Is your fund well positioned to weather the storm?

In our update of November 3, we opined that it was too early to call the end of the market correction. We also opined that some markets, or sectors, would be harder hit than others, including Canadian equities versus US equities. Since that time, the S&P 500 has lost another 3% or so, versus some 1.5% for the S&P/TSX. Also as predicted, some technology companies have incurred significantly heavier losses than the broader market. By way of example, Apple has lost some 15% of its market value just in the past two weeks, compared to 12% for Facebook and 10% for Amazon.

The road remains bumpy, and there is no indication as to when the onslaught will stop. Perhaps the market is looking for a piece of good news, or some evidence of seller exhaustion in order to reverse course. Technically speaking, market indices have yet to display any signs of being oversold.

Fundamentally, investors are concerned about the risk of slower economic growth, which would lead to slower earnings growth. This is important because earnings growth has been the market's major pillar of support, in the face of significant headwinds such as tighter liquidity, higher interest rates and trade frictions. The fear has always been that, when earnings euphoria dies, the bull market will die with it.

What will happen next will therefore largely depend on two things: to what extent will earnings slow down beyond 2019, and what will the Federal Reserve (and other central banks) do. In terms of earnings, investors are now anticipating a 10% growth in 2019 earnings, which is significantly higher than the long-term average of 4% or so. Thus and considering the headwind effects discussed in the earlier paragraph, and the fact that much of the 10% is attributed to one time factors (e.g. tax cuts), earnings growth at this pace is not sustainable and is bound to slow down significantly. However, barring any full blown recession, we are not looking at a major collapse in corporate earnings, at least not for the time being. Which leads us to the next point: are we heading towards a recession and what will the Fed do about it if that is the case?

For now, US economic growth is forecast to slow down from nearly 3% in 2018 to 2.7% next year and 2.1% in 2020. Thus, again, we are talking about a slow down, not a full blown recession. Moreover, to the extent that inflation remains relatively benign, there is a good possibility that the Federal Reserve will end its monetary tightening some time next year. So the sooner, or the more evident, the signs of a slow down will be, the sooner will the Fed end the current cycle of rising interest rates.

As such we would be looking at two possible scenarios in terms of market outcome. The first (or Scenario 1) would be one of continued earnings growth, albeit at a slower pace, which could see markets rebound in the near future, putting an end to the equity correction. Under this scenario, US equities will out-perform Canada and other markets, sectors such as technology, industrials and commodity-based ones will outpace defensive or interest sensitive sectors, the US Dollar will remain strong and bonds will remain sluggish. The other scenario (or Scenario 2) would be one of slower economic growth and slower earnings, which will lead to weaker equities in general, lower interest rates and higher bond prices. Under this scednario, Canada will out-perform the US, interest sensitive and defensive sectors, including utilities, REITS and defensive sectors such as consumer staples and health care will do better.

To help you navigate this uncertainty, we have introduced a new tool that allows you or your advisor to identify how funds are positioned to weather either scenario. The tool allows you to sort funds, starting with those that have the highest exposure to cyclical stocks (e.g. technology, industrials, transportation, consumer discretionary or merchandizing) or funds with the highest exposure to natural resources (e.g. energy, materials and precious metals). Those would be the funds that you can choose to over-weight if you believe that Scenario 1 (i.e continuing bull market) will prevail. Likewise, you can choose to sort funds starting with the highest exposure to interest sensitive sectors(e.g. telecom, utilities and REITS) or those with the highest exposure to defensive sectors (e.g. consumer staples and health care). Those would be the funds that you should over-weight if you believe that Scenario 2 will prevail.

Click here to start using this powerful tool and always remember to conduct your own due diligence and consult your advisor before making any investment decisions.

November 23, 2018

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