Commentary

Canadian Balanced Q1 2016

04/01/2016

Market Overview

Frank Mersch & Rick Brown
Equity

After underperforming the U.S. for five consecutive years, the Canadian market is finally starting to outperform… at least for now. While pessimism towards both Canadian equities and the economy is still quite pervasive, we believe that we may have seen a bottoming out on a handful of commodities, which typically bodes well for Canada. Any positive news from emerging markets, Europe or commodities will likely provide positive momentum for Canadian stocks as well.

Canada has been a leading indicator for global weakness in equities and as such, investors have likely oversold and shorted Canada too aggressively. From where we sit, oil prices are now at cycle lows; and with the energy sector weighting within the TSX now approaching historical trough levels, the risk-reward equation becomes more balanced. While oil may be range bound in the near term, the best companies will prosper, and once again grow and acquire production. The “obvious” shorts are no longer obvious; and so wholesale shorting will no longer be the norm.

Global financial concerns have recently allowed the gold sector to attract bids. With negative interest rates in a number of countries, some are pointing to gold as a safe alternative to government and corporate debt. While we understand the logic of the argument, we also recognize that the gold equities really have no appreciable production growth potential. Rationalization, as well as merger and acquisition activity, is likely the only course for growth.

Despite outperforming in the past quarter, the Canadian market has followed a similar path to that of the U.S. A big downdraft in January was led by commodity-related securities. The Canadian financials sector corrected, but not to quite the same degree as the U.S. banks. Like the U.S. market, the rebound in oil prices solidified the market and set the stage for a substantial rebound led by all commodities. Due to the proliferation of shorts in our market, we had big moves in the golds, metals and oils. The financials also rebounded and have outperformed their U.S. counterparts by an approximate 2-to-1 margin. This is somewhat surprising, given the increased exposure of Canadian banks to energy, the struggling Western Canadian economy, and a less likely increase in net interest margins (no rise in Canadian rates = less spread). Nevertheless, it is now obvious that Canada, for the time being, is the better beta trade, at least compared to the U.S. Coinciding with the rise in commodities, the Canadian dollar staged a massive rally, which underscores its “petro-currency” status.

Our view is that Canada remains susceptible to broad, tradable swings in sentiment. However, as time progresses, Canada will become increasingly correlated to the U.S. domestic economy and U.S. fundamental strength. As such, there will be quarters of outperformance and underperformance, but Canada should not continue to underperform the U.S. to the same degree it has in the past few years.

Fixed Income

As the new year began, market optimism was quickly shattered over concerns that China was slowing much faster than anticipated, alongside rumours of large portfolio reallocation taking place by large sovereign wealth funds. On this news, bids quickly evaporated and the market for risk assets, including high-yield bonds, sold off through most of January, bottoming out in mid-February. We don’t believe anyone anticipated such a weak start to the year. Although many had hoped for a market correction, when it came, those same people were challenged to find an entry point. Cash and short positions began to build as the market tried to avoid further pain.

Fixed income spreads widened, and then tightened as the quarter came to a close. Spreads traded in a staggering 200 basis point range during the quarter, but ended around 10 basis points wider than at year end. In term of interest rates, the 10-year yield fell from 2.27% on December 31 to a low of 1.66% on February 11, before ending the quarter at 1.77%.

Interest rate-sensitive products, such as government bonds, performed better than most segments of the bond market as interest rates moved lower. Longer-duration assets (those with greater interest rate sensitivity) performed best as investors scrambled for the safety of bonds. Those same assets may suffer as cash and risk appetite returns to the market. We anticipate that interest rates will reverse course and start to move higher from current levels as data in the U.S. will likely lead to a higher probability of further rate hikes by the Fed than what is currently priced into the market.

Macro View

Global growth is still decelerating. We are on pace to have the slowest GDP growth rate since 2009. World Bank analysts are forecasting 2.9% growth, compared to the 4% average rate from 2000-2011. We would agree this represents a more sustainable rate, given China’s slowdown from a “supercharged” economy.

When we analyze the winners and losers, commodity-importing economies have grown much more robustly. The strugglers have been commodity-exporting countries such as Brazil, Canada, Russia and Australia. U.S. growth has managed to stay around 2 ½ percent although recent numbers are slightly weaker. The GDP growth gap between U.S. and Canada is now the widest it has been in 20 years. Given the current glut in oil, we don’t anticipate the gap narrowing much this year.

U.S. growth will continue to be supported by consumers, who are in good shape. With full employment and rising minimum wages, we expect solid income gains. Offsetting this are lower net exports, which are quite a drag to the overall picture. In Canada, it is the opposite: exports rose 4%, but imports dropped by 1%. The other bright spot for Canada is government stimulus spending, but it may take some time for the effects to kick in, as spending is focused on infrastructure projects, which tend to have long lead times.

Despite the weak outlook for Canada, the dollar jumped 10% during the quarter. The reasons for this surprising about-face has been the weakness of the U.S. dollar, short covering, and oil prices which re-bounced from an oversold bottom. If the Canadian dollar continue to be strong, we could see a further rate cut, although this seems unlikely. Rather, we may have some short-term weakness if OPEC cannot reach a resolution with Iran, which has been aggressively ramping-up production.
The bottom line is that the U.S. is still the best economy. But the quality is falling. The consumer must remain robust to keep the party going.

Market Outlook

We are starting the second quarter with the Dow Jones Industrial Average, S&P 500 and NASDAQ all up. The treasury yield is down 1 basis point, gold is down to $1218 per ounce and oil is at $36.67 per barrel. March was one of the biggest positive months in a long time, yet strength in the Canadian dollar wiped out much of the gains Canadian investors might have made south of the border.

So, what will April bring? Analysts are expecting S&P 500 earnings to be down 8.5% in the first quarter, which would be the biggest downdraft since the third quarter of 2009, when profits dropped 16%. Ninety-four companies have issued profit warnings and we expect more to do so in the coming days. Analysts have ratcheted down estimates, and earnings are in their own growth recessions. China continues to slow and early signs of banking problems have surfaced. Last year, utilities profits were down 16%, energy down 60% and materials down 7.3%. Analysts are now forecasting another 22% drop in earnings for materials, and are predicting negative earnings for the energy sector. The industrials sector’s earnings are expected to drop by 9% after a pretty rough year.

For the past year, markets have been tied to crude oil prices. The Saudi-Iranian conflict shows no sign of resolution. Iran oil exports have risen to 2.92mm barrels per day and recent data shows further output. Saudi and Russian oil production also increased. A meaningful production freeze looks like an unlikely event.

Throughout the world, interest rates appear to be going down rather than up, and negative interest rates are now a common discussion. The market now takes the view that we are unlikely to see any U.S. interest rate hikes in the near term. We anticipate a tough quarter for the energy sector’s earnings, which will disproportionately weigh on overall earnings (when excluding energy, earnings forecasts for the quarter are simply mediocre). So what has changed since the Fed’s December interest rate increase? Nothing, except for Fed Chair Janet Yellen’s recent comments giving markets a “green light” for the near future. The Fed has taken a dovish stance, but it was only last December that it was hawkish – underscoring how wishy-washy the current Fed is. Something has spooked the Fed’s thinking recently for it to do such an about-face.

Front Street Balanced Monthly Income Class

Formerly the Front Street Diversified Income Class

The Front Street Balanced Monthly Income Class underperformed the S&P/TSX Composite Index during the period.
A significant detractor from the Fund’s performance included holdings in Performance Sports Group, which surprised markets by slashing its earnings guidance. High-yield securities also underperformed in January’s downturn. Our financials sector holdings also detracted from performance: we had increased the Fund’s financials sector weighting in the fourth quarter, after which the sector underperformed badly in January. We then reduced our weighting to protect capital, only to see financials experience a limited recovery thereafter.

We anticipate mixed results from equities in the coming period, and believe that we may see some weakness in commodities. We have positioned the Fund for better results from the high-yield segment. We believe that Canada will be hard-pressed to maintain positive economic growth in the coming period.

Front Street Growth & Income Class

The Front Street Growth & Income Class underperformed the S&P/TSX Composite Index during the period.
A significant detractor from the Fund’s performance included holdings in Performance Sports Group, which surprised markets by slashing its earnings guidance. A lack of exposure to gold and other metals hurt performance because the Fund did not take part in the sector’s rally. Our financials sector holdings also detracted from performance: we had increased the Fund’s financials sector weighting in the fourth quarter, after which the sector underperformed badly in January. We then reduced our weighting to protect capital, only to see financials experience a limited recovery thereafter.
Out outlook for the coming period is neutral. We are expecting further volatility, but things should firm up towards the quarter’s end.

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