Welcome to the Chalten Investment Review for Q3 2017. Last quarter we highlighted how currency movements can impact the returns of a diversified portfolio and the merits of keeping currency exposure on the equity side of your portfolio while hedging currency exposure on the bond side of your portfolio. July brought another meaningful appreciation of the Canadian dollar against the US dollar to just below 1.25 CAD/USD. Through August and September the exchange rate shifted up and down and settled back at about 1.25 at the end of the quarter but overall nearly 4% stronger since the end of Q2. We reiterate that over the short term this will have a negative impact on our USD denominated investments (like US stocks) but in the long run currency exposure should help provide a valuable diversification benefit. Fortunately the US stock market return was quite strong over the quarter so even with the CAD strength investors earned a positive return on their US stock investments.
In general equity markets moved higher around the world over Q3, even for Canadian investors. Global bond yields remained largely where they were at the beginning of the quarter after moving around a bit in between. Global economic data also remained relatively unchanged in the third quarter. For many investors, this steady market progression and economic stability represents a significant disconnect from what they’re hearing in the news on a daily basis. Forget for a moment that the financial media and market commentators tend to hype things up a bit. There are some genuinely unsettling things happening in the world right now! Why don’t we see it in the financial markets and economic data?
The answer might lie partly in how the market values stocks and bonds. The value of a company (and ultimately the stock or bond of a company) is the value of all future cash flows expected to be generated by that company discounted back to the present using a suitable risk adjusted discount rate. All other valuation approaches are just simplified derivations of the discounted cash flow valuation model.
- Take, for example, a company that generates $10 per year in perpetuity. What would you pay for that company? With a discount rate of 10% you would pay $10 / .1 = $100. The question is how much of that $100 value is expected to be generated in the next 5 years? In the next 10 years? In our simple example only 38% of the value is attributed to cash flows generated in the next 5 years and only 61% to cash flows generated in the next 10 years. A large proportion of the value of the company today comes from cash flows expected to be generated way in the future. Beyond five years we may well have different technologies, different regional economic strength, different trade dynamics and different political leadership.
The market is a very complex dynamic mechanism that rewards risk taking over time. Current events are important in that they shape the world views of market participants, but if most of the value of stocks and bonds comes from cash flow generation 5 or more years away, the impact of these events might be limited.
This is just one of many explanations for why investors might perceive a disconnect between market levels, economic data and the reality of what we hear in the news everyday. The market will go up and down, sometimes a lot at once; sometimes it will seem the market is responding to current events and sometimes not. For certain there will be pundits both before and after market movements attributing it to something that may or may not be right! It’s best to ignore it. A successful long term investment experience will be driven more by managing your behaviour through seemingly puzzling market situations and real market volatility than by actually trying to avoid market downturns. Set your portfolio to accommodate your risk tolerance and rebalance in a disciplined and planned way around your target allocation and you’ll have a good long run investment experience.
In fact, since our last review we wrote a short piece about how stomaching short-term volatility is the hardest thing about being an investor – (see “What is the hardest thing about being an investor?”) The long-term evidence is clear and we present it around four main assertions:
- Long-term stock market returns are quite attractive
- In the short-term returns can be quite volatile
- Adding to the angst for Canadian investors can be the volatility of the Canadian dollar
- Yet it makes sense for Canadians to diversify globally
Staying the course and managing our own emotions and behaviour during market volatility is challenging in the short-term but worth it if you want to give yourself the best chance of having a good investment experience over time. We encourage you to look at the data presented in the piece.
Q2 Market Review
In local currency terms, global equity markets were again broadly up during the 3rd quarter of 2017 and this quarter that finally also included the Canadian stock market. Even with the strong relative appreciation of the Canadian dollar over the quarter, Canadian investors still saw positive returns for their US and International stock investments. The Bank of Canada did indeed raise its benchmark rate for the first time in 7 years and the Canadian dollar continued its appreciation, especially against the US dollar. In the US, natural disasters likely stalled the economy somewhat and there remains uncertainty over the prospects for major legislative changes, the latest issue being tax reform – yet the market continued to be unphased. Stock markets outside of North America also continued to move up in local and CAD terms.
- The total return on the Canadian stock market was 3.7% for Q3 2017 in contrast to the negative performance in Q2.
- In the US, the total net return of the S&P500 in Canadian dollar terms was 0.3% for Q3.
- The total net return for the S&P Global ex-US BMI Index of stocks outside of the US (in Canadian dollar terms) remained solid again this quarter at 2.1%.
- The Canadian dollar gained almost 4% against the US dollar during the quarter.
- Total return for Canadian bonds was -1.65% this quarter, negative but still ahead of US and Global bond returns in CAD terms.
Financial Planning topics of interest
On July 18 the federal government announced proposed changes to the way private corporations are taxed. The purpose of the changes is to help level what the government perceives to be an unfair playing field for small business owners compared to those who don’t manage their finances through a corporation. Specifically, the proposed changes address three areas:
- Income sprinkling
- Passive investments held in a private corporation
- Tax planning designed to convert income into capital gains
You can read a little more context and detail in our recent piece “Unfair or not, get ready for changes to the taxation of private corporations”. The government’s consultation period to gather feedback from interested parties has just ended and final legislation is some time away, but we would strongly advise small business owners to get ahead of this and start asking their tax advisors how these changes might impact their specific situation.
Locally, the new provincial government in BC raised provincial personal income tax rates on those earning greater than $150,000 from 14.7% to 16.8% and raised the general corporate income tax rate to 12% from 11%.
In closing we’ll advise to not be surprised when there seems to be a disconnect between current events or what you hear in the news and the direction or volatility of the markets. Markets are complex dynamic systems and to a large extent stock and bond valuations are anchored by a reflection of what may happen far into the future. While prices can be volatile in the short term, the market always has a long term valuation anchor to temper that volatility.