As investors say goodbye to 2018, one thing they’ll likely remember is saying hello again to market volatility.
With markets selling off this year in response to rising yields and concerns about trade and global growth, “2018 was a reminder that volatility exists […] and can happen quickly,” said Robert McKee, vice-president and portfolio manager at Mackenzie Investments.
Further, with FAANG stocks driving the markets, 2018 provided a reminder that unproven business models come with risks, said McKee. For some tech companies, “the perception of growth or profitability […] and the reality can change very quickly.” He avoids such stocks where long-term demand for a product is poor or unclear. No one knows what Facebook will look like in 10 years, he said, referring to the time period he uses to forecast growth.
Jennifer Hartviksen, head of Canada fixed income and senior portfolio manager at Invesco, said the biggest surprises in 2018 came from idiosyncratic places, which highlights the importance of active management.
This has inspired her management theme for 2019: “What you don’t own is as important as what you do own,” she said. In 2019 that means avoiding “blowups” from a single name.
There are plenty of potential economic developments to keep managers alert.
Giles Marshall, vice-president and portfolio manager at Fiduciary Trust Canada, expects headwinds for equity markets because of ongoing rising rates and slower growth (see table below). In 2018, talk of synchronized global growth faded out in the first quarter, and “the U.S. did all the heavy lifting” thanks to its fiscal policy, he said. “Earnings are going to decelerate […] quite markedly in 2019,” he forecasts.
At a 2019 outlook event in Toronto on Dec. 4, executives from Franklin Templeton Investments took a similar view. Ian Riach, senior vice-president and portfolio manager for multi-asset solutions, said the firm was slightly underweight North American equities.
In Canada, the concentration in financials and resources as well as some economic indicators are cause for concern, he said. Debt-burdened households reducing spending will put pressure on growth, he said, while historically strong employment numbers mask a decline in the long-term, full-time jobs that contribute to stable growth.
In the U.S., companies will have a hard time matching 2018’s earnings, Riach said.
“The risk of profitability and peak margins declining from here is high in our minds,” he said.
“If earnings are vulnerable to disappointment, coupled with valuations that are at or slightly above fair value, this is just leading us to be a bit cautious at this stage of the cycle.”
Riach said he’s leaning to more defensive-oriented names with a history of dividend growth.
With the extended bull run, Marshall urges caution, suggesting advisors dampen clients’ return expectations after the prolonged period of solid returns in balanced portfolios and little volatility. He’s slightly overweight in his cash and bond positions, he said.
U.S. growth is an economic development to watch in 2019, said Hartviksen, adding that a slowdown would weigh on riskier credit assets, which have done well in the last decade of low rates and accommodative monetary policy. “Given how tight valuations are, despite the good fundamentals we have been reducing our risk” across multisector credit strategies, she said.
Still, no one’s ringing alarm bells about growth.
“We do not anticipate a global recession in 2019, and we don’t anticipate an American recession,” said David Stonehouse, senior vice-president and head of fixed income at AGF. While U.S. growth will likely decelerate as tax reform effects taper and consumer strength wanes, he’s optimistic that companies’ capex should gradually roll out, as it was restrained in 2018 in part from share buybacks. Thus, “You won’t get destroyed with respect to corporate bonds next year,” he said.
In the medium term he’s underweight corporate bonds given tight spreads, as well as high leverage ratios as the economy decelerates. That includes names in automotives, industrial high yield and semi-conductors.
The other key global economy, China, struggles with reform and tariffs but, on the plus side, is applying gradual stimulus, Stonehouse notes. McKee said a slowdown of the Chinese consumer would affect retailers like Nike, so he’ll be assessing his firm’s exposure to the country.
Riach said his short-term view of China, which is threatened by trade pressures, is leading to a “less-than-enthusiastic” emerging market equity outlook for 2019. As the largest export destination for emerging market countries, those economies are tied to China’s.
“We would prefer to see some outright policy action before declaring that the coast is clear,” he said.
While his firm is neutral on emerging market equities in the near term, Riach is overweight developed global markets. European growth hasn’t been strong enough for the central bank to start increasing rates, he said, which should give equities a boost, and many stocks have low valuations reflecting risks such as Brexit.
“With nascent growth, valuations so low and pessimism so high for the area, we believe that performance in the euro zone could surprise on the upside,” he said.
Wrangling with rising rates, disruption
In addition to managing geographic exposure, McKee said the new year will require managing exposure to companies based on their financial statements, especially as credit becomes more expensive. He ensures the companies he holds have strong balance sheets and aren’t reliant on refinancing debt.
With rising yields—which could rise more than expected if inflation increases—Marshall has an active call for the first time to hold cash in the fixed income part of his portfolios, and remains “significantly” overweight investment-grade corporate bonds.
“The spreads are narrower than average, but there’s still reasonable yield pickup,” he said. He’s also short duration versus the bond universe. Describing his defensive stance, he said, “We think it’s going to be difficult to make money in bonds.”
Riach said he also prefers shorter duration, and corporate over government bonds. “Corporate bonds, up to a point, are less sensitive to the general level of interest rates than Government of Canada bonds are,” he said.
While he’s underweight fixed income generally, he said he prefers global bonds to domestic ones.
Hartviksen said she generally avoids disrupted retail, as exemplified by the Sears bankruptcy. “We are avoiding over-levered retail models that aren’t going to make sense going forward, like the department store,” she said. Her picks include Parkland Fuel and First Quantum. Calgary-based Parkland is a growing marketer of fuel products; First Quantum is a copper producer in Zambia with positive fundamentals that will benefit from strong copper demand, she said.
In addition to his reduced exposure to over-leveraged and cyclical corporates, Stonehouse is generally underweight tech, with its recent poor performance. He’s constructive on healthcare and expects industrials, where he’s been overweight, to look better if the extended economic cycle continues.
In EM, Hartviksen will be watching Turkey, Argentina and Brazil—countries with U.S.-dollar-denominated debt that experienced currency devaluation in 2018 as the Fed raised rates. For example, she moved back into some tier-1 Turkish banks after assessing their need to refinance loans and after the country narrowed its current account deficit.
While Stonehouse is tactically “somewhat bond bearish,” long-term sovereign bonds have been the only disappointment in the space. “While I’m still not optimistic yet about bonds, we’re getting to an interesting point,” given the rate hikes to date and the late cycle. “Bonds to me, as we progress through next year, look more and more attractive,” he said.
Waiting game with equities
With his forecast for rising rates and slower growth, Marshall is slightly underweight U.S. equities, he said, and slightly overweight international equities based on valuations.
McKee said he’s waiting for better buying opportunities with valuations generally elevated based on current earnings. In the meantime, like Hartviksen, he finds opportunities in one-off names—stable companies with good valuations that aren’t economically sensitive.
An example is telecom Comcast, which experienced a sell-off in 2018 over video distribution concerns. However, the company is competitive in the U.S., with a diversified business that includes content ownership, he said.
Table: Projections for economic growth in 2019
|Region||Projected growth for 2018||Projected growth for 2019|
|Canada||2.1%||2.1% (As of Nov. 20, CIBC forecasts 1.8%)|
|Oil-importing emerging market economies||4.4%||3.9%|
Source: Bank of Canada’s monetary policy report (October 2018)