Commentary

Canadian Equity Q2 2016

07/01/2016
Frank Mersch, Gerard Ferguson & Rick Ummat

About Brexit

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:

  1. The Bank of England offered $345 billion in liquidity
  2. Japan took foreign exchange steps
  3. Italy offered €40 billion injection to its banks
  4. The European Central Bank may loosen the rules for bond purchases
  5. Bank of England indicated that it will likely have to ease policy in the summer
  6. A tsunami of mergers and acquisitions transactions
  7. Brent crude oil has held close to $50/bbl
  8. 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.

Market Overview

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.

Front Street Tactical Equity Class

Volatility and macroeconomic risk were two prominent themes in the second quarter of 2016; however, against this uncertain backdrop, hcapital markets performed admirably, even absorbing the results out of the U.K. with minimal damage (although there was a powerful knee-jerk day one response). This volatility spread to commodities as well. In Canada, we witnessed increased interest across the resource spectrum with the materials (+26.4%), energy (+8.6%) and utilities (+5.9%) sectors leading the way. Although the health care (due to heavyweight Valeant Pharmaceuticals) and information technology sectors lagged most major indexes (S&P 500 Index, +2.5% and S&P/TSX Composite Index, +5.0%), both had fairly strong quarters. Specific to the Front Street Tactical Equity Class, it returned +5.3%. Though its return didn’t keep pace with the market, it was reasonable, given the fund’s risk profile.

From a company-specific perspective, many of our past performers (Boralex, Uni-Select and Sleep Country) again contributed materially to performance. Two others themes/holdings worth highlighting:

  • Gold: last quarter, we highlighted the precious metals sector as a big contributor to the fund, and although we reduced our weighting entering the second quarter, the group as a whole was again a powerful contributor, with names like Franco-Nevada, Detour Gold, and Agnico Eagle all exhibiting strong performance. With negative interest rates prevalent and growing, the Fed has pushed out raising interest rates, and the underinvestment in the space over the past five years is beginning to have an impact on global production (which is now falling). We remain committed to the group but again, we have reduced our weighting (or replaced it with options) as we feel the group’s volatility needs to be monitored closely.
  • As e-commerce platform targeting small- and medium-sized businesses (SMBs), Shopify has emerged as an industry leader, achieving a 105% three-year sales growth rate. We view the company as a one-stop shop for merchants who use the software to create and maintain an online retail presence, as they also provide services such as payments, inventory controls and logistic maintenance. Reasons why we like the stock include its growth profile; revenues grew almost 100% year-over-year in the last quarter alone. Growth is primarily driven from an increase in merchants, higher average revenue per user and additional service offerings, which help to retain merchants. It is also an industry leader; when Amazon.com shut down its competing offering, Webstores, and then chose Shopify as its transition path for the merchants using Webstores, we saw it as a glowing endorsement and a testament to the superiority of the Shopify platform. As for merchant count, Shopify has more customers than its two main competitors combined. Lastly, we like the market dynamics, with Euromonitor estimatings e-commerce sales to increase by 50% over the next three years. What’s interesting for Shopify is that the bulk of the growth will be in the small- and medium-sized business segment, which is the company’s focus.
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