August 2009
Hurry up, and wait
Equity markets rebounded in spectacular fashion during the second quarter, after three successive quarters of gut-wrenching decline. The recovery in markets reflected growing confidence that global credit markets had stabilized, eliminating the risk of the “depression-deflation” scenario. As a result, asset values recovered to levels more appropriate to recessions, and the MSCI World equity index rallied 19.7% (US$).
The improvement in credit market conditions was evidenced by the steady decline in the London Interbank Offered Rate (“LIBOR”), and in the VIX market volatility indicator, to levels pre-dating the failure of Lehman Brothers. The easing of credit fears was of particular benefit to global banks and insurers; in Canada, the S&P/TSX Financial Services index was one of the top performers, posting a 34.5% gain over the three-month period. In the US, major banks were able to secure almost $100 billion of new equity capital from investors, and 10 firms were able to repay $68 billion of emergency government aid. Equally important was the steep yield curve, which is enabling banks to rebuild their underlying capital by expanding their loan margins. However, as the quarter ended there were growing concerns about European bank exposure to Eastern Europe, where weak economies risk triggering currency devaluations and sizeable credit losses, as was witnessed in Southeast Asia a decade ago.
The economy – Expect a sluggish recovery
While equity markets soared during the second quarter, the economy continued to soften. Canada’s economy contracted at a 5.4% annual rate in the first quarter, while the US slowed at a 5.7% pace. Unemployment rose to 9.5% in the US and 8.4% in Canada; the contraction in Europe and Japan was even more pronounced. The World Bank now expects the global economy to contract by 2.9% in 2009 (previous estimate -1.7%), and rebound by a tepid 2.0% in 2010.
We have been expecting that the economic rebound would be subdued. The US economy usually exits recessions with a growth surge, benefiting from pent-up consumer demand, low interest rates and inventory restocking. However, recessions associated with credit crises have tended to last longer and yield more subdued recoveries because access to credit remains constrained. And the credit picture remains challenging, with credit card delinquencies continuing to rise. The housing sector also continues to soften; although the rate of price declines is slowing and affordability is the best in a generation, the rate of foreclosures continues to grow. The combination of weaker job prospects and shrinking wealth is eroding consumer confidence; the US index fell to 49.3 in June. The US consumer is thus aggressively rebuilding savings – the savings rate reached 6.9% in May. In addition to consumer caution, the expiry of certain fiscal incentives will also constrain growth, by an estimated 2% versus its potential in 2010.
The second quarter equity market rebound featured a strong pro-growth bias, similar to that witnessed in 2007. This was evident in the leadership of emerging markets (MSCI index +33.6% US$) as well as in sector returns, with the economy-sensitive sectors posting strong gains while the more defensive sectors languished. This was particularly true in Canada, as highlighted in the table:
A sub-par economic recovery in 2010 may cause many economy-sensitive companies to post disappointing earnings, limiting their potential after recent gains. Investors should thus consider a more cautious course until the economic picture clears.
Interest rates – Growing discomfort
The optimism that carried equity markets higher during the second quarter produced disappointing returns from bonds, as investor attention shifted to the longer-term consequences of the massive fiscal and monetary stimulus programs. The growing unease amongst investors regarding the future course of long-term bond yields is highlighted by the surge in the implied volatility of interest rate swaps.
The Congressional Budget Office estimates that the US federal budget deficit could remain above $1 trillion per year well into the next decade, adding fuel to concerns about “crowding out” pushing rates higher. Some upward pressure on interest rates would be normal as the economy recovers. However, higher personal savings will mute the impact of rising government borrowing. In addition, the overall level of US corporate indebtedness is not excessive. Corporate bond defaults continue to rise owing to aggressive lending to high-risk borrowers during the credit bubble; credit spreads will remain wider than during past economic cycles, as a result of tighter lending standards.
Historically, periods of excessive monetary stimulus have been associated with a subsequent rise in consumer price inflation. While there is a risk of future monetary inflation, the subdued pace of the economic recovery means that the world may not face capacity pressures until 2011- 2012. However, concerns about future US dollar purchasing power also derive from a second source; comments attributed to senior officials in France and in China, America’s biggest creditor, focused attention on the possibility that the US dollar could lose its reserve currency status. Should this occur, US borrowing costs would rise. However, there is no obvious candidate to replace the US dollar in global commerce – certainly, economic conditions in Europe and Japan would disqualify their currencies from consideration. The most likely course is that major Central Banks will continue to diversify their foreign exchange reserves away from the US dollar, with developing countries like China opting to convert their dollars into commodities (gold, oil, copper) needed to support economic growth. Commodity prices would then be sustained above levels justified by global economic growth alone, further advancing our case in favour of a secular bull market in industrial commodities.
Earnings – Excessive optimism
“Sell in May and go away.” Though trite, there is some truth to this old Wall Street adage. Two factors contribute to this investment insight:
- The bulk of mutual fund purchases occur early in the year. Since December 2004, 56.5% of net mutual fund purchases have been made in the first quarter. In Canada this can be attributed to RRSP flows; interestingly, the US and the UK have savings programs that may similarly influence their financial markets.
- Earnings estimates trend down over the course of a year. Generally, the year begins with consensus earnings growth forecasts above 10% as equity analysts and company managements view the future with optimism. However, as the year unfolds, optimism wanes in the face of actual results. This is significant because share prices respond to earnings trends, as highlighted dramatically over the past year.
Consensus expectations are for S&P 500 earnings to surge 25.8% in 2010, to a level only 12% below the 2007 record. This seems a very generous forecast given that:
- 1) Economic growth, and hence revenue growth, will be modest.
- 2) Bank profitability will be diluted by higher capital ratios and the increase in shares outstanding.
- 3) Borrowing costs will be greater than during the 2007 credit bubble. 4) Tax levels will be rising as the government seeks new revenue sources, and certain Bush-era tax incentives expire.
Time for a pause
Equity markets have enjoyed a spectacular second quarter. There now appear ample reasons for markets to pause and allow fundamentals to catch up with valuations.
Given the present uncertainties, we would advocate that investors consider scaling down the risk within their portfolios on a tactical basis. One way of achieving this would be to rebalance portfolios back to their target investment mix; given the bipolar nature of the rally, this would trigger some profit taking in the resource and emerging market positions. Similarly, within the bond market, it may be advisable to shift from junk-bond funds to better quality corporate bond funds, like those managed by our Sentinel team. Investors may wish to consider shifting some of their US holdings into “hedged” US equity funds given the longer-term vulnerability of the US dollar. A subdued economic recovery suggests that quality businesses that generate excess cash, like those favoured by the Ivy team, remain an attractive option for risk-averse investors. Investors are also likely to award premium valuations to companies with superior internal growth prospects, benefiting our Bluewater and Universal funds. Some companies will look to grow through acquisition, and small-capitalization companies favoured by Saxon may become targets due to their discounted valuations. Overall, our focus will remain on adding value through security selection given the challenging business environment.