Global stock market returns were very robust during the
third quarter as concerns about a "double dip" recession faded. The US stock market (as measured by the
S&P 500) returned +10.7%, pushing the year to date return into positive
territory. The Canadian dollar gained 3%
against the US dollar resulting in the S&P 500 in Canadian dollars
returning +7.0% . The Canadian stock
market (as measured by the TSX Composite) gained 9.5%.
During Q3 it became increasinly obvious that
the deleveraging of US consumer blance sheets would cap the growth prospects
for the US economy for a number of years.
While the US housing has not declined
further, it also has not provided any
additional stimulus to the economy.
Housing starts remain at depressed levels and housing prices have
flattenned out even though a significant number of homes are valued at less
than the mortgages asssociated with those homes.
The biggest concern about the prospects for the US economy has
been the stickiness of the unemployment rate at historically elevated levels. Job
growth is resuming, but not at a rate quick enough to absorb all the new
entrants to the job market and bring down the unemployment rate. Current job growth is not at the pace that
the US has experienced in prior recoveries.
The sluggish recovery and its impact on job
creation has become the key issue in the upcoming midterm elections. Republicans look poised to gain control of
the house and make gains in the senate.
This development is being warmly received by the markets as political gridlock
will limit new spending programs and reduce the resulting business uncertainty.
There is also optimism that the anti-business rhetoric emanating out of
Washington over the last 2 years will dissipate. A more balance tone out of Washington can
only add to investor confidence and halt the slide in valuations related to the
uncertainty and fear that currently pervades the market.
Having highlighted a lot of the negatives, all is not gloomy. The
rest of the world continues to grow at healthy rates. Globally focussed
companies, like industrial and technology companies, continue to exhibit robust
growth. The recently released Chicago
PMI (pointing to healthy manufacturing in the Midwest) and the ISM Manufacturing
Index all show that while US manufacturing is slowing, it continues to grow.
Our portfolios are structured to focus on companies that have greater
than average exposure to international markets.
Just because a company is domiciled in the US, does not mean that it is
overly dependent on the US economy for its sales growth. Over 1/2 of the companies in the Dow Jones Industrial
Average have greater than 50% of their sales outside the US. There is a strong proven correlation between non-US
sales as a percentage of total sales and overall enterprise sales growth. A slow growth US economy coupled with
significantly faster growth in the rest of the world will lead to decent
revenue and earnings growth for those companies well positioned. The stocks that we own on behalf of our clients
that are in the Dow Jones Industrial Index tend to fall into this category of having
a high percentage of their sales outside the US.
A final point related to the US market is about valuations. US stock valuations are at historically low
levels, as can be seen in the following chart showing the price to book ratio on
a 20 year basis.
The next chart shows the equity risk premium for the US market,
which is a way of measuring the risk tolerance associated with equities. The
higher the risk premium, the less risk tolerant equity holders are, and the
cheaper the stocks are. We are currently
in a period with an elevated risk premium, which is a fancy way of saying that
stocks are cheap. The current low stock valuations
are currently related to investor fears related to deflation, which is similar
to what the Japanese began experiencing 20 years ago.
The most interesting charts were those charts comparing stock
market valuations vs. bond market valuations.
The chart on the left shows the free cash flow yield of the S&P 500 being
at its cheapest level vs. the BAA corporate bond yield. When comparing the earnings yield of stocks (blue
line) vs. High Yield Bonds (the red line), we get a similar looking chart. We
would expect high yield bonds to have higher yields than S&P 500 stocks as
they are generally perceived to be riskier assets. Again the current relationship (similar
yields) makes little sense, unless we are in, or investors believe we are in a
deflationary environment.
While deflation is a risk and a concern of investors, we do not
believe there is material risk of this occurring. Recent data points from both the CPI and PPI
provides scant evidence that we have entered a period of deflation.
We are still in the camp that says US growth will remain slow and
uneven. Growth prospects for US
companies remain positive. There has been little change in sales growth or
earnings growth expectations since the beginning of the year.
While Canada was the first
G7 country to raise interest rates, recent signals from the Bank of Canada
indicates that they will pause and not raise rates further till at least next
year. Canada's GDP, for the first time
in almost a year, shrank in July. Other reasons for the pause include slowing housing
activity, declining retail sales and the US economy being weaker than expected.
We are firmly in the glass half full camp when it comes to the
outlook for the stock market. We are cognizant that all is not great in the US
or the world, but believe that there is sufficient global GDP growth for stocks
to continue to make gains. Expectations
remain conservative, and valuations are at multi-year lows. These all should
lead to equities providing decent returns over the next few years and their
outperforming the returns of bonds.
