our view, the normalization of Fed policy is a sign that the US economy is recovering from the financial crisis and may now be strong enough to stand on its own, without the need of aggressive Fed liquidity. The recovery of the US economy has significant consequences for both the equity and bond markets. For the equity markets, stronger economic growth would likely translate into stronger corporate earnings. For example, S&P/TSX earnings look to have bottomed following a challenging 2013 and continue to trend higher. Looking at forward earnings estimates, they are pointing to 10% earnings growth over the next 12 months. We believe further upside in equity prices is likely to be driven by earnings growth rather than multiple expansion, which has been the dominant driver of gains in recent years. Looking at equity valuations, while they are no longer cheap they are not excessively expensive, in our opinion. Currently, the S&P/TSX is trading at 19.4x trailing earnings and 2x price-to-book (P/B), which equates to just a 2% premium to their long-term averages. Similarly, the S&P 500 is trading at 17.9x trailing earnings (a 9% premium to its long-term average) and 2.7x P/B (a 5% discount to its long-term average). While valuations are above their long-term averages, they remain below levels typically seen at major market tops, implying the potential for further expansion. Our base case view is that stocks will rise in line with their earnings growth over the next 12-18 months; however, we cannot rule out further multiple expansion in this cycle.
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While equities are trading at modest valuations premiums to their long-term average it is important to emphasize that equities look attractive relative to bonds, which is an important factor in our overweight recommendation. One way to contrast valuations between stocks and bonds is to calculate the current equity risk premium (ERP) embedded in stocks and determine whether that premium is warranted given economic and market conditions. A simple approach to calculating the ERP is to compare the earnings yield (inverse of the P/E) for an equity index, in this case the S&P 500, and subtract that from the yield on government or corporate bond yields. Currently, the earnings yield of the S&P 500 is 5.50% while the 10-year Treasury yield is 2.50%, resulting in an ERP of 3%. We note that over the last half century the ERP has averaged 0.25%, which implies that equities currently appear cheap relative to bonds. We believe that over time the ERP will contract, with the government bond yield rising and the earnings yield on the S&P 500 declining. If correct, this would result in stocks outperforming bonds. We Expect the ERP to Contract over Time
International and Emerging Markets From the late-1990s to 2008, the emerging markets (EM) were the place to be. Over this period the iShares MSCI Emerging Market ETF (EEM-US), our proxy for EM, trounced the returns for the S&P 500. However, since 2010 the S&P 500 has outperformed the emerging markets, which we expect to continue. First, on a relative basis the developed markets, particularly the US and Canada, are showing stronger economic momentum than EM. For example, India and China GDP growth has slowed materially in recent years, which is having a negative impact on EM growth. Second, as we saw in late 2013, EM is often at the mercy of Fed policy changes, as their currencies often depreciate in response to Fed tightening, which then leads to foreign capital outflows. With the Fed looking to end QE in October, this could be a potential headwind for EM. Finally, from a technical perspective the S&P 500 remains in a strong relative uptrend versus EM, which is showing little signs of ending. All told, our preference is for the developed markets, with the US market being our top pick. Given the strength of the US dollar and weakness in the commodity complex, we see the S&P 500 outperforming the S&P/TSX in the coming months and would encourage investors looking for international exposure to look at our neighbors in the south. We See the S&P 500 Continuing to Outperform the Emerging Markets
Underweight Government Bonds A key factor in our underweight recommendation in bonds is our belief that bond yields will move slowly higher as the economic recovery continues. Our proprietary bond forecasting model, which estimates fair value for the Government of Canada (GoC) 10-year yield, is currently suggesting fair value of 3.40% compared to its current level of 2.15%. Based on our expectations for economic growth and output from our bond model, we see the potential for the GoC 10-year yield to rise to a range of 3.25% to 3.50% in 2015. If correct, this would result in a 9% to 11% loss for the GoC benchmark 10-year bond over the next 15 months. As such, we recommend an underweight in government bonds. Our Bond Model Suggests Fair Value is 3.40% for the GoC 10-Year Bond Yield
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Overweight Credit Within bonds our preference continues to be with corporate credit, particularly higher quality issues as we get later into the business/market cycle. Currently, Moodys Baa bond index, which we use as a proxy for North American corporate credit, is yielding 4.82%, representing a spread over the 10- year Treasury yield of 2.29% or 229 basis points (bps). The long-term average spread for this corporate bond index has been 200 bps, with typical lows in the spread between 125 to 150 bps. This suggests the potential for further spread tightening. Additionally, corporate balance sheets are the strongest they have been in decades, with high cash balances and low debt-to-total-equity ratios. For example, US nonfinancial corporations are currently sitting on roughly US$1.9 tln in cash, while companies in the S&P 500 have a net-debt-to-EBTIDA ratio of 1.60x the lowest level since 1990 based on our available data. Given the strength of corporate balance sheets and the potential for further spread tightening, our clear preference is for corporate credit over government bonds. Corporate Spreads Are Above Their Long-term Average Suggesting the Potential for Further Tightening
Underweight Cash We are currently underweight cash given low nominal yields and negative real yields, after adjusting for inflation. However, given the recent decline in the S&P/TSX, which did result in some intermediate term technical damage for the Canadian equity market, we are monitoring the equity markets closely and should we see important technical supports being broken, we would consider trimming our maximum overweight position in stocks and raise some cash. This would be more of a tactical move, as the long-term outlook for equities remains constructive, while cash yields remain very low.
Conclusion As outlined above, we remain constructive on equities given an improving North American economy, the prospect of stronger corporate earnings, and attractive valuations when compared to low-yielding bonds. We have made no changes to our asset allocation calls in Q3/14, but given the recent short-term weakness in the S&P/TSX we are monitoring the equity markets closely, and should we see important technical levels on the S&P/TSX be broken, we could make a tactical call to reduce our maximum equity overweight and raise some cash. For now, we are maintaining our maximum overweight in equities given improving fundamentals and supportive technicals.
Ryan Lewenza, CFA, CMT SVP, Private Client Strategist
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Current Asset Class Weighting
Asset Class Weightings Profile Cash Bond Can. Equity Intl. Equity U.S. Equity Alternative Income & Capital Preservation 40% 40% 20% 0% 0% 0% Conservative 15% 65% 20% 0% 0% 0% Moderate 5% 47% 15% 15% 15% 3% Growth 0% 20% 20% 10% 40% 10% Global Equity 0% 0% 20% 20% 45% 15% General Asset Class Ranges Cash Bonds Equities Alternative Income & Capital Preservation 40 75 15 40 0 20 0 Conservative 15 30 60 65 10 20 0 Moderate 5 10 45 65 25 45 0 5 Growth 0 5 15 40 50 70 10 15 Global Equity 0 0 80 85 15 20 Profile Descriptions Description Income & Capital Preservation Virtually any loss is unacceptable. Investors primary objective is to achieve a return that keeps pace with inflation. Fixed income and cash make up the largest portion of holdings. Conservative Losses can be tolerated, but erosion of regular income payments cannot. Stability of coupon or dividend is the primary concern as many investors will employ this income for cost-of-living expenses. Bonds tend to make up the largest proportion of holdings. Moderate Some higher risk positions tolerated but these are typically offset with blue-chip dividend paying equities or low-risk bonds. Growth Willingness to take speculative bond and equity positions though growth portfolios are typically biased towards equities. Strong earnings growth or high yields usually take preference over valuations. Some defensive constraints may be employed, but even these may be removed for highly risk-tolerant investors. Global Equity A willingness to ignore home-country bias and allocate holdings internationally. International equities typically receive weightings equivalent to or greater than domestic securities. These investors recognize that Canada represents only ~3% of global equity markets and are willing to source investment opportunities outside our borders. Income & Capital Preservation
Conservative
Moderate
Growth
Global Equity
Cash 40% Bonds 40% Can Equity 20% Cash 15% Bonds 65% Can Equity 20% Cash 5% Bonds 47% Can Equity 15% Intl Equity 15% US Equity 15% Alt 3% Bonds 20% Can Equity 20% Intl Equity 10% US Equity 40% Alt 10% Can Equity 20% Intl Equity 20% US Equity 45% Alt 15%
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Asset Class Descriptions
Major Asset Class Descriptions Cash Bonds Equities Alternatives Characteristics Liquid assets. Generally, straight cash or securities with one year or less remaining to maturity. Bank balances, money market funds and 30- to 90-day bonds would all be proxies for cash. Debt instruments that are promises from governments or corporations to pay a series of coupons and return principal to investors at maturity. Bonds, like equities, are priced and traded and therefore investors can realize profits or losses on their investment prior to maturity. Shares of publicly traded companies. Equities are a claim on the future cash flows and profits these companies are able to generate. Alternative assets can encompass a broad range of investments including real estate, gold, commodities, hedge funds and private equity. Alternative strategies also include hedging and short-selling. Strengths Often ignored during periods of rising equity markets, cash is a critically important defensive asset during periods of declining prices. The standard deviation for cash and equivalent assets tends to be low and cash is seen as a store of wealth in anticipation of better investment opportunities. For investors able to wait to maturity, highly rated bonds such as AAA-rated bonds can provide very predictable returns. Bonds usually have lower standard deviations than equities, and corporate bonds provide more protection than equities in the event of bankruptcy. Historically, long-term returns on equities have been superior to returns on fixed income investments (see periodic table on page 3). Investors are entitled to all company issued dividends. Equities tend to be liquid and are easily priced. Generally, equities will rise in inflationary environments. There are periods where bonds and equities are highly correlated. Alternative assets can provide the needed correlation in these instances. Alternative assets often allow allocators to target returns based on highly specific economic conditions and can be used to hedge against unlikely, but potentially disastrous, market events. Weaknesses Cash pays little or no interest. Held for long periods, cash is almost always a losing investment due to inflation and/or bank fees. Defaults are more common for lower rated issuers and therefore loss of income or principal is a risk. Bond prices are interest rate sensitive, so while volatility is typically less than for equities, it is still present. Historically, returns for bonds have been lower than equities. Unlike equities, bond payouts typically do not increase over time. Equities are more economically sensitive than other asset classes. Deflationary environments are usually difficult for equities. The standard deviation for equities is higher than other asset classes, which means investors are more likely to experience steeper losses under some market conditions. Weightings to alternative assets are generally kept at low levels (510%). Overweighting alternative assets may increase portfolio risk. Investing in alternative assets often requires a highly specific skill set (option trading knowledge, for example). Pricing of alternative assets can be difficult. Important Investor Disclosures Complete disclosures for companies covered by Raymond James can be viewed at: www.raymondjames.ca/researchdisclosures Raymond James Ltd. (RJL) prepared this newsletter. Information is from sources believed to be reliable but accuracy cannot be guaranteed. It is for informational purposes only. It is not meant to provide legal or tax advice; as each situation is different, individuals should seek advice based on their circumstances. 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