The return of risk

Hey there, time traveller!
This article was published 30/12/2017 (2922 days ago), so information in it may no longer be current.

Investors will miss 2017. It’s been a good year. The Canadian stock market hit new heights, while the U.S. stock market utterly smashed previous milestones.

Europe started gaining momentum. So, too, have emerging markets. Even Japan — once considered a hopeless case — has provided decent returns to investors.

All of this foretells more good times lay ahead for investors in 2018, right?

Yes… and no, say three industry experts. While 2018 will likely continue to provide returns for stock market investors, this bull market has been trotting since March of 2009, and is a sporting a large silver streak on its back.

“We’ve got this aging bull market that refuses to retire,” says Shailesh Kshatriya, director of Canadian strategies at Russell Investments Canada in Toronto.

This has made markets expensive. The amount of dollars you must pay to own most stocks is growing for every dollar these companies earn.

Yet don’t expect the bull to die this year.

Rather, assume the markets to continue to roll — only with more risk than this past year, says Mike White, a Toronto portfolio manager with Picton Mahoney Asset Management.

“Many people would assume this has been a very long bull market cycle, and it has to end because it’s gone on for so many years.

“But bull markets don’t die of old age or from being perceived to be expensive.”

What slays bulls and resurrects bear markets are recessions. The temptation is to file that comment under “obvious” in your mental dossier, but the coming of a recession isn’t always recognizable.

Moreover, the indicators of ominous economic conditions can show themselves, and a bull market can keep stampeding just the same.

So far, however, the prospect of a recession is rather slim — at least for the coming year.

What’s more, is on a global basis, the conditions look much brighter than in some time.

“There’s no longer the U.S. pulling everybody else along,” White says. “That’s good news.”

Kshatriya says Russell forecasts roughly two per cent GDP growth across the board.

“Overall, looking at the key developed and key emerging market regions, the cycle is broadly supportive.”

Additionally, Canada will likely benefit from global growth, especially as commodities gain momentum after going through a long rough spell.

“Generally, commodity prices overall — as a big blanket statement — are low. Yet, when we look at what’s called the demand-and-supply ratios, we see the demand greater than the supply,” says Tim Pickering, chief investment officer with Auspice Capital Advisors in Calgary.

These conditions for commodities haven’t been seen since the late ’90s and early 2000s before the tech bubble burst.

Pickering calls the situation “intriguing.”

Basically, high demand and low supply tends to result in higher prices. And this is expected to play out in oil, which will undoubtedly benefit Canada.

“The world is after crude oil. The world is expanding,” he says. “Demand side of the equation is strong.”

Among the indicators of robust global demand is Brent Crude — the global price for a barrel of oil — which is trading much higher than West Texas Intermediate (WTI) — the North American price.

This will help dampen the impact of increased shale oil production in the United States, which in the past has helped keep prices depressed.

The reason for that is the U.S. is now an exporter of oil. Rather than building up supply, producers sell to the international markets to get that higher Brent price.

That oil prices are on the rise is great news for Canadian producers, but Pickering says the challenge remains a lack of options for customers.

“The problem is we have limited export capacity and no direct tidewater access, and yet the world is after the heavy sour oil we produce, and the producers are making money again, but they can’t get their oil out of Canada easily.”

Currently, Canadian oil trades on a per-barrel discount of more than 30 per cent to the WTI price. The discount is even deeper for natural gas, another driver of the energy industry — also because of a lack of customers other than the U.S.

Still, Pickering forecasts Canadian energy producers’ profits will grow as demand continues to rise with improving global economic conditions.

All of this is good news, indeed. So where are the dark clouds, then? Well, the risks are the result of improving economic conditions.

For one, we can expect higher volatility in the year ahead.

Markets will move higher, but likely with bigger speedbumps than anything we’ve experienced in quite a while.

“It’s every investor’s dream to be along for the ride we’ve experienced in the market over the last year or so,” White says, adding we have yet to see even a minor correction for several months.

There’s a lot of euphoria, and we’re quite willing to shake off negative thoughts.

“We’ve digested a lot of bad news that would have otherwise derailed an economy in past years,” he says.

The current conditions are stoking investor greed. And when things go wrong — like three per cent drop in the stock market — many investors get spooked, and they tend to sell low after buying high.

Additionally, investors are less inclined during bull markets to de-risk their portfolio.

“If you’ve been able to beat the market in an environment this friendly to risk, you’re probably taking on more risk than you realize,” says White, a hedge fund manager who specializes in risk-reduction strategies.

Volatility is often only problematic, however, if you can’t stomach the price swings to the downside, and then panic and sell.

The bigger risk for 2018 is rising interest rates that should come as the economy continues to heat up.

“It’s not about the first half of 2018, but the back half of 2018 where we get more concerned,” Kshatriya says.

Russell Investments forecasts three more hikes in the U.S. and couple more in Canada in mid- to late 2018. Kshatriya’s advice: fixed income with short durations can help manage volatility for the first half of the year. But as 2018 greys, investors may want to tire-kick fixed income — bonds — with longer durations.

“When you become concerned about downside volatility in the stock markets, duration becomes more of a friend than a foe,” he says.

So, while markets will start the year with more bangs for bucks, we should start easing back on the risk in our portfolios toward the end of the year to help preserve those nice gains built up over the many years that have come before 2018.

Happy investing!