November 2019 Market Newsletter

This is a copy of a newsletter I sent out to my clients over the weekend. My thoughts and observations below are gathered from analysts and portfolio managers, mainly when I attended an investment conference in late October 2019. I thought you might enjoy the read.

I have recently returned from an exceptionally good investment conference and I wanted to share some of the things I learned there. This newsletter will summarize information from analysts, portfolio managers, technology and innovation business leaders and more. Main speakers at the conference included David Frum, US political analyst and news commentator, Anla Cheng, Founder and CEO of SupChina, an expert on all things China, “Downtown” Josh Brown, The Reformed Broker and a leading investment manager from New York, and more.

The information in this newsletter is to make you aware of what is happening in the economy and what these trends might lead to. Again, no one knows the future. The information here is not a prediction of the future or a guaranteed of what to will happen. Please speak with me or your financial advisor about what might be the right things for you to do going forward. Often, doing nothing and staying the course is the right advice.

CONTENTS

• Trump, Tariffs and the Election
• Domestic and global interest rates and how this changes things
• Don’t fear the recession
• De-globalization continues
• Time to think differently about growth and income
• Reframe – health insurance as a retirement asset class

Trump, Tariffs and the Election

With Washington embroiled in an unfolding impeachment or Trump, not be much regular government business is being done. We will see how this plays out over the next 3-4 months. It is very likely that Trump will be impeached in the House of Representatives (dominated by Democrats) but unlikely the Senate will also vote to impeach. About 20 Republican Senators in the House will need to vote against Donald Trump for the Senate to impeach, and at this time it looks unlikely. There is always an off chance that Trump’s actions could so alienate his own party, threatening their individual re-election chances, that 20 senators could flip sides, but I wouldn’t bet on it.

This leads to a central question about the character of the US President. With the US economy in good standing coming into the 2020 election the central question will be about the values of the US, and what type of country and leader people there want. There is a strong dislike for Trump among women and there is 50% of the country that is solidly against Trump. Will this result in a Democratic win? Not sure currently, especially since the Democrats have yet to find a leader to rise above the noise. Even though Elizabeth Warren seems to be gaining momentum, Joe Biden is still my favorite to win. He has the faith of the black democratic caucus, which represents over 25% of the votes in the party. This is probably why Trump is so aggressively looking for dirt on the Bidens.

There is a chance with everything happening around impeachment and his erratic behavior that Trump creates a situation to galvanize Democratic support, so they sweep the House, Senate and the Presidency. If that happens we could expect a wave of new Democratic legislation coming out of the US not seen since the 1970s.

And what is happening with the economy? US imposed tariffs have slowed international trade, especially from China, to a crawl. The barriers to entry, for both workers as well as goods, has made the US an unattractive place for highly skilled migrant workers to go to. Many US tech firms are opening offices in places like Canada and Europe to house such workers instead of moving them to the US. This will also slow US growth, but not necessarily US company profits. And government spending in the US is as high as it has ever been. In 2019 Trump will run a deficit of over $1 Trillion (with a $22 Trillion federal debt). In 2020 the deficit is expected to grow much more. All this spending is only supported by low interest rates. There is not enough economic growth to handle this new debt at an interest rate above 2%. This is another reason Trump is pushing the Federal Reserve to continue to lower interest rates – stimulate the economy and allow his administration to increase debt levels on more spending.

Eventually these debts will need to be paid off. Excessive debt can only be paid off 3 ways; more taxes, spending cuts or inflate your way out of debt (think of the early 1980s). The US will eventually have to pay the piper, but the plan seems to be to try kick that can down the road indefinitely. Let’s see how that works out for them…

Domestic and global interest rates and how this changes things

Over the last decade we have learnt one very important lesson – low interest rates are very powerful. Having started this cycle of long-term low interest rates it seems increasingly difficult to kick the habit. It is almost like an economic drug we have all become addicted to. At the end of 2018 the US Federal Reserve tried to increase rates to slow economic growth and balance the economy. This resulted in a sharp decline of the stock markets at the end of the year. As soon as the Fed backed away from further rate increases then markets came roaring back.

The rest of the world is not the US or China. These two seem to be the only economies left that can influence monetary policy by using interest rate cuts. In Europe and Japan rate cuts have not helped the economies recover. In fact, they are solidly into negative interest rates. There is over US$15 Trillion in negative interest rates worldwide. Think of it this way: you now must pay the bank money each month to look after your money instead of them paying you for the privilege of holding your deposits as a source for lending.

Low and negative interest rates have another major implication – savers can no longer get returns off bank deposits or guaranteed investments. Even in Canada, which still has positive interest rates (but they are declining), the real rate of return is negative. Assume that inflation is running at 2% (that is about what it is) and you are getting 1.6% on a one-year GIC, after the one year you have lost 0.4% purchasing power of your dollar. Your dollar grew by 1.6% but the cost of goods grew at 2%. You are losing money!

There is also another force that could very possibly come into play. With some much money in the world at such low or negative interest rates, savers will eventually capitulate with bank deposits and look for alternative investments. This scenario is being called a “melt-up”. Unlike a melt-down, where fear and loss leads to more and more people pulling their money from the market, a melt-up creates a virtuous cycle where more and more people begin to reinvest their money in equities and other income generating assets (discussed in another section) leading to higher returns in those assets, and then more money flows in chasing those returns. A melt-up is a steady reallocation of savings assets into equities and alternative income generating assets that will drive up the return on those assets. It will be hard to know if and when this melt-up starts, but we will all see it clearly in hindsight after the gains have been reaped.

Don’t fear the recession

Will there be a global recession? We are already into a global slow-down, but there is no guarantee that a recession will come out of it. The US is actively trying to ward off recession with interest rate cuts. They have made three cuts so far this year and there will probably be another one early in 2020. All major economies in the world (except Canada) are now cutting interest rates to stimulate their economies. The US and China could effectively engineer a soft-landing (where the economy slows but does not go into negative growth before reaccelerating).

Some might argue that the world is already in a recession. Economies like Japan and parts of Europe have already entered recession territory. The rest of the EU and UK are on the edge. China has slowed a lot from its historical high growth rates and this is new territory for the world’s second largest economy. Manufacturing in the US and China are already in recession, and growth rates among manufacturers has gone negative.

For us living in Alberta, after 5 years of serious economic slowdown, it seems like business as usual. Even for many of these economies the pain from a recession is not that much. Even if things get worse and we enter a real recession, it won’t feel like our world is changing that much. This is going to be a normal slowdown or recession – nothing like the Great Recession of 2008/09. Economies routinely go through periods of slower or negative growth before reaccelerating again. It’s normal, and in fact it’s healthy. A recession cleans up many poorly run companies that need to go bankrupt, allowing for their capital and assets to be redistributed to healthy, growing companies.

A slowdown or recession will also probably mean short-term losses on the stock markets. This is a buying opportunity when prices for good companies go on sale. This is where good active fund management will shine. Selling off losing companies and putting that cash into good companies when their stock price is depressed. Investors will reap a high return when the markets come back to life. It will be great if you have some cash on hand to get into the markets if/when there is a pull-back on prices.

De-globalization continues

One reason for manufacturing being in a recession now is the trade war. The amount of goods traded between the US and China has dropped off sharply this year. This looks like we are still in the early days of de-globalization.

What is globalization and de-globalization? Globalization is the growth of inter-connected trade and product supply chains that has arisen over the last 4 decades. As the iron curtain fell, China opened to the rest of the world and India modernized, production of goods has moved to lower cost parts of the world and businesses have gone global in both their sales and production of goods and services. De-globalization is the reverse. Taking apart these trade routes and supply chains. Becoming more self-sufficient as a country and focusing on local neighbors and regional networks of trade.

De-globalization will have major impacts on the free flow of goods and people around the world. It will cause inflation in many products that we have come to think of as cheap. It will increase barriers in the world where different regions could be opposed to one another and growing in diverse directions. For instance, Huawei as already resigned itself to the fact that the US and many allied nations will have a completely different 5G network architecture to that of China and eastward looking countries. If you are old enough you will remember the Cold War, where there were two major world orders between east and west, USA and USSR, and their entire economies, infrastructure and technology progressed on separate tracks. De-globalization could take us back to such a world. It will take at least a decade to redesign a de-globalized world.

With this type of upheaval there will be winners and losers among global companies. A good investment management team, looking ahead to managing these risks, will be better positioned to make money in this environment. I think a passive, index-based investment strategy could see some material losses. Look for investment managers who see these storm clouds on the horizon and take the risks seriously.

Time to think differently about growth and income

Savers and those looking to generate zero risk income are in a very difficult situation. Things must be done differently. Income from traditional government bonds are no longer an asset class that will help you reach your goals. We must look for income from other, alternative sources. The most common sources are high-yield and emerging market bonds, infrastructure projects, Real-Estate Income Trusts (REITs) and high dividend and/or preferred shares.

Investors looking for growth need to move more towards equities to get the same rates of return they once got with a balanced investment approach. It is projected that a traditional balanced investment, with 60% stocks and 40% bonds, will produce about a 5-6% return over the next 10 years. This is down from the 7-8% growth we have had for the past 10 years. Those in pure bonds or conservative investments will drop down to 3-4% growth rates. If inflation is running at 2%, your real rate of return is only 1-2% for bonds. Savers using GICs and other guaranteed investments will likely be losing money after inflation for these investments.

If you need to grow your money at about 5% to reach your targets, you will need to have more stocks/equities. If you need income, you will need to invest in alternative income generation assets that have a higher yield.

If you are a mid-career investor, looking to have 6-8% growth rates for the next 20’ish years before retirement, a balanced approach will probably not get you there. For these returns you need to take more risk. A Low to Medium risk investor will probably have to move up to full Medium levels of risk to get those 7-8% long-term returns. It is not unreasonable to look for 100% stocks/equities while you are still in your 40s and even 50s.

One way to manage risk and still get a high return in retirement is by using a Cash Wedge strategy. This puts 2-3 years of income needs into a safe, cash investment and allowing you to leave the remainder in higher growth investments. Market volatility will not affect your income cash flow, as the money comes from your cash wedge, not from your market-based investments. This provides insurance of your income through retirement.

Reframe – health insurance as a retirement asset class

So, you’re saving for retirement and things are going well. You’re reaching your goals of having enough money saved to provide income for you for the rest of your life. Things are looking good. But wait. What if life doesn’t go exactly as planned (almost a certainty)? What if you and/or your partner have a prolonged period of healthcare as you age. This is much more common than you think. The chances that a Canadian will need either home care or facility care runs over 50%. The chances that one partner in a couple will need care with age runs over 80%. With the cost of care being $3,500 to $4,000 per month ABOVE normal living costs, this can quickly eat away at a retirement nest egg and destroy it.

For example, if you have $1,000,000 saved and it is growing at 4% per year, and you are drawing off $5,000 per month for income, this nest egg will last 27.5 years. How fast will the same money be depleted if you added $3,500 to the monthly withdrawal ($8,500 per month)? The answer is 12.5 years!

Now, if a 55-year-old woman (women cost more for this insurance than men) buys $800 per week in benefit (works out to $3,467 per month tax free) she would pay $271.97 per month. Assume she pays her premium for 25 years, until age 80, and then she enters a long-term care situation, should she have purchased the insurance or not?

If she had just saved the money and earned 5% on it after tax (so this would have to be a TFSA or it would need to earn more), she would have $144,095 after 25 years. Assuming she needs $3,500 per month for her care needs, and she is still earning 5% on the money, the capital will be depleted in 3 years 8 months. If she was in care for 5 years, she would need an investment that earns 15.95% return after tax for the extra 1 year 4 months!

It is very dangerous to enter retirement without a plan for your long-term healthcare needs. There will be a lot of pressure on the healthcare system to provide care for the massive wave of Boomers that will all need care around the same time. Unless you really have a lot of money and maybe additional passive income sources, the cost of care in the future could seriously undermine your retirement plans.

The cost of a long-term care policy might be the smartest investment you make to protect your retirement. With this same woman example above, if she has a 50% chance of needing care, and she invests $81,591 over 25 years she could draw out money for 3, 4, 5, even 10 years. The length of the benefit is unlimited. Here is a risk adjusted return on her investment for reasonable timeframes of needing care (rate of return of a claim X 50%):

• 1 year: -91.5%
• 3 years: -4.3%
• 5 years: 7.8%
• 7 year: 11.7%

Simply put, if you have a care need that lasts longer than 3 years you have a positive risk adjusted rate of return. If you have a shorter care need or no need at all there is a loss of the money – potentially a total loss. This is offset by the potential to safeguard your retirement form being financially destroyed from a prolonged need for care. I would not gamble with the statistics. The odds are 50/50 you will need care and the average time needing care is now over 3 years. Your retirement plan might need to be secured with a plan for your long-term care.

Thanks for reading,

Mitch Reynolds, MBA, CFP, CLU, RRC, EPC

Advisor & Financial Planner, Sun Life

403-212-1111 or [email protected]