"It's tough to make predictions, especially about the future." - Yogi Berra

As we close out the first year of a new decade and look forward to the opportunities and challenges facing us in the future, we wanted to share our thoughts on where we see the markets going as we move forward.  Making a prediction is about the future is an impossible endeavour; however, by giving careful consideration to the past, there are many lessons to be learned that can better prepare us for the future. 

When building portfolios, it's very easy to look at a past performance metric of a group of funds - 1 year, 3 year, 5 year, etc. - to determine the best option to invest in for the future.  Unfortunately, these numbers can never be relied on as indicators of future performance but, at the time, they seem like a brilliant idea.  If selecting managers was that simple though, our job would be a lot easier.  The same can also be said when looking at the overall markets and trying to decipher what the next ten years will look like. 

In this article, I'm going to take a look from the start of each decade, beginning with the 80's and working my way up till now, analyzing what happened in the previous decade, what the prevailing investment decisions would have been and what actually happened in the decade that followed. 

In 1980, if you were looking at the past decade of performance to build a portfolio, you would have seen the following numbers from the markets:

*Total return in Canadian Dollars, Source: Bloomberg

Throughout the 70s, the Canadian and EAFE (Europe, Africa and the Middle East) markets outperformed the US as resource prices and inflation skyrocketed through the decade.  Looking forward, one would have likely expected that trend to continue and, with foreign content already limited to 10%, the strategy would be to maximize your Canadian exposure with very little allocated to the other two markets.

Here's what happened:

*Total return in Canadian Dollars, Source: Bloomberg

During the 1980’s, inflation hit its peak and began to fall as resource prices came back down to earth.  This fueled the equity markets that were generating the majority of their income from manufacturing and also initiated a 30-year bond bull market with falling interest rates.   Japanese markets surged as “Japan Inc.” was seemingly buying out the United States by acquiring businesses and real estate.  The foreign direct investment combined with the booming manufacturing industry caused US equity markets to rise to historic highs. As a result, the TSX lagged the other two indices and a heavy Canadian portfolio under-performed. 

Given these factors, the strategy changed when looking ahead to the 90’s as investors were now maximizing foreign content and ensuring a robust allocation to Japan. 

Let's see how that worked out:

*Total return in Canadian Dollars, Source: Bloomberg

Sadly, the EAFE markets grossly under-performed the S&P500 as the Nikkei hit its high in 1989.  For Japan, once feared to be taking over the world, this would lead to a multi-decade slump in their economy and equity markets.  The S&P seemed poised to go up forever as Silicon Valley and the US technology industry were dramatically changing how the world operated.  Throughout the 90’s, the US markets continued to rally and the Canadian Dollar dropped to around $0.65 on the US dollar, which further fueled returns on foreign assets. 

In the early 90’s, Canada’s debt to GDP level was similar to the current levels in countries like Spain and Italy today.  This lead to more and more Canadian investors looking for ways access foreign and US equity markets as their RRSPs still had severe foreign content limits.  The response of the Canadian mutual fund industry was a class of mutual funds that circumvented the foreign content limits and allowed Canadian investors to access foreign content without restriction for a nominal fee.

Of course, this wasn't like 1990 (or 1980) and this time it was different and, thus, the plan was to shift as much as possible to the US, leaving Canada and the EAFE markets as under-weights.

How did we do this time?

*Total return in Canadian Dollars, Source: Bloomberg

A tragic pattern has officially developed here.  As we know very well in Ottawa, the tech industry crashed and the US markets fell back down to earth as Canadian resources once again drove the TSX to outperform. 

The question now becomes, what will the next 10 years look like?

As it stands today, we know that the Canadian markets have gone through a decade of outperformance over US and global equities as a result of increased demand for our resources and confidence in our sound financial system.  We recognize that strong growth in the emerging markets (China, India, Brazil, etc.) should maintain this trend, making Canada a reasonable place to allocate capital as the secular, resource-driven bull market continues.  However, that’s only part of the story. 

With the materials and energy sectors accounting for over 50% of the index, the TSX does not offer sufficient diversification when forming a portfolio and exposes investors to greater risk as a result.  According to a 2007 report from London-based research firm Euromonitor International, an expected 700 million Chinese citizens will enter the middle class by 2020.  As the middle class in China and other emerging nations continues to grow, energy and materials will not be the only sectors where demand will increase. Consumption driven sectors like Consumer Staples, Consumer Discretionary and Information Technology are very likely to outperform under these conditions as well.  In a Canadian-based portfolio, those 3 sectors combined would account for less than 10% of your equity weighting if you own the index.  On the other hand, approximately 40% of the S&P500 is comprised of these sectors at this time. 

Though it may seem risky given the current political and economic environment in America, now may be an ideal time to buy low on US markets.  Investing broadly in the S&P500, via an ETF for example, may not yield the optimal results as there are surely areas in the US economy that will struggle.  However, with an active manager selecting the best companies, that have strong balance sheets and the foundation to take advantage of the growth from the emerging middle class, there is significantly less risk and an opportunity for greater returns. 

Over the next quarter, we will be focusing our research on how to adjust our portfolios to optimize our Canadian equities while potentially trimming back on the allocation where applicable.  We will also be looking to the best US equity managers to see if there is a fit going forward.  As always, we never make wholesale changes without ample discussion with our clients and each account will be handled on an individual basis.  Ultimately, we feel we would be doing our clients a disservice by simply sticking with the status quo in our industry today, which is an extreme overweight to Canadian equities, without exploring opportunities abroad. 

If at anytime you’d like to discuss your portfolio, please do not hesitate to contact us.