Commentary

Canadian Equity Q1 2016

04/01/2016

Market Overview

Frank Mersch

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.

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 Tactical Equity Class

The Front Street Tactical Equity Fund underperformed the S&P/TSX Composite Index for the quarter. Markets were preoccupied with anticipating the Fed’s sentiment, which quickly went from hawkish, when it raised interest rates in mid-December, to dovish as markets struggled early in 2016.

Not surprisingly, gold—and gold stocks in particular—experienced a strong upward move, reacting to increasing occurrences of negative interest rates around the globe, as well as the Fed’s increasingly dovish stance. While we have since trimmed or exited holdings in most of our names, we continue to hold some, particularly Franco-Nevada. Other contributors included Facebook and Constellation Brands.

Our outlook for equities is fairly neutral, and we expect to continue to see some volatility or “choppiness” in the coming quarter.
However, we believe the TSX could outperform the S&P in the second half of 2016. By then, it will have been 18 months since Saudi Arabia increased oil production, resulting in the sharp drop in prices, and we should begin to see production roll over. This would provide the necessary backdrop for oil prices to stabilize and, therefore, a rebound in the resource-biased TSX.

Front Street Hedge Fund

The S&P/TSX Composite Index rose 634 basis points (bps) in March. Following a weak start in January and February, the index gain pushed into positive territory with a 484 bps advance during the quarter. All sectors had a positive contribution, with the exception of health care. The financials and energy sectors rebounded, leading all groups with contributions of 349 and 215 bps, respectively. However, materials (gold and metals) led all sectors on a year-to-date basis, contributing nearly 50% of the index’s positive performance.

Now for the mea culpas. The portfolio faced four significant challenges in the quarter, including two mistakes on our part.

  1. First, we had an overweight exposure to financials. As we entered the year, we positioned the portfolio with an aggressive 30-40% financial weighting, mostly comprised of U.S. holdings. We erroneously took the Fed at its word and anticipated a period of rising rates. Fed indecision and policy changes precipitated a correction, and financials were hardest hit, as it now appears we may not see any rate hikes at all. Surprisingly, Canadian banks, with their large energy exposure, rebounded while their U.S. counterparts only recovered half of their losses. With a growing likelihood of no interest rate increases, the financials’ growth rate has slowed. Here is where we made our second mistake: we sold off our overweight allocation to financials – and proceeded to get “whipsawed” as equity prices rebounded. The mistake has been in not holding Canadian banks, at least for now.
  2. One of our long-time securities was very hard hit. Performance Sports Group, the leading supplier to the hockey and baseball industries, issued a surprise warning on its earnings. The stock dropped 70%, which has impacted our returns by 1 to 1.5%. The earnings warning was surprising in that all of the company’s segments were hit: hockey was down 9%, Easton division registered a 31% drop in revenue, due to a change in baseball bat regulations, and one of its major customers, Sports Authority, declared bankruptcy.
  3. While we moved reasonably quickly to decrease our U.S. currency weighting from 40% to less than 10%, we were nevertheless impacted by the strength of the Canadian dollar. Its rapid rise negated any returns from our U.S. holdings.
  4. In an environment of no foreseeable rise in interest rates, the discussion of negative interest rates has cropped up, which has made a case for rising gold prices and a bounce in metals. While we do not believe we will see negative interest rates in the U.S., they are now prevalent in Japan, Germany and a few other small countries. We did own some gold companies, but not enough, and sold too early. We did not hold any metals and are unlikely to own them, especially given slowing growth of China.

All was not bad, however: we did start to buy oils. We currently have a 15% weighting in oils and as the year plays out, we believe this group will likely rise, depending on the overall environment. We are still baffled by the outperformance of Canadian banks given the Alberta economy. While we believe oil companies’ fundamentals will improve, we don’t believe the Alberta economy will turn positive until late 2017 or early 2018. Given the challenging quarter, we have had to modify our strategy, but we do have time in 2016 to recover.

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