Central Bank Policy Mistake?

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Rabbie Gill

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Main Article

TRI fears the Bank of Canada and US Federal Reserve are making a policy mistake by continuing to raise interest rates in an economic environment which still hasn’t fully digested past interest rate increases.

While TRI believes equity markets such as the S&P 500 will be challenged into the end of 2019 and early 2020, we have been expecting an important weekly and monthly cycle low in the October to December 2018 time frame.  The nature and length of the rally out of these cycle lows help identify the potential paths market might take in 2019.

Macro Trends

  • Equities are bouncing out of a potential daily, weekly and monthly cycle lows. Volatility is expected to be higher with a corrective rally in the process.
  • Interest rates and yield curves are rising. Canadian and US bonds (10 year+) are becoming very attractive as they begin to bump into overhead resistance levels.
  • USD has made new yearly highs and has confirmed the Feb 2018 as the most recent 4-year cycle low.

TRI Cycle & Trend Signals

Source: Fieldhouse Capital Management

* TRI Cycle and Trend Signals are dynamic and may change on a daily, weekly and monthly basis, without notice. The indicators are at a point in time and do not imply that the current trend will persist and should not be considered investment advice.

Canadian Economy – Moderating Expectations

On October 24, 2018 the Bank of Canada raised its Overnight Interest Rate by 0.25% to 1.75%.  This is the 5th increase of the Overnight Interest Rate since July 2017.  The market is pricing in two more rate increases by April 2019, which would take the Overnight Interest Rate to 2.25%.  The BoC states “the policy interest rate will need to rise to a neutral stance to achieve the inflation target”.  TRI agrees inflation is currently running slightly above 2%, as shown below, but is forecasted to fall back to the 2% level in 2019 and 2020 and not at risk of accelerating higher.

Source: Bank of Canada

TRI fears the BoC and US Federal Reserve are making a policy mistake by continuing to raise interest rates in an economic environment which still hasn’t fully digested past interest rate increases.  TRI believes interest rates are likely past the “neutral level” for this economic cycle.  Any further interest rate increases from here will only exacerbate the already slowing economy.

TRI finds the October 2018 BoC Canadian real GDP growth outlook puzzling, as we digest the details.  It raises many questions as to the robustness of economy that will slow to 1.9% for the next two years.

  • Consumption is expected to drive more than half of real GDP growth over the next 2 years, growing at 1.2% and 1.1% in 2019 and 2020, respectively. Net immigration into Canada is expected to be in the 320,000 to 350,000 people annually over the next several years, providing just under 1% population growth.  Does this imply the real wealth of existing Canadians and their spending will be almost flat for the next 2 years as net immigration drives most of the real economic growth?
  • Housing’s contribution to growth is expected to be flat, implying housing starts, housing sales and construction will maintain record high levels. Given the increasing housing regulations from all levels of government, higher interest costs, tighter financial conditions and slowing economy this forecast appears optimistic.
  • The sum of expected net exports for 2017 to 2019 is expected to be negative, albeit 2019 and 2020 are expected to be marginally positive. Do businesses have a NAFTA hangover and do we need a weaker Canadian dollar to help make us more competitive; weaker currency usually comes with lower interest rates…

The economy, along with markets move in cyclical patterns driven by the change in the relative cost of money and goods. TRI believes the current economic cycle is topping and is focusing on capital preservation over the next 12 to 18 months.  TRI is excited about the value opportunities that will arise in late 2019 or 2020. Until then, let’s see what the markets are telling us.

Equity – Is the Seasonal Correction Over?

TRI has identified the February 2018 as the most recent seasonal cycle low for the S&P500 Composite, along with several other global equity markets.  From the February low the S&P 500 Composite Index rallied into the end of September 2018, proceeded to fall just under 12% from its all-time high.  This rapid decline in equity markets caught many investors by surprise and today the fear and headlines of market crashes are more common than not.

While TRI believes equity markets such as the S&P 500 will be challenged into the end of 2019 and 2020, we have been expecting an important weekly and monthly cycle low in the October to December 2018 time frame. The S&P500 has bounced 6% from its October 29 lows with preliminary indications that low has potentially marked the daily, weekly and monthly cycle lows.  We will need to see weekly and monthly swing lows and upturn in our indicators to confirm.

Source: Bloomberg Finance LP

The nature and length of the rally out of the weekly and monthly cycle lows help identify the potential paths market might take in 2019.  If the markets rally in a corrective manner, that is prices are overlapping, into the next weekly cycle high and they peak in a left-translated manner and rollover in before reaching new highs.  Then it will be time to get defensive.  If the S&P rallies to the 2,850 to 3,000 level, then the first quarter of 2019 will likely be range bound before more weakness into the summer of 2019 and that is when to get more defensive.  And what if we have a blow-off top that takes us to the 3,000 to 3,200 level … then the market has bought itself more time.

The S&P/TSX Composite has also corrected about 12% from its 2018 highs.  However, in contrast to the S&P500 which has essentially doubled from its 2011 price level, the S&P/TSX Composite has been flat on a price basis over that period. We believe the sideways price action of the S&P/TSX Composite over the past several years is telling of the weak underlying secular fundamentals of the Canadian economy.

Source: Bloomberg Finance LP

S&P/TSX Composite monthly cycle topped in July 2018, or only 4 months after its February low. A monthly cycle that tops before the 6-month mark a first indication of upcoming weakness.  In October the S&P/TSX broke those February lows is likely finding an important weekly and monthly bottom in this range. Expectations are for the bounce out of the weekly and monthly cycle lows to be a counter-trend bounce into late 2018 or early 2019.

Fixed Income – Higher Yields

The Canadian yield curve is moving higher with the front-end rising in conjunction with BoC raising its overnight policy rate and long-end rising as the past simulative monetary conditions support positive economic growth rates (which TRI believes are topping).

The 10-year Government of Canada bond yield has exceeded 2.5% for the first time in 4 years.  That level was first broken in 2011 and support tends to become the new resistance level. The rate of increase in 10-year Gov’t Can bond yield is starting to moderate as it bumps into the 2.5% to 2.8% resistance zone.

Canadian and US bonds (10 year+) are becoming very attractive as they move into overhead resistance levels. If longer term interest rates increase another 0.25% to 0.50% and peak in early 2019, then TRI believes these bonds will offer compelling value.  Cyclically TRI expects bond prices to bottom and yield to top in the December 2018 to March 2019-time frame.

Source: Bloomberg Finance LP

Currencies – New Highs for USD

The US Dollar rallied to new yearly highs this past week, which is now the 8th month since the latest monthly cycle low of February 2018.  In our view, this is a positive cyclical development for the USD confirming a right-translated seasonal cycle advance and the February 2018 as the 4-year cycle low.  Once the current weekly and monthly cycle peaks, we expect the USD to hold above the February 2018 low and then rally to new cycle highs.

Source: Bloomberg Finance LP

Investment Philosophy

The Total Return Investor investment objective is to:

  • Protect capital and limit drawdowns while delivering better risk-adjusted total returns.
  • Actively invest across a wide range of asset classes.
  • Provide comprehensive risk management, focusing on how risks relate to each other and not limited to how risks relate to benchmarks.

TRI process is a disciplined and flexible asset allocation framework seeking total returns by managing tail risks, exploiting market volatility and minimizing drawdowns.

Disclaimer: This material has been provided solely for information purposes for the use of the recipient and Fieldhouse Capital Management Inc. (FCMI). This material does not constitute an offer or an invitation by or on behalf of FCMI to any person to buy or sell any security. It should not be assumed that the methods, techniques, or indicators presented in these pages will be profitable or that they will not result in losses.  Any reference to past performance is not necessarily a guide to the future and the value of investments may fall as well as rise.  FCMI accepts no liability for any direct or consequential loss arising from investments made in accordance with the attached material. The research and analysis contained in the attached material has been procured from sources which are believed to be reliable and accurate.[/vc_column_text][/vc_column][/vc_row]

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