In February, we saw a reintroduction of volatility in the market. The steep drops early in the month were partially clawed back as cooler heads prevailed, but that left many investors with chilly reminders of the recession of 2008. Despite the perceived similarities, we believe this situation is far from the economic fall 10 years ago, as stated in our letter to investors here. Having said that, we see higher volatility persisting in the near future. In this economic update, we’ll talk about why volatility is here to stay and how to manage it. First, let’s start with a note on the Canadian economy.
*Equity Indices - FTSE Global Indices in CAD, Bonds - Barclays Global Aggregate Canadian Float Adjusted Bond Index
With the recent release of the 2018 federal budget, it’s worth having a quick refresher of our Canadian outlook. The budget itself largely focuses on equality and does not significantly change the outlook on the Canadian economy. One item that stands out is a reduced tax rate on small business income from 10.5% to 9% and a stiffer penalty on passive income earned by small businesses. Small business owners may view this as a mixed message. With the added pressures of higher wages, lower US taxes, and NAFTA concerns, the environment for doing business in Canada is stressed. The messaging in the budget supports our relatively smaller weight in Canadian equities.
To start, lower regulation is driving higher growth and inflation, and therefore higher interest rates. For the past 10 years, interest rates have been sitting at record lows, and while the increase is positive, it’s a big change from what this market has come to accept as normal.
In addition to market volatility, it seems President Trump is stirring the political pot and posing more of a threat to kick a leg out of the base that supports geopolitical stability. Global markets, which already have their own uncertainty, are now resting on this wobbly base, and this is fostering an environment for amplified uncertainty.
The chart below indicates the spike in volatility seen in February. It’s not untrodden territory, but it’s a big jump from what we saw in 2017.
Source: Yahoo Finance
We believe the global market is well-equipped to handle higher volatility and rising rates. Bank reserves are shrinking, but they’re still in excess of $2 trillion. The risk aversion that has accompanied the recovery since 2008 is now changing to investor confidence, and that is reflected in the drop in excess reserves. Unwinding the stimulus that central banks supported is a delicate transaction and is often coupled with market swings, but it’s both necessary and expected.
Priced in their respective currencies, Canadian and US markets were down about 5% last month. The TSX and S&P 500 levels in the chart below show us how the largest companies in these markets performed and handled February’s volatility. Comparing the performance to results from Invisor’s Balance Growth and All Equity portfolios, we can clearly see how the impact of the market drop was minimized. Our portfolios have exposure to the USD (a form of diversification) which helped offset the impact, but they are also exposed to many other markets which responded to the drop differently.
As investors, we prepare ourselves for, and expect, volatile environments by investing for the long term and keeping a diversified portfolio. Diversification helps to reduce the impact of volatility on our portfolios. Often with this method, events that adversely impact one area of a portfolio can be avoided, and net performance is stronger in the end. February’s returns in our portfolios are an excellent – and encouraging – indicator of this rule.
A Changing Environment
We’re out of the news cycle where the market is breaking records day after day. What the start of this month may be indicating is that the recent years of double digit growth may be nearing their end. A rising rate environment means pressure on both bonds and equities. Fundamentals are still strong, and we maintain a positive outlook on the global economy – after all, higher interest rates are the natural result of stronger growth. Going forward we expect moderated growth in equities and fixed income, and we expect the ride to continue to be bumpy.