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The Skeptical Investor

Despite the risks, this market is driving higher. Watch McIver Capital Management’s Skeptical Investor video where Portfolio Managers Ethan Dang and Matt Ehrenreich discuss the resiliency of this market.

Trade War Cycle – Wash, Rinse, and Repeat

Global financial markets continue to face ongoing uncertainty surrounding U.S.-China trade tensions, slowing global economic growth, yield curve inversion, and central bank policies. Despite all the uncertainty, markets remain resilient and this is a sign of strength. Let’s look at trade tensions and their ripple effects on the economy and how central banks are collectively combating the global economic softness.

U.S.-China trade tensions continue to be a key area of uncertainty for the markets. Since implementation of the first tariffs back in July 2018, a pattern has emerged in the trade war saga. A picture is worth a thousand words and the Trade War Cycle illustration below captures succinctly the repeating pattern witnessed by investors over the last year. This chart provides a simple mental model for tracking the trade war situation amid all the noise, and more importantly, gives us a way to detect deviations from the current cycle of behaviour.

We remain of the view that trade tensions will be prolonged due to deeper issues surrounding technology, although there is hope of an interim deal in the coming weeks or months as high-level trade delegates from both countries are expected to resume discussions in October. As a gesture of good faith leading up to October, the U.S. has delayed putting tariffs on certain Chinese goods (electronics and clothing) until December 15th and China has begun to purchase soybeans and pork from U.S. companies. But don’t hold your breath, we have seen this movie before.

Global Economic Growth

The ongoing trade tensions between the world’s largest two economies have no doubt weighed on global economic growth and business confidence. The global manufacturing sector (as tracked through Manufacturing PMI) has seen weakening data, especially in Europe, and companies have delayed or reduced their investments in capital projects due to trade uncertainty. Companies have also begun shifting a portion of their production capacity away from China by setting up factories in neighbouring countries, such as Vietnam and Indonesia.

However, the manufacturing sector does not represent the whole economy. In most developed countries, and increasingly more so in China, the services sector is a significant driver of the economy. The good news is the global services sector (as tracked through Services PMI) is holding up well. Furthermore, unemployment rates in North America remain at record lows and consumer spending is still strong.

Yield Curve Inversion and Recession Fear

There have been plenty of news headlines and media attention focused on yield curve inversion in the U.S., which occurred at the end of August 2019. Yield curve inversion occurs when short-term interest rates exceed long-term interest rates and has been a reliable precursor to recessions. The caveat is that there is a time lag between initial yield curve inversion and when a recession hits the economy. Counter to intuition, yield curve inversion has been a good intermediate-term buy signal for stocks. Over the past seven economic cycles, even after the U.S. 2-year to 10-year yield curve inverted, the median gain for the S&P 500 has been 21%, with a recession arriving a median of 19 months down the road. It is important to note that history speaks to probability, not certainty. Hence, it is wise to keep an open mind to different outcomes. But if history is any guide, yield curve inversion does not imply an immediate end to a bull cycle.

So why is there a time lag between initial yield curve inversion and a recession? There are two main reasons. First, when the yield curve inverts, financial conditions tighten because it’s not profitable for banks to borrow money under short-term rates and lend out under long-term rates. But banks don’t stop lending overnight, financial conditions tighten over time. Underneath the hood, credit spreads (an indicator of company defaults) are still tight, meaning the risk of defaults is relatively low. In addition, U.S. initial jobless claims remain stable. A spike in initial jobless claims could signal trouble in the labour market, which eventually impacts consumer income and spending. Second, when the yield curve inverts, central banks generally step in to lower short-term interest rates in an attempt to stimulate the economy. This is exactly what is happening now and lowering the cost of borrowing can generate a positive impact for the markets.

Central Bank Policies – Don’t Fight the Fed

The playbook in this bull cycle has been “Don’t fight the Fed”, meaning invest in a way that aligns with the current monetary policies of the U.S. Federal Reserve (and global central banks). When central banks are lowering interest rates (in easing mode), it can provide a powerful tailwind for businesses and the markets.

Case in point, the U.S. Fed cut interest rates by 0.25% to the 1.75%-2.0% range on September 18th and there is a 70% chance of another 0.25% rate cut by year-end*. The European Central Bank (ECB) also lowered rates further into negative territory on September 12th and relaunched quantitative easing (QE) of 20 billion euros per month (with no end date). For now, the Bank of Canada (BoC) and Bank of Japan (BoJ) have kept interest rates unchanged in their latest meetings.

In summary, financial conditions continue to remain relatively healthy and inflation is under control, allowing central banks to be accommodative while waiting for a resolution on trade tensions. No doubt, a U.S.-China trade deal would be a positive catalyst for re-accelerating global growth.

*Source: Bloomberg

Ethan Dang, CFA, MBA is a Portfolio Manager at McIver Capital Management at Canaccord Genuity.

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What Economic Issues are Impacting You

As we head into the fall and the days become shorter, it’s time we have a cold hard look at an economic issue which may impact you.

That Hissing Sound

If you live in the Vancouver region, or if you have real estate holdings in the area, you are likely very aware of the major correction in real estate prices.  Additionally, if you have read or heard our thoughts at McIver Capital Management, on market corrections in general, this one should come as no surprise.

Universally, all markets correct, and they always will. Commodity, precious metals, stock and bond markets and of course real estate are no exception. While this is true, during the period in which a market is rising quickly, many people feel as though the market never will. This is, in fact, exactly what perpetuates a rising market. As these feelings of inevitability and invincibility take hold of more market participants, rampant speculation begins, pushing prices even higher – and therefore reinforcing the flawed original feeling that the market will never go down again. This creates the speculative bubbles which often end badly for most and that everyone seems to claim, in hindsight, that they clearly saw coming.

But we did see it coming and spoke of it often in our publications, talks and speaking engagements over the past 3 years. The reason why we were confident was because of a very powerful force in nature called ‘normalization’.  It’s the same force of nature which makes 1,000 foot tall trees extremely unlikely. We also use market normalization to great advantage on your behalf in our sophisticated investment process.

Market normalization

Simply stated, market normalization is the tendency for all markets to return to their long-term average rate of return from a period of either outperformance or underperformance.  If, for instance, the market for a particular asset has a 5% long-term rate of return (measured over several decades or potentially even centuries depending upon the asset) and has recently experienced several years of 20% growth, it makes sense to limit or eliminate your exposure to it because it will indeed normalize.  The manner in which a market normalizes can vary greatly.  It may fall quickly and give up all those excess gains above 5%, all at once. Alternatively, it may also simply go flat and not move either up or down and normalize through time by generating zero return. Most often, a market will normalize by experiencing a mixture of the two; falling somewhat and then going flat for several years.  Either way, exposure to an asset class which has experienced long-term outperformance should limited or eliminated altogether.

The same is also exactly true of an asset that has recently underperformed its long-term rate of return, but clearly it would be in reverse. This would be an asset that it would make sense to increase your exposure to.

What has taken place in Vancouver real estate is a perfect example of market normalization. The only unique thing about this normalization is that the trigger for the correction was taxes.

Politicians Don’t Fix Bubbles

About 3 years ago the narrative regarding Vancouver real estate changed from referring to it as a ‘real estate bubble’ to calling it a ‘housing crisis’, and we knew then that the fix was in.  Politicians do not fix bubbles because too many people are at the party making money.  But they do smell an opportunity when the word ‘crisis’ is added to the narrative.  And they pounced, each level of government eager to get a hand on the profits.  What resulted is the present cocktail of real estate taxes, each claiming the moral high ground because the taxes are aimed at ‘fixing’ the ‘crisis’.

We now have the “Empty Homes Tax”, the “Vacancy and Speculation Tax”, the “Foreign Buyers Tax” and perhaps the most cynical of all being the misnamed “School Tax” (which is simply capital appropriation by the Province). The most ominous potential new housing tax, hinted by the federal Liberals when they began making you report the sale of your principal residences for the first time on your tax return, is a potential capital gains tax on your principal residence.

Sand In The Machine

If you throw enough sand in the machine, eventually the machine stops.  That’s just what happened to real estate. And it’s much worse than most in the real estate industry would have you believe.

The problem with the real estate industry is that there is virtually no one actually on the side of the consumer.  Real estate agents, the real estate boards, banks and lenders, developers and real estate marketing agencies are all on one side of market and all want you to believe that the market will virtually always rise.  On our side, we effectively have just the Bank of Canada, whose mandate is to protect the economic future for Canadians.

The reality on the ground is that depending the part of Greater Vancouver you are reviewing; property prices have fallen as much as -30% from the most recent (2019) assessments and as much as -50% from the assessment two years ago.

This is significant on many levels.  Those that had been speculating, particularly on borrowed money, may have been caught without a chair when the music stopped and are now being forced to sell. Many of these investors did not borrow from traditional lenders and instead borrowed from dark money pools made available by private lenders. These high interest rate loans were made on the assumption that real estate prices would continue to grow at 15%+ per year.  Clearly in financial distress, these sellers are selling at prices which continue to make the entire industry and real estate market unsettled. These sales have also caused some shock waves on both social and traditional media when they have been reported.

Others who have speculated in real estate, but in a less aggressive fashion and with less leverage, will be next to sell, but will likely only do so when the market bottom has been established.

And for everyone else? Billions of dollars in wealth has, fairly suddenly, been eliminated from the local economy. While much of this home equity wealth was only on paper, the evaporation of it has a huge impact on the decisions local consumers make. For most us, our equity in our home is our primary financial asset and the cornerstone on our financial safety.  How confident will Vancouverites now be about buying that new car, or going out for that fancy dinner? It’s very likely that many will be less confident to make those spending decisions. This will impact our local economy.

Sand Stays In The Machine

A snap back recovery is very unlikely due to the sand still fouling the machine.  Even if events overseas increase the number of people wishing to move to Vancouver, the punishing potpourri of taxes remain.  Accordingly, we can expect no massive influx of foreign capital to drive this market back up to the dizzying heights of 2 years ago.  Additionally, the sting and physiological damage of this correction will remain for some time.

For the record, I don’t pretend to be a real estate expert. However, we at McIver Capital Management certainly are experts in ‘markets’ in general.  Very likely this market normalization correction will result in a -30% to -50% initial correction off the highs from two years ago (which has happened in some areas of the local market already), then eventually bottom and stabilize. It’s likely that the market will remain fairly flat for some time after stabilizing.

We have no crystal ball, but governments change and in time the various tax regimes will change with them.  As those changes takes place, optimism will return, and the next real estate cycle will begin.  Hopefully we all will be wiser the next time.

Neil McIver is Sr. VP and Portfolio Manager at McIver Capital Management at Canaccord Genuity.

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Robo-Advisors 2019: Still Waiting for the Revolution

It turns out that automated portfolio advice is not the Field of Dreams. “If you build it, they will come,” has not worked out for the robo-advisory industry — yet.

Just a few years ago, prognosticators gazed into their crystal balls and predicted that investors would pour their money into robo-advisors. In 2016, KPMG projected that assets under management would be $1.5 trillion in 2019 and $2.2 trillion in 2020. Juniper Research expects assets under management worldwide to hit $4.1 trillion in 2022. However, that is nowhere close to what’s happening, and these projections seem to have fallen victim to the First Law of Forecasting: Give them a number, or give them a date, but never both.

According to a variety of analysts, there is considerably less than $1 trillion worldwide managed by robo-advisors as of May 2019, and the $2.2 trillion mark won’t be reached until 2022, according to some optimistic forecasts. Backend Benchmarking says $440 billion is managed by robo-advisory services as of mid-2019, while the Aite Group says it’s in the $350 billion range. Last fall, the research group Autonomous NEXT estimated that the market encompassed $660 billion in assets. To keep these figures in perspective, there is an estimated $22 trillion in investable assets out there–with over $9 trillion sitting in cash accounts, uninvested….CLICK for complete article

Taxes versus the Necessities of Life: The Canadian Consumer Tax Index

  • The Canadian Consumer Tax Index tracks the total tax bill of the average Canadian family from 1961 to 2018. Including all types of taxes, that bill has increased by 2,246% since 1961.
  • Taxes have grown much more rapidly than any other single expenditure for the average Canadian family: expenditures on shelter increased by 1,593%, clothing by 769%, and food by 639% from 1961 to 2018.
  • The 2,246% increase in the tax bill has also greatly outpaced the increase in the Consumer Price Index (750%), which measures the average price that consumers pay for food, shelter, clothing, transportation, health and personal care, education, and other items….CLICK to view index

Waiting for the “Big Fish”

Andy Preikschat, manager of the private Edgebrook Fund, released his annual mid-year letter to shareholders. He has been kind enough to share it with us this year, at the halfway point of his 30 year plan. Find out about his investment strategy as well as some of his recent buys and sells of Canadian listed companies in the fund. ~ MT Editor

At Edgebrook, we sit on the edge of a brook, patiently waiting to seize that big fish. What does a “big fish” look like? To us microcap investors, a “big fish” is a microcap company with all three of the following necessary criteria: #1 Market Leader in a niche category, with Incentivized Fanatics who won’t bamboozle us, with the potential to Grow Earnings (and the stock price) at least 3-5x over 3-5 years… CLICK to read the complete letter