3rd Quarter Commentary

18 October, 2016

Never in the 250-year modern history of Western culture, with the exception of the communist states, has government intervention played such a large role in the valuation of financial assets.

Never in the 250-year modern history of Western culture, with the exception of the communist states, has government intervention played such a large role in the valuation of financial assets.

Through the tool of monetary policy, which effectively determines the amount of money in circulation, both in paper and electronic form, the world's central banks have taken measures which has resulted in a distortion in the valuation levels of stocks, bonds and real estate.

Interest rates, which are effectively the cost of 'renting' money, normally are determined through the forces of supply and demand.  When demand for money rises, interest rates rise, which has the effect of reducing the money in circulation and dampening economic activity.  When demand for money falls, the opposite occurs.

This natural process has been 'regulated' by central banks around the world, since 1913 when the U.S. government established the Federal Reserve, America's central bank.  Each sovereign nation has their own central bank, but certain nations central banking policies have more influence than others due to economic size.

History has demonstrated that this experiment with a central bank (as opposed to a shared responsibility among private banks) has resulted in boom and bust economic cycles due to their attempt to fine tune economic activity, theoretically, for the public good.

The other tool governments have used historically is fiscal policy - the implementation of taxation and expenditure policies also for the purposes of fine tuning the economy…for the public good.

Fiscal policy is supposed to use simulative measures such as deficit spending (borrowing to spend) when the economy is weak, but to then repay this debt after the economy strengthens.  In practical application, fiscal policy has been a one-way street with debt continuously accumulating over the course of generations as it is a popular policy with the uninformed public which results in re-election of the spendthrift politicians.  Accountability is transferred to future politicians and repayment to future taxpayers.

Of course, such policy has its limits as Greece has found out, amongst several other Southern European countries.  Just like a credit card limit, the borrowing capacity of a nation is effectively limited by its annual economic production as measured by GDP (gross domestic product).  Total tax revenues are directly related to economic activity.

At present the G7 nations which are the most economically advanced countries in the world have reached spending levels where their accumulated debt now exceeds the annual product of their economy.  Studies show that debt/GDP ratios exceeding 90% result in slower economic activity.  This can be clearly seen in today's global economy.

In an attempt to stimulate the economy, with fiscal policy now off the table for most G7 nations, governments have turned to monetary policy.  The systematic lowering of interest rates to encourage spending and borrowing by the consumer has been used historically for this purpose.  Unfortunately, this most recent attempt has not worked.  The economies of the G7 and other advanced countries are essentially stagnant.  This is also a function of an aging global demographic.

Some countries have resorted to 'negative' interest rates where borrowers are paid and depositors are charged an interest rate (yes the world is upside down).  This too has failed as evidenced in Japan and some European nations.

What zero per cent interest rate policy 'has' accomplished though is to push valuations of stocks, bonds and real estate to extraordinary and unjustifiable levels (at least by historical standards).  In the absence of a catalyst, or an agent of change, however, this condition will persist.  The implications though is that it makes the decision for the appropriate asset allocation of an investment portfolio extremely difficult - and fraught with risk.

Since this manipulation is occurring at the highest levels of government and for political expediency, it is completely unpredictable.  Attempts to hedge risk by buying gold or other measures, can easily be undermined by a change in political policy that cannot be anticipated.

At present, we must navigate within the confines of the current rules of the game.  Given current conditions, the benefits of owning stocks, 'slightly' outweighs the benefits of owning bonds.  The benefits of owning USD stocks, slightly outweighs the benefits of owning Canadian stocks, and by extension, the USD over the CAD. 

The August to October period has historically had the greatest number of major stock market declines and so any changes in your current asset mix should only be considered after the favourable season has begun for the stock market (October 28th), and only if the U.S. Presidential outcome appears to be predictable at that point.  

U.S. corporate earnings have been declining over the last 5 quarters.  Stock valuations generally follow the rate of growth of corporate earnings.  Thus, the recent increase in the stock market's value in the 3rd quarter has resulted in the continued stretching of market valuations to unjustifiable levels.  That being said, valuation distortions can persist for long periods of time. We expect corporate earnings to begin demonstrating rolling 12-month increases that are more in line with historical experience in the 6% range, in the final quarter of 2016.

I encourage you to stay in regular contact with me at least semi-annually to ensure your asset mixture is suitable for your objectives and overall financial circumstances.