has all the easy money been made? · them to participate in easy money opportunities as they become...

Has all the easy money been made?Evaluating the current U.S. macroeconomic environment and financial markets

In a Nutshell • Though the U.S. equity markets are experiencing heightened volatility,

economic data does not indicate that a recession is imminent.

• U.S. companies are attractively priced; the TD Wealth Asset Allocation Committee remains overweight U.S. equities.

• Staying invested throughout changing economic cycles can lead to better long-term performance.

N E W T H I N K I N G

Damian Fernandes, Vice President & Director at TD Asset Management

New Thinking | Has all the easy money been made? PAGE 2

Since the end of the 2008-2009 financial crisis, equity markets have mostly moved higher, allowing investors to benefit from an upswing that has lasted for almost a decade. The bull market that began March 2009 has seen the S&P 500 Index rise more than 300 percent; a boon for investors that were severely impacted by the financial crisis1. However, bull markets do not last forever, and global stock markets declined sharply in the final quarter of 2018. The decline of U.S. equity markets has led investors and pundits to believe a recession is imminent, raising the question, has all the easy money been made?

Our answer is no! In fact, in early January, the TD Wealth Asset Allocation Committee (WAAC) upgraded equities from neutral to overweight; highlighting the firm’s belief that the outlook for equities is now more positive, than it was a year ago. The current viewpoint of TD Asset Management (TDAM) is that U.S. equities are attractively priced, and in this paper, we will focus on the fundamental underpinnings of this belief; namely that a U.S. recession is unlikely and that valuations have returned to reasonable levels. Additionally, we will discuss current equity market opportunities and why we (TDAM) believe investors should consider remaining invested throughout the economic cycle.

1The cumulative return of the S&P 500 Index TR between from March 2, 2009 to December 31, 2018 was 339.38%. Data taken from Bloomberg Financial L.P. Data as of December 2018.

The current economic environmentThe synergistic relationship between the economy and financial markets is broadly understood by investors, as the economic exchanges between individuals and corporations are essential to the overall economic output (i.e. Gross Domestic Product or GDP) of a nation. As the contributing factors of a nation’s GDP remains strong, such as low unemployment and strong business activity, financial markets, in theory, should mirror that strength.

Though overall economic health of a nation is based on various factors, the phase of the economic cycle plays a determining role. In the case of corporations, the quality of their financial earnings and equity returns could be impacted by changes in the economic cycle; whereas individuals would be concerned about their employability and their ability to purchase essential

goods and fulfill their financial commitments. Negative changes in the economic cycle could adversely impact corporations and individuals, which in turn would be reflected in financial markets.

Current economic activity in the U.S. is strong and most companies are reporting quality earnings; however, this has not been reflected in recent market activity. Amongst developed economies, the U.S. is much further advanced in its economic expansion, as demonstrated by the growth in the labour market (i.e. historically low unemployment) and wage increases. The uptick in wage growth and fall in unemployment are strong indicators of a stable and growing U.S economy. As illustrated in the following charts (Chart 1 and Chart 2), average wage growth in the U.S. is high, relative to other developed countries.


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&Chart 1: Unemployment rate among developed economiesA comparative look at unemployment rates, from 2000-Q1 to 2018-Q4

Chart 2: Annual average wage growth among developed economiesA comparative look at the growth in average wages, from 2000 to 2017

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Despite the indications of a strong economy, and strong corporate earnings by U.S. companies, U.S. financial markets have been under pressure over the past several months; creating a disconnect between reported economic activity and financial market activity. As illustrated in the chart below (Chart 3), the sudden increase in investor anxiety has led to a market downturn.

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Chart 3: Investor Anxiety coinciding with Market Sell-offA contrasting look at the S&P 500 and VIX from Jan./18 to Dec./18

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Data as of December 31, 2018. Source: TDAM, Bloomberg Financial L.P. Please Note: 4-Year average calculated from Jan./14 to Dec./18.The CBOE Volatility Index or 'Fear Index', known by its ticker symbol VIX, is a popular measure of the stock market's expectation of volatility implied by S&P 500 Index options.

Why the rise in market volatility?The increase in market volatility and heightened investor anxiety can be partly attributed to macroeconomic headwinds, such as the escalating U.S.-China trade war and the raising of interest rates by the U.S. Federal Reserve (i.e. the 'Fed'). Regarding trade, the U.S. continues to impose tariffs on Chinese imports, though the impact of these tariffs on U.S. consumers has so far been marginal, they may become significant over time. The U.S. has also imposed protectionist measures with other major trading partners, such as Canada, Mexico and the European Union.

In response to U.S. trade actions, China and other countries have implemented tariffs on U.S. goods.

To date, China's measures have been relatively restrained. However, as the largest U.S. trading partner, China's retaliatory measures could have more far-reaching implications on the U.S. economy, should they decide to be more aggressive in their approach. Investors understand the interconnectedness of Chinese manufacturing and U.S. businesses; and realize the negative implications to those businesses if trade tensions escalate. Presently, both nations are negotiating the terms of a new trade agreement that seeks to benefit both economies. During this negotiation period, all tariffs have been suspended. Despite the encouraging signs from the trade talks between China and the U.S., significant risk remains, which can adversely impact U.S. companies and their investors.


In the wake of the 2008-2009 financial crisis, central banks around the world lowered interest rates to stimulate growth. More recently, rates have been on the rise, advancing towards more normalized monetary policy, as many countries have begun to emerge from the depths of the financial crisis with increased economic production and rising inflation.

As mentioned earlier, the U.S. is much further advanced in its economic expansion. The low interest rate environment, which revived the U.S. economy, also established a 'new normal'

regarding interest rate expectations in the minds of investors. As the Fed and other central banks begin to remove their supportive policies, by raising interest rates and ending large-scale purchasing of government bonds, investors are beginning to worry about the longevity of the current economic cycle – given that a major stimulating force behind it is being withdrawn. Declining investor confidence in the actions of the Fed is being reflected in capital markets, as anxiety spikes with each rate increase and the resulting market sell-offs reach greater depths (see Chart 4, below).

In the present, the Fed has adopted a neutral stance – forgoing further raising interest rates, to prevent the economy from experiencing a downturn. The U.S. economy is at a pivotal point, given the actions of the Federal Reserve, the current uncertainty stemming from U.S.-China trade relations and other macroeconomic events. For investors, the confluence of these events has led many to believe an economic downturn is near, resulting in a flight to safety. This raises the question; has the near decade-long prosperity come to an end? Has all the easy money been made by investors? Again, our answer is no.

Evaluating the economyOur response to this question is based on an in-depth look at the U.S. economy. As noted earlier, growth in employment and wages are important indicators of a strong economy and their forward-looking trajectories are telling of a country's overall economic health. In evaluating the U.S. economy, a forecast of the U.S labour and consumer market was developed using an equally-weighted index of relevant economic variables; back-tested over a 40-year period, allowing for changes in the economic cycle to be reflected. By taking this data-

Chart 4: Equity Markets vs. Interest RatesA contrasting look at the S&P 500 Drawdown and US Treasury 10-yr yield, from Jan./17 to Dec./18

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driven approach, we can identify and quantify previous recessions, understand the conditions that created them and determine if one is likely to occur in the near future. The following two charts (Chart 5a & Chart 5b) illustrate the findings of our data analysis and suggest that the U.S. economy will not enter a recession in the near term (i.e. 12-18 months).

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Chart 5a: U.S. Labour Momentum Recession IndicatorCaptures growth rate in U.S. Labour Conditions as an indicator for recessions

Chart 5b: U.S. Consumer Recession IndicatorConsumption, Income, Home Prices and Confidence as an indicator for Recessions

Data as of December 31, 2018. Source: TDAM, Bloomberg Finance L.P. Years

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Indicator falling below zero indicates a high likelihood of an upcoming recessionCalculated as the average of 1 yr % Change in: (i) Non-Farm Payrolls; (ii) Initial Jobless Claims; (iii) Unemployment Rate and; (iv) Index of Aggregate Weekly Hours.

Indicator falling below 0% indicates a high likelihood of a recessionCalculated as average YoY % growth in: (i) Real Personal Income ex-transfer payments; (ii) Real Retail Sales; (iii) Personal Consumption Expenditure (PCE); (iv) Case Shiller Home Price index and; (v) Consumer Confidence


Similar analysis was conduced around the U.S. financial markets and manufacturing sector; our models showed a weak indication of a near term recession occurring in the in financial markets, whereas the manufacturing sector showed no signs of an imminent recession. Based on the combination of these analyses, the likelihood of a U.S. recession in the near term is low.

Evaluating the marketApart from the actions of the Fed and current U.S.-China trade relations, various global macroeconomic events, such as a strengthening U.S. dollar and declining commodity prices, have also contributed to the current low-growth environment present within the U.S. economy. Though this economic period has been one of the weakest post-war era recoveries, corporate fundamentals have been strong and are positively growing. A key reason for the observable strength of U.S. corporate fundamentals is the operational efficiencies gained through technological advancements, such as automation and production outsourcing. As U.S. corporations overhaul their manufacturing plants with new technology capable of producing products at a faster pace and lower cost per unit or as many companies outsource their production facilities to low-cost economies; their variable costs of

production begins to fall over time. The cost-savings gained through increased manufacturing efficiency has resulted in rising operating margins for U.S. companies; as indicated by the S&P 500 Index2.

As observed in Chart 6 below, the operating margin of the S&P 500 Index has trended mostly upward since 2010, highlighting the increasing ability of U.S. companies to generate profits from their business operations, even during global macroeconomic events such as the European debt crisis, a slowing Chinese economy, collapsing commodity prices and rising geopolitical tensions. The profitability of U.S. companies has remained resilient through these events and is indicative of the strong earnings opportunity, available to investors.

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Chart 6: The increasing operational efficiency of U.S. Companies over timeA historical look at the quarterly operating margin of of the S&P 500 Index, from 1990 to 2018

Data as of December 31, 2018. Source: TDAM, Blomberg Financial L.P.

2Operating Margin measures how much profit a company makes on a dollar of sales, after paying variable costs of production such as wages and raw materials, but before paying interest or tax. It is calculated by dividing a company's operating profit by its net sales.


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Though operating margin can gauge the profitability of a business, the free cash flow production of a business is of equal importance3. The profitability of a company indicates the effectiveness of their business model, whereas free cash flow indicates the company's ability to return value to shareholders through dividend payments or stock repurchases. Hence, the value of a company is based on how efficient they are at maximizing their revenues, converting said revenues into profits and disbursing cash from the

profits generated to shareholders.

The chart below (Chart 7) illustrates the free cash flow per share of the S&P 500 Index over two decades. As observed, the cash-generating capacity of U.S. companies has significantly risen over time; indicating the increasing ability of U.S. companies to grow shareholder value by paying dividends or buying back stock. Alternatively, companies can reinvest these funds into their company, towards profit-generating projects.

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Chart 7: The cash-generating capacity of the S&P 500 Index has increased in recent yearsA historical look at the annual Free Cash Flow per share of the S&P 500 Index, from 1992 to 2018

Data as of December 2018. Source: TDAM, Bloomberg Financial L.P.

3Free Cash Flow represents the cash a company generates after cash outflows to support operations and maintain its capital assets. Simply, Free Cash Flow is the cash left over after a company pays for its operating expenses and capital expenditures. 4The FCF per share of the S&P 500 Index from 2014 to 2018 totaled 591. The aggregated FCF is divided by the final index price level of the S&P 500 Index on December 2013 (i.e. 1,848), resulting in 32%. Hence the market capitalization of the S&P 500 index has increased by (approx.) 32% over a 5-year period. Data taken from Bloomberg Financial L.P. Data as of December 2018.

In reviewing the past five calendar years, a period in which macroeconomic uncertainty has been elevated, the S&P 500 Index has increased its market capitalization by (approx.) 32%4. Simply put, in a market environment where investor sentiment has been low and uncertainty about the health of the U.S. economy has been high; U.S. companies have increased aggregate shareholder value by almost a

third. Within the current low-growth macroeconomic environment, U.S. equities have reward investors immensely, as strong Free Cash Flow production, coupled with solid profitability, has resulted in increased shareholder value. If the U.S. economy is heading towards a recession, which our models do not indicate, then not participating in this value creation can be a lost opportunity for investors.


Identifying the opportunityThough many investors are apprehensive about investing in the current market environment, they should also recognize the potential opportunity within it, as recent volatility has resulted in more attractive valuations for many publicly traded companies. In fact, price-to-earnings (P/E) ratios

of the S&P 500 over recent months indicate that a valuation reduction has occurred, which we believe is unjustified5. The chart below (Chart 8) illustrates how the aggregate P/E valuation of the S&P 500 Index has fallen from its earlier highs.

Chart 8: Market Anxiety can be the begining of Investor OpportunityA constrasting look at the S&P 500 Index and S&P 500 Index P/E Ratio, from Jan./18 to Dec./18

5Price-to-earnings (P/E) ratio is calculated by dividing a stock market's value or price by the aggregate earnings per share of all companies over the next 12 months. A lower number represents better value.

For investors, the market downturn can be an opportunity to invest in undervalued companies before the market rebounds. As observed in Chart 8, the valuations for companies within the U.S. are now below their earlier highs, creating a timely opportunity for investors to consider purchasing and/or increasing their holdings of high-quality companies within their portfolio. In the long run, as the market begins to

move upwards, investors will benefit from the price appreciation and income (i.e. dividends) generated from the equities of these companies.

Historically, this has proven to be a winning strategy. The following chart (Chart 9) depicts the total returns of the S&P 500 in the year following a 20% decline in trailing P/E ratios from 1926 to present.

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Data as of December 2018. Source: TDAM, Bloomberg Financial L.P.


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As Chart 9 illustrates, the market typically rebounds after a precipitous fall in valuations. The proven strategy for long-term investors is to remain invested during market turbulence, as timing the top and/or bottom of market movements is exceptionally difficult. By staying invested, investors can capture the early gains of the market resurgence. Furthermore, with the cash-on-hand investors may have, they are able to purchase additional shares and/or units of investments they currently have or desire to include in their portfolio.

Though the current chaos in U.S. markets may lead many investors to believe that a recession is imminent, our data-driven approach indicates otherwise. In fact, there have been many calls by market pundits and observers for the end of the current bull market, with many market observers declaring the end of 'easy money' opportunities at various points in time; since the end of financial crisis. The investors that heeded those calls, lost out on the growth in equity markets (i.e. the easy money), that would have benefitted their portfolio.

Chart 9: S&P 500 IndexTotal Returns in the Year Following a (20%) Decline in Trailing-P/E Ratios, From 1926 to December 2018

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Though no one can definitively state when the current bull run will come to an end, based on the economic indicators we have evaluated (i.e. Labour Markets, Consumer Market, Financial Market and Manufacturing Sector), we believe there is no indication of a recession occurring in the near term. Presently, U.S. Corporate fundamentals are strong and market valuation of U.S. equities are reasonably priced.

Despite current volatility in the U.S. equity market, we see investor panic as unwarranted, if economic growth and corporate fundamentals remain

favorable; which we believe them to be. This can present a timely opportunity for patient investors, with a long-term investment time horizon, to capitalize on the compounding growth potential of quality businesses.

Finally, TDAM believes that patience, investment diligence and having a long-term outlook can position investors to benefit from opportune moments that arise in equity markets; allowing them to participate in easy money opportunities as they become available.

Chart 10: A long term view can lead to easy money being madeThe peformance of the S&P 500 Index and equity flow in the U.S., from Jan./07 to Dec./18

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Easy Money is in reference to investors benefitting from the stock markert's upward movement/price appreciation; particuarly over the past decade. Data as of December 2018. Source: TDAM, Bloomberg Finance L.P.

Barron'sNov. 2009

MarketWatch Nov. 2011

The Street May 2012

Morningstar Dec. 2013

CNBC Mar. 2015

Easy money being made, again?

Appendix6

Provided below are the definitions for the economic variables referenced in Charts 5a and 5b:

Non-Farm Payrolls: Nonfarm payroll is a term used in the U.S. to refer to any job with the exception of farm work, unincorporated self-employment and employment by private households, nonprofit organizations and the military and intelligence agencies. Proprietors are also excluded.

Initial Jobless Claims: Initial Jobless Claims measures the number of individuals who filed for unemployment insurance for the first time during the past week. This is the earliest U.S. economic data, but the market impact varies from week to week. A higher than expected reading should be taken as negative/bearish for the USD, while a lower than expected reading should be taken as positive/bullish for the USD.

Unemployment Rate: The unemployment rate is a measure of the prevalence of unemployment and it is calculated as a percentage by dividing the number of unemployed individuals by all individuals currently in the labor force. During periods of recession, an economy usually experiences a relatively high unemployment rate.

Index of Aggregate Weekly Hours: Indexes of aggregate weekly hours are calculated by dividing the current month's aggregate hours by the average of the 12 monthly figures, for the base year. For basic industries, the hours aggregates are the product of average weekly hours and employment of workers to which the hours apply (all employees or production and nonsupervisory employees). At all higher levels of industry aggregation, hours aggregates are the sum of the component.

Real Personal Income ex-transfer payments: Real personal income less transfer payments, a measure intended to strip out some of the impact of automatic stabilizers in the personal income data.

Real Retail Sales: The U.S. Census Bureau maintained time series of monthly sales and end-of-month inventory estimates of U.S. retailers.

Personal Consumption Expenditure (PCE): A measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

Case Shiller Home Price Index: A monthly index that tracks changes in the price of residential real estate in 20 major metropolitan regions in the U.S.

Consumer Confidence: Consumer confidence is an economic indicator that measures the degree of optimism that consumers feel about the overall state of the economy and their personal financial situation.

appendix6The definitions of the economic terms referenced in this document were taken from the glossary of the U.S. Department of Commerce, Bureau of Economic Analysis website. https://www.bea.gov/

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