WILL CHINESE AND EUROPEAN ECONOMIES HAVE A SIGNIFICANT INFLUENCE ON GLOBAL MARKETS?

The answer to the title is a resounding yes. The strong North American stock markets during the third quarter (S&P 500 in Canadian dollars + 2.5%, S&P / TSX Composite +5.4%) were related to improving Chinese and European economic data. As a reminder, the 2012 economic data showed signs of a Chinese slowdown (due to declining exports) and a continuing European recession. Recently, reports have highlighted stabilization in the European economies and acceleration of the Chinese economy. This renewed acceleration of global growth is positive for equity markets.

The recent Purchasing Managers Index (PMI) reports lead us to conclude that the European economy is bottoming and the Chinese economy is growing again. The PMI is a leading indicator for what is transpiring in the manufacturing sector. A PMI above 50% indicates that manufacturing sentiment is growing, while a reading below 50% implies that manufacturing is contracting. The blue line in chart 1 demonstrates the European Purchasing Managers Index (PMI) crossing above 50%. The black line in chart 1 tracks the growth of the Euro zone economies. This line is approaching zero, indicating that Europe is finally recovering from a deep and protracted recession.

Chart 1: Leading indicator (PMI) points to improving domestic demand growth in Europe 

      Source:  Thomson Reuters, Credit Suisse Research

Chart 2 is the data set for Chinese PMI. The PMI New Orders Index is popping above 50%, implying that manufacturing sector activity is accelerating. Both the stabilization of the Euro zone economy and the economic growth acceleration in China (world’s second largest economy) are positive for global economic growth and stock prices.

Chart 2: Recent PMI new orders suggest improvement in Chinese GDP growth

 

Source:  Credit Suisse

For this quarter’s commentary I was tempted to repeat last quarter’s title, “It’s all about the Fed, again”. The Fed continues to influence North American markets. The Fed's commentary four months ago hinted that they would ease their bond buying program. Most investors expected that this would occur at the September 18th Fed meeting. Bond prices declined significantly as interest rates shot up in anticipation of a change in Fed policy. Yields on ten year government debt rose from 1.6% to 3.0% in just four months.

At the September 18th meeting, The Fed surprised the financial markets by announcing that there would be no changes in their quantitative easing program. They re-iterated that any pullback in bond purchases would be data dependent. The Fed Chairman opined that the data did not support a taper at the current time. When mentioning data, they are specifically referring to employment data, as the Fed has a dual mandate that takes into consideration both growth (which has been ok, but not great) and employment (improving but still tepid as of the August report). Some investors speculated that The Fed did not want to taper the bond buying program in advance of the looming debt ceiling debate in Washington.

Whatever the reasons for their inaction at the September meeting, it resulted in interest rates declining across the yield curve. Ten year government bond yields backed off to 2.6% and bond prices recovered some of their summer losses. Low interest rates will continue to provide support for rate sensitive portions of the economy such as autos and housing.

Another benefit of the Fed's ongoing quantitative easing program and continued low interest rates is the positive influence on stock and house prices. When asset prices increase in value, consumers feel more confident about their financial well being, even without an increase in income levels. With the stock market indices hitting record highs and housing prices in most markets recovering to pre recession levels, consumers are feeling wealthier. This positive confidence ultimately translates into increased consumer spending, providing a boost to the economy. This "Wealth Effect" creates a positive feedback loop. Heightened economic activity translates into higher incomes, increased consumer demand and business investment.

The US economy continues to grow. While 2.0 - 2.5% growth does not appear to be strong relative to prior recoveries, the private sector is growing in excess of 2.5%. A shrinking government sector is holding back the growth numbers for the overall economy. Stabilization of the government sector of the economy should result in higher growth rates for the entire economy.

We anticipate with a strengthening economy, The Fed will begin tapering their bond buying program at some point in the near future. Even with the recent rise in interest rates, the bond markets remain in a low rate environment, with yields of less than 3%. The bottom for interest rates in this cycle is behind us. We are transitioning from a declining rate environment to a rising rate environment. This means that bond returns are likely to be less than the current meagre dividend yields. The bond market will be a tough place to make money and invest over the next few years.

In our last commentary, we discussed plausible year end targets for the S&P 500. After a great third quarter, we are over half way to our December 2013 target. While upside of 3% may not appear material, it is still attractive compared to 2.6% bond yields. The potential exists for more gains in 2014 based on the same exercise we did last quarter. An S&P 500 target of 1880 for year end 2014 is achievable if we assume the index trades at 16 times trailing earnings, which is its historical average. This implies US stock market returns in excess of 10% between now and the end of 2014.

Clearly we find stocks more attractive than bonds, especially when considering that we are nearing the end of the current interest rate cycle of declining rates. Interest rates have begun to moving up, and will continue rising over time. In this scenario, bonds are likely to have a difficult time returning much more than their current low single digit yields. Stocks on the other hand offer potential for double digits gains over the next five quarters, with dividend yields that are similar to bond yields. Dividend payouts should continue rising as company profits are at record levels and corporate balance sheets are flush with cash. This will provide further support for continued stock price gains.

The most important factor for our conclusion that stocks will outperform bonds goes back to the rising interest rate scenario. Rising interest rates are typically bad for bonds but good for stocks, especially if the rate increase is due to an improving economy. While the Fed might not have enough data at the current time to support pulling back on their bond buying program, the financial markets are anticipating that it will occur. The other key factor is the improving economic data from Europe, China and the improving US auto and housing markets. Our conclusion is economic growth is picking up, which will result in a cycle of rising interest rates and stock prices.

INTEREST RATE AND BOND PRICE PRIMER

Understanding stock movements is relatively straight forward. Rising earnings, dividends and stock prices is generally considered a good thing for equity investors. When considering bonds, the first thought would be that rising interest rates would be positive for bond investors as they would be paid higher interest rates. The reality is a little different in that rising interest rates results in declining bond prices. Bond prices and interest rates have an inverse correlation. So why is it that rising interest rates is negative for bond prices and bond holders?
The easiest way of explaining this is by example. If you buy a ten year bond at $100 that has a 2% coupon, you will earn $20 in interest over the life of the bond. Assuming rates never change and ignoring interest com-pounding (for simplicity), the price of the bond will remain at $100 till the $100 principle is repaid in ten years.

Bonds, like stocks, do trade on a secondary market. You can buy ten year bonds when they are issued (which we will call "new" bonds for our example) or you can buy "used" ten year bonds on the secondary market. For our example, a "used" ten year bond will be considered any ten year bond that has less than ten years to maturity. A "new" bond will turn into a "used" bond the day after they are issued.

Buying a "used" bond with a maturity of ten years less a day is virtually identical to a "new" ten year bond. For our example, we will assume that they are equivalent. If we buy a "new" 2% ten year bond, and the following day interest rates for ten year bonds pop to 3%, "new" bonds issued after the change in interest rates would be priced to yield 3%. These "new" bonds would pay $3 of interest per year or $30 over the ten year life of the bond. Since the bond we bought yesterday (with a 2% coupon) only pays $20 interest over its ten year life, it is obviously less attractive than a bond that pays 3%. There needs to be another mechanism to entice buyers to buy our now "used" 2% ten year bond on the secondary market. This mechanism is price. For buyers to get a 3% equivalent yield from a "used" 2% coupon ten year bond, the price of the "used" 2% bond would drop from $100 to $90 at the same time that interest rate rise to 3%. A buyer (but not the initial holder) of the "used" 2% bond would then realize interest of $20 and capital gains of $10 over the ten year life of the bond (assuming the bond is held to maturity). This is the same as a buyer of a "new" 3% bond receiving interest of $30 over 10 years with a return of principle that is equal to what was paid for the bond. Of course, the initial buyer of the 2% bond (when it was considered "new") would realize a capital loss of $10 / bond when interest rates rose from 2% to 3%. This is why bondholders lose when interest rates rise. Their bonds are re-priced to reflect the higher interest rates.

What happens to the "used" 2% bond over the intervening years? Assuming interest rates remain at 3%, the price of the 2% bond will rise approximately 1% per year. This means that the bond holder will receive both 2% of interest plus 1% in capital gains each and every year. The math also means that the further out the maturity for any bonds held, the larger the loss on the price of the bonds when rates rise, all else being equal. We have already seen an example of what happens when rates rise and how it impacts a ten year bond. If the same example is applied to a five year bond, a rise in interest rates from 2% to 3% will result in the price of a "used" five year bond dropping to $95. The reason the bond price only drops $5 (vs. $10 for the "used" ten year bond) is because buyers of the bond need only a 5% discount to offset the five years of receiving a 2% coupon, in-stead of 3% for the more recently issued "new" bonds.

These examples are extreme, as bonds rarely have such big overnight moves (2% to 3%). While rapid and significant decreases in bond prices do happen, they tend to play out over a number of days and weeks rather than overnight as we have illustrated. While rising interest rates are positive for prospective bond purchasers (as they receive higher rates), they are negative for existing bondholders due to bond price declines.

ITS ALL ABOUT THE FED (Again)

This quarter’s newsletter will focus exclusively on the US markets. The European and foreign markets have remained relatively stable. The key influence on the US markets are the recent statements by Federal Reserve Board Chairman Bernanke. His remarks, which are typically cryptic, leads to a positive “read” on the US economy.

The financial markets saw a marked increase in volatility during the recently completed fiscal quarter. The quarter began on a strong note with a strong upward trend. Mid-quarter comments from The Federal Reserve Board (the Fed) Chairman Bernanke concerning a sooner than expected end to the Fed’s easy money policies resulted in a sell off in all asset classes. Both stock and bond markets posted significant declines in a relatively short period of time as investors adjusted to the prospect of higher interest rates. The US stock market (as measured by the S&P 500) gained 2.4% during the quarter, while the Canadian Market (as measured by S&P/TSX 300) declined 4.9%. Exposure to resource and gold stocks weighed heavily on the Canadian market. The Canadian bond market declined 2.4% as yields on the benchmark five year bond increased from 1.2% to 1.8%.

Chairman Bernanke’s comments signalled conditions for a change in monetary policy. He reiterated that the Fed would not remove the excess liquidity previously injected into the financial system thus avoiding the risk of creating a tighter credit environment. The Fed has no interest in contracting credit conditions and potentially choking off the fragile economic recovery. The Fed would initially reduce bond purchases prior to commencing a money tightening policy. A 1% rise in interest rates from current historically low interest rates, would be unlikely to hinder economic growth.

Any discussion of an impending transition from an “easy money environment” of low interest rates to a more neutral policy will result in heightened investor anxiety. We believe that the Fed's exiting its ultra low interest rate policy should be viewed as positive. It reflects the anticipation by the Fed of a sustainable, improving US economy. Make no mistake about it, the US recovery is happening. US Auto sales growth remains healthy while housing activity is red hot. The excess supply of housing inventory of two years ago has reversed and there is now an under supply of homes for sale. The result is new home starts reaching post-recession highs and rising home prices. These positive trends have translated into improved employment data.

Over the last couple of years, we have witnessed low interest rates driving stock market gains. This is not sustainable over the long term. A strong, growing economy fuelling growing corporate earnings is needed to support rising stock prices over a longer period of time. The fundamental underpinnings are in place to enable a healthy stock market over the next couple of years. The stock market will not rise in a straight line without corrections. Volatile stock markets have typically been the norm, unlike the relatively calm markets of the last nine months. The stock market is in a choppy consolidation phase, which is likely to persist through the summer. Stock price fluctuations are currently reflecting the tug of war between an improving economy and the prospect of rising interest rates.

We believe that the Fed has the best view of the economy. When investors come around to the concept that rising interest rates is a positive read for economic and corporate outlooks, the stock market will resume its upward trajectory. With the recent bond market decline, we continue to believe that bonds are not a profitable near-term investment. Our concern remains that a stronger economy will result in higher interest rates, even if the majority of the near-term increase has already occurred. From a historical perspective, a move from 1.6% to 2.5% for the US ten year bonds is a big move. While 2.5% is still considered low, it does not provide enough of a cushion to reflect the risk of another big rate increase sometime over the next year.

Our bullish view of the stock market has been based on attractive stock valuations. After the sizable US stock market gains over the last year, it is increasingly difficult to call the market cheap. The US stock market currently trades at 16 times trailing earnings, which is more in line with its historical fair value. As such, we would characterize the stock market as reasonably valued. We prefer not to assume that valuations will rise in excess of fair value when analyzing future market trends. We maintain this conservative approach in order to more realistically determine asset allocations. Future stock price gains are likely to come from earnings growth than from increased valuations. Applying a 16 multiple on 2013 S&P 500 estimates ($108), yields a target of 1730 by the end of this year. This results in a potential 8% return by year end.

Since the recession of 2008-2009, investors have flocked to bonds due to their perceived safety and income orientation. Chart 1 highlights that only in the last year have investors begun to put money back into the stocks. Equity markets inflows have been inconsistent and still represent only a fraction of the money that has poured into bond funds over the last four years. As a significant amount of money remains sitting in cash accounts or bonds, stock market inflows could persist for a number of years. The great rotation from bonds into stocks has barely begun.

Chart 1: Cumulative Fund Flows

Source: BMO Capital Markets Strategy Group


We remain positive on the US stock market due to an improving economy, increasing corporate earnings and relatively low interest rates. We believe that the US stock market offers the best potential risk adjusted returns. Valuations rising to something closer to fair value have made individual stock selection increasingly important in generating positive returns.

DOW HITS RECORD ALL TIME HIGH, NO ONE CARES

Stock markets rocketed upward during the recently completed quarter with both the Dow Jones Industrial Average and the S&P 500 gaining in excess of 10% to close at record levels. The Canadian stock market as represented by the S&P / TSX index gained 2.5%.

This is one of the quietest, most unloved bull markets we have witnessed. The stock market is at record highs, but no one seems to care. Where prior market records were met with euphoric investors clamoring to invest in stocks, current highs are being met with apathy. Instead of headlines trumpeting investor optimism, we find investors and media pundits are questioning when the market "bubble" will burst. The concern is that the Fed Reserve Board (The Fed) will end the liquidity induced party. The Fed's low interest rate policy is pushing investors towards stocks, given few alternatives that provide attractive returns. After 4 years of steady outflows from stock funds, money is beginning to flow back. This movement towards stocks has the potential to continue for an extended period of time. We recognize that the Fed will have to raise interest rates at some point but we do not believe this will occur in the short-term. The impact on stocks from the inevitable rise in interest rates will be mitigated by both a strengthening economy and improved corporate outlooks.

The Fed's easy money policy is not the only factor driving stocks higher. Concerns weighing on markets in 2012 are beginning to recede. Despite last year's negativity influencing the markets, North American economies still managed to grow. Last year's fiscal crises will not materially impac the global economy going forward as sufficient progress has been made towards resolution.

The US economy appears to be gaining momentum aided by rising auto production and housing activity. We have spoken of the virtuous cycle of increasing activity in these sectors fueling employment growth which cycles back into further demand for these economically important sectors.

These trends should continue for the remainder of the year. The continuing positive data points from the purchasing managers index (an indicator of manufacturing strength) highlights the growth of the manufacturing sector. Buoyed by household wealth recovering to near all time highs, we are also seeing increasing levels of consumer confidence.

While the private sector of the US economy is relatively healthy and gaining strength, the public sector (government) is not as healthy. Federal and State Governments are facing growing deficits and are beginning to restrain, and in some cases, cut spending. As politicians in Washington were not able to reach a deficit reduction agreement, sequestration was implemented to force a reduction in government spending. Sequestration will constrain economic growth, but not enough to offset the positives or damage the recovery.

Stock prices tend to move in sync with earnings. Earnings continue to increase, achieving record levels. With a positive economic outlook, earnings growth should persist. Stock valuations are at a slight discount compared to historical levels based on the Price/Earnings ratio (Chart 1). Stock prices have the potential to increase due to both continued earnings growth and reasonable valuations.

Chart 1: Forward Price / Earnings

Source: JP Morgan

US stocks should continue to outperform Canadian stocks as they have heightened growth opportunities. The US economy appears to be accelerating, while the Canadian economy is slowing. Part of the slowdown is fueled by a pause in the already overheated real estate market. Canadian consumers are more in debt than US consumers were at the beginning of the financial crisis in 2008.

A significant portion of the Canadian stock market is exposed to commodity stocks. These companies benefited from the Chinese infrastructure boom which led to a commodity super cycle. With a pull back in Chinese investment spending, the commodity super cycle appears to have concluded. The next leg of the Chinese growth story is more likely to be led by consumer consumption (where a large number of US companies are well positioned) rather than investment and infrastructure spending.

As previously discussed, we are not overly excited about the bond market. So far this year, this has been the correct call as bonds have returned less than 1%. Assuming GDP growth in North America remains above 2%, bond holders will at best only make the current coupon of 2% - 3%. The risk to bond prices is ultimately to the downside as a strengthening US economy will eventually lead to higher interest rates.

The stock market has moved up almost in a straight line this year. This is obviously not the norm. Typically, there are corrections even as the stock market moves to higher levels. We cannot predict what will precipitate a correction, or even when it will occur, but we assume that the next downdraft will be a short term event. The stock market should continue to move up. We based this on: continuing low interest rates, an improving economy, increasing corporate earnings and undemanding stock valuations. We continue to believe that the US Stock market continues to offer the best potential risk adjusted returns for the remainder of 2013.

Q4 2012 Commentary

The US election and the fiscal cliff dominated financial headlines over the last three months of 2012. The bitter election campaign ended with the re-election of President Obama and preservation of the status quo in both the Senate and the House of Representatives. Despite daily fluctuations there was little overall market movement as most investors concluded that there was a strong incentive for politicians to reach a settlement on the fiscal cliff issue. The US stock market was down slightly during the quarter, while the Canadian stock market was up fractionally.

While US politicians debated government spending and taxes, sluggish US economic growth persisted. As the American politicians were successful in negotiating a deal, we remain guardedly optimistic for growth prospects in the US economy in 2013. Recent economic indicators provide a hint of a more robust economy in the near future. The first signal is a continuation of the trend toward increased auto sales. Home starts and prices also continued to rise up from historically depressed levels. While both auto and real estate activities do not have a direct influence on US stocks, they do impact the economy and employment numbers. As we have previously discussed, growth in auto sales and housing creates a virtuous cycle of increased employment feeding into increased consumer spending providing the seeds for further growth in housing, autos and the economy in general.

Although the fiscal cliff was averted, the negotiated deal primarily addressed taxes by making the “temporary tax cuts” permanent. Spending issues were not addressed in this version of the deal; however this is unlikely to influence the short-term economic prospects in 2013. Alternatively a near-term austerity program (that would cut spending this year) may negatively impact the fragile economic recovery currently taking place. The key to maintaining the economic recovery will be to put in place a long-term economic framework that will address the growth in spending and debt accumulation.

US companies are in better shape than they were 4 or 5 years ago. The average corporate balance sheet has either excess cash or has significantly reduced its debt loads. The past few years have seen companies streamlining their operations in order to yield more efficient operating structures that result in higher profit margins. The combination of wary investors and increasing corporate earnings will provide an opportunity to obtain stocks at attractive valuation levels (Chart 1). In light of the lifting of the most recent macro concerns (fiscal cliff), we see stock prices continuing to move upward in 2013. We believe it is increasingly unlikely that valuation will contract from current levels, and if anything, there exists the potential for valuations to rise as consumer confidence increases.

            Chart 1

         Source: BMO Capital, Factset, IBES, Compustat, Federal Reserve

A number of macro factors have impacted investor confidence and investing patterns. These concerns include, but are not limited to: The European debt crisis, the toxic US political environment, uncertainty over higher tax rates and continued deficit spending. When we look at these concerns we see: a stabilization of the European debt crisis, a recently completed US election and a stabilization of the tax rate for 98% of the US population. The US deficit stills needs to be addressed, but it can be dealt in the future. From an individual American perspective, more people are employed and the value of their homes and stock portfolios are rising. It is anticipated this will lead to increased confidence in their individual financial situations. These rising confidence levels could result in cash inflows into the stock market leading to stock valuations moving back  their historical levels. Individual investors remain skeptical that stocks are a better investment than bonds. Their focus remains on yield and income rather than capital appreciation. Any change in investor attitudes to risk would be positive for stocks.

While the Canadian economy has been one of the brighter spots in the global economy, there are some future challenges. Recent Canadian economic forecasts have been slightly downgraded. Canadian household debt to disposable income ratios (Chart 2) are currently above where US household debt to disposable
incomes ratios were in 2008. There are signs that the Canadian housing market is slowing down, in part related to a change in government mortgage regulations. The critical question will be whether this housing slowdown is just a temporary pause or the beginning of a slide in home prices with consequent negative implications for the economy.

              Chart 2: Canadian Debt to Disposable Income

              Source: Statistics Canada

A large portion of Canadian stock markets gains have been fueled by gains in commodity stocks. As emerging market economies experience slower growth rates and a de-emphasis of infrastructure spending, it is uncertain whether the super cycle for commodity stocks will continue. While we expect the Canadian market to achieve positive returns over the next few years, the gains will not of the same magnitude as experienced before the onset of the 2008 financial crisis. If anything, stock selection will be even more critical.

Bond yields remain near historic lows. The slow pedantic rate of economic growth suggests that bond yields will remain relatively stable, albeit with low rates of return. We believe that we are the point in the cycle where the 10 year rates are goo proxies for the expected long run rate of return. This is similar to what was achieved in 2012. We continue to appreciate the relative stability of bond investments in an environment of flat interest rates. We remain concerned that as interest rates rise, bond prices will decline. For the income portion of our portfolios we have been employing a strategy that provides superior yields
over 10 year bonds while at the same time hedging the risk of rising long term rates. Call or email me to find out more about this strategy.

As we look into 2013, stocks should continue to outperform bonds with US stocks outperforming stocks in other regions. While we prefer companies that pay decent dividends, we will not pay up for high dividend payers where there is little likelihood for dividend growth. We remain focused on companies where positive sustainable trends will contribute to continued sales and earnings growth.