November 8th, 2015

CIO Quarterly Strategy Review

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.