All Eyes on The US FED This December
Jordan James - Nov 28, 2018
Global markets have been going through a fairly substantial correction. The decline in a number of the market sectors had started much earlier than this recent broad-based pullback in US indexes. This softening started in the early part of 2018 with food and consumer product companies and then worked its way through other sectors of the economy. Apple, Amazon and Boeing have been some of the last few names to correct. For better or worse, due to their weighting these companies have had greater influence on the US stock market indices. As a result, they have magnified both the move up and now the move down.
We believe that the end of this correction is near, though one wild card yet to be seen is the US Federal Reserve’s forward commentary for 2019. We expect a rate hike to come out of the FED’s meeting in December, however we are less than certain regarding their forward guidance for future rate hikes in 2019. If the Fed continues with a “hawkish” path of hiking rates next year, then the likelihood of a bounce back market recovery is slim. This uncertainty is causing us to be cautious as we approach the December Fed meeting.
There are clear signs that the global economy has been slowing. Over 45% of US stocks have corrected 20% from their highs in September. US housing starts have been slowing, October’s reading of durable goods orders has fallen, and the PMI (The Purchasing Managers’ Index – which is an indicator of economic health for manufacturing and service sectors) has also been falling. This should provide the Federal Reserve with economic evidence to proceed cautiously with future rate hikes.
Global PMI and the US 10yr Treasury rates are important to Canadian rates, as our domestic bond yields have tracked their American counterparts over the past two decades. We can then expect, based on historical trends, that falling US yields will put downward pressure on Canadian yields as well.
The chart below compares the forward-looking portion of the global manufacturing survey, new orders for goods, with the 10yr US Treasury yield. From a 2017 high over 55, the new orders index is now approaching the 50 level. An index reading below 50 indicates a worldwide contraction in manufacturing activity. We have also seen the largest decoupling between global PMI new orders (falling) and real bond yields (rising) since 2007. If growth slows in line with global PMIs, the US bond yields will start to fall.1
TSX has been in negative territory for much of this year and is roughly at the same level as it was in 2014 and 2008. We see a continuation of volatility for both the TSX and the Canadian economy. Real estate continues to soften in many of the “hot markets”, which will put negative pressure on economic growth. Canadian oil producers have been struggling with the massive discount of Western Canadian Select oil to global oil prices (WTI, Brent crude). Canadian crude recently hit lows of $22 (more than 50% discount to WTI). Canadian energy producers have been managing these low prices by driving down operating costs, which negatively impacts Canadian economic growth.
As these negative economic issues play out, future direction of rates is less than clear. This uncertainty has created a real opportunity in preferred shares, as both the rate/reset and perpetual preferred shares have dropped on average 10%.
We are building positions in both types of preferred shares with issuers such as George Weston, Fortis, Empire Life and Shaw Communications. The average yield has been around 5.5%. This income is distributed in the form of Canadian dividends, which is subject to lower taxation for non-registered money with the benefit of the Canadian dividend tax credit. Not only do we feel that this is an attractive opportunity for yield, but also a potential opportunity for capital appreciation as many of these preferred shares are trading at large discounts to issue price.
Although this has been a challenging year, value stocks have outperformed of late. Some of our larger holdings have been in value names such as Johnson & Johnson, Procter and Gamble, Verizon, Coca Cola and Fortis, which have been hitting new highs. We have prudently been taking profits on some of these positions that have outperformed.