Global equities, as represented by the MSCI World Index, returned 5.35% in Q1 2017 (in Canadian dollar terms, net of dividends). Sector leadership this year shows a marked shift from the types of stocks that enjoyed an initial bump in the aftermath of Trump’s victory. Thus far in 2017, cyclical stocks and industries are no longer outperforming. This likely reflects a more sanguine appreciation of the challenges that the new administration faces in implementing its agenda. It might also reflect a consideration as to whether or not the suite of policy proposals can instill the confidence necessary to accelerate U.S. GDP from the 1.6% growth rate that Bloomberg consensus expects this year. Regardless, global equities undoubtedly benefited from the synchronized uptick in global GDP growth with key PMI’s from the U.S., Europe, China and Japan remaining clearly above 50, a level that denotes growth and expansion.
NexGen Global Equity Fund
The Fund made a small number of investments during the quarter:
- The Fund has established a position in WS Atkins – U.K.’s largest engineering firm and 11th largest in the world. Atkin’s clients include defense, public infrastructure and energy sectors and the U.K. and the U.S. are the company’s two largest markets. Subsequent to quarter end, Canadian peer SNC Lavalin approached WS Atkins with a takeout offer of £20.80 per share, a 35% premium to the prior trading session’s closing price. At time of writing, WS Atkins put out a release indicating that their Board would accept the offer should it be finalized.
- The purchase of WS Atkins was financed by trimming back positions in Costco and Philips 66. The weights of the two stocks as at quarter end was 1.46% and 1.45% respectively, vs. the more normal weighting of approximately 3.0%. While we remain confident that both stocks can achieve our target hurdle rate of 10% per annum (inclusive of dividend) over the medium-term (which we define as the next five years), they both faced industry headwinds through the first couple of quarters in 2016.
Market Review and Outlook
Thus far in 2017 volatility seems to have disappeared from the equity market with the popular proxy for volatility, the CBOE’s VIX Index, averaging just 11.7* during the quarter. After their sell off in Q4, bonds have been similarly stable, with the U.S. 10-Year Treasury remaining in a tight range between 2.3% and 2.6%*.
But the lack of action in fixed income is very interesting. At the end of 2016 a seeming consensus emerged on Wall Street: the uptick in growth – further accelerated by the new government’s imminent reforms – would lead to an inevitable pick up in inflation and in turn to an increase in interest rates. While markets aren’t perfectly efficient, they are – barring predictable outbursts of euphoria or despair – generally good at pricing in fundamental information. Markets certainly aren’t perfectly inefficient.
So why haven’t U.S. interest rates caught up with the program and continued their Q4 spike? While it is obviously impossible to answer this with any certainty, the composition of, and expectations for inflation, probably offer up some clues. Depending upon the method of inflation estimation (CPI or the Fed preferred PCE), housing comprises between 35-45%; transportation and food/beverage are the next largest contributors at ~15% each; health care and other consumer goods such as apparel fill out the rest. U.S. housing has been enjoying a renaissance for a few years now and the S&P CoreLogic Case Shiller index of 20 U.S. cities was up 5.73%* in January, and thus solidly contributed to inflation. But pricing power has been difficult to come by in the other categories. Integrated supply chains, competition from new retail channels (specifically Amazon) and overcapacity in certain industries (specifically automobiles) resulting in intense competition have all conspired to keep price increases tepid in a broad range of consumer goods. Even health care cost increases have slowed as generic drugs continue to increase in number and availability and pharmacy benefit managers get ever more aggressive in composing their approved drug lists. While wage inflation is picking up, it only partially flows through to prices for goods and services. With energy prices steady (WTI prices returned to nearly $50 a barrel for the first time in summer of 2016), headline measures of inflation may well soften in the second half of 2017.
As such investor expectations of future levels of inflation remain muted. Certainly, they’re up from where they were a couple of years ago (when fears of deflation were widespread), but they’re still muted. As at quarter end, the U.S. inflation swaps market was pricing in 2.4% inflation five years from now. The forward market was pricing in the 5-Year Treasury to yield a whopping 2.1% five years from now. Given the pricing pressure that more than half the inflation basket is facing, those two figures seem reasonable. Given the continued voracious investor appetite for yield, why would rates sky rocket higher given such a meek inflation backdrop.
So what does all this mean for global equities and where are the risks? If the Fed continues to raise the short end of the curve, without some sort of parallel move in long-term rates, the curve would thus flatten; this is frequently a pre-cursor to a U.S. recession. Also, any protectionist trade measures implemented by the new U.S. government could certainly have the unintended consequence of raising prices. But on a more positive note, a reasonably stable medium-term interest rate outlook would be an unambiguous positive for stocks. Both from the standpoint that it would serve as a valuation tail wind to the entire asset class and that it would provide borrowers – both consumer and commercial – with a measure of visibility and confidence, that would in turn help sustain the growth cycle.
* Source: Thomson Reuters
For more information about NexGen Global Equity Funds, please contact your financial advisor.
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