U.S. & Global Balanced Q1 2016
Frank Mersch & Rick Brown
To say that U.S. stock market performance has been volatile and disappointing during the early part of 2016 would be an understatement. The main culprit seems to be ongoing weakness in commodity prices and emerging markets performance. While these challenges are not new, for some reason both investors and the Fed were spooked. At the close of 2015, the Fed raised interest rates for the first time since before the financial crisis of 2008, and indicated to the market that they foresaw four rate hikes for 2016. However, markets responded by selling off aggressively into the first weeks of 2016. The financials sector—which would have been the biggest beneficiary of rising rates—got hammered, alongside the rest of the market. At the same time, high-profile commodities fell to levels not seen in over a decade, perhaps the main cause of the markets’ violent reaction. Throughout the period, the U.S. economic data remained stable, albeit a bit slower pace. What was most surprising was the Fed’s “flip-flop”. Fed Chair Janet Yellen stood at the podium this quarter talking about zero interest rates, and went so far as to indicate that negative interest rates could be a policy tool. At the same time, OPEC (specifically Saudi Arabia) continued to increase production, putting further downward pressure on oil prices. The Saudi-Iran hostilities seem to be of continued concern for oil prices.
As quickly as the market corrected, it began to rebound, despite no change to the fundamental backdrop. The Fed became more and more dovish, seeming to have no idea what to do. Within the Fed, there is a rising constituency that questions the overall policy. Nevertheless, what turned the market was a bounce in oil prices and a massive bout of short covering. Commodities have led the rebound. With the Fed’s more cautious stance, the U.S. dollar declined 10% against the Canadian dollar from its mid-January highs. All these events stabilized the market. As we ended the quarter, the U.S. market closed modestly up over the period (and almost flat over the past 12 months). However, the weakness in U.S. currency meant a sharply negative return in Canadian dollar terms.
When we dissect the events in the quarter, U.S. financials were hit the hardest, declining 22-30%. Since then they have only managed to recover half of their loss. The health care area has been hit hard as well, despite attractive growth fundamentals. Utilities and telecoms have been the best performers, while the technology sector has been a mixed bag. What has become evident as the year progresses is that we may be entering into a global profit recession. Poor productivity growth, weak demand and general lack of pricing power have set the stage for a weak first quarter earnings period. Also, U.S. companies will be squeezed in the near term by higher labour cost as they boost payrolls. While we do not believe we will see a recession in 2016, we may skirt close to sub 1% GDP growth in any one quarter in 2016.
Finally, the relationship between oil and the stock market has continued in lock step. Oil goes up, high yield rallies and markets rally. We believe that at some point this relationship will abate, as fundamentals will dictate sector performance.
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.
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.
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 2.92 million 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.
The Front Street Global Balanced Income Class underperformed the S&P 500 during the first quarter of 2016. High-yield assets experienced a very challenging January. Expecting a rally in financials, we had positioned the Fund with an overweight allocation to the sector toward the end of the fourth quarter of 2015, but the rally did not materialize. In addition, the strong and rapid rise of the Canadian dollar made matters worse, detracting from the Fund’s performance.
We have a better outlook for U.S. equities than for their Canadian counterparts. Earnings overall should improve. We expect to see some weakness in the Canadian dollar, but it should be increasingly stable in the coming period.