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
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
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.
