q2 review and outlook - picton mahoney revie… · 4 q2 review and outlook the fed, under jerome...

Q2 REVIEW AND OUTLOOK

WHAT DOES THE CURVE HAVE TO SAY?

PAUSE, BOUNCE – NOW WHAT?

MOVING F R OM “ IF” TO “WHEN”

A FORK IN THE ROAD

GE OP OLITICS: A CONF IDENCE GAME

2 REVIEW AND OUTLOOKQ2

As our late-cycle roadmap continues to evolve, stock markets have reached a critical juncture, with all eyes focusing on the U.S. Federal Reserve and its ability to placate investors by – they hope – extending the current economic cycle. A swift and powerful easing process could certainly buoy equities, but we continue to explore ways to position for diverging outcomes that might occur.

OVERVIEW

VIEW PMAM VS. CONSENSUS

R I S KMacro risk remains muted as the U.S. Federal Reserve (the Fed) continued to turn more dovish, with rate cuts now back on the table. Falling global rates have given at least a temporary boost to credit conditions.

S A M E

MACROECONOMICS

G LO B A L R E A L G D PGlobal growth expectations continue to grind lower. China’s economic growth keeps decelerating as the leadership adds small but focused stimulus, but nothing too dramatic yet.

LO W E R

U. S . R E A L G D P The labour market remains tight, but is not yet showing signs of concern. Confidence is off peaks, but still robust. Growth expectations have fallen below 2%.

S A M E

C A N A D I A N R E A L G D P The Bank of Canada (BoC) continues to reiterate its cautious stance, with the next move expected to be a cut. It remains concerned about oil-sensitive parts of the economy and the highly indebted consumer’s ability to weather higher rates.

LO W E R

U. S . I N F L AT I O N U.S. inflation is just below target, and the risks appear balanced in both directions.

S A M E

EQUITY RETURNS

U. S . E Q U I T I E S U.S. equity return expectations in the high single digits might be possible for the year if the Fed gives the market what it wants (aggressive cuts) and China trade talks don’t devolve further.

S A M E

E U R O P E A N E Q U I T I E S Europeans are keenly focused on the European Central Bank’s (ECB) next move, to see whether or not it has truly run out of bullets. Falling Purchasing Manager Indices (PMIs) and weaker global trade continue to drag down the prospects for European equities.

B E A R I S H

C A N A D I A N E Q U I T I E S Return expectations are too optimistic given the many risks and few positive drivers. An inverted yield curve and tighter lending standards will weigh on the key financial industry in due time.

B E A R I S H

BOND YIELDS

T R E A S U R I E S ( U. S . 1 0 - Y R )U.S. rates across all tenures fell below the Fed’s new median estimate for the neutral rate as expectations changed from rate hikes to cuts. We expect rates to rebound some from these extreme levels, and eventually fall as the cycle ends.

H I G H E R

I N V E S T M E N T- G R A D E C O R P O R AT E B O N D SCorporates bonds do not perform as well in this phase of the economic cycle. The current makeup of this group is the lowest quality it has ever been, with yields artificially driven down by the chase for yield.

H I G H E R

H I G H - Y I E L D C O R P O R AT E B O N D SThe high correlation of corporate spreads to the CBOE Volatility Index (VIX) suggests yields should widen over time, although a lack of product may distort market pricing in the near term.

H I G H E R

OTHER

W T I C R U D E O I LOPEC cuts and backwardation are providing near-term support to the oil price, but the threat of higher U.S. shale production as prices rise keeps oil prices trapped in a trading range. However, beyond Q3 the dynamics become increasingly bearish for oil.

S A M E

E P S G R O W T H ( S & P 5 0 0 ) Margin pressure from higher wages, rates and import prices will hurt earnings, as will decelerating final demand.

LO W E R

P / E ( S & P 5 0 0 ) Stretched multiples fell back, relative to their own history, but are still above average. Higher rates still make equities less attractive than bonds by some measures.

LO W E R

”PMAM” refers to Picton Mahoney Asset Management. PMAM view is relative to the Bloomberg consensus estimate for each category. As at June 30, 2019.

PICTON MAHONEY HOUSE VIEW


The Fed, under Jerome Powell, took a direct path to “normalize” monetary policy by aggressively raising interest rates, with the rationale that U.S. growth was robust and that inflationary pressures were building. However, in the vicious fourth-quarter sell-off last year, it became clear that markets believed the Fed had been too aggressive in its tightening process. Market fears set the stage for a somewhat dramatic pause in the tightening process that the Fed clearly signalled back in January. Year-to-date, we have seen the typical bounce in equity prices associated with such a pause. Markets now seem to be treading water, waiting for clearer signals as to whether the Fed’s previous tightening program was too much or it has managed to engineer a “Goldilocks” mid-cycle slowdown, with economic growth rates that are not too hot or too cold, but just about right. The trouble is that right now many signals are mixed and could point one way or the other in the very near future.

Historically, during the second three-month period following a Fed pause, market returns start to go in one of two directions, depending on whether a recession is in sight or not. For the quarter ended June, markets have performed more in line with a pre-recession scenario, rather than behaving as though we are leading up to a more desirable mid-cycle slowdown. As evidence: equity returns were fairly muted in the second quarter, while longer-term interest rates fell quite significantly. Credit spreads of poorer-quality companies widened somewhat, indicating investors may have started demanding more compensation for liquidity and potentially greater solvency risks. During previous lead-ups to a mid-cycle slowdown, credit spreads have tended to behave well. In addition, gold prices rose and crude oil prices fell, again more typical of a pre-recession dynamic than an approaching soft landing.

Against this backdrop, the Fed has become clearer about its next move, which will be to lower short-term interest rates. The key debate will become whether this easing cycle will occur soon enough, and whether the Fed will be aggressive enough to mitigate building recessionary risks, given the current late-cycle dynamics that exist. In our last review and outlook, we suggested it is possible that too much damage has already been done to global economic growth (through increased policy rates, an uncomfortably strong U.S. dollar and increased trade tensions), making the potential for an economic stall very real. If a Fed policy U-turn is indeed too late, it could have negative near-term implications for portfolio returns.

PAUSE, BOUNCE – NOW WHAT?

5REVIEW AND OUTLOOKQ2

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Source: Bloomberg L.P. and PMAM Research. As at June 2019.

End - 2020 End - 2021Current End - 2019

FED CUT: MOVING FROM “IF” TO “WHEN” – AND BY HOW MUCH?

The June Federal Open Market Committee (FOMC) meeting provided another key pivot in policy, with the Fed opening the door to lowering interest rates. While the market is expecting (or demanding) imminent interest rate cuts by the Fed (Figure 1), actual FOMC voters are still debating when and by how much they should change interest rates. FOMC board members each place their suggested future interest rate path in a summary known colloquially as the “dot plot.” Their different views range from that of perennial super-dove James Bullard, who is on record as calling for a 25-basis-point cut at the June

meeting, to another voter who placed the 2019 dot higher by 25 basis points – that is, still making the case for a hike this year. All the other voters appeared split between holding steady in 2019 and cutting 25 to 50 basis points.

Fed Chair Powell summed up the Fed’s conundrum in statements prior to the June FOMC meeting. Although the Fed has a mandate to target a 2% inflation rate over time, and current expectations suggest the Fed is undershooting this target, Powell’s fear of creating bubbles and/or other unintended consequences is evident:

FIGURE 1: LONG-TERM OUTLOOK FOR THE FEDERAL FUNDS RATE

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“In addition, over time, inflation has become much less sensitive to tightness in resource utilization. This insensitivity can be a blessing in avoiding deflation when unemployment is high, but it means that much greater labor market tightness may ultimately be required to bring inflation back to target in a recovery. Using monetary policy to push sufficiently hard on labor markets to lift inflation could pose risks of destabilizing excesses in financial markets or elsewhere.”

FIGURE 2: ALTERNATIVE MEASURES OF CORE INFLATION

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Inflation that remains stubbornly below target is a worthy reason for the Fed to cut interest rates. Indeed, many “market-based” measures of inflation (e.g., Treasury Inflation-Protected Security (TIPS) break-evens, an inflation rate “forecast” embedded in the yield of a U.S. TIPS) have fallen, which is a concern Powell has mentioned explicitly. The U.S. core Personal Consumption Expenditure Consumer Price Index (PCE CPI) is also below target.

However, as Figure 2 shows, various other core inflation measures suggest it may actually be above target.

It appears, however, that the market has backed the Fed into a corner, and that interest rates will be cut sooner rather than later. We expect a 25-basis-point cut at the upcoming Fed meeting in July to start the process. However, debate could be lively in Fed circles as we move through the year, especially if the U.S. economy holds up and risk assets continue to march higher.


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If the market takes it as a foregone conclusion that the Fed will begin cutting interest rates sooner rather than later, the next key question should be whether the cuts come fast enough to extend the cycle, or whether they will be too little and too late to avoid some sort of economic recession. Using previous cycles as a guide, we are tracking key economic variables and how they have performed around first Fed cuts over the last 35 years. Our goal is to understand whether these variables are performing more in line with a mid-cycle slowdown (which is generally positive for risk assets) or with the lead-up to a recessionary environment (which is generally not positive for risk assets). We found three pre-recessionary easing periods (2007, 2000, 1989) and three mid-cycle easing periods (1984, 1995, 1998). Comparing current data to these periods helps to determine whether this new easing will prove too late to prevent recession in the U.S. or will indeed extend the cycle and keep the global economy growing.

DIVERGENCES OCCUR DEPENDING ON WHETHER FED CUTS ARE ON TIME OR NOT

As shown in Figure 3, pre-recession cuts feature a flat/stable unemployment rate going into the cut; the rate then rises afterward, while cycle-extending cuts are characterized by unemployment rates falling into the cut and continuing to fall afterwards.

Consumer confidence measures also tend to take opposite directions shortly after the first Fed cut of the cycle, depending on whether or not these cuts are too late to prevent recession. Figure 4 shows the Conference Board’s “Present Situation” index presented in the same way as the unemployment rate chart in Figure 3. This confidence measure tends to fall after pre-recessionary cuts. Perhaps more telling, it tends to rise into the cut when it is not pre-recessionary (compared with going sideways in pre-recession periods).

FIGURE 3: CHANGE IN UNEMPLOYMENT RATE AROUND FIRST FED CUTS

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FIGURE 4: CHANGE IN CONSUMER CONFIDENCE – PRESENT SITUATION AROUND FIRST FED CUTS

Net % Tightening Standards - Commercial and Industrial Loans for Large/Medium ( 9m lead, lhs inverted)

Other data series that we have laid out in the same way as the two charts above also suggest that we are close to a significant fork in the road, and that the next three to six months will be a make-or-break time for the current cycle.


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In our last quarterly review and outlook, we added more colour to the simplistic view of inverted curves, making the case that it is the pace and synchronicity of yields falling that most accurately foretells the onset of a recession. These dynamics suggest that the current cycle is long in the tooth and that recession risks are building.

In considering the yield curve, it is important to understand the concept of the “neutral” rate of interest – the interest rate above which the Fed Funds rate becomes restrictive to economic growth. During economic expansions, the Fed Funds rate is presumably kept below the neutral rate.

As the economy heats up, the Fed raises rates until they surpass the neutral rate, to rein in economic excesses, especially inflationary pressures associated with full economic growth. In past cycles, the Fed went well above the neutral rate, and for significant lengths of time, before the economy felt the brakes being applied.

However, as trend growth and inflation rates have fallen over time (perhaps due to demographics, technological advances and other structural forces), it has taken less interest rate tightening for the economy to stall out. For example, the 2008 recession occurred after the Fed raised rates to just barely the neutral rate; within a year, the economy was tumbling lower. The December 2018 rate hike pushed the Fed Funds rate over the neutral rate for this first time this cycle, and risk assets tumbled until the Fed abruptly halted the tightening process. Curiously, at its June meeting, the Fed lowered its estimate of the neutral rate of interest to 2.5%, from 2.75% (it was 4.0% in 2014). This seems a clear indication that the economy has become more sensitive to fewer rate hikes – and tends to suggest that the Fed cuts may indeed prove too little, too late, unless the easing is more aggressive than the Fed is currently contemplating (a possibility, especially given Fed members’ divergent views, as noted above).

The shape of the yield curve has been a handy tool to navigate economic cycles, with a flattening curve that dips into inversion (with short-term interest rates higher than long-term rates) being a harbinger of recession. Across the yield curve, evidence is mounting that the economy is stalling:

• The two-year/Fed Funds yield curve is below zero/inverted.

• The 18-month/three-month yield curve is below zero/inverted.

• The 18-month/three-month Fed Funds Futures curve is negative (i.e., the market is pricing in three or four rate cuts).

WHAT DOES THE CURVE HAVE TO SAY?

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FIGURE 5: OVER TIME IT HAS TAKEN LESS INTEREST RATE TIGHTENING FOR THE ECONOMY TO STALL OUT

Neutral Interest Rate


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The trade war between the U.S. and China has certainly not helped matters, with tit-for-tat tariff dynamics having a negative impact on global growth. These tariffs disrupt the global supply chain – and some 30% of trade in the U.S. is part of the global supply chain; in China, the proportion is even higher, at some 40%.

Given the relative size of these two economies, the ripple effects are meaningful. “Backward participation” is a way of describing how much of an economy’s value-added exports originates in other countries. Foreign inputs in total exports are higher for China than for the U.S. A related measure, “forward participation”, would show that 23% of U.S. exports are used as inputs in other countries’ exports. In totality, foreign value-added accounts for roughly one-third of global trade.

Trade imbalances have been a key part of the Trump tariff policy with China. However, there are other dynamics at work in this trade spat. It is estimated that some 70% of counterfeit and pirated goods come from China. Conversely, the U.S. stands out as the country whose intellectual property rights are the most often infringed upon, with the top category of pirated and counterfeit goods being electric machinery and electronics. This makes for a difficult negotiation process for both parties, and one that may drag on for some time, adding another “end of cycle” risk to the equation.

In the interim, the U.S. has been substituting some trade away from China, so tariffs on Chinese goods have not really affected U.S. inflation. Yet, aside from substituting trade goods, there may be other types of collateral damage caused by this “war.” CEO confidence has slipped considerably (albeit from high levels). Falling CEO confidence, combined with rising interest rates, has probably not been a good recipe for capital spending. Figure 6 shows that certain capital expenditures measures have fallen sharply over the past several months.

It is also worth noting that job growth at smaller companies has also turned negative for the first time this cycle (Figure 7). This is significant, because smaller companies represent a disproportionate share of jobs in the U.S. economy.



Durable goods new orders excluding transportation Y/Y%

GEOPOLITICS: A CONFIDENCE GAME

FIGURE 6: CAPITAL SPENDING IN DECLINE

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FIGURE 7: JOB GROWTH AT SMALLER COMPANIES HAS TURNED NEGATIVE


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For its part, China has enacted some stimulus measures to aid its economy, which has been decelerating persistently on reported measures since early 2017. However, “Total Social Financing” (a catch-all term for state- and local-level government stimulus) has ticked only modestly higher (Figure 8). Chinese policy-makers have avoided rolling out what they call “flood-like” stimulus (as in 2009 or 2016), in which they ease on all fronts, including housing, infrastructure and interest rates. Policy makers likely see such measures as a last resort, as they can create bubbles in the housing market and/or excessive leverage in the financial system. For the time being, China’s measures seem focused on domestic growth, but are not sweeping or large enough to provide a real shot in the arm for the global economy.

In Europe, the economic deterioration is even more significant, although some of this is likely due to the deterioration in the performance of China, its important trading partner. An unmistakable slowdown in growth (Figure 9) has been met by little action by policy-makers thus far.

ECB Chair Mario Draghi has recently discussed the need for new stimulus measures, but with longer-term interest rates probing new lows – France recently joined Germany with a negative yield on ten-year government bonds – more monetary policy stimulus may not offer much bang for the buck. Certain countries, such as Germany, seem to have ample firepower for fiscal stimulus, but the European political framework may not be conducive to these sorts

of measures. Hopefully, the European Union will enact some measures soon enough to give at least some modest support to the global economic outlook.

These geopolitical and global economic deceleration issues are evident in an index tracking global economic policy uncertainty. This uncertainty has risen steadily through 2018 (Figure 10). There is now a somewhat perplexing disconnect between elevated levels of policy uncertainty and stock market implied volatility measures (the VIX implied volatility index). This divergence may resolve itself in a rather unpleasant manner if near-term indicators of recessionary risk continue to build.

Global Economic Policy Uncertainty IndexCBOE VIX Index

FIGURE 8: CHINA STIMULUS: WHEREFORE ART THOU?

FIGURE 9: EUROZONE GROWTH AND BUSINESS CONFIDENCE IN DECLINE

FIGURE 10: NOTABLE DISCONNECT BETWEEN POLICY UNCERTAINTY AND IMPLIED VOLATILITY

Eurozone Industrial ProductionIFO Germany Business Expectation


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A strong U.S. dollar is also a headwind for U.S. corporate earnings, as a significant portion of the S&P 500’s top line is earned abroad. Figure 12 shows that revenues for S&P 500 companies are vulnerable as previous U.S. dollar strength works its way through the global economy.

As the economy decelerates, one would expect corporate earnings to do the same, especially for more cyclically influenced companies. Our proprietary economic cycle model has rolled over, and suggests the same thing will occur for corporate earnings this coming year (Figure 11), with earnings growth grinding toward zero over the next six to 12 months.


FIGURE 11: EARNINGS GROWTH ROLLING OVER

Predicted by economiccycle model


FIGURE 12: REVENUE GROWTH VULNERABLE TO STRENGTH IN U.S. DOLLAR

CORPORATE EARNINGS RISK


WHAT DOES ONE DO RIGHT HERE?

We are certainly not alone in our concerns about whether markets are vulnerable to increased recession risks. The most recent Global Fund Manager Survey from Bank of America/Merrill Lynch noted a record-high level (34%) of affirmative responses to the question, “Have you taken out any protection against a sharp fall in equity markets in the next three months?” Similarly, a recent Ned Davis Research (NDR) Crowd Sentiment poll suggests that current sentiment does not appear overly bullish or bearish at this point (Figure 13)*.

Year-to-date, stock market performance was dominated by defensive and/or quality growth sectors and themes as longer-term interest rates fell. Our quantitative research indicates the most favoured (and potentially crowded) style factor in North America is “low volatility” (peppered with biases toward quality and toward large capitalization, in Canada and the U.S., respectively). Again, this suggests

* The indicator is a composite reading based on many different individual sentiment indicators that represent the psychology of a broad array of investors.

that investor positioning already reflects many concerns about global growth (although this seems paradoxical, given the strong equity returns that have been generated thus far this year). Sharp and fast style/factor rotations have been known to erase relative performance trends very quickly in the past few years, especially following macro surprises, so perhaps the largest pain trade for investors would not be the development of a recessionary environment but, rather, a mid-cycle environment with a reacceleration in global growth metrics.

We believe the next three to six months could lead to major changes in portfolio positioning for investors, depending on whether central bankers act quickly and aggressively with monetary policy easing measures that dampen recessionary fears and brighten the outlook for the global economy. For now, our probability-weighted base case expects the following:

• Macroeconomic and earnings data disappoint.• Cyclical sectors and themes remain under pressure in

the near term.

• Risk assets, including equity markets, become increasingly vulnerable to a sharp corrective phase in the near term as economic data deteriorate and before the Fed becomes more aggressive in its easing process.

• This backdrop leads to bigger monetary stimulus globally (and maybe even some sort of resolution on trade), setting the stage for a significant stock market rally into the 2020 U.S. presidential election.

As mentioned, the VIX index appears stubbornly low, or at least disconnected from other measures of apprehension regarding geopolitical risk or economic policy direction. We believe investors could take advantage of relatively low implied volatility to add tail risk protection, something central to our hedged mandates.

Source: Ned Davis Research. As at June 30, 2019.

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FIGURE 13: CROWD SENTIMENT IS FAIRLY BENIGN


Clearly, the Fed is becoming more concerned about the economic backdrop and falling inflation risks. However, it is not in an enviable position. Since the 1980s, the Fed has not cut rates when corporate credit spreads remain relatively behaved (like today), equity markets are close to highs (like today), and economic data have not deteriorated dramatically (like today). A pre-emptive cut would be unprecedented, but markets are anticipating one nevertheless, and have backed the Fed into a corner. As we have outlined in the past, this backdrop reminds us of the environment in 1998 to 2000, when the Fed went from being worried about “irrational exuberance” in 1996 to cutting interest rates three times in six weeks in 1998 in response to building macro fears that were punctuated by Russia defaulting on its debt and Long-Term Capital Management being caught highly levered and off-side in its bond portfolio. Stock markets fell 20% in six weeks

in mid-1998 (similar to the decline we experienced in the fourth quarter of 2018) before recapturing their highs in short order (like the current year-to-date performance), and then soared to new highs as a looser monetary policy combined with stronger economic growth and a bubble environment in technology stocks following the birth of the Internet. The similarities in stock market performance alone, although with some modest timing differences, are evident in Figure 14 below.

The fork in the road lies before us! Given somewhat defensive positioning by investors and a Fed ready to lower interest rates, if the economic cycle takes a turn for the worse we expect any negative reactions to be short and sharp. We also expect that the pay-off of an aggressive monetary policy easing response will be quite bullish for risk assets.

Source: Bloomberg, PMAM Research. As of June 30, 2019.

1,300

1,250

1,200

1,150

1,100

1,050

1,000

950

900

3,200

3,000

2,800

2,600

2,400

2,200Mar-1998

S&P 500 ( Current, right hand and top axes)S&P 500 ( 1998, left hand and bottom axes)

May-2018 Jul-2018 Sep-2018 Nov-2018 Jan-2019 Mar-2019 May-2019

May-1998 Jul-1998 Sep-1998 Nov-1998 Jan-1999

IN CONCLUSIONSHADES OF 1998?

S&P 500 (1998, left hand and bottom axes) S&P 500 (Current, right hand and top axes)

May-2018 Jul-2018 Sep-2018 Nov-2018 Jan-2019 May-2019 Mar-2019

1,300

1,250

1,200

1,150

1,100

1,050

1,000

950

900

3,200

3,000

2,800

2,600

2,400

2,200 Mar-1998 May-1998 Jul-1998 Sep-1998 Nov-1998 Jan-1999

FIGURE 14: SIMILARITY OF CURRENT U.S. EQUITY BEHAVIOUR TO 1998


SECTOR OUTLOOKS

CONSUMER DISCRETIONARY

Consumer Discretionary stocks stalled slightly in the second quarter, after bouncing off their December lows, with fears of an economic downturn continuing to weigh on cyclical names. Looking forward, Fed rate cuts in the U.S. may provide a short-term lift for the markets and the sector, but the material risk of a global downturn remains. We have reduced our overweight position in the sector and pivoted into more defensive names, complemented by smaller weightings in cheap, cyclical stocks with still-strong fundamentals that continue to perform at a high level.

For example, we added to our position in Restaurant Brands International Inc. (QSR), which we view as more defensive in nature, with an increasingly delevered balance sheet, significant opportunity for unit growth and accelerating free cash-flow potential. New management appears to be highly focused on driving organic growth across all banners – as opposed to cost cutting – which marks a positive change from previous leadership.

BRP Inc. (DOO) is a more cyclical stock that is delivering exceptional results and market share gains, benefiting from disruption of its key competitor, Polaris Industries Inc. We believe that the stock has over-corrected and should benefit from multiple expansion.

INDUSTRIALS

Although the market continues to rally, we remain positioned in more defensive names. Economic declaration at the margin, peak cycle concerns and the ongoing dispute between the U.S. and China are still cause for uncertainty, particularly regarding perceived lower-quality or cyclical names (e.g., construction firms, equipment dealers, trucking). Demand indicators and manufacturing indices are eroding as capital

goods orders and freight volumes moderate. We continue to favour companies with a history of compounding, idiosyncratic growth angles and/or opportunities to improve return on invested capital (ROIC). Waste Connections Inc. (WCN) remains a preferred name; its management team continues to deliver solid growth, impeccable execution and continued accretive M&A. We are also positive on Canadian Pacific Railway Ltd. (CP), given its industry-leading growth profile and its track record of improving expense management through the disciplined implementation of precision scheduled railroading. We also remain bullish on Air Canada (AC), based on its free cash flow-generating potential and its valuation disconnect relative to peers.

MATERIALS

There was a distinct dichotomy in the performance of precious and industrial metals in the second quarter. Gold caught a massive bid following the FOMC meeting in mid-June, which confirmed the Fed’s intention to adopt a more dovish stance to spur economic expansion. A potent mix of a weaker U.S. dollar, falling yields and rising macro uncertainties all helped fuel gold’s rally. While we believe gold will likely see a near-term pullback, due to crowded positioning, the rally could be viewed as an opportunity, because our cycle analysis shows that gold tends to outperform once the Fed enters into a rate-cutting cycle. We continue to increase our core precious metal holdings, such as Agnico Eagle Mines Ltd. (AEM) and Franco-Nevada Corp. (FNV), as well as selectively adding a number of mid-cap gold producers for incremental torque to the underlying commodity.

As expected, industrial metals sold off during the quarter on weaker-than-expected Chinese economic data and the escalation of the U.S.-China trade dispute. Following the correction, our view has shifted from bearish to more neutral, mostly due to increased dovishness from the Fed


(as well as a number of central banks around the world) and the higher likelihood of a détente, rather than an escalation, in the U.S.-China trade war.

HEALTH CARE

In the second quarter, the Health Care sector continued to underperform the S&P 500 Index (up about 7.3%, year-to-date, compared with about 17.7% for the S&P 500). Issues such as presidential election rhetoric, unclear health care reform policies, pricing issues, a China trade deal, the Mexican tariff over immigration issues, economic strength and a “risk on, risk off” tug of war continue to pressure sector performance. In the second quarter of 2019, distributors (about 6.88%) and tools (about 4.94%) outperformed the S&P 500 Index (about 3.57%), while drug retailers (about -16.4%) and biotechnology (about -5.25%) were the worst-performing subsectors.

Several recent events in Washington, D.C., suggest a volatile second half of the year. On June 24, President Donald Trump issued an executive order (EO) mandating increased transparency for health care pricing (primarily hospitals) with the aim of lowering health care costs. The EO requires Health and Human Services (HHS) to issue a proposal within 60 days to require hospitals (only) to post information on charges (already required) and negotiated rates (possibly subject to legal challenge) in a user-friendly format (a formidable challenge). No implementation date is specified. It also directs agencies to address transparency regarding patients’ out-of-pocket costs for medical services and to end surprise billing. It is unclear if the EO will have any force of law or prompt any immediate changes, leaving the key specifics and legal justification to HHS to develop through the formal rule-making process over the coming months.

Regarding drug pricing transparency, the path forward is not clear. There appears to be a deepening rift between White House officials and the HHS Secretary; in the meantime, Senate Finance Committee Chair Chuck Grassley has announced that he is opposed to the Trump administration’s idea regarding an international pricing index (IPI) of Medicare Part B drugs (physician-administered drugs). The IPI, as articulated by HHS late last year, entails a large-scale demonstration that would tie Part B drug prices to ex-U.S. prices in 14 countries, while also changing the average selling price add-on percentage for physicians to a fixed amount.

The Affordable Care Act (ACA or “Obamancare”) appears to be headed for the Supreme Court, with the Federal Fifth Circuit Appeals Court determining whether both parties, or either party, have “standing to appeal.” If the court allows

the lower court decision to stand (i.e., repealing Obamacare), the defendants could appeal to the Supreme Court on the standing issue, and a likely stay would maintain the status quo pending final resolution. It is also possible that individuals facing potential harm could be granted standing to defend the ACA instead: they would not be hard to find, with coverage for about 20 million people at risk.

CONSUMER STAPLES

We remain overweight in Consumer Staples while the markets exhibit volatility and the political environment remains unstable. Consumer Staples remains a safe haven for investors, given tepid but consistent performance even in times of volatility.

Canadian Consumer Staples’ performance was muted in the second quarter, in line with the TSX, with a rotation out of defensive names into cyclicals at the tail end of the quarter. However, strong performance was seen in Empire Company Limited (EMP/A) and Alimentation Couche-Tard Inc. (ATD/B), two of our top positions. Empire’s very strong same-store sales (SSS) momentum, coupled with austere margin growth from cost-cutting initiatives, has led to significant EPS outperformance relative to other Canadian retailers. ATD/B is also coming off a few behemoth quarters, with accelerating SSS and numerous drivers to continue this momentum. In addition, ATD/B has done an excellent job paying down debt on its balance sheet, providing further optionality through acquisitions.

U.S. Consumer Staples performed slightly better than their Canadian peers, but also in line with the broader market index. Our long position in Walmart Inc. (WMT) has performed well on strong SSS momentum and expense control. WMT has also benefited from defensive rotation stands to outperform in a market downturn as consumers shift their spending to discount retailers.

INFORMATION TECHNOLOGY

The MSCI World Information Technology Index and the S&P/TSX Composite Information Technology Sector Index generated 3% and 12% total returns, in the second quarter, respectively, with tepid growth in many pockets of the segment. Hyperscale data centre demand continued to be sluggish as the end-market undergoes a digestion period, while automotive and industrial demand has also moderated, weighing on the semiconductor complex. Additionally, the U.S.-instigated trade war and Huawei ban are creating uncertainty in supply chains and weighing on both confidence


and end demand. This finally came to roost in the second quarter, with the PHLX Semiconductor Index falling 3%, after having shrugged off headwinds in the first quarter, when it climbed 21%. At the same time, regulatory scrutiny in many geographies continues to threaten the business models of the social behemoths. Enterprise digitization and changing consumer behaviours favour the sector. Accordingly, we enter the third quarter with a neutral stance on the sector. Our favorite themes include: 1) service provider network densification ahead of 5G deployment; 2) expansionary business model transformations; and 3) the broadening appeal of online subscription models.

In Canada, we continue to like CGI Group Inc. (GIB/A CN). The company’s return to organic revenue growth in recent quarters has helped drive strong EPS growth. We like the product and customer focus that George Schindler has established since the start of his CEO tenure in October 2016.

Internationally, we like Salesforce.com, Inc (CRM US). The company is a provider of a best-in-class customer relationship management (CRM) platform and is a long-term growth compounder. Salesforce recently announced the proposed acquisition of leading analytics platform Tableau Software Inc Class A (DATA US), which is expected to help continue the company’s strong growth. The company continues to benefit from a large and growing total addressable market (TAM), while gaining share; CRM is the fastest-growing segment in enterprise software. Further upside could potentially come from expansion into the C-suite and/or adding vertical solutions. CRM is largely immune from the trade war headwinds, and continues to have a healthy economic backdrop.

FINANCIALS

We remain cautious on the outlook for the Canadian banks and mortgage finance companies and prefer select positive change stories in financial services, including Element Fleet Management Corp (EFN), Intact Financial Corporation (IFC), Brookfield Asset Management Inc (BAM/A) and TMX Group Ltd (X).

The second quarter was another volatile quarter for the bank group, with some interesting takeaways. For the second quarter in a row, we saw the majority of the group miss earnings estimates. Lower-than-expected earnings for the group were largely driven by weakness in Canadian retail banking; operating leverage was squeezed by slowing revenue growth in the face of higher costs. Additionally, credit loss continued to normalize, providing a headwind to earnings growth in the core retail domestic segment. On the

positive side , the capital markets and wealth management businesses rebounded nicely from the choppy first quarter, given the improvement in overall markets and increased activity levels. Credit is an area that is increasingly receiving attention; we saw loan losses increase across the group, largely driven by idiosyncratic events and some general weakness in the commercial and consumer credit books as the credit cycle continues to progress. We expect this focus on credit to remain a major theme, because the near-decade-long tailwind provided by a benign credit environment looks to become an increasing headwind to earnings growth. We are not expecting large loan losses in the near term, but do believe that weaker financial conditions in Canada will begin to manifest themselves in a normalization of the credit cycle, and this will become a headwind to earnings and dividend growth for the bank group in 2019–2020.

Other big-picture themes we have been focused on continue to play out. Consumer loan growth continues to decelerate and is now at its lowest level in nearly two decades, while a strong focus on raising core deposits has increased deposit costs and taken a bite out of the margin expansion thesis for select players. We continue to highlight the inherent value in core deposit franchises (especially as financial conditions tighten) and how they become key differentiators for the group; we believe this theme will continue to play out. In our view, funding costs will dictate risk appetite as we progress through the cycle. Those who lack strong stable deposit franchises are forced farther out along the risk curve to support earnings growth, compared with peers who benefit from a significant funding advantage. We believe that this behaviour increases a bank’s beta to the credit cycle, and continue to be cautious about these lower-quality names. We have seen this behaviour manifest itself recently with acquisitions/growth of higher-risk assets and out-of-footprint expansion. Although valuations for the bank group are approaching more attractive levels, we have a more tempered outlook on EPS growth prospects; we believe that a selective approach is more important than ever, and that the dispersion of returns is set to increase in a more meaningful way. Our core Canadian bank holdings include Royal Bank of Canada (RY) and The Toronto-Dominion Bank (TD).

In the insurance space, we continue to favour Sun Life Financial Inc. (SLF); we believe its strong free cash-flow generation, conservative balance sheet and capital strength are clear differentiators. We are also positive on Intact Financial Corporation (IFC), as we believe signs of positive change are set to become increasingly evident in its personal auto and U.S. specialty lines businesses, and we like its defensive characteristics in the Canadian Financials space.


ENERGY

It was a volatile quarter that saw an April rally turn into a steep sell off due to Trump’s decision to escalate the ongoing trade war with China, as well as growing signs of sluggish oil demand, especially in emerging market countries.

Trump’s decision to further sanction Iran and cut the latter’s exports to zero is introducing a meaningful risk of disrupting Persian Gulf oil exports for the first time in nearly three decades. This, combined with seasonality, the recent dovish tilt by the Fed and the implementation of IMO 2020 in the fourth quarter of 2019, should generate a positive environment for crude in the second half of 2019. That being said, the longer-term outlook for crude is increasingly cloudy: there is currently over three million barrels/day of non-OPEC production growth coming onstream in the next 18 months, whereas world crude demand growth appeared to have slowed to below zero (as of the second quarter) for the first time since 2009, due to a combination of secular/regulatory pressures on demand, sluggish emerging market economies and global substitution into cheaper fuels such as liquid propane gas and liquid natural gas. (LPG/LPN)

We continue to focus ownership in higher-quality midstream names and exploration and production companies (E&Ps). that have conservative balance sheet leverage and shareholder-friendly capital return policies, such as Cenovus Energy Inc. (CVE), Canadian Natural (CNQ), Parex Resources Inc (PXT), Whitecap Resources Inc (WCP) and Pembina Pipelines Corp (PPL).

COMMUNICATION SERVICES

We would like to rename this group the “Siamese sector,” given that the names can’t be separated from one another in terms of valuation. This quarter has been marked by what is, in our view, a major development for the Canadian wireless industry: Rogers Communications Inc.’s (RCI) announcement, which was subsequently matched, that it would go ahead with unlimited plans, doing away with overage charges (which currently account for about 5% of revenue) and launch Equipment Installment Plans (EIP) (in contrast to the current model of handset subsidies). We believe there is long-term value in this decision, which reduces customer service costs meaningfully, makes plans simple by placing the focus on network quality and also helps tackle the rising burden of subsidies. We also believe, however, that there could be some near-term negative surprises, because we believe value-conscious customers are likely to react first (overage reduction happens immediately), and upgrades are more

likely to be a push/nudge product. Shaw Communications Inc (SJR) remains our favourite name; it appears well positioned to continue executing its wireless growth strategy (wireless subscription growth in its third fiscal quarter topped expectations), and it has now moved very close to achieving the right balance between subscription growth and profitability in wireline. Finally, a slowing wireless market is much less of a negative for Shaw, unlike the Big 3, given it is growing from a low base and has to worry less about balancing growth and profitability.

UTILITIES

Utilities continued their winning ways in the second quarter, returning 5%, compared with 2% for the broader index quarter to date total return (QTD TR). A decline in bond yields continues to provide the biggest tailwind for Utilities. Adding to that is near-certainty about earnings, which is valued highly in this market, where fewer names are topping expectations. That said, Canadian Utilities are somewhat challenged with regard to M&A growth, given their higher cost of capital compared with U.S. peers. As a result, we are underweight in the group. Our favourite name in the space remains Brookfield Infrastructure Partners L.P. (BIP), for its attractive combination of defensiveness and growth. From an earnings standpoint, 2019 should see a step-up in earnings growth. Also, we would not be surprised if BIP’s expectations of the value to be extracted from some of its large acquisitions (such as Enercare) are higher than street expectations. Finally, from the standpoint of M&A, we will not be surprised if BIP makes an acquisition or two in the data infrastructure space (towers in India, for example), which would also be accretive to earnings.

REAL ESTATE

It was a weak quarter for Canadian REITs, which returned -1.7%, compared with 2.6% for the S&P/TSX Composite Index (TR). Given that Canadian REITs trade at a wider-than-average premium than other yield sectors (Utilities, Telecommunication Services, Financials and pipelines), this underperformance does not overly surprise us. Our largest position continues to be in Colliers International Group Inc (CIGI), which we believe is in the middle of a long-term consolidation story in commercial brokerage. We believe that Colliers, as one of the top-four brokerage services, is excellently placed to capitalize on this trend. Additionally, low bond yields have pushed institutions to own more real estate directly (in search of yield), and that


in turn has raised the value of global brokerages (compared with local mom-and-pop brokerages) as institutions seek comprehensive global solutions. We think Colliers is well placed to generate double-digit earnings growth for multiple years. In terms of valuation, Colliers trades at about 14x P/E (2020E), offering about a 0.5x premium to CBRE Group Inc (CBRE) (vs. about 1.2x premium historically) and a discount of about 2.5x discount to the S&P 500 (owing to concerns over the potential for recession in commercial real estate). We believe the concerns are exaggerated, as brokerage business models have evolved to include more recurring revenue (outsourcing and leasing). Approximately two-thirds of Colliers’ revenue is recurring, and its balance sheet is in excellent position to take advantage of any slowdown (with debt-to-EBITDA of about 2x).

This report was written as at June 30, 2019, and is intended primarily for institutional investors. It is provided as a general source of information and should not be relied upon as investment advice, a forecast or research, and is not a recommendation, offer or solicitation to buy or sell securities in any jurisdiction or to adopt any investment strategy. The information contained in this report has been obtained from sources believed reliable; however, the accuracy and/or completeness of the information is not guaranteed by Picton Mahoney Asset Management (PMAM), nor does PMAM assume any responsibility or liability whatsoever. All opinions expressed are subject to change without notification. PMAM funds may currently hold long and/or short positions in the securities of the companies mentioned in this report. Past performance is not indicative of future performance.

This report may contain “forward-looking information” that is not purely historical in nature. Forward-looking statements are not guarantees of future performance and involve inherent risks and uncertainties about general economic factors. There is no guarantee that any forward-looking statements will come to pass. We caution you not to place undue reliance on these statements, as a number of important factors could cause actual events or results to differ materially from those expressed or implied in any forward-looking statement made. This report may not be reproduced, distributed or published without the written consent of PMAM.

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