Economic Update
For the first time in five years, the TSX beat its US counterpart, the S&P500, ending the year up 21.1% while breaking all-time highs. Canadian Markets were largely buoyed due to an almost doubling in oil prices since the lows seen this past January. The steep recovery came on the back of an agreement to curb oil output, reached between both OPEC and non-OPEC producers (including Saudi Arabia and Russia) marking the first joint action in 15 years.
Canada has performed very well over the past decade relative to other G7 countries and 2016, in particular, proved to be a great year for job creation. However, housing affordability and household debt, as well as slowing growth in Asia, are still big issues. When overlayed with a general shift toward a more protectionist mood all around and especially in the US, under the newly elected Donald Trump, this could pose a threat to an export-oriented economy such as ours. These potential challenges are why the International Monetary Fund (IMF) downgraded Canada’s GDP growth rate to 1.9% for the year ahead.
Many believe that we have finally turned a corner in terms of the bottoming of global bond yields and interest rates and are calling 2017 the year of reflation – that is, rising nominal growth including wages and inflation. This overall intentional increase in global economic activity would have additional benefit for our resource-heavy economy due to firmer demand for industrial commodities. In addition, previously announced infrastructure and fiscal stimulus measures should begin to trickle into the real economy over the next 12 months and our cheaper dollar should help exports.
Amid this uncertain backdrop, Governor Stephen Poloz is in no rush to raise rates, especially in light of current higher than desired unemployment and muted inflation. On the other hand, in what was almost unanimous predicted, the US Federal Reserve hiked their rates on December 14th for only the second time in the past ten years. The committee is currently projecting three more rate hikes throughout the upcoming year if the conditions of a continuing rise in inflation and tighter US labour market hold. This divergence in interest rate policy between the US and Canada is a natural consequence of each country being at different phases of the business cycle. While the US is currently situated in a cyclical upswing, Canada lies at the mature part of the cycle; this divergence in economic policy also remains a central theme going into 2017.
In a move whose consequences are still being felt, Prime Minister of India, Narendra Modi, made the decision to demonetize 500 and 1000 rupee notes to be replaced with the new 500 and 2000 rupee notes. The aim of this move was to combat corruption, tax evasion, and counterfeiting. This surprise announcement, which affected 86% of all cash in circulation, caused Indian stocks to tumble. This could plague a usually expansionary manufacturing sector in the coming months. Time will tell as to whether Modi’s action will have its intended effects or simply reset the clock on the same process beginning all over again.
Of course, we can’t provide an economic update without including a word on the world’s second-largest economy. So, what’s causing China’s engine to rattle lately? China has slowed considerably since the double-digit growth we saw back in 2010 and is now battling currency woes as the yuan declines against the dollar. Indeed, China’s RMB hit an eight-year low this past November. Some feel that the devaluation of the yuan is inevitable, but policymakers are worried that a sudden drop could destabilize the financial system and hurt investor confidence. For these reasons, they are attempting to limit outflows through tighter capital controls. The issues that will play on China now and into 2017 include the weaker yuan, talks of a potential trade war with the US, and a slow-down in the property market.
Where does that leave us globally? Well, the IMF has cut its global growth forecasts for the next two years with an expectation for 2017’s global growth at 3.4%, citing uncertainty over Brexit, aging demographics and continued rising debt levels. In terms of looking ahead, we will continue to witness a passing of the baton from monetary to fiscal policy as an economic growth and market driver. While we don’t believe we will see a large scale transition from globalization to de-globalization it’s certainly plaguing the general public and is something to watch for.
The year 2016 turned out to be a real boon for investors with exposure to equities and Canadian equities in particular. Regardless, with valuations stretched into the multiples close to those of Black Tuesday, which some say marked the beginning of the Great Depression, we remain cautious. With limits on how high real yields can go in the shorter-term and continued risk in the equity markets, we remain on tenterhooks and contend that exposure to non-traditional investments is of paramount importance to ensuring effective diversification.
"...for I have learned in whatever situation I am to be content. I know how to be brought low, and I know how to abound. In any and every circumstance, I have learned the secret of facing plenty and hunger, abundance and need."
Philippians 4:11-12
Fund Highlight
Fixed Income is a very broad category that typically has a lender and a borrower with interest charged as payment. In the investment world, fixed income is often too simply equated with only traditional government bonds or corporate bonds. However, this category is much more inclusive and may contain private debt, infrastructure financing, mortgages, bridge financing, GICs, term deposits and even cash, to name a few.
From a portfolio perspective, fixed income investments typically have a lower risk profile compared to equity investments. This is because there is often collateral in real assets supporting the loan, and lenders often position themselves to be the first paid when something goes wrong. In addition to a typically low-risk profile, fixed income investments are often relied on by investors to generate income to meet regular cash flow needs.
Problems can arise when investors become solely dependent on the traditional definition of fixed income for their cash flow needs and for low portfolio volatility. Although both government and corporate bonds are readily available, they may not always provide the stable returns that people expect with a low-risk investment. In today’s low-interest rate environment, more than 70% of government bonds in the developed world are yielding less than 1%. This return is hardly conducive for most cashflow needs and is unlikely to even cover annual inflation. But in addition to low yields, we have also witnessed an increase in bond price volatility as this segment of the market more readily responds to various economic actions and events. Increasingly, investors are beginning to recognize that traditional bonds are no longer the safe, steady, cash-flowing investment they have historically assumed.
At Covenant Capital, we believe that accessing a broad spectrum of fixed income options gives investors the best chance of achieving a well-diversified, better yielding, low-risk fixed income allocation. Integrating more than just traditional government or corporate bonds requires the inclusion of investments such as private debt strategies, mortgages, infrastructure, factoring, and bridge financing. These “non-traditional” fixed income options provide real diversification as each investment may not respond in the same way (or at all) to market events.
Factoring is a type of lending that uses the accounts receivable of a business as the basis for the loan, instead of credit or collateral of a hard asset, such as real estate. This non-traditional investment type provides our Covenant Fixed Income Pool with regular interest cash flow and has contributed significantly to its return. In addition, the issues that typically influence traditional fixed-income investments (such as volatility, due to market events) have not played an important roll in the performance of this investment. This lack of correlation has added true diversification, which has reduced volatility risk and increased return within the portfolio as a whole.
Since the inception of our Fixed Income Pool, we have observed that our diversified blend of investments has lowered risk and produced a much smoother ride compared to the more recent rollercoaster experience exhibited by both the traditional US and Canadian bond indices. In fact, during the last quarter of 2016, the Canadian bond index dropped to -3.48%, while the Covenant Fixed Income Pool powered through its second best quarter on record with a return of 1.7% for the quarter. The index ended 2016 with an annual return of 1.3% compared with 5.4% for the Covenant Fixed Income Pool.
"May the Lord give strength to his people! May the Lord bless his people with peace!"
Psalm 29:11
The Burden of Debt
As some may know, one of the values that we ascribe to at Covenant Capital is the minimization of the use of debt. In today’s environment of very low interest rates, the math will often work out to the advantage of the borrower, especially if the loan can be invested for a higher return. However, we believe that unless necessary, it is unwise to put ourselves under indebtedness, even if the return is attractive. This might seem foolishness in the eyes of a society focused on material gain, but Proverbs warns that a “borrower is a slave to the lender” (Prov. 22:7).
Indeed, indebtedness today restricts tomorrow’s time, energy, and assets that could be used in a better or more generous way. Debt is a real burden, not an imaginary one. The freedom that comes with paying off creditors is significant. Is the bondage that we place ourselves under really worth the “thing” we’re buying today? Sometimes the answer might be “yes,” but we would like to encourage you to take the time to think this through in its entirety, and to recognize that the math should not be the principle ruling the decision. Seek out wise council and remember that nothing is a good deal, unless you can afford it. Romans 13:8 says “Owe no one anything, except to love each other.” Is your debt restricting your ability to love generously?
"In all things I have shown you that by working hard in this way we must help the weak and remember the words of the Lord Jesus, how he himself said, 'It is more blessed to give than to receive.'"
Acts 20:35