Time to downgrade long-term expectations

• Latest Canadian GDP data have hightened the risk of recession north of the border, although it might be too early to reach such conclusion.
• While US numnbers remain healthy and broadly within expectations, we are mindful that the Fed's dovish pivot is mainly driven by concerns over a possible, if not likely, economic slowdown.

• The massive rally staged since last December is mainly explained by market psychology rather than fundamentals, which means investors should downgrade their expectations of future long-term returns.

Last week, fears of an economic slowdown were intensified by wicked GDP data from Canada. In the fourth quarter of 2018, the Canadian economy grew at an anemic rate of 0.1%. This translates into a paltry annual growth rate of 0.4%, versus 3% for all of 2018. The decline was atributed to numerous factors, including a drop in retail sales, double-digit decline in business investments, sluggish household spending, lower real estate activity and what have you.

There was nothing exceptional to which one could attribute this poor report. The economy has simply slowed down on almost all fronts, which means the threat of a recession on our side of the border is now real, although such outcome is still far from inevitable. Obviously, this throws a major dent in Mr. Poloz' assessment, partcularly the part where he thought interest rates were sufficiently low to stimulate the economy. This now remains to be seen. However, one thing is for sure. What we said last week about the possibility of interest rates rising again is now off the table. With such poor numbers, there is no way the Bank of Canada would consider raising interest rates for months to come.

Elsewhere in the world, the news is not much better. In China, GDP growth forecasts for the year have been revised down from 6.5% to 6% although some stimulus is on the way. In Europe, Mohamed El Erian, the famous ex-asset manager at Pimco (now with Allianz), believes the forecasts for Europe are too optimistic and that the continent will be challenged to reach 1% GDP growth this year.

This leaves us with one bright spot, the U.S.. There, expected GDP annual growth of 2.6% remains healthy, albeit lower than last year's number, now revised up to 3.1%. That said, one cannot ignore a couple of major issues:

First, the U.S. cannot keep holding the global economic fort indefinitely. Unless China and Europe pick up steam again, the slowdown is bound to reach the U.S..

Second , if the Fed has pivoted in favour of more accommodating monetary policy, that is because they have concerns that late cycle fears are fairly justified.

Third, the latest indications are that the Fed might announce it will end its balance sheet reduction process by year-end. It means that, between now and year-end, a good amount of liquidity will still be taken from the market, which cannot be good for bonds or for stocks.

Until last week, the market continued to ignore such considerations and seemed wanting to go up, regardless. However, last week's test of the critical 2810 level for the S&P 500 failed, and the index was pushed down. Even good news on the trade negotiations with China was not enough to take the market beyond its resistance levels, which is a powerful sign that the rally is losing steam.

Still, all such developments do not warrant any major action or change in your investing strategy. That should only be done if something unexpected happens. On that, we can truthfully say that, since year-end, nothing fundamental has changed or anything unexpectedly positive has happened. To the contrary, the massive equity rally that we have seen has been fully based on expectations (i.e. investor psychology), not market data. S&P 500 earnings have hardly changed. What has changed is that investors are now willing to pay 19 time trailing earnings for US equities (versus 16 times back in December) without anything concrete to justify such major shift in sentiment.

Unfortunately, this is how markets operate. In our update of January 20, entitled "Seeing the future", we proposed a range of possible outcomes in terms of what return you can expect your equity portfolio to deliver in the next 10 years or so. We strongly invite you to read this note. What we said was that, of the three factors that account for market returns(i.e. dividends, earnings growth and valuation), the latter is the wild card that is impossible to predict. What happened in the last two months fully demonstrates our point in that market valuation jumped from 16 times earnings to 19 times in a very short time frame, without any concrete justification.

This means that, as you relish the nice return enjoyed since last December, it's time to throw a resounding note of caution. As we outlined in Seeing the future, the higher the market P/E ratio, the lower the expected long-term return. In other words, it's now high time to manage your expectations and may be recalibrate your equity allocation accordingly. When you do that and by how much depends on your personal circumstances and is something you should be discussing with your advisor.

March 5, 2019

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