I can’t help but think back to a phrase I first heard in the early 1990’s, “the Goldilocks economy”, the reference is to the children’s story, The Three Bears. It best describes the current state of the US economy as being not too hot and not too cold or in other words an economy with moderate economic growth and low inflation. So far, it seems like everything is just about right. US GDP has continued to pick up through 2017 with the latest third quarter reading of 3.2% up from 1.2% and 3.1% in the first quarter and second quarters respectively. Inflation has remained in check notwithstanding the latest November reading of headline inflation, which climbed to 2.2% mostly due to rising energy prices. Excluding food and energy, core inflation is running at 1.7% and more importantly, the latest reading for the Federal Reserve’s (Fed) preferred measure of inflation, the Personal Consumption Expenditures (PCE), was only 1.5%, well below the Fed’s notional target of 2%. The other factor the Fed looks at in determining future interest rate policy is employment, which has remained solid so far in 2017 with the November unemployment rate at 4.1%, a 17-year low.

Even though the economies north and south of the border continue to muddle along, some economists are describing the current environment, particularly in the US, as one of the best in a long time. The combination of synchronized global economic growth, low inflation, a reasonably accommodative central bank and rising corporate earnings are quite a powerful combination that could keep this market going for a while yet. The final reading for US second quarter GDP ticked up to 3.1% from 3.0%. This would normally suggest a reasonably strong hand-off for the back half of 2017, although we may see a hit in the third quarter due to missing output caused by hurricanes Irma and Harvey. This may cause a bigger rebound in the fourth quarter as rebuilding and spending on reconstruction takes place.

Last quarter we talked about how soft sentiment data such as the survey of expected business conditions could be a leading indicator of a stronger US economy ahead. However, with US GDP coming in at 1.4% for the first quarter down from 2.1% in the fourth quarter as well as weaker industrial production and retail sales in May, the hard data is mixed at best. Nevertheless, this did not stop the US Federal Reserve (Fed) from increasing the federal funds interest rate again in June for the second time in 2017 citing the continued strengthening of the US labour market and expansion of economic activity including household spending and business fixed investment. It also appears there could be one more rate hike between now and year-end based on the Feds projections from its June meeting. The Fed also announced it will begin unwinding its $4.5 trillion in securities holdings by decreasing the reinvestment of the principal payments it receives from securities held on its balance sheet. Effectively, the Fed will cap (in graduated increments) the amount it will reinvest from maturing securities going forward, which equates to another form of monetary tightening, the exact impact of which is uncertain.

While I have been investing for over 30 years, which I guess still makes me a youngster compared to one other here at Cumberland, I must admit that coming to work has never been more interesting than it is now. While the S&P500 total return index (“S&P500 Index”) being up 11.3% since the election certainly is interesting, in reality it is the US President that is keeping us, and the rest of the world, on our toes.. Even the TSX index has increased 7.3% on a total return basis over the same time period.

During the first quarter of 2017, the S&P500 Index was up 6.1% . Adjusting for currency, the S&P500 Index returned 5.3%, as the Canadian dollar appreciated by about a half of a cent, closing the quarter at US$0.75.

The Trump presidential victory on November 8th, once again, demonstrated that anti-establishment politics appear to be becoming the new normal. The initial reaction, as the election results were being announced, was investor panic. The Dow futures were down 800 points overnight and the S&P500 futures down 5%. However, the S&P500 quickly shifted direction after the President-Elect’s acceptance speech and has generated a total return of 5.0% in US dollar terms from the election-day through to December 31st 2016. The TSX followed suit with a total return of 4.8% over the same period.

Unlike the first quarter of 2016 where we experienced a fairly swift correction on global growth concerns, fear of rising interest rates in the US, falling commodity prices and the second quarter Brexit surprise vote, the third quarter has been relatively quiet from an economic and political standpoint. Perhaps this lull, combined with a relatively benign quarter for earnings, was the right combination that allowed markets to grind higher.

The biggest news development during the quarter came in the final few days – this of course was Britain voting to leave the European Union (Brexit) on June 23rd. The S&P500 lost 133 points or 5.3% in two days, only to recover most of the losses (99 points or 4.9%) by June 30th. We published our thoughts on Brexit in a quick note at that time, but it’s probably worth a recap along with our subsequent thoughts. To simplify, Brexit probably means three things: reduced economic growth in the short term at least for the UK and the EU, greater uncertainty and possibly a stronger US dollar.

The North American equity markets were off to one of the worst starts to the year since 2009. We saw both the TSX and the S&P500 indices decline almost 9% and 11%, respectively, at their low points in January and February of 2016. In Canada, slowing emerging market growth, in particular China, as well as lower oil prices which hit a 13 year low and negative investor sentiment were the main factors driving the TSX Index lower. Oil, which began the year at US $37.04 hit a low in February of US $26 before bouncing back to close at US $38 on March 31st. In January, the Canadian dollar also hit a 13 year low of US $0.685 before recovering to almost US $0.77 by the end of the quarter. The recovery was initially triggered by news that the Bank of Canada (BoC) left its benchmark rate unchanged at its January meeting, rather than making the anticipated cut. In its January statement, the BoC said that inflation in Canada is evolving broadly as expected.

The fourth quarter ended up with a pretty decent bounce in U.S. equities but not much of a recovery for the TSX. While commodities like oil (-17.9%), copper (-8.8%) and gold (-4.8%) continued to see downward pressure during the fourth quarter, the performance of the commodity-related equities was more muted. Instead, some index heavyweight stocks such as Valeant, Canadian Pacific Railway and Magna International weighed down the TSX. Much of this was earnings related, either coming up short of expectations for the current quarter or numbers coming down in future guidance. In Valeant’s case, issues around disclosure, potential regulatory investigations and now the medical leave of the CEO have pressured the stock. During the fourth quarter, the TSX returned -1.4% while the return for 2015 was –8.3% weighed down by Energy, Materials and Industrials sectors. While the annual number might sound bad, it actually looks good in comparison to the equal weighted TSX index, which was down -14.1% for the year. The equal weighted index is a better reflection of what has happened with the broad range of companies in the index during the year as it weighs each company equally while the headline TSX index is a market capitalization weighted index, meaning it can easily be skewed by the performance of a few large companies.

In Canada, after suffering a mild recession in the first half of 2015, the third quarter GDP growth rate was 0.6%. However, October’s GDP at 0% does not point to any real improvement and the recent trends in retail sales and employment continue to look daunting. While the latest reading of October retail sales managed to stay positive at 0.1%, after removing the effects of price changes, retail sales in volume terms declined 0.3%. Employment recovered in October mostly due to temporary work in public administration related to the Canadian elections only to see the unemployment rate move higher in November to 7.1% up from 6.6% in January of 2015. Overall, the Canadian economy continues to look weak especially compared to the U.S. Our Bank of Canada Governor, Stephen Poloz, has made it clear that monetary policy divergence from the U.S. will remain a prominent theme in 2016.

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Third Quarter Review North American Capital Appreciation Strategy September 2015

It’s official, after four years we finally had a market correction. Of course, it is natural to speculate on the worst possible outcome. After all, emerging markets have sold off, commodities have collapsed, volatility has skyrocketed and there is continued uncertainty around future actions of the US Federal Reserve.

Overall however, the economic data in the US is still pretty good and fundamental valuations have improved. Moreover, the signs we consider evident of a bear market are simply not there. We went through this in some detail at our September client quarterly presentation and on a number of our conference calls. As our chief strategist Gerry Connor has said many times in the past, bear markets are usually associated with a recession or at the very least higher interest rates, neither of which appear to be on the horizon. While the Fed is likely to move to raise interest rates before year end, we do not believe there will be significant enough of a change in policy to derail this bull market.

If we recap what happened over the summer, in general the second quarter earnings results came in better than expected. Second quarter earnings estimates at June 30th were expected to be down at -4.6%. However, nine of the ten sectors were above consensus with better than expected growth rates, and overall earnings were only off by -0.7% from original estimates of down -4.6%. While still a negative number, bear in mind we have the energy sector down significantly at -55% in the quarter and without that drag, these earnings results would have been positive.

Clearly, a recognition by the market of slowing industrial profit growth in China, the 40% drop in the Shanghai Composite from mid-June through August and the collateral impact it could have on developed markets had a lot to do with the recent market correction. However, when we take into account the normal shape of the yield curve (see Exhibit 1), which usually inverts prior to a recession or in anticipation of a bear market, positive ISM (Institute of Supply Management) manufacturing data, current low levels of employment as well as the positive consumer confidence readings we are seeing in the US, these just do not support the beginning of a recession or bear market.

While the latest payroll data for September came in weaker than expected, the unemployment rate is still a staggering 5.1% such that the number of people receiving unemployment benefits is the lowest that has been seen in 15 years. The ISM manufacturing data (see Exhibit 2) also remains positive and has been in expansionary territory for most of the past six years. Recessions do not typically coincide with periods like this. Finally, when we look at the latest housing and auto sales data, we note that single-family home prices grew steadily for the 12 months ending July by +4.7% and September US auto sales hit a record at 18 million units, which is the highest seen in ten years. Even Volkswagen had a surprise increase in sales for the month of the September.

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