March 2010
“ On a Clear Day You Can See”
- Lerner and Lane
The first quarter of 2010 unfolded much as anticipated. Economic data was encouraging, and generally confirmed that Canada and the US were on a renewed growth trajectory; growth estimates for 2010 increased steadily over the period. Investor reactions to negative surprises, like China’s decision to tighten bank lending or Greece’s flirtation with sovereign debt default, were sharp but transitory. Capital markets were volatile, but ended the period with gains.
However, the equity and bond markets now appear headed on divergent paths. The prospect of heavy sovereign debt issuance is now pushing government bond yields higher, and producing the anticipated final stage of the narrowing of corporate credit spreads: during the first quarter, Canadian corporate bonds gained 2.2% while government issues returned only 0.9%. By contrast, the equity markets ended the quarter on a strong note, approaching new highs led by the more economy-sensitive market segments – technology and materials. Overall, the Canadian stock market posted a return of 3.1% for the quarter, while Canadian investors earned 1.6% from the S&P 500 and lost 1.0% from the MSCI World Index as the Canadian dollar registered another strong advance.
These events have only served to reinforce our conviction that economic growth this year will be subdued in North America and Europe as the period of consumer deleveraging continues; sadly, it is fair to say that this “moderate growth” scenario is now the market consensus. We expect that price inflation will similarly remain in check due to excess capacity, but rates are likely to remain sensitive to supply pressures. Equity markets will remain range-bound along a generally upward trending path, but still subject to periodic corrections triggered by economic surprises or disappointing earnings news as investor expectations adjust to the moderate growth environment.
Time to look to the future
Investors are now more sanguine about investment prospects for 2010. Thus, it is an opportune time to consider some of the themes that may drive investment returns in 2011 and beyond.
Theme #1: The need for infrastructure investment is becoming critical
Financial “bubbles” are a reflection of excessive capital being directed into one part of the economy. It may appear axiomatic, but whenever there is a “bubble” there will also be another segment of the economy that is being starved for capital. As anyone who has had to dodge concrete crumbling from a freeway overpass can attest, infrastructure in North America certainly fits this description. Perhaps the most extreme example of the consumption “bubble” starving infrastructure investment is California, where consumers (a.k.a. taxpayers) passed Proposition 13 that limited the state government’s ability to impose new taxes, thus heralding its current fiscal crisis.
The capital investment required to upgrade our public transportation infrastructure will total many billions of dollars, over many years. Construction companies, engineering firms, cement producers, and steel producers are just a few of the business segments that should enjoy flush order backlogs as the spending takes place. Mackenzie’s Universal Global Infrastructure Fund is well positioned help investors exploit these opportunities.
Theme #2: Consumer spending should thrive – in emerging economies
The pace of economic growth in Europe and North America is likely to remain subdued for some time due to the bursting of the residential real estate bubble and, more specifically, the resulting deleveraging of consumers. Emerging economies, by contrast, did not experience the same financial excesses and are thus enjoying a more robust post-recession economic rebound. Consumer spending in these economies is thus poised to surge, reflecting the increasing purchasing power of their growing middle class. This will offer investors who venture abroad numerous opportunities for superior investment returns without the risk that trade frictions will disrupt demand for their goods and services. Mackenzie Cundill Emerging Markets Value Class and Mackenzie Universal Emerging Markets Class are two vehicles targeted at this growing investment region.
Theme #3: US healthcare – the clouds are parting
The Obama administration’s success in getting its healthcare legislation passed through Congress was one of the highlights of the first quarter. Attention focused initially on the closing of tax loopholes that would cost AT&T $1 billion, and Deere and Caterpillar $250 million between them. This aspect is consistent with our view that taxes generally will be rising.
The opportunity presented with the passage of this healthcare legislation has received far less attention. Investors had expected the legislation to impose punitive measures, such as price-caps or generic substitution, on the healthcare industry. The consensus earnings growth forecast for this industry was thus a moribund 8% versus 28% for the S&P 500, and the sector underperformed the market by 1.6% in the first quarter. Instead, it was the insurance industry that was cast as “the villain” by legislators. The healthcare industry now offers investors the opportunity to acquire strong franchises with superior profitability, at a discount valuation, with growth potential derived from 30 million newly-insurable prospective clients. An added bonus is that this sector is a major beneficiary of a declining US dollar due to its substantial international operations. Mackenzie Universal Health Sciences Class provides investors with a top-ranked vehicle for taking advantage of this opportunity.
Theme #4: Currency devaluations – the new G8 policy
Employment prospects within Europe and North America are improving. However, an extended period of subdued 2%-2.5% economic growth, and the financing challenges still being faced by small business, traditionally the largest contributor to job growth, means that unemployment could remain elevated for some time yet. Leaders in the US and Europe face a daunting task – reinvigorating their economies despite being under fiscal duress and having domestic demand constrained by a deleveraging consumer; many see exports as the new growth engine.
In order to improve the competitiveness of their export industries in the global marketplace, political leaders of the G8 developed countries are looking to influence foreign exchange markets to their benefit. Some are looking to devalue their currencies – Japan’s leaders have now made it clear that they wish the yen to weaken. Others are looking to boost the currencies of their trading partners – witness the ongoing efforts by the US Congress to pressure the Chinese authorities to revalue the renminbi. Unfortunately, you may recall from Canada’s experience in the 1990s, that the pressure to boost trade through currency devaluation can persist for some time.
We remain positive on the prospects for the Canadian dollar. As highlighted in our last commentary, Canada should benefit from growing demand for industrial commodities and should attract investment capital as corporations become more attuned to the security of supply challenges of frontier resource deposits. We expect the Canadian dollar to maintain a positive trend versus the currencies of its G8 trading partners. The challenge faced by investors in the US and Europe, however, is how to safeguard their purchasing power when authorities are intent on devaluing their currencies. One solution will be to diversify into strong currency countries, like Canada. Another solution that appears to be gaining traction with investors is to buy gold bullion, the quintessential “hard currency.” Mackenzie Universal Gold Bullion Class offers investors a potential means of profiting from robust global demand for gold.
Theme #5: Equities outperform bonds over the long term.
Some may consider this my most controversial proposition. Investors have long taken for granted that equities always outperform bonds. Historically, this has generally been true, and it certainly is consistent with the maxim that equity investors merit a return premium because of the added capital risk they assume when investing in stocks. However, recent experience has called this proposition into question – only serving to highlight that investor experience is sensitive to market valuations at the beginning and the end of the measurement period. For example, over the 30 years ended December 2009, the TSX returned 9.43% per annum while the DEX Universe bond index returned 9.94% per annum. If we examine this period in blocks of 10 calendar years, bonds bettered equities in 12 of 21 periods. Of course, in 1979, the Canadian stock market’s last resource boom was coming to an end, and long Canada bond yields stood at over 10% and were headed to post-war highs above 18% (October 1981).
Despite recent history, setting an investment strategy assuming that bonds will continue to outperform equities in the coming years is risky. Today, 30-year Canada bonds yield only 4.1%, so it would take only a 25 basis point increase in market rates to produce a negative total return on the bond. Bonds are a much riskier proposition at 4% yields than they were at 10% yields. Given improving economic prospects, and upward pressures on yields due to heavy government funding demands, we advocate investment strategies that favour equities and employ bonds to temper overall portfolio volatility.