Love Letter – May 2018

June 1, 2018

“Offence wins games, defence wins championships”

With a record of 59 wins and only 23 losses, the 2017-2018 season for the Toronto Raptors was a franchise best and was enough to clinch the Eastern Conference title and the 2nd best win-loss percentage in the league. However, despite this regular season performance, the Raptors were decisively swept out of the playoffs in the 2nd round by LeBron James and the Cleveland Cavaliers. Offence wasn’t the problem, as the Raptors averaged 107 points per game during the playoffs (not materially different than the 111 point average during the regular season). Rather, it was the dismally high number of points allowed while the Raptors were playing defence (known as “defence rating” in NBA statistics). For yet another season, the Raptors strong offense earned them a spot in the playoffs, but a weak defence cost them the championship.

After several years of playing offence, we think investors should regard the U.S. Federal Reserve as formidable an adversary as LeBron James was to the Raptors. From an investment perspective, portfolios need to defend against steadily rising interest rates. With robust economic conditions in the U.S (unemployment rate near a 48 year low, inflation trending higher), it is not a question of whether the Fed will keep hiking rates but how quickly. Since rising interest rates have a dampening effect on the economy, Fed rate hiking cycles dating back to the 1980s have been followed by recessionary periods (see exhibit 1).

Talk of recession may seem contradictory given current economic conditions and interest rates that are still well below historical levels. While we believe the near-term outlook remains positive, our concern is that further tightening by the Federal Reserve over the next 12-18 months could halt the current positive economic momentum. As highlighted in exhibit 1, the U.S. economy and asset prices have been acclimatizing to lower and lower interest rates for the past 30+ years. It is noteworthy that the last two recessions were triggered at progressively lower absolute interest rates. After a prolonged period of ultra-low interest rates since 2008, we think the economy’s ability to absorb higher interest rates may be limited.

Based on current market expectations, the Fed is expected to raise interest rates another 0.50%-0.75% during the remainder of 2018, and a further 0.50%-0.75% in 2019, bringing short-term rates to 2.75%-3.25%. Inflationary pressures, which are currently building, will ultimately dictate the pace of further rate hikes. Preferring to err on the side of caution, we consider it prudent to continue preparing for a likely slowdown that rising rates may trigger. In line with March 2018’s edition of The Love Letter, and consistent with recent transactions in our managed portfolio program, we have already started to take defensive steps to preserve your capital. Over the next 12 months, our intention is to continue removing risk from client portfolios by gradually reducing exposure to “long-only” equity investments. Areas where we intend to add exposure include: investment grade and government fixed income, alternatives, structured products, rotation into defensive sectors, and higher interest-bearing cash. This defensive strategy will allow us to reinvest in equity markets should valuations become more compelling in future.

As we near an expected inflection point, we look forward to meeting with you individually to provide greater insights into our market thesis, review our investment strategy, and address any concerns you may have.

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Love Letter – April 9, 2018

April 9, 2018

U.S. – China protectionist trade rhetoric adding to short-term volatility, but our positive thesis intact

Though markets are generally rational, they occasionally do crazy things.” (Warren Buffett, Berkshire Hathaway 2017 Annual Report, February 24, 2018)

Despite the strongest global economic growth in many years, capital markets have been volatile and performed poorly so far in 2018. As of the close on April 6, most global equity markets were in negative territory YTD and the MSCI World equity index was down 2.4% YTD. While inflation worries and higher interest rates triggered the sell-off in early-February, protectionist trade rhetoric emanating from the White House, and profit-taking in the technology sector have contributed to further deterioration in investor confidence in recent weeks (exhibit 1).

Quite contrary to media headlines on trade, geopolitics, and day-to-day swings in the marketplace, we continue to view fundamentals as positive, valuations as reasonable, and risks worthy of monitoring but manageable. In this newsletter we outline several reasons to maintain the course of a diversified investment portfolio strategy. Read More…

Love Letter – March 2018

March 27, 2018

Notwithstanding near-term trade uncertainties, interest rates remain the primary risk to our outlook

Entering 2018, we regarded the pace of interest rate hikes as the primary risk to capital markets. Although trade uncertainties and geopolitical concerns have dominated headlines in recent weeks, our portfolio management strategies continue to be guided mainly by our interest rate outlook.

The broadly held thesis is that gradually rising interest rates will eventually put the brakes on economic activity, and at the same time will make interest-bearing investments more attractive relative to equity investments. On March 21, the U.S. Federal Reserve’s rate committee followed through with a widely anticipated 0.25% rate increase (to 1.75%) and modestly increased its interest rate outlook. The committee’s median forecast now points to a Fed rate of 2.25% by the end of 2018, 3.00% by the end of 2019, and 3.5% by the time 2020 is over. Even though these interest rate levels may appear low from a historical perspective, we think a doubling of the Fed rate over the next 30 months could prove challenging to equity, bond, and real estate prices which have adjusted to a lower rate environment since 2009. With this timetable in mind, we continue to have a constructive view on equity markets for much of 2018, but expect returns to dip starting sometime in 2019.

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