What's Up With Inflation?

Lots and lots of central bankers gathered at a yearly meeting in Jackson Hole, Wyoming over the weekend to discuss inflation and how best to get it fired up again.

The grand conclusion: it's not so easy.

The US Federal Reserve believes that economic growth will continue to improve in the 2nd half of 2015 and that with this growth, inflation will naturally re-assert itself.

Bank of England Governor, Mark Carney, is in the same camp, although he admitted that they need to pay attention to what is happening in China.

The public optimism they hold is intended to transcend into the psychology of markets and the economy in general, however according to Bloomberg:

 "At Jackson Hole, academics effectively delivered a beating to central banks' confidence in their ability to predict and manage their key variable, by pointing out wide gaps in knowledge about how inflation works."

In Europe and Japan, extraordinary monetery policy easing has yet to positively impact inflation. The Euro economy has improved, Japan is still struggling.

Falling commodity prices, especially in energy, have been a significant contributor to the current lack of inflation and have complicated the experts ability to predict the outcome.

Why is this important?

Because the US Federal Reserve and The Bank Of England are going to start raising interest rates and if their timing is off, there is a risk that this could choke off the 2 economies that have been growing in a global economy that has been struggling: Europe, Japan, Canada, Australia and China have all been lowering interst rates or easing monetary policy with extraordinary stimulus.

In fact, despite their optimism, the latest data on inflation from the US shows a rate well-below the Fed's target:

The uncertainty surrounding the timing of raising interest has been one of the catalysts that has created recent stock market volatility.

The real question on monetary policy, on the global scale is:

Is it wise to raise rates when there is so much global uncertainty? We believe it is not. The market odds on a September increase  by the Fed are 36%.

Central bankers and finance ministers will gather to further discuss this further when the G20 meets later this week. We are of the opinion that it should not be a country by country decision (to raise/lower interest rates), but a joint decision considering the global outlook.

With this in mind, we remain cautious on the outlook for global financial markets and will continue to be defensive with our client portfolios.

www.highrockcapital.ca

After A Volatile Week:

An Update On The Balanced Model

Generally speaking, the 60/40 model (60% equity / 40% fixed income) should be basically close to flat on the year, however, it would depend on the weightings of the various sub-asset classes as to exactly how this would look at this moment.

My old model (2010-2014) is in fact down approx. 1% thus far this year.

Our new model (slightly adjusted earlier this year: increased cash position, reduced exposure to pref. shares, lower ETF costs among other changes) is up by approx. 1% on the year.

Europe, Australia and The Far East indexes (large and small companies) continue to be the best performers in the models.

The Canadian Preferred Share index is the worst performer.

Interestingly, the composition of the Canadian Preferred Share Index has been changing: as older, higher yielding issues are matured, they are being replaced by more recent, lower yielding issues (lower interest rates) which has reduced dividend distribution and made them a less desirable asset class.

Government and Corporate Investment Grade Bonds have made positive contributions, High Yield bonds are negative.

Also and interestingly, High Yield bonds are down less (thus far this year) than the S&P TSX and the S&P 500. This makes sense, because as I have pointed out in past blogs, Canadian High Yield offers better risk-adjusted returns than either of those 2 indexes over time:

As far as the equity markets contributions, as I have suggested earlier, non-North American (developed market) Indexes have out-performed, North American indexes are negative and Emerging Market indexes are basically flat (which, all things considered, is a bit of a surprise).

Remember, with a balanced portfolio, it is the re-balancing that will guide you on how next to proceed. Sell over-weight, out performing asset classes and buy under-weight under-performing asset classes. As the cycle progresses, out-performing assets will likely under-perform in time and under-performing assets will likely out-perform in time. Don't try to time the cycle, let the portfolio tell you when to trade.

What Now?

Expect The Unexpected!

Equity Markets are cheaper:

S&P 500 is down 12.5% from its highs (May 2015).

Canada (S&P TSX) is down 15.5% from its highs (Sept. 2014).

Japan down  10.5% (Jul. 2015).

UK down 15% ( Apr. 2015).

Euro down 16.5% (Apr. 2015).

Australia down 13% (Apr. 2015).

So we have our correction.

Volatility hit levels not seen since 2009 on Monday (near 55 on the VIX) but closed back below the weakest levels in 2010 and 2011 yesterday (at 36 on the VIX).

Historically, higher volatility spikes early on, but volatility levels remain lofty for a period of time following the big spikes, but gradually decrease.

The S&P 500 should see some further buying support at last Octobers lows near 1820-40, if that holds, then we could possibly move back to the 2000 - 2100 level (as the next move).

Otherwise the up-trend line from the 2009 bottom will be the next test of support at or near 1700.

The 2007 high near 1600 follows that.

Until the up-trend line is broken, we are still in a long-term (secular) bull market.

Key Catalysts will be:

What will happen to the Chinese economy, will it be able to restructure and return to growth?

Will the US economy lift off in the 2nd half of 2015?

Both of these resolved in a positive way should help commodity prices eventually find support.

This will assist developing economies.

Inflation will likely remain low for some time to come.

 At this point we have not seen what the collateral damage has been and if there will be "knock-on" effects after the equity market melt-down.

Certainly the trillions of $ of realized and/or unrealized losses will leave investors a little less wealthy, but the impact on the market psychology will take a little while to determine.

So we shall be watching closely.

Remember, that these are all short-term phenomenon and despite all the doom and gloom that may be foisted upon us by the media in the next little while, we have to stay focused on the long-term:

Most importantly your future goals and managing the risk of not achieving them. 

Stay Tuned.

www.highrockcapital.ca

It Pays To Be Patient

If you had cash to invest, yesterday was a brilliant day in the equity markets.

If you didn't, I suspect it was a bit gut-wrenching.

I believe that properly building an investment portfolio should take years (not days) to complete.

In the short-run, you may lag behind the "market", but different asset classes will have their "moments" when investors/traders give up on them because they are not performing and hit the sell button that sends them to very reasonable price points and if you have been patient, provides a great buying opportunity.

There have been 2 very decent buying opportunities in the equity markets over the past year:

Oct 15, 2014 and yesterday. 

If you look back over my blog since its inception and have perhaps had the chance to listen to our weekly webinars, we (my business partner Paul and I) have been relentlessly (almost ad nausseum) beating the drum on how and why equity markets were expensive.

So we have been patient, until yesterday, when opportunity permitted us some great purchase opportunities for our clients.

I feel sad for those investors who's advisors put their money in to the market at any price, without some analysis of market trend, because not only did they miss yesterdays opportunity, but they also likely had to sit and watch while the value of what they owned (at higher price points) slipped further into the red.

That is where having a good, patient discretionary portfolio manager can be a real advantage: when opportunity arises, they can act quickly (of course within the parameters of your pre-established investment strategy) to adjust to changing market circumstances. That is added value. That is what you are / should be paying for.

An advisor who has to call you to get permission to make an adjustment may not be able to get to you in time.

Sometimes it pays to be patient and have cash ready for an opportunity when it arises and it may take months and sometimes years to get "fully" invested. Yesterday was a good day for those folks.

It is webinar Tuesday at 

www.highrockcapital.ca

Feel free to tune in to our recorded version at or about 5pm:

http://www.highrockcapital.ca/current-edition-of-the-weekly-webinar.html

We will talk about the current state of financial markets and the global economy and other wealth management issues.

See you then!

Perspective

I have been through many market "sell-offs" over the 35 odd years that I have been participating in financial markets and it amazes me how similar they all are.

For months and months upon months, markets remain over-valued (one extreme) and all of a sudden everyone comes to their collective senses?

Makes me shake my head in wonder.

In the early going, the most exposed traders, those who have gambled using borrowed money (leverage) are the first to liquidate (because they have to) as the assets that provide the collateral for the loan, fall to levels where the lenders demand more money to protect the loans. Traders must then sell more liquid assets to cover the required payment, further driving prices lower.

So we will get (quite quickly) to the other extreme.

Then we will need to assess the "collateral damage", both financially and psychologically on market participants.

There will be some potential for large highly leveraged institutions and hedge funds to suffer significant losses and that may exacerbate the situation, however, lessons learned from 2008 should likely limit this (although, there are many who, overwhelmed by their lack of good sense may get stung again).

There are under-currents in the global economy, as we have been suggesting consistently that have been less than positive and these may become more front and center as the weeks progress.

The S&P 500 will open another 3% (approx.) lower this morning and has blown through most minor support levels. There is strong support at last year's lows at 1820-1840.

It is August, so liquidity levels are less than normal and those traders who wish to capitalize on investor fears will be doing their very best to use the volatility to their advantage.

Have you heard from your advisor?

Traditionally, this is the time when advisors show that they care about you (or they don't). If they aren't calling to discuss your concerns, they don't really care.

Interestingly, it is also a time when discretionary portfolio managers can also add value.

Non-discretionary managers have to call you and ask you if they can place a trade (or even cancel an order). A large, non-discretionary practice has to call hundreds of families.

This can be daunting and leaves some clients (who do not get the first call) at a disadvantage.

In any event, remember that, like the swinging pendulum, we will see extremes, but eventually cooler heads will prevail, finding value and moving markets back to equilibrium.

www.highrockcapital.ca

Whoosh!

One of our on-going Themes for 2015 and one that we talk about regularly on our weekly webinar is that Bond Markets lead other financial markets. On Tuesday we pointed out the historical correlation between the US High Yield Bond Market and the S&P 500 as an example of one of the many reasons why we continued to be very cautious and defensive with client portfolios:

It appears that the S&P 500 finally got the message yesterday and sellers emerged.

Volatility spiked to levels we saw during the Greek Crisis in June and it does not look like this is the end of renewed volatility as we head into September (historically the most volatile month of the trading year):

We do expect some initial buying support to enter the market at or near 1980-2000 in the S&P 500, however there are mounting uncertainties in the global economy and this still over-valued equity market index may face further downward pressure if longer-term selling (profit-taking) materializes. 

We think that there will be buying opportunities, but patience is required. We want to see clear signs of better value and new money entering the market before we would be comfortable to commit client capital.

Further, we are concerned about some of the deflationary forces (from commodity prices) that have been emerging and the Bond Market's are telling us that further caution is warranted for the time being.

We have also been rather vocal about the new low return environment that we are now in and this increase in volatility will contribute further to that.

Remember, that this is part of the ongoing cycle and over the longer-term, this will fade and we will return to growth.

Diversified portfolios that have been regularly and properly re-balanced will come out of this in a year or so to continue thier growth trajectory. 

www.highrockcapital.ca

Shelter Costs Are Rising

US consumer prices were little changed in July as a whole.

However, what is buried inside this number is of some interest:

Shelter costs, which account for approx. 1/3 of the Consumer Price Index rose by .4% after an increase of .3% in June.

A rental vacancy rate at a 22 year low is driving rents higher: they were up .3% in July.

One of our add on "Themes" for 2015 is that the US Consumer (who has historically represented close to 2/3 of the US economy) demographic is changing structurally: Baby Boomers, the once "big spenders" are focused on retirement and not out-living their savings and that the now biggest cohort, the Millennial's, do not have the earning power, have significant student debt, expensive rent and generally different spending priorities.

So expectations of a rebound in consumer spending to drive the US economy may be over blown.

Add to that the increase in the value of the $US for emerging economies, China, Europe and Canada (and the current sate of their respective economies) and the potential consumer for US exports diminishes as well.

In July, US consumers were upbeat, increasing spending on automobiles and at restaurants, but it is difficult to see how that will be able to continue to drive spending down the road given what is going on in the global economy.

The "wealth effect" of better asset prices (since 2009) has not been significant as the "wealth gap"  (between the wealthy and the middle class) has widened and consumer spending has not rebounded to the same degree as in previous economic recoveries.

With that in mind, the majority of economists suggest that a 1/4% increase in the Fed Funds rate by the Federal Reserve will have a limited impact on the consumer and expect that this will allow them to move in September.

Interestingly, investors are split on the Fed's move.

If the Fed does move in September, then markets may be in for more of a shock.

Stay tuned!

www.highrockcapital.ca

Commodity Prices, China and "Emerging Markets" ...

Are all in this mornings financial markets news headlines.

Certainly these issues are front and center for their implications on developments for the global economy.

The key question (and there appear to be many opinions on the answer):

Is China in control? Are they being proactive or reactive? 

This all remains to be seen, in time.

Emerging economies are getting caught in the fall-out (Chinese  Yuan devaluation and equity market sell-off) there is currency, bond and equity market volatility and investors are moving away from that risk as a result.

Ever wondered what the (MSCI) Emerging Markets (Equiy) Index is comprised of?

• Remeber that it is companies, not countries that comprise this index.
• There are 836 mid and large sized companies which are domiciled in 23 different countries:
• Top 15 companies:

click on this table to enlarge

• Many of these companies are recognizeable names.
• Many have a more global scope than the country in which they are domiciled.
• But the importance of owning an "index" is the diversification provided by owning many companies (836 in this case).

So even though "emerging economies" are in the headlines and are struggling in the global economic environment, the companies that are contained in the index may have very diverse sets of circumstances working for and /or against them.

When the indexes are sold as a whole, many very solid companies may be taken lower in price as a result, but in time as value is recognized they will "bounce" back in price as investors uncover the value that was created. This unfortunately, may take time to happen. 

So it is important to remember that the purpose of owning this index (or any index for that matter) is for long-term growth and from time to time there may be short-term downward pressure on prices, but that eventually, as the good companies remain solid, they will bring the index back to realistic growth levels.

Today is "Webinar Day" at 

www.highrockcapital.ca

We will post a recorded version of it at approx. 5pm (EDT), so feel free to tune in at:

http://www.highrockcapital.ca/current-edition-of-the-weekly-webinar.html

and now that I am on the "bandwagon"

GO JAYS!

The Dog Days Of Summer

The rise of Sirius (the dog star) late in the night sky in the constellation Canis Major, has historically been identified with the hottest and most humid days of summer and hence the expression: "Dog Days".

Most folks are in "vacation mode" (in the Northern Hemisphere anyway) and traditionally financial markets experience low volumes of activity.

It is a great time, before the rigours of "back to school" kick in and we get sidetracked by Blue Jay fever (even I have jumped on the bandwagon) to take stock of your situation and assess where you are as we enter into the last phase of 2015.

Best way to do this?

Lounge in your beach chair, cast out your fishing line, hoist the main sail, line up your put (or whatever you may be relaxing with) and as you do that, give thought to all of the things in life that are important too you.

Take all those important things and determine what it is that you need to do to make sure that all those important things remain as your life's key goals and objectives.

Family, professional, charitable, financial, health, travel and any other priorities that you might have.

If you can, write them down and list them in order of the timing in which you might want to achieve them.

Then, put them away (for now) and go enjoy the last few weeks of summer. We can pull them out again in September and start to work on how you are going to make them all happen.

 Deflation? or Inflation?

This is the crucial argument for the foreseeable future and one of the key reasons why we believe that we are in a low return environment and will be for some time.

For most central banks, their monetary policy is mandated to maintain "price stability". In the US, the Federal Reserve has a dual mandate which adds "full employment" to the equation.

The going rate for most central bank's targets for "core" inflation (excluding the more volatile food and energy components) is 2%.

Currently, core inflation is running well below targets on a global scale.

However, it is not just the current status of inflation that we need to be concerned with. We also need to think about what the future holds.

Traditional economic theory instructs us that economic growth breeds the demand for goods and services that push prices higher (and hence consumers demand higher wages to continue to be able to afford those higher costing goods and services).

With that in mind, the US Federal Reserve expects growth in the US economy to pick up steam in the 2nd half of 2015, which in turn would (according traditional economic theory) infer higher rates of inflation in the future.

That would justify their desire to raise the Fed Funds rate in September by 1/4%.

However, their are other forces at work:

If we look at the global economic picture, it is not so rosy:

Today's data show that Europe continued to struggle in the 2nd quarter of 2015:

however, Euro Area core inflation picked up slightly in July:

New data on US Producer Prices released this morning also show continued low inflation:

Meanwhile commodity prices continue to decline and historically, commodity prices have been a strong indicator of future inflation (or deflation):

We can say that there is certainly a likelihood of continued low inflation.

However, US manufacturing data released this morning showed better than expected growth :

This may add to the Fed's expectations of improved economic growth.

All the new economic evidence/data continues to balance the argument:

Inflation is currently low, likely will remain so in the near future and economic growth, while improving slightly in the US, remains subdued globally.

We continue to monitor developments.

www.highrockcapital.ca

US Consumer: Buying New Cars and Driving Them To Restaurants

Retail Sales for July were higher by .6% and May and June's data were revised higher as well, based on higher auto sales (+1.4%) and restaurants (+.7%).

I have continued to expound, regularly, on the changing demographic of the consumer and while this latest data does not change our longer-term outlook, it may encourage the US Federal Reserve, giving their forecast on better US economic growth for the 2nd half of 2015 greater credibility (although data revisions can and may make these numbers less reliable in the short-term).

Even though there may be some better US domestic data, there are still global forces at work and recent economic activity in China (slowing export growth and currecy devaluation) and other developing economies as well as lower inflation data in Europe are all necessary considerations for the Fed in its September policy deliberations.

While many believe that a 1/4% increase in the Fed Funds rate will not be significant, it does have the ability to add uncertainty to an already struggling global economic situation.

Stay Tuned.

www.highrockcapital.ca

Managing Expectations

This may or may not come as a shock, but for the forseeable future folks, we are "oficially" in a low return environment:

Low economic growth, low revenue growth, low earnings growth, low commodity prices, low wage growth, low inflation  and low interest rates = low returns.

So we have added this to our list of Themes for 2015.

Almost every chart that I popped up on yesterdays webinar had a "down" arrow for the recent direction of that particular price or economic statistic.

And there were many more.

As I have said often enough, recently, we have had multiple years of above average returns and this next part of the cycle is inevitable as we move back to the average.

What investors need to guard against is taking on greater risk in order to attempt to continue to get better returns. 

If you have a plan and strategy, stick with it.

Ensure that your asset allocation is balanced and / or re-balanced and sit tight.

If you have new cash to add, be patient.

If you want to discuss it in more detail?

www.highrockcapital.ca

I Get Mail:

A client from my life just before this one wrote me:

"Your questioning and caution of the markets these days are what impresses me about you. You were cautious with my entry into the market at the end of 2014 looking for opportunities."

 

I am not in favour of selling and buying in an effort to "time the markets" on a regular basis. However, after more than 35 years of watching markets and understanding both short-term trading and long-term investing behaviour (from market participants),  a case can be made for being patient when putting money (especially new $$)  into the market if certain asset classes appear to be overly expensive.

I have had this conversation many times with clients and former colleagues: different asset classes will out-perform (or perhaps we can say "over" perform) at certain times in a market cycle and they will under-perform at certain times.

Once you are fully invested, re-balancing is the key to making position adjustments because the portfolio will tell you when a particular asset has out-performed because the weighting (of that asset) will move to a level above the initial allocation weight.

For example, if you started with US equities at an 18% weight as part of the initial asset allocation and when re-balancing (later on in the life of the portfolio, after US equities have out-performed) you find yourself with US equities at 22% of the total portfolio, the action required to get you back to the original asset allocation is to sell (take profit) on the 4% that you are overweight.

If you are overweight one asset class because of out-performance, then you are underweight another, somewhere in the portfolio. 

The cash generated from the sale of the US equity overweight is then used to purchase whatever you are underweight.

The mistake that many make is hanging on to the overweight position because it is going up. Or worse changing the allocation to allow for a greater weight in the over-weight position.

That is a trap that many fall into. The key to long-term growth is the discipline of re-balancing. A good portfolio manager will have that discipline.

Getting fully invested is another matter:

It is easy for an advisor or portfolio manager to fully invest you immediately, it requires a lot less work.

However, understanding the cyclical nature of markets and asset classes is where a good manager can add value over the longer term. 

If US equities are out-performing and over-valued, a correction is a greater likelihood as a law of averages.

Last October was no exception.

If you waited patiently and kept new cash dedicated for US equities (and some other equity assets) you could have got prices better than where they closed at the end of December 2013.  Waiting certainly paid off.

We sat on some $$ ear-marked for Canadian Government Bonds from 2011 until mid 2013 ("taper tantrum") before putting that money to work. We missed out (opportunity cost of waiting) on perhaps 2% (net)  of income over this period, but saved asset depreciation of over 10% and picked up cheaper assets to boot.

There can and will be opportunities and good (patient) managers will be able to pick up this extra value from time to time (and earn the fees that they charge).

Today is "Webinar Tuesday" at High Rock, feel free to listen in on our recorded version later today:

http://www.highrockcapital.ca/current-edition-of-the-weekly-webinar.html

It Is Employment Data Day!

Financial market traders and their media equivalents get all excited about this data, but it is subject to potentially significant revisions each month so for us with longer-term time horizons we should really be focusing on the longer term trends.

However, if the US Federal Reserve and the Bank of Canada are basing their next stage of monetary policy on the trend (and wage growth is the key component) then we do have to pay attention to data that may impact the decision making process.

In the context of our theme that their is a structural shift in consumer spending occuring, wage growth is interesting from the perspective of :

1. Is there wage growth?
2. If so, what are consumers doing with the money?

At the moment, wage growth has been minimal despite rising employment in the US (although labour force participation has been shrinking), which means that consumers (by and large the "middle class") have had less money to spend.

Todays reports really did not show any significant change:

In the US non-farm payrolls rose by 215,000 (slightly less than expected) and revisions to previous months were slightly higher.

Year over year wages in the US grew by 2.1%, below expectations. Labour force participation remained at the lowest level since 1997 at 62.6%.

Inflation (or lack thereof) was at the forefront of the Bank of Englands decision to hold rates steady yesterday.

Central bankers globaly are concerned about the lack of inflation growth.

The US Federal Reserve will not be an exception.

In Canada, small growth in employment and no change in unemployment will likely not change the BOC's current thinking.