Volatility is back, again | #FinanceFridays with Kathryn Del Greco, CIM, FSCI, CSWP

A return of concerns over slower global economic growth, the unwinding of quantitative easing, and geopolitical tensions conspired to bring volatility back to financial markets. After a prolonged period without a meaningful pullback, equity markets dropped over the September to October period. Since the lows, the S&P 500 Index has once again reached new highs and the S&P/TSX Composite Index has recovered roughly 40% of its losses. In this issue of Monthly Perspectives, we examine the return of volatility and highlight investment solutions designed to mitigate the downside risks associated with equity markets. Additionally, we discuss what the shift in expectations for global growth means for key sectors of the North American equity market and uncover factors pointing to a positive, longer-term outlook for equities. We remind investors that short-term volatility is an unavoidable part of investing, however, they can be prepared for it by having a well-diversified portfolio with an asset mix designed to meet their investment goals and risk tolerance. Doing so, can mitigate market downturns and help investors remain focused on their long-term goals.

Shifting expectations

Yogesh Oza, M.Econ, CFA; Robert Marck, CPA, CMA, CIM

From the Ebola outbreak to slowing global growth, news items have played a significant role in bringing volatility back to the
financial markets. To address this development, we explore the potential effect of the softer global growth outlook for some key North American market segments, such as natural resources, financials, consumer staples and consumer discretionary sectors. At a time when negative headlines seem to regularly make the front page of many newspapers, we read the fine print to discover the silver lining and uncover reasons why investors with a longer-time horizon should remain positively inclined.

Natural resource sectors adjusting supply to lower global growth expectations

Recently, energy and industrial commodity prices have come under substantial pressure on the view that moderating economic growth outside of the U.S. could lead to excess supply situations. Such worries were stoked by a number of bearish data points. In early October, the International Monetary Fund (IMF) reduced its 2014 global growth forecast by 0.4% to 3.3%, while the outlook for 2015 was nudged lower by 0.1% to 3.8%, compared to its April forecasts. A primary concern is that the euro zone might be on the verge of another recession as anemic growth may not ward off disinflationary forces. Additionally, China’s economy has been showing signs of moderating growth and the leadership has indicated a reluctance to provide additional material monetary stimulus in fear of fueling already hot credit markets.

With global growth expectations being downgraded, the Parisbased International Energy Agency (IEA) also took a cautious stance. The IEA reduced its forecast for global oil demand for 2014 by 0.2 million barrels per day (mb/d) to 92.4 mb/d, less than the worldwide supply, which in September stood at 93.8 mb/d. Thanks in part to rising Libyan production, OPEC’s (Organization of the Petroleum Exporting Countries ) crude oil output surged to a 13-month high. The same global growth concerns also weighed on industrial metal prices. Many mining projects that were shelved during the Great Recession have been ramping up to commercial production levels. A Reuters survey indicates that over the next six months, more than one million tons of new copper capacity will come on stream at a time when ex-U.S. growth expectations are slowly moving lower. Synchronization of base metal production growth with projected global demand over a multi-year time horizon is a challenge for mining companies, given the long lead times required to build new mines. As such, near-term supply and demand mismatches can result.

While there might be a short-term oversupply situation in some commodity markets, ultimately, energy and base metal mining companies tend to adjust their production profiles to line up with a more modest growth outlook. This generally means that those projects that were marginally economic will either come off line or be ramped up at a more gradual pace. In turn, as companies expand production at a more measured pace, supply eventually balances out with demand at a global level.

Fig 1

Canadian Interest Sensitive Stocks

Volatility is back again Fig 1

In the energy sector, given the high production decline rates that shale resource wells experience in the first year of production, more gradual development schedules might ultimately prove to be more prudent in terms of putting less stress on company balance sheets, improving cash flow predictability, and dividend sustainability.

In addition to production growth rates being adjusted lower, Canadian energy prices may also find support as companies take steps to diversify end-markets for their production. For example, British Columbia’s liquefied natural gas (LNG) projects are moving forward, albeit slowly, to ship Canadian natural gas to Asia. Canadian energy companies are also keen on helping Europe safeguard more reliable energy supplies. As North American energy infrastructure capacity continues to increase and more global markets are made available over time, it is expected that prices realized by Canadian energy producers will trend closer to global benchmarks.

With recent global growth woes stoking fears of potential excess supply, volatility returned in a big way to North American natural resource sectors. As commodity producers adjust production profiles, commodity prices may be supported by moderating supply growth. The sharp downturn in natural resource stock prices suggests that softer growth expectations may already be priced in.

Declining interest rate expectations not bad for all financials

The recent slowing economic data out of Europe and other international economies has tempered economists’ rate-hike expectations and raised the possibility of low rates continuing for the foreseeable future. The low rate environment has been prevalent for the past five years and while there had been some expectation that the economy would strengthen enough in 2015 to allow central banks to increase rates, it appears this view may have been premature.

To illustrate the divergence in stock performance of interest sensitive financial sub-sectors in Canada, we take a look at real estate companies, banks and insurance companies from the end of Q2/14 to today (figure 2). Generally, a rising rate environment has a positive effect on some companies and a negative effect on others. For example, Real Estate Income Trusts (REITs) are negatively impacted by rising interest rates because they increase the cost of debt used to finance the real estate assets. Conversely, rising rates are generally positive for banks and insurance companies. Banks are able to earn a better return when interest rates increase (assuming a normal shaped yield curve) as they can lend money at higher rates (mortgages, loans) than they are paying for the deposits to fund the loans. This increases the net interest margin (spread) the banks earn. Life insurance companies are able to discount future liabilities further with increased interest rates and generally benefit from a higher rate environment.

Fig 2

Canadian Interest Sensitive Stocks

Volatility is back again Fig 2

Figure 2 shows that share price performance of the three sub-sectors followed a similar path until the end of September, at which time, interest rate hike expectations became subdued. What followed was a noticeable divergence of stock performance with REITS, which benefit from low rates, outperforming banks and insurance companies. We believe this is due to rate hike expectations being pushed into the future. Not all financial companies react the same way to changing interest rates and a well-diversified portfolio of financial holdings will help to mitigate volatility in pricing from changing rate expectations.

The U.S. consumer recovery has paused but the trend is undeniably positive

Finally, we review the health of the consumer in the U.S. Elevated fears of slowing global growth outside of the U.S. may spill over and affect the U.S. economy, thus dampening the recent resurgence of the U.S. consumer. To help understand the state of the U.S. consumer, we take a look at two key economic indicators: retail sales and consumer confidence.

Fig 3

Retail Sales vs. Consumer Confidence Index

Volatility is back again Fig3

First, let’s look at retail sales. Following seven consecutive monthly gains, U.S. retail sales fell by 0.3% in September—creating negative sentiment in the market. Retail monthly sales increased from US$332 billion in December of 2012 to US$442 billion by the end of September 2014, a significant increase. The key message, however, is that while volatility in monthly economic data is back, the direction of retail sales in the U.S. from late 2009 until now is undeniably positive.

A low rate environment is not necessarily a negative for financial stocks

Another economic indicator we considered is the U.S. consumer confidence index. Consumer confidence is an indicator that measures the degree of optimism consumers feel about the overall state of the economy. This helps determine potential spending in the economy because with increased confidence usually comes the willingness to purchase additional goods. Although confidence has been flattening over the past three months, it has steadily improved since 2008. Additionally, while choppy consumer economic data may also be back, leading to some volatility in share prices of consumer companies, we believe the U.S. consumer is healthy overall, which should be a tailwind for the consumer discretionary and staples sectors.

Although market volatility is back, there are reasons to remain positive

As mentioned earlier, the bevy of bearish headlines has led to an increase in market volatility and caused investors to be more cautious. On a positive note, we believe that falling commodity prices will lead to more measured production growth, supporting commodity prices. Further, a low rate environment is not necessarily a negative for financial stocks and is a tailwind for the consumer sectors.

Low volatility solutions for volatile times

Badan Fong, CFA; L.J. (Ketan) Desai, CFA

After several years of relative market stability, the recent spike in volatility sent a chill through markets in September and October. While sharp downswings in the markets are never comfortable, some investors are able to tolerate the volatility. However, for those investors who determine they have a lower tolerance for risk than a typical equity allocation requires, but still need equity exposure to meet their investment objectives, low volatility strategies can offer an effective solution.

Low volatility investing

Low volatility strategies aim to provide some downside protection when investing in equities, while retaining the ability to participate in rising markets. These strategies can be considered within the equity allocation of a portfolio to help generate superior returns versus bonds, while reducing the overall risk profile of the portfolio relative to equities alone.

TD Asset Management was the first to launch a low volatility fund in Canada and is a leader in this segment

Low volatility strategies tend to have a higher weighting in dividend- paying, non-cyclical stocks in sectors such as utilities, health care and consumer staples. These strategies typically exhibit a value style that—as studies have shown—tends to outperform a growth approach in the long run. Collectively, these exposures tend to result in a portfolio that is less sensitive to market fluctuations.

All low volatility strategies are not created equal

While low volatility strategies tend to demonstrate common characteristics, investors should keep in mind that differences can exist between solutions. For example, some low volatility solutions are constructed using stocks that have demonstrated the lowest volatility over a specified period of time with little regard to other elements of portfolio construction, such as sector or regional diversification. The PowerShares Canadian Low Volatility Index Fund has a significant relative overweight to Canadian financials with approximately 56% exposure versus the S&P/TSX Composite Index of approximately 35% (Source: Morningstar® Direct, as at September 30, 2014).

It is important to note that while targeting lower volatility is a compelling investment objective, there is no guarantee that this goal will be met in all time periods. In addition, investors should be aware that during periods of sustained rising equity markets, low volatility strategies are expected to lag the performance of a broader market.

Low volatility mutual funds

For investors seeking a low volatility fund, TD Asset Management (TDAM) is a leader in this segment and was the first to launch a low volatility fund in Canada. TDAM currently manages four low

volatility strategies: TD Canadian Low Volatility, TD U.S. Low Volatility, TD Global Low Volatility and TD Emerging Markets Low Volatility. In addition to TDAM’s offerings, Royal Bank of Canada offers the RBC QUBE Low Volatility funds and Mackenzie Investments launched the Mackenzie U.S. Low Volatility Fund in April of this year.

For those investors approaching or currently in retirement, and who are looking for a fund-of-funds solution as a core building block for their portfolio, the TD low volatility series of funds can be found in the TD Retirement Portfolios. These portfolios use a combination of low volatility equities and a flexible fixed income approach that focuses on corporate bonds. They also hold the TD Risk Reduction Pool, which employs both equities and options to help limit the portfolios’ downside while seeking long-term capital appreciation.

Low volatility Exchange Traded Funds (ETFs)

In addition to actively managed low volatility funds, investors can gain access to North American and international low volatility strategies using passive ETFs. Broadly speaking, ETF providers use one of two key ways to construct low volatility portfolios. One is to rank stocks in a given universe based on their past volatility. For example, the BMO Low Volatility Canadian Equity ETF screens the 100 largest and most liquid equity securities in Canada to construct a portfolio of the 40 least market sensitive stocks based on their sensitivities to market movements. Similarly, the First Asset MSCI Canada Low Risk Weighted ETF re-weights all the constituents of the market capitalization weighted MSCI Canada Index such that stocks with lower historical return variance over a three-year period are given higher weights in the portfolio.

Low volatility strategies can offer an effective solution for investors with a lower tolerance for risk who need equity exposure to meet their investment objectives

Despite being relatively more complicated, we prefer the MSCI Minimum Volatility Indices’ methodology, which uses a proprietary methodology to optimize a parent MSCI index for the lowest absolute volatility subject to certain rules. These rules include limits on index turnover, as well as maximum and minimum weights for stocks and sectors. For example, the iShares MSCI USA Minimum Volatility Index ETF tracks the performance of the MSCI USA Minimum Volatility Index. This index measures the performance of the top 85% U.S. listed equity securities by market capitalization that have lower volatility relative to the companies included in the parent MSCI USA Index.

Understanding your goals and risk tolerance, and selecting investments that suit your circumstances are key to achieving your investment objectives. If periods of volatility make you uneasy, consider adding low volatility strategies as part of the equity allocation in your portfolio.

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Markets have tread a steady upward path for quite some time and the recent divergence from that path has resulted in some discomfort for many investors who have grown accustomed to the positive trend. While the recent turmoil in markets has led many financial pundits to make claims that volatility is back, the reality is that the market has been experiencing much milder swings than it has during many periods since the turn of the millennium.

A little thing called recency bias

Art Czyzyk

The human brain is one of the most fascinating, interesting and incredibly complex machines known to exist. From walking down stairs (which in itself is an extremely complicated act) to juggling knives to, well, studying themselves, our brains perform tasks that are nothing short of a miracle. Unfortunately, when it comes to investing, they (and you) are not as rational as you think.

Here’s the problem: we are creatures of habit. We grab the milk out of the fridge in a well-practiced manner, we take the same route to work, we eat and sleep at a certain time, and we even sit in a certain way when we read. The reason is simple, our brains are smart. They outsource their neuron labour so they can focus on more complex (new) issues at hand. This habitual behaviour allows our brain to reduce the amount of information it has to store, i.e., we don’t need to remember the route we took to work three months ago; we just need to remember yesterday. Unfortunately, the brain’s preference for remembering and recalling only the most recent occurrences biases our thinking, creating a contextual drift commonly known as the recency bias.

The recency bias is pretty simple. We’re inclined to use our recent experience as the baseline for what will happen in the future. This bears repeating: you are naturally inclined to use your recent experience as the baseline for what will happen in the future. This means that the context we apply to our thinking at any given moment can be thought of as a recency-weighted sum of previous experiences or memories. This works fine for our everyday lives but when it comes to investing, you can see how it can cause problems. The most obvious of which is that it blinds us from the big picture.

So what can you do about it? First, be aware. The recency bias is sub-consciously marinating on the back burner. Bringing it to the front (consciousness) allows us to figure out how it works. Once you know that, you can not only compensate for its shortcomings but use it to your advantage. For example, we tend to remember the last item on a list, or the last thing we hear or read. Why not be strategic about it? Think long term.

Important information

The information has been drawn from sources believed to be reliable. Where such statements are based in whole or in part on information provided by third parties, they are not guaranteed to be accurate or complete. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information does not provide financial, legal, tax or investment advice. Particular investment, trading, or tax strategies should be evaluated relative to each individual’s objectives and risk tolerance. TD Wealth, The Toronto-Dominion Bank and its affiliates and related entities are not liable for any errors or omissions in the information or for any loss or damage suffered.

Full disclosures for all companies covered by TD Securities Inc. can be viewed at https://www.tdsresearch.com/equities/welcome.important.disclosure.action

Research Ratings

Action List BUY: The stock’s total return is expected to exceed a minimum of 15%, on a risk-adjusted basis, over the next 12 months and it is a top pick in the Analyst’s sector. BUY: The stock’s total return is expected to exceed a minimum of 15%, on a risk-adjusted basis, over the next 12 months. SPECULATIVE BUY: The stock’s total return is expected to exceed 30% over the next 12 months; however, there is material event risk associated with the investment that could result in significant loss. HOLD: The stock’s total return is expected to be between 0% and 15%, on a risk-adjusted basis, over the next 12 months. TENDER: Investors are advised to tender their shares to a specific offer for the company’s securities. REDUCE: The stock’s total return is expected to be negative over the next 12 months.

Conflicts of Interest 

The Portfolio Advice & Investment Research analyst(s) responsible for this report may own securities of the issuer(s) discussed in this report. As with most other employees, the analyst(s) who prepared this report are compensated based upon (among other factors) the overall profitability of TD Waterhouse Canada Inc. and its affiliates, which includes the overall profitability of investment banking services, however TD Waterhouse Canada Inc. does not compensate its analysts based on specific investment banking transactions.

Mutual Fund Disclosure

Commissions, trailing commissions, performance fees, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus, which contains detailed investment information, before investing. The indicated rates of return (other than for each money market fund) are the historical annual compounded total returns for the period indicated including changes in unit value and reinvestment of distributions. The indicated rate of return for each money market fund is an annualized historical yield based on the seven-day period ended as indicated and annualized in the case of effective yield by compounding the seven day return and does not represent an actual one year return. The indicated rates of return do not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder that would have reduced returns. Mutual funds are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer and are not guaranteed or insured. Their values change frequently. There can be no assurances that a money market fund will be able to maintain its net asset value per unit at a constant amount or that the full amount of your investment will be returned to you. Past performance may not be repeated.

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