Canadian Balanced Q2 2016
Frank Mersch & Rick Brown
Welcome to the summer of 2016. The violently flat paradigm that the U.S. and, to a lesser degree, global markets have been stuck in for the past two years, continues following the U.K.’s vote to exit the European Union (“Brexit”). Brexit perplexity, an enigmatic U.S. Federal Reserve Board and U.S. presidential theatrics are scaring investors away from the facts once again. Yet, with all this uncertainty, we are very close to new highs. To be sure, these are confusing times, with many negatives including Brexit, negative interest rates, Trump uncertainties, protectionism, immigration, U.K. recession risk, ISIS, employment rates, Middle East instability, central banks out of ammunition, high frequency trading, ETF’s and China risks, etc.
While we do not disagree that this summer noise will unnerve markets, we do believe that a contrarian approach may be warranted. It seems a good time to invest when there are many negatives and investors are bearish. We believed prior to Brexit, that we would see some improvement in earnings in the second half of 2016 and that the U.S. economy would continue to improve. More importantly, with firming oil prices, many global risks have also improved, as defaults became less of a concern. Post Brexit, many developments have occurred to explain why global markets have rebounded.
The response has been as follows:
- The Bank of England offered $345 billion in liquidity
- Japan took foreign exchange steps
- Italy offered €40 billion injection to its banks
- The European Central Bank may loosen the rules for bond purchases
- Bank of England indicated that it will likely have to ease policy in the summer
- A tsunami of mergers and acquisitions transactions
- Brent crude oil has held close to $50/bbl
- The U.S. dollar move has been moderate
The results of Brexit, while still not totally known, will likely bring further monetary easing in Europe. Coming into Brexit, the market was assigning a rate increase for July and September. That now appears to be off the table.
The bottom line is, Brexit is ultimately a political crisis and one that is not likely to be resolved in a hurry. There will be many twists and turns in the path to ultimate resolution. There may yet be circumstances that give rise to bigger systemically risky events. For now, we don’t think we are quite there and we can now focus on stocks again.
The Canadian market continued its outperformance in the quarter. Momentum continues to pull the market higher. The strength has come from resource cyclicals as we have seen the stabilization of energy, and rebound in basic materials. With all the noise around the world, gold has once again become a safe haven. Certainly with over 20 trillion dollars trading at negative yields, gold becomes even more compelling.
Resource cycles typically contain three phases: U.S. dollar depreciation, economic progression and late-cycle inflation. We believe we are now seeing a transition from U.S. dollar weakness to economic re-acceleration. Resource stock outperformance—despite U.S. dollar strength—confirms this transition. In fact, south of the border, we now see wage pressures starting to rise, which will set the stage for late-cycle inflation. Any stability in oil prices will only confirm this upward bias.
The third phase should occur later this year or early in 2017. Over the past 11 years, U.S. real rates have turned negative three times and each time they did, resource sectors had a sizable leg of outperformance. Assuming a $50 oil price, we believer CPI should surpass 2%. Investors should remember that relative resource rallies outperform the TSX by 43%. This rally is five months old and, to date, we are only half way to the 43% outperformance. Thus, the odds favour a continuation of the current rally until the end of this year and into early 2017.
While gold equites have outperformed more than oil, we are reluctant to eliminate the group given the uncertainties of Brexit, presidential elections and China. As such, gold remains an insurance policy.
It is striking how closely oil prices, crude inventories, oil rig counts and energy stocks are tracing the 1998-1999 experience. It seems like we are taking the same 18-month duration it took for rig counts to bottom out in April 1999. The 2014-2015 oil bear market was never about demand, but rather, supply. The key going forward is the lagged impact of weak oil prices on supply.
Admittedly, Iran coming back delays the pinch point between a balance of supply versus demand. Nevertheless, the longer oil stays below $50, the more likely further supply constraints will persist. Thus, starting in the second half of 2016, global oil markets should begin the process of rebalancing, a process that should last at least a year. As such, energy stocks remain a core holding in our equity portfolios.
Regarding base metals, we have seen a sizable bounce from acutely oversold positions. While we are unlikely to see the same demand we saw during the 2001 to 2010 period, we recognize that global copper production growth will continue to subside given that nearly $85 billion in capital expenditure has been removed.
The rest of the market will likely underperform commodities over the next year. Financials will benefit from better oil prices, as the risk of large defaults abates. That being said, low interest rates and the flattening of the yield curve does not help net interest margins for the financial industry. Strong capital market operations will offset some of the negatives, and meanwhile, hefty dividend yields relative to bond yields should limit valuation erosion.
As we progressed through the second quarter of 2016, uncertainty over the impending Brexit vote gave way to fear and negative sentiment as the results came in on June 23. Remarkably, the market started to recover quickly afterward, trading higher as June closed.
Market volatility was elevated for the period. The U.S. 10-year bond started the quarter with a yield of 1.77%, and traded as high as 1.93%, before dropping sharply after the Brexit result to 1.36% before ending the quarter at 1.47%.
At the moment, globally, one-third of all sovereign debt is trading at negative yields, meaning investors are willing to invest in assets that guarantee they lose money if held to maturity, rather than taking a risk that could lead to losing more money. These are truly unprecedented times, with equity markets at new all-time highs and interest rates at all-time lows. In such a low-yield environment, investors are being forced to take on more risk than they historically have in the hopes of achieving their financial goals. For many, the idea of investing sovereign debt at historically low levels is absurd, so money will continue to flow into assets classes like equities and high yield.
Longer-duration assets performed best as investor scrambled for the safety of bonds. The risk now is that those same assets may suffer as cash and risk appetite returns to the market. Interest rate sensitive products, such as government bonds, performed better than most sub-asset classes of the bond market on the back of lower interest rates and Brexit fears. In addition, European assets came under pressure because of Brexit uncertainty. We believe that money will flow back into the market and into corporate debt given that investors’ appetite for yield cannot be achieved in sovereign debt.
Formerly the Front Street Diversified Income Class
The Front Street Balanced Monthly Income Class generated a +1.8% return in the second quarter of 2016. After a very difficult first quarter, the fund rebounded as the Canadian equity market continued to outperform its U.S. counterpart. The fixed income portion of the fund (60%) also rebounded as high-yield securities moved higher with the emerging stability in the energy market.
As we navigate through these uncertain times, it has become quite evident that conventional income holdings, such as banks and other financials, are challenged when interest rates remain low and negative. Typically in an income fund such as this we would carry a heavy financial weighting. This is not the case today as net interest margins have become more and more compressed.
Meanwhile in Canada, we have seen a strong rise in commodity prices from very depressed levels, with gold and base metals registering big returns. For a fund such as this, we elected to invest in the gold trade, but not in base metals. Also, the smallest and least liquid securities have had the biggest bounce. As such, we decided to forgo this risk in favour of liquidity.
During the quarter, we increased our oil weighting and have now moved all of our cash back to Canada. While we do not anticipate a major run in the Canadian dollar, we do believe that $0.80 against the U.S. dollar could easily be in the cards by year-end.
As always, this fund will maintain its conservative stance, with a focus on maintaining liquidity.
he Front Street Growth and Income Class registered a +1.1% return for the second quarter of 2016. While this by no means is extraordinary, it does reflect the changes implemented in the quarter.
During the last three months, we were probably more conservative than we should have been. We had a 30-35% fixed income weighting and, for much of the quarter, carried far too much cash. Not having enough resource holdings in the portfolio was our biggest missed opportunity.
The big double-digit returns in base metals, golds and oil and gas have impacted the fund, relative to the index. While we did hold some senior gold companies and oil and gas equities, we were underweighted in both until the middle of the quarter. A lack of metals holdings also detracted from performance. Since these three industry groups accounted for essentially all of the returns for the TSX, the fund’s underweight positions negatively impacted its relative results.
Today we have an equal weighting in golds and a slightly overweight allocation to oils. We still lack a metals weighting and at this stage we are reluctant to chase. Should anticipated weakness occur we may revisit this position.
Looking forward, we believe that we may see a pause in the commodity run but we do not see a major pullback. We think a consolidation would be healthy and expect further gains in the group as we finish the year. Certainly, we believe that the oils still have some catching up to do.