Benefitting From Volatility

by Gavin Graham, Chief Strategy Officer January 26, 2016
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
In previous market reviews, we have noted the increased level of volatility in global stock and bond markets over the last few years, and pointed out this development reinforced the importance of maintaining a diversified portfolio of different asset classes for pension funds and investors generally. 2015 is now in the books, with disappointing performances from most North American stock markets and emerging markets. Furthermore, these lacklustre returns were accompanied by an enormous amount of volatility, including a period in August when some stock markets fell almost 20% over worries about economic and political developments.

Only the NASDAQ, which rose 7.5% last year, produced a competitive return, with the S&P500 up only 2% and the Dow 0.5%. NASDAQ’s strength was due to the dominance of a few large technology companies, such as Apple, Google (now known as “Alphabet”), Amazon, Facebook and Netflix, while most stocks were actually down for the year. Canada’s S&P/TSX fell 10%, and the UK’s FTSE100 8.4%, both having large weightings in energy and commodity companies, while although Germany’s DAX and the Japanese Nikkei225 were up 7% and 17% respectively in local currencies, for a US investor, these rises were mostly eroded by the strength of the US currency.

The first few days of 2016 have seen yet more violent market movements, almost all downwards. The US indices were all down 6-7% in the first week of 2016, and although the S&P/TSX and FTSE fell by a smaller 3-4%, worries over the slowing Chinese economy saw the Nikkei off 7% and the Shanghai Composite down a remarkable 12%. Concerns over Chinese GDP have dominated discussions of the outlook for 2016, with most observers believing that Chinese growth is well below official estimates of 6.5-7%. The lower demand from China for commodities has driven base metals such as copper zinc, nickel and aluminium to levels not seen since the financial crisis in 2008-09.

Meanwhile, Saudi Arabia’s attempt to gain control of the oil market by increasing production has driven the price of a barrel of oil down to U$30, a 10 year low and wreaked havoc on the oil producing economies of emerging markets such as Russia, Brazil and Indonesia, not to mention western Canada.

The question for investors is whether this represents a permanent alteration in the behaviour of markets, or whether the present sharp moves are reflecting the end of a long period of remarkably low interest rates. When the US Federal Reserve (the Fed) raised short term interest rates by 0.25% to a range of 0.25-0.5% in December, it was the first time interest rates had risen from their record lows of 0-0.25% since early 2009, over six and half years ago. The last time the Fed began raising interest rates was 2005, and the last time that they had been increased was 2007. Thus investors have become accustomed to interest rates of less than 0.25% for the last half decade, and anyone who has entered the market in the last nine years has never experienced rising interest rates.

Stock markets have understandably done well in such an environment, with the broad based US S&P500 Index almost tripling from 666 in March 2009 to 1925 at time of writing, having risen above 2000 during 2015. Other equity markets around the world have done well too, although the performance of many of them has been eroded for US dollar-based investors by the strength of the US currency over the last five years.

Canada’s S&P/TSX Composite has been a laggard, as its high exposure to energy and other commodities, combined with the sharp fall in the Canadian dollar over the eighteen months, has reduced returns to both domestic and particularly, overseas investors. Nonetheless, the index is still over 50% higher than at its lows in 2009, which, combined with dividends, has far outpaced the return available from cash and matched that from government bonds.

Despite these positive returns, the turmoil in the markets in recent weeks has made many investors extremely nervous. After the sharp rebound from the lows of the financial crisis in 2009, the returns from the Canadian equity market have been disappointing. Simply investing in the broad stock market in Canada over the last five years through a passive instrument such as an index fund or index Exchange Traded Fund (ETF), such as the well-known iShares S&P/TSX 60 would have resulted in a small loss before dividends, although a US investor holding the S&P500 ETF or index fund would have made about 8.5% p.a. Meanwhile, a Canadian government bond would have returned 3-3.5% p.a. This variation in returns reinforces the necessity of having a portfolio diversified between not only different asset classes such as bonds and stocks, but also different countries.

In such an uncertain environment, it is sometimes difficult to retain sight of one’s long-term objectives. Put another way, a pension fund is intended to preserve the real value of the investor’s capital after inflation, while generating sufficient income to supplement that provided by the basic government Canada Pension Plan (or Quebec Pension Plan in La Belle Province). Only equities can preserve the real value of assets over the long term. Bonds are claims on governments or companies in nominal terms and while guaranteeing return of the investor’s initial capital and a fixed income for the period of the bond, provide no protection against the erosion of living standards by inflation.

While nominal inflation as measured by the Consumer Price Index has been very low in the last few years, this situation will not continue indefinitely, and such items as college tuition, insurance, health care and government fees and taxes have definitely not been declining. While there are inflation-protected bonds available issued by federal and provincial governments, their scarcity has made them extremely expensive.

Using a tax-effective vehicle such as an RRSP or an Individual Pension Plan (IPP) or Personal Pension Plan (PPP) allows investors to accumulate assets in a tax-deferred environment, with no capital gains tax or taxes on income. One of the advantages of the PPP available to incorporated individuals is that the Canada Revenue Agency (CRA) assumes a minimum rate of return for the Defined Benefit (DB) portion of the pension plan of 7.5% p.a. and allows catch-up payments when this rate of return is not achieved. Given the disappointing performance of the Canadian equity market over the last 5 years and the low yields on investment grade bonds, it is highly unlikely that most PPPs will have matched this target return.

Thus while volatility may be concerning in the short term, and it is possible that after a long bull market, rising interest rates in the US will again lead to a fall in markets this year, the investor with a long-term view and using a flexible and tax effective vehicle as the PPP can take advantage of this volatility to make additional contributions to ensure the future of their retirement. Volatility is not inherently a bad thing; when stocks go up quickly, investors are generally pretty happy!

Even when the volatility is on the downside however, it allows owners with PPPs to take advantage of lower prices in a way that is not available to those who can only use RRSPs. Therefore, rather than being concerned at the present volatile markets, investors with PPPs should regard them as a potential opportunity.

Source: All information taken from Bloomberg and Globe and Mail January 12th 2016

APPENDIX

Investors should remember that every year since the end of the financial crisis in 2009 has seen a meaningful correction in the S&P500 Index (all returns in US dollars).

Market correction (%)Annual return (%)
2010-Spring-1615
2011-Summer/Fall-192
2012-Spring-1016
2013-Spring-632
2014-Fall-714
2015-Summer-121


Source: Steadyhand Investment Management

Last year and 2011 certainly felt like (and were) pretty serious corrections but the US equity market still finished the year in the black. Bull markets do have a life cycle and age over time, so 2016 could be the year when a sharp sell-off does result in a negative year, but the above table is a reminder that sharp downward moves are not infallible forecasters of performance.