November 2009
“Must be the Season of the Witch”
September and October are the months that traditionally spook investors. Major market events that become part of investment legend – the Crash of ’29, the Crash of ’87, the Twin Towers, and last year’s collapse of Lehman Brothers, all occurred at this time of year. It is thus hardly surprising that investors came into the autumn period focused less on the beauty of the leaves, and more on the perils lurking in the dark. They took no comfort from the fact that equity markets had rebounded by more than 50% from their March lows; rather, this was seen to make some form of retribution all the more likely.
And yet, capital markets rewarded intrepid investors once again in the third quarter, with MSCI World equity index gaining 7.5% (C$). The improvement was driven by further evidence that the global recession ended in the second quarter, which prompted the IMF to increase its forecast of global growth for 2010 to 3.1% from 2.0% just six months earlier.
The improvement in economic sentiment was most pronounced in Europe, where markets responded with an impressive 12.6% (C$) gain. The rebound in corporate profits was another key driver of the market advance; S&P 500 operating earnings for the first half of 2009 were up 24.9% from the second half of 2008, and are forecast to improve a further 10.9% in the second half of this year. Initial concerns that inflation would results from the massive Central Bank and government economic stimulus programs, which pushed rates higher early in the quarter, were quelled by data showing consumer prices remained subdued, and interest rates ended the quarter lower than where they began. In Canada, the bond market provided investors with a return of 2.7% for the third quarter.
While capital markets posted gains, and volatility steadily diminished, foreign exchange markets witnessed a resumption of downward pressure on the US dollar. Concerns that the US dollar would lose its reserve currency status resurfaced as officials in Russia and Singapore cited the need to diversify their reserves from the dollar, and OPEC mused once again about pricing oil based on a basket of currencies. The US dollar lost ground against all major currencies during the quarter. The Canadian dollar’s 8.6% gain against the greenback meant that, once again, Canadian investors were well served investing locally as the S&P/TSX index returned 10.6%.
The plight of the US dollar, and the improving outlook for global economic growth, resulted in sharp gains for the price of gold and industrial metals. Commodity-sensitive markets were thus particularly strong performers during the September quarter. The Brazilian market rose 21.3% (C$) and the Australian market 20.3% (C$). In Canada, the market’s advance was paced by the 12.4% gain of the Materials sector, with energy issues rising 9.0%.
The Wicked Witch of the West
As investor attention turns to 2010, capital market forecasts are clouded by the prospect of a subdued economic recovery in North America and Europe. Our forecast of growth of 2%-3% is inconsistent with past experience; normally, after a recession, the economy rebounds at a torrid 6%-7% annual rate. While it is always risky to say that “this time it’s different,” the tepid rebound in consumer confidence and the steady increase in US residential mortgage delinquencies, increase the likelihood that consumers will boost their savings levels in an effort to rebuild their balance sheets, and companies will show restraint in rebuilding inventories due to the high cost of financing their working capital requirements.
The spectre of sluggish growth suggests that 2010 earnings forecasts for North America and Europe at about 25% reflect excessive optimism. The earnings improvement witnessed thus far has been derived mainly from margin improvement associated with cost cutting; revenue growth has generally proven disappointing. Profits in the financial sector will also be tempered by the challenges in the commercial real estate market, where vacancy levels continue to rise and the industry faces pressure as mortgages extended during the credit boom come up for renewal. By contrast, consensus earnings growth of 29% in 2010 appears achievable in Emerging Markets. The leading Asian and Latin American economies did not experience the same credit bubble that the OECD nations did. As a result, consumers in these markets are positioned to drive a more traditional economic rebound, with growth in excess of 4%.
The Good Witch of the North
Despite the risk of earnings disappointment, investment prospects in 2010 are encouraging. We remain of the view that a new bull market began in March, and any interim correction should be considered in this context. The most important single contributor to our optimistic bias is the mountain of cash that investors built as the financial crisis triggered a “flight to safety” of unprecedented magnitude. Despite the rally in capital markets, investors have been slow to commit this cash to long-dated assets. Canadians hold an estimated $600 billion in money market funds and in bank accounts, on which they are earning a negligible return; the amount held by Americans is of course many times this amount.
Investors have begun to redeploy their money market holdings. Bond and balanced funds have been the primary recipients of these contributions; as investor confidence mounts, it is likely that more of this money will be directed towards equities. Government bonds are likely to be less attractive as investors contemplate the upward pressures on interest rates that will accompany economic growth. Corporate bonds remain attractive given the substantial yield premium they offer over government issues; these credit spreads will likely narrow over the coming year as business conditions improve. We have been adding corporate bonds to a number of our balanced funds in order to capitalize on attractive opportunities – we expect bonds to contribute to a fund’s return, not just temper its volatility.
The US dollar’s vulnerability suggests that US exporters, and US multinationals, will be more competitive in foreign markets, and should enjoy a boost to earnings as a result. Investors may also wish to consider shifting their US holdings into “hedged” US equity funds. The weaker US dollar and improving global economy will also keep commodity producers in the spotlight, benefiting Canada as well as many emerging markets.
Certainly, the longer-term case for industrial commodities remains intact – prices are likely to rise steadily over the coming years, as it becomes more challenging to meet growing demand with economical new sources of supply.
The market recovery has seen lower-grade companies outperform the top quality companies by a wide margin. This reflects the re-valuation of poor quality business from “bankruptcy risks” to “going concerns” as credit market conditions have improved. However, a subdued economic recovery is likely to see leadership return to quality companies. Businesses that are more profitable, and have a stronger balance sheet, are likely to gain market share from their weaker, low-quality peers. Growing confidence in the boardroom will also see the recent surge in merger and acquisition (M&A) activity continue into next year, benefiting the valuations of better small and mid-cap businesses. In general, this will represent a market environment where stock selection will be paramount, and the “macro” call will be of less significance to fund results. The Mackenzie teams are poised to take advantage of these opportunities for our clients.