Before the Bank of Canada’s decision to hike interest rates in June, the U.S and Canada’s central banks had been following an uncommon diversionary path for almost 18 months. That trend created a cyclical tailwind for the U.S. dollar, but when the Bank of Canada surprised investors with its most recent hike, the loonie came roaring back.
“Things shifted very quickly, and in the three months to the end of July the loonie appreciated 8.5% against the U.S. dollar,” says Jeremy Peng, Director & Portfolio Manager at NEI Investments
. “That is a very significant change. If you are a Canadian invested in the S&P500 even though the index returned positive 4.1%, you got negative 4.8% because of the currency.”
Peng was surprised that the Bank of Canada changed their stance so quickly, although he does believe the central bank’s move makes sense due to the synchronized nature of the economic recovery amongst most developed nations.
“Valuations for asset classes have been high for a while because of the aggressive loosening and QE, which has contributed to ultra-low yields on bonds,” Peng says. “So, when this effect is reversed we expect bond yields to move up to their historical average, although it might take a while, but at least the trend has been established and they may actually be moving upward.”
Peng believes a tightening trend across the board will impact the price of stocks as well as bond yields. With bond yields slowly normalizing, Peng expects equity valuations to reflect that move.
Despite his view on bond yields, Peng still favours equites in the current markets. Although he believes rising rates will put pressure on most asset classes, he does think that strong corporate results will support equity growth.
“The E - earnings - in the P/E is very important, and right now we’re seeing companies, especially in the U.S., reporting very strong earnings,” Peng says. “It is a good sign that companies are actually generating good earnings growth and that makes sense because the global economy is much healthier. Both bonds and equities are going to be under some pressure, but equities are supported by strong earnings and that is why we still favour them.”
Peng believes that investors are not paying enough attention to U.S. small cap dividend paying stocks, mainly because most ETFs do not offer exposure to those stocks. Although small cap returns have been positive, they have underperformed mega cap year-to-date. Peng does not expect this underperformance to continue for very long.
“Things usually reverse after a while, but it is always hard to time this kind of small cap vs large cap,” Peng says. “We usually have a structure position exposure to small cap dividend payers in our yield focused products and always rebalance to the target weight when they are under pressure. In the long-term we expect things to reverse and we’ll be able to benefit from that.”
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