Bull or bear? Storm clouds gather on the horizon

Q&A  | Debt, disruption among risks, says Felix Narhi, chief investment officer and portfolio manager for PenderFund Capital Management Ltd.

Q: The current American bull market began in 2009, following the Great Recession, and is now officially the longest in American history. Should that worry investors, or is there still room for this bull to run?

 

A: The truth is that we don’t know. Investors should keep in mind the great investor Peter Lynch’s advice: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

 

Nevertheless, just about everything is cyclical, so investor behaviour should be different depending on where the market is in the cycle. One should be more aggressive early in the cycle, neutral mid-cycle and then more cautious near the end of a cycle. From a historical perspective, we are breaking new ground for the length of the current cycle, and valuations are somewhat elevated as well. But the S&P 500 is not the only game in town. There are many markets and individual companies in the world which are in a different part of the cycle that we believe are attractively valued.

Q: What factors are most likely to cause a market downturn, if one is to take place?

A: The most likely cause of a downturn is a recession. Historically, the stock market usually drops before a recession arrives as investors begin to anticipate a slowdown. The news cycle can change the psychology of the market as well. Today the main drivers of the American market have been the large tech stocks like Amazon [Nasdaq:AMZN] and Netflix [Nasdaq:NFLX]. If such stocks lose favour, the market is likely to struggle.

Q: Canadian markets haven’t exactly mirrored American markets and have experienced a minor correction already. What are the implications for Canada if the U.S. markets experience a correction?

A: It is hard to say, but the factors that have led to the widening relative outperformance of the S&P 500 include the benchmark’s high exposure to info tech and Trump’s recent tax cuts. Conversely, the main drivers of Canadian markets are its banks and firms exposed to natural resources.

Over the long term, both markets have generated attractive returns. However, there are many long stretches where one benchmark outperforms the other, because of the exposure to sectors and industries that perform differently depending on the economic cycle.

Q: Investor and business confidence has not been as strong in Canada as in the U.S. How much of this is attributable to the uncertainty over the North American Free Trade Agreement (NAFTA)?

A: It depends on the sector. Clearly the uncertainty of NAFTA impacts the auto and dairy industries differently than the high-tech industry. However, much of the business confidence in the U.S. can be attributed to Trump’s pro-business agenda and recent tax cuts.... Canadian businesses have not benefited from a similar tailwind and are facing a more protectionist White House. We believe these factors account for most of the disparity in business confidence.

Q: It has now been a decade since the last American recession, which became global. Canada did not suffer as profoundly as the U.S. did, thanks to our banking system. Are we necessarily any more insulated now?

A: One of the lessons from the U.S. housing crash was that there is a reflexive connection between credit and collateral, where the act of lending can change the value of the collateral. The marginal buyer, who often needs access to easy credit, tends to set the clearing prices. Troubles in the U.S. housing sector first emerged with lenders to the subprime homebuyers, which spread to the rest of the sector. The good news is that Canada’s subprime market is much smaller than in the U.S., which triggered its housing bust and led to the Great Recession. On the other hand, residential real estate prices and affordability levels in many parts of Canada have risen to higher levels than the U.S. at its peak. According to a recent survey from Manulife Bank, nearly three-quarters of Canadian homeowners would have difficulty paying their mortgage every month if their payments increased by as little as 10%. Even a modest increase in interest rates or a dip in house prices would cause real hardship for many Canadians. In our opinion, the risks in Canada are higher today than they have been in a long time.

Q: The last tecession in the U.S. was triggered by a real estate asset bubble, and the one before that was triggered by a stock market bubble – the dot-com crash. What are the big risks today?

A: From a macro perspective, rising political and social unrest, as well as disruptive shifts in technology, are creating risks and instabilities that are directly impacting economies and businesses around the world. In addition, extreme weather events and natural disasters appear to be growing risks.