Preparing for a Tough Environment

We are cautious on the outlook for equities and have begun to reduce our exposure to the US stock market.  For the year to date, the S&P 500 Index has significantly outperformed other developed markets.  The bulk of this outperformance, however, can be attributed to just three factors: a handful of mega technology stocks, the growth in earnings from a one-time lowering of corporate tax rates, and the positive effect of the strength of the US dollar on investment flows into North American capital markets.

The Trump Administration’s aggressive stance on US trade policy is primarily responsible for undermining our confidence.  We are concerned that global economic growth and corporate earnings will be adversely affected by disruptions in worldwide trade.  Other White House policy decisions add to our angst, such as restricting immigration to the US when the economy is running at full employment.  Doing so may result in inflationary wage pressures and in turn, could lift interest rates higher than is generally expected. Moreover, it is not clear that corporations have the pricing power to pass along increased labour/input costs to their customers.  If they don’t, we could see narrowing profit margins and the rosy consensus forecast for S&P 500 earnings sabotaged over the next 18-24 months.

We are particularly concerned about Canada in light of US trade ambiguities when coupled with the sizeable pricing discount experienced on Canadian oil exports due to a lack of pipeline capacity, the stalling Vancouver and Toronto housing markets, and an overly leveraged Canadian consumer. We continue to be underweight Canadian equites and believe these issues will put downward pressure on the USD/CAD exchange rate over the medium term.

Despite recent weakness, we continue to overweight international equities on the basis of attractive valuation, superior future growth and investor apathy.  Closer cooperation between Europe and Asia in the face of hostile US policies may pave the way for better future investment prospects outside of North America.

Normally a move out of stocks would prompt us to increase in our bond allocation. However, the interest rate normalization process underway does not make this a viable option.  In anticipation of a more difficult environment for interest sensitive assets, we will continue to upgrade the credit quality and reduce the duration of the fixed income portfolio.  We will be holding higher cash balances as we prepare for the tougher environment ahead.