July 20, 2018

 

2018 Q2

Overview & Outlook

My focus for this report is to briefly cover a few points on tariffs as that's one of the obvious clouds looming over everyone's heads. I'm also going to switch gears and talk about certain developments that aren't as clear and obvious – yet are critical factors and events to account for when making investment decisions.

 

Trade & Tariffs

Trade and tariffs essentially go hand in hand, making the news surrounding this topic a key contributor to the turbulent market this past quarter. Briefly touching on US-China first, President Trump is committed to imposing tariffs on China; he has made that clear and has already put his words into actions. As it currently stands, the bulk of the pressure is on imports of machinery, auto parts, and medical devices, which on their own shouldn't have any sizable impact to consumer prices – at least not in the short-term. While everyone is focused on tariffs between the two countries, it seems as though behind the scenes there is interesting movement taking place in the FX market with the US Dollar & Chinese Yuan pair. Where the Yuan has held its strength, it is now weakening, which could have large implications on trade by directly affecting the import/exports of the two countries - an effect that that can be more impactful than tariffs. It's something I'm closely watching and will touch on again in the next report.

Chart of the Chinese Yuan recently weakening against the US Dollar (trend depicted with the black line) all while tariffs are taking place. 

Shifting gears, and perhaps a little more important to us in Canada is the negotiations surrounding NAFTA. Specifically, the imposed tariffs on steel and aluminum imports and the impact they are going to have on the Canadian Economy. Steel especially, crosses the boarder multiple times as it goes through different processes for refinement. And as the tariffs stack up, the price increase will directly affect the costs for commercial and residential construction in Canada and by extension condo prices; in what is already a heated market.

 

Powell, the current Chair of the FED, is a rather interesting character with a simple approach to communicating to the public. Unlike the past PhDs who ran the FED and used complex and sometimes confusing jargon to state their intentions with US interest rates, Powell tends to use simple and plain English. And what he's clearly articulating to the public is that he plans to continue to hike US rates.

 

With our neighbours down south of the boarder raising interest rates, we too now may be pressured into increase ours – otherwise we'll find ourselves with a much weaker dollar, so the incentive to raise rates is definitely there. With that said, potential rate hikes in Canada will affect both small business debt and people who own a mortgage. With all this in mind, I strongly encourage people, including business owners, to pay down their debt as this stands to be one of our country's biggest risks.

Interest Rates, Debt, and Emerging Markets

The conversation about interest rates and debt doesn't stop there. Let's now continue with US interest rates. First off, it is clear that interest rate hikes are leading to a strengthening US Dollar, but what are the implications of these ongoing hikes? Well, when there's an increase in the US interest rate, we typically find a corresponding increase in the LIBOR rate. Think of it as a type of "prime rate" (similar concept to the "prime rate" plus a certain percent you would have on a mortgage). Except the LIBOR rate is used as the benchmark globally for many credit card rates, mortgages rates, corporate lending rates, and other forms of global debt. 

 

If we look over the past decade, we've seen companies' interest coverage ratios drop. Meaning that the amount of cashflow a company is generating is having a harder time covering (paying) the interest expense to lenders. What I find to be incredible about this is that if interest rates have been dropping for the past decade, interest expenses should be dropping too - but instead they've kept on increasing. Now, the only factor that could have increased interest expense in a declining interest rate environment is taking on more debt. It's not much of an issue if interest rates continue dropping, but what if they begin to go up? Companies have racked up all this excess debt assuming interest rates would stay low.

 

The impact of rising interest rates can cause a chain reaction of dangerous events, which are important to consider when it comes to portfolio construction. If the LIBOR rate increases, then companies whose debt is linked to this rate will see an increasing interest expense, which means their interest coverage ratios will fall as they have a difficult time paying the interest expense; the companies will become more financially distressed. If this happens we will find that their debt quality may be downgraded by the rating institutions. If the grade (quality of debt) drops below a BBB- rating they'll lose their "Investment Grade" status, which can put those companies in a dangerous position, as many investment and asset management institutions who only buy "investment grade" will be forced to sell their positions - putting downward pressure on the market.

 

So how does this impact your investments?

The bulk of the companies that are running the risk mentioned above are non-US emerging companies. Most emerging market companies have difficulty raising capital in their home markets, so they turn to the US to raise the funds. In doing so, they raise US dollar denominated debt, agree to pay the LIBOR rate of interest plus some, and need to pay the principle of the debt back in US dollars - it's a great deal for the US lending institutions, as all the risk is placed on the non-US company borrowing the money.

 

Now here's a scenario to think about: if an increase in US interest rates increases the LIBOR rate, which makes the debt more expensive and puts companies in greater financial distress. Then, as if that isn't enough pressure cutting into the company profits, the increase in interest rates causes the US Dollar value to grow stronger than the currency of the other countries, which means these companies need more of their own home currency to convert it to US Dollars to pay back the debt. It's a double threat and it all stems from interest rate hikes, which are made to simply keep inflation in check. Bottom line, investing globally means being aware of this potential problem, and the best way to increase protection is to avoid buying basket-type products (ETFs), and instead actively select investments that are least impacted by this growing debt problem.

Final Thoughts

We live in a world where people want to be quick to act, standing ready to pull the trigger on a trade, or perhaps simply relying on a fast algorithm to act in milliseconds. What we forget to realize is that things take long to play out. Nothing happens overnight. Whether it is coming to terms on NATFA, or China Tariffs, or the emerging market debt problem, everything takes time to play out. There's no need to make rash decisions when the big picture has yet to unfold. Just remember that as investors we're the tortoise, not the hare.

Thanks for reading.

Your Financial & Investment Advisor,

Gianluca Folino

Let's Talk.

(905) 896-9060  x3818

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