The Canadian and U.S. stock markets reached record highs in 2019, but a lot of investors were spectators.
If we judge by what’s been selling in the fast-growing world of exchange-traded funds (ETFs), investors have been very much focused on bonds, dividend-paying defensive sectors such as utilities and low-volatility stocks.
When the herd does something in investing, it’s tempting to try to find fault. We can easily do that with the conservative investing trend of the first half of 2019. After stocks fell last year, the obvious smart thing to do was to buy ETFs tracking the major stock indexes and wait for the usual slingshot effect.
But the weird state of affairs in financial markets means conservative investors didn’t do too badly in the first half, and they may be positioned well for what comes in the rest of 2019 and into next year.
The big story in the $181-billion ETF sector in Canada in the first half was a massive inflow of money into bond funds. According to National Bank Financial, the flow of investor dollars into ETFs holding government and/or corporate bonds was double the amount going into equity funds.
It’s a mark of how unusual conditions are in financial markets that investors made out pretty well with bonds in the first half, although not as well as those who bought stocks when they were cheap. The benchmark FTSE Canada Universe Bond Index produced a total return of 6.5 per cent from January through June, while the S&P/TSX Composite Index made 16.2 per cent. Total returns include index changes up or down plus either bond interest or dividends.
Other popular choices in the first half include ETFs holding low-volatility stocks, which move up and down in price less violently than the broader market. In general, they have delivered returns as good or better than broader market indexes in Canada.
The concept of diversification in investing – there’s nothing more fundamental – is based on the reasonable expectation that different types of assets rise or fall in price at different times. Today, we have multiple sectors doing well: The major stock indexes, low-volatility stocks and bonds.
Low interest rates are what tie all of this together. They help bonds thrive, and defensive sectors such as utilities and real estate that play a big part in low-volatility ETFs. Low rates fuel the broader stock market because they’re seen as friendly to growth in economic output and corporate profits.
We’ve spent years in a sweet spot of low rates and steady, if modest, economic growth. The housing market has benefited, and so have people who borrowed amounts that would be crushing if rates were at levels considered normal 15 years ago. We also have a pretty strong job market, although income growth has lagged.
Arguably, we have an economy today that suits the broadest possible cross section of the economy and financial markets. It won’t last indefinitely. We will either switch to faster economic growth, which is bad for bonds and defensive stocks because rate would rise, or the economy will deteriorate and thereby create problems for stocks.
Which fork in the road should you take as an investor? If you consider both risk and reward potential, more conservative investing makes sense.
After the double-digit gains of the first half of the year for the Canadian and U.S. stock markets, downside risk outweighs upside potential. Plus, there’s concern in both Canada and the United States about slower economic growth.
Bonds and defensive stocks may not have much room to run, but they’re vulnerable to a sharp decline only if interest rates lurch higher. That seems unlikely right now.
The latest economic forecasts from several of the big banks have the Bank of Canada holding its benchmark overnight rate steady for the rest of this year and either holding in 2020 or cutting mildly. Bond yields are expected to either move sideways or drift a bit higher over the next 18 months.
If you play defence with your investing in the second half and you’re wrong, you’ve missed out on some gains. Aggressive investors are more vulnerable.
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