The last few days of July have seen the global trade outlook improve significantly and, as such, stock markets and pro-cyclical stocks in particular, such as industrials, have outperformed, while bond yields increased. Consequently, our model’s momentum indicators are pointing to a strong overweight position in equity. Yet, with Donald Trump at the helm and the November mid-term federal elections in the U.S. less than four months away, the potential for the U.S. president to continue exploiting global trade issues opportunistically to gain political ground remains a cause for concern. Case in point, the Trump team just threatened to impose tariffs of 25% (up from an initial proposal of 10%) on $200 billion of Chinese exports to America. Maybe because the measure won’t be in place, at the earliest, before the end of August, equity markets have largely ignored the headline for now. But the rhetoric could escalate at any time, even though we still believe that cooler heads will prevail in the end. For the month of August, we are thus remaining neutral on equities against bonds, waiting at least for some of the fog to clear up before committing to a different position.
Regional Allocation & Sector Allocation
There are no major changes to our regional allocation this month with our largest overweight remaining Canadian and emerging market equities. Canadian stocks remain historically cheap relative to U.S. equities. We are particularly optimistic that Canadian oil companies can grow their cash flows this year, even though the discount on the Western Canadian Select is at record levels. We continue to expect Canadian crude oil prices to remain strong in 2018 and 2019 on the back of strong global demand for oil, a tightening global oil market and as constraints on market access in Canada get resolved. The latter development would allow Canadian oil companies’ prospective cash flows to be revised upward as well as see permit contracted valuation multiples to improve. This combination would be a powerful return generator in a sector that accounts for a very significant proportion of Canadian equity market.
We are also maintaining our overweight position in emerging equity markets as these remain cheap relative to developed markets. Macroeconomic conditions continue to be ideal for emerging markets, with low real interest rates, soft inflation measures and easy financial conditions. Both leading economic indicators and forward earnings for emerging markets are also accelerating relative to developed markets. We obviously remain concerned by global trade tensions but our emerging market position is still relatively small in the portfolio; thus worth the risk, in our opinion, given the high potential of emerging markets. A full fledge global trade war could dent our performance. Such an event would put an end to our optimistic emerging equity market forecasts … until valuation becomes very attractive or trade issues get resolved.
For the month of August, our sector allocation has not changed. We are still recommending that clients overweight positions in the Industrials, Financials, Energy, Information Technology and Consumer discretionary sectors in both the U.S. and Canada. For Canada specifically, we also recommend keeping the overweight in the Materials sector.
Canadian Bond Allocation
We are also keeping our neutral stance on corporate bonds this month as valuation still remains historically rich, especially when adjusted for elevated corporate leverage. We remain concerned by the decelerating global economic momentum, the eventual slowdown in earnings growth and the expansion of corporate and public debt while major central banks are withdrawing their monetary stimulus. All of these factors should ultimately hurt the relative performance of credit in the second half of the year.
Growing apprehensions over geopolitical uncertainties and increasing trade war hostilities should negatively impact investment decisions and the profit margin outlook of corporations. We are still not necessarily calling for corporate spread to get wider in August. However, as spreads are historically tight with little to be gained in terms of further compression, we prefer remaining on the sidelines until further notice.
