Commentary

U.S. & Global Equity Q1 2016

04/01/2016

Market Overview

Frank Mersch

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.

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

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.

Front Street Global Opportunities Class

The Front Street Global Opportunities Class underperformed the S&P 500 during the period.

The strengthening Canadian dollar neutralized any gains achieved in the Fund. Though we moved to adjust fairly quickly, the Canadian dollar rally was swift and strong. 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. The Fund’s position in Performance Sports Group significantly detracted from its performance, as the company surprised markets by slashing its earnings guidance.

We expect the coming period to be volatile, but we maintain a positive bias as earnings are expected to rebound in some sectors and the Canadian dollar should stabilize.

Front Street US Equity Class

The Front Street U.S. Equity Class materially underperformed the S&P 500 for the quarter (-13.2% versus +1.35%).* Weakness in the health care sector and in enterprise software, coupled with an outsized move in foreign exchange, were the the primary drivers of underperformance as the Canadian dollar appreciated by over 6% against the U.S. dollar during the quarter.

We remain committed to the Fund’s core holdings. Overall net exposure was reduced dramatically in the later stages of the quarter after buying aggressively during the massive sell off at the beginning of the year. However, we will likely begin buying again as we now see a low likelihood of aggressive Fed interest rate hikes, which should reduce volatility and allow equity markets to move higher. On a stock specific basis, we increased the Fund’s weight in Amazon, as the sell off provided an attractive buying opportunity. From a sector perspective, we initiated a large position in defense companies, as we view the sector as being low volatility in an overall volatile stock market. In addition, defense companies do very well in election years historically, and especially near the conclusion of a two-term presidency.

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