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Don't Fight The Fed

Speculation regarding the US Federal Reserve Board's Open Market Committee (The Fed) quantitative easing program was the dominant theme impacting financial market over last three months. The Fed ultimately signaled that until the unemployment rate was reduced to more reasonable levels they would continue to be accommodative. This accommodative policy combined with the belief in the old adage of "Don't fight the Fed" fueled stock market gains. In a similar vein, the European Central Bank (ECB) President also provided soothing commentary to the markets by stating that he would do everything within his power to prevent further deterioration in Europe. The probability of any of the member countries exiting the Euro decreases with this reassurance. In a bid to reignite a sluggish economy, The Bank of China also began a new round of accommodative monetary policies. With the availability of “easy money”, a number of investors were caught chasing a rising stock market. In light of the current round of global synchronized easing, perhaps the new mantra for investors should be "Don't fight the Feds".

With mediocre economic growth, bond yields remain near historic lows. The slow pedantic rate of economic growth suggests that bond yields will remain relatively stable, with low rates of return.

The official US government data continues to show lackluster US GDP growth, even though there are pockets of strength. Both US auto sales and retail sales data came in better than expected. In our April quarterly commentary, we discussed our belief that housing was close to a bottom. We have increased confidence that not only has housing seen the bottom, but we are now starting to see resurgence in housing and remodeling activity. While we still do not want to make any sort of call on a significant increase in housing prices, rising housing activity is positive for both future employment growth and US GDP growth. The US Consumer Confidence Index surpassed expectations in September producing the best data point since the beginning of the recession.

A wise market pundit once told me that the better we can define the problem, the closer we are to the bottom. There is a high level of awareness of these fiscal problems across all segments of the population. Issues such as the Euro crisis, the slowing Chinese economy, the US political gridlock and the potential fiscal cliff in the US are discussed over dinner in many homes. With everyone able to accurately describe in exacting detail these potential risks, one must conclude that these concerns are largely reflected in current stock valuations and prices.

Investors are tired of the never ending discussions of an impending recession, the financial crisis, and housing troubles. They would like to move on. Europe has not blown up, and investors are beginning to believe that it is unlikely to happen. The big question plaguing investors has morphed from “how will we handle the crash” to “what would market valuations be if there is no European crisis ?“ If we believe that the crisis can be contained, and the three most important central banks in the world continue to ease, then we can make a case for valuations (and stocks) being higher than their current position.

We meet a lot of Canadian investors who want to avoid US based investments. These investors feel more secure allocating their entire stock portfolio to Canadian equities. Their assumption is that as long as the Canadian economy continues to chug along, they are insulated from what is occurring outside our borders. We believe that this could not be further from the truth.

Canadian Commodity producers (metals, energy and agriculture related companies) sell the majority of their products to other global companies. Sales prices (typically denominated in US dollars) are determined by global forces that are largely influenced by the American, European and Chinese economies. Owning primarily Canadian stocks will not insulate investors from events outside our borders. Furthermore, they are at increased risk due to a lack diversification within their portfolios. Most Canadian companies in the same sector are typically correlated to the same macro factors. An example of this is the energy and gold producers' fortunes are tied to the price for oil, natural gas or gold.

The advantage of investing in US stocks is the ability for true diversification. The Canadian market is based primarily on financials and resource stocks whereas the US market has a both a depth and breadth both within and between the various sectors. The Canadian market has a relative paucity of choices, thus narrowing the possible candidates that could be considered for an individual’s stock portfolio.

Concerns in regards to a weak US dollar negatively impacting US stocks may in fact represent an advantage. US companies that are international players may benefit competitively from a devalued US dollar due to their US dollar based costs falling lower than their foreign competitors. To complete this cycle, the foreign income may translate back into US dollars at a higher rate thus providing a further lift to earnings.

We continue to recommend a balanced portfolio, with a bias towards conservative stocks. Equities are likely to be the primary financial beneficiary of the current global synchronized easing. We do own bonds, but due to their low yields, we are relatively underweight this sector. In the fixed income sector, our preference is for high grade corporate bonds. On the stock side, we are investing in high quality, dividend paying companies that have the continued ability to grow both earnings and dividends in the current sluggish economic environment. 

The US Deficit: How and when does the US get out of this mess?

The US Deficit was greater than $1,000,000,000,000 in each of the last 4 years.  I have written the number in its numerical form, and not in its abbreviated form ($1 Trillion) to highlight how large a number that is.  The US government debt has increased from $9 Trillion to over $14 trillion in 4 short years, currently representing 70% of US GDP.   Without a change to taxation or spending, the debt will continue to rise.  When the debt/GDP ratio gets to unsustainable levels, interest rates will begin to rise.

The question that needs answering is how did we get here? The first side of the deficit equation is about taxes. Historically, US spending have averaged 20% of GDP while taxes have run at the 18% level.  This 2% annual deficit was considered sustainable by a majority of economists.  During President Obama's term, US tax revenues have averaged 16% of GDP.  This is related to a combination of the recession and a gradual decline in the number of US citizens paying taxes.  Current figures estimate only 50% of the US population pays taxes as compared to 66% 10 years ago. (See Chart below).                                                                                                                                                           

Source: IRS, Heritage Foundation

The other side of the deficit equation is about spending, which has averaged 25% of GDP over the last 4 years.  This is related to the combination of a weak economy and an increase in social programs and regulations. The latter suggests that a portion of the spending increase is structural rather than cyclical.

From a simplistic perspective, we need to see a decrease in spending and an increase in tax revenues, in order to drop from the current 9% gap to the historical 2% gap. Republicans and Democrats have not come to terms on how to achieve a more balanced budget.  The philosophical questions that the 2 political parties are debating is not should we reduce the deficit, but how should we close the gap between spending and revenues?  The democrats on the far left would like to close the gap entirely through increased taxes while the right wing republicans would like it to do it entirely through spending cuts.  The most practical method of bridging the gap is via a combination of spending cuts and increased revenues so that they move closer to their long term averages.

While both parties recognize what is necessary to reach a negotiated agreement, neither side wants to overtly yield in an election year.  Until we have one party firmly in control of the White , the Senate and the Congress or increased willingness to compromise between the parties, the risk remains of continued inaction.

Implications of the US Election

During the second quarter, Mitt Romney won enough delegates to lock up the Republican nomination for the US presidency, effectively signalling the start of the US presidential race. As we write this commentary, President Obama has a slight lead, but the election is still too close to call.  We do not profess to be smart enough to pick the winner, but we can discuss the implications of a democrat or republican victory.

If President Obama wins another four years in the White House, we can expect more of the same; a continued push for higher taxes, increased spending for social programs and increased regulatory oversight.  The success of his agenda becoming law will depend on the makeup of both the house and the senate.  We presume that if President Obama retains the Senate, he would still have to deal with a Republican majority in the House of Representatives.  This would lead to continued gridlock with little progress being made on deficit reduction.  Corporate spending would also be constrained due to the uncertainty related to future tax levels and regulations.  Which party controls the Senate remains a tossup, but it is unlikely significantly impact the balance of power in Washington.  If current spending patterns continue apace, further rating downgrades of US debt should be expected. The first rating cut last summer had minimal impact, but a second or third rating cut has the potential to damage the US economy.

On the other hand, a victory for Mr. Romney and his platform would be looked on more favourably by US investors.  Mr. Romney is talking about scaling back US government spending to levels that are closer to the historical norm of the last 50 years (see box on page 3).  While we are not certain that there would be a significant reduction in taxes, we are confident that there would be more certainty related to the level of taxation and regulations faced by companies.  Mr. Romney understands that US spending is pushing the cumulative debt load of the country to a level that is ultimately unsustainable.   Hard decisions need to be made now or the country will be faced with even more difficult choices in the future, akin to what Europe is currently facing.  If Mr. Romney is leading in the polls heading into the fall, stock markets are anticipated to react favourably to the perception of a changing of the guard.  If Mr. Romney wins the fall presidential election, supported by Republican majorities in the House and the Senate, he would be able to fulfill his promises.

Second Quarter Market Commentary

After six months of uninterrupted gains, the global stock markets declined during the last quarter.  The US stock market as measured by the S&P 500 lost 3.3%, which translates into a 1.3% decline in Canadian dollars. The resource heavy Canadian stock market was further impacted by declining energy and metal prices resulting in a decline of 6.4%.

The European debt crisis is dampening global economic growth.  The US Economy has slowed to 2% GDP growth during the last quarter.  Emerging market growth has also been negatively affected by the European debt crisis.  Global economic growth forecasts for 2012 have recently been lowered to 3.0% - 3.5% from a forecast of 4.0% six months ago.  For the moment, 2013 global economic growth is projected to reach 4%.

It is not surprising with all this negative news related to the European debt crisis and global growth, bonds returned 2.3% during the last quarter.  The yields for 10 year US government bonds declined to a generational low of 1.5%.  These historically low bond yields reinforce our belief that stocks will outperform bonds in the long term.

Conditions are ripe for the commencement of a long multiyear bull market in stocks.  Widespread negative investor sentiment, anxiety about the future and low valuations provide seeds for the next bull market. Potential catalysts to ignite investor enthusiasm include sustained global growth and evidence of firm plans to deal with European and American deficits. While we continue to favor stock over bonds, we recognize that growth and debt uncertainties are unlikely to disappear overnight.  The foundation for the next bull market remains in place, but fears related to these concerns will cap the near term upside, at least until we get clarity on the US presidential election.

European and American politicians understand the need for fiscal restraint and debt reduction. The European countries remain hampered by their inability to sell austerity measures to the voters.  US politicians are fighting a philosophical battle on the measures needed to reduce the deficit.  Both political parties understand the necessity of moving towards a more balanced budget, but differ on the timeframe and the mechanisms required (increased taxes vs. reduced spending) to achieve deficit reduction.

Typically when credit ratings decline, bond yields will increase as bond prices decline. In a world where sovereign debt ratings are under pressure, the continued decline in long term US government bond yields stands out as an anomaly.   On the surface this appears illogical but with the persisting European debt crisis, the US is currently perceived as the “best house in a bad neighborhood”.  The US government has continued to rack up record deficits resulting in increased risk of a credit rating downgrade. US cumulative debt as a percentage of GDP is approaching levels where bond prices decline due to the need for higher yields.  The US needs to get its fiscal house in order to prevent a fiscal crisis similar to that in Europe.

The US Government is collecting taxes at the relatively low rate of 15% of US GDP.  This compares to around 35% in Canada and Japan and 40-45% for most European countries.  This leaves some room to raise American taxes whereas the European economies have minimal flexibility in their ability to further raise taxes. 

Despite recent “doom and gloom” there are some positive signs.  There is no immediate recession call (except in select European countries). Stocks remain attractively valued.  Recent evidence  further supports our thesis that the US housing market is in a bottoming phase.  As we have previously discussed, any growth in housing activity would be positive for the economy and for employment.

We continue to recommend a balanced portfolio, weighted toward conservative stocks. Within our stocks we have taken a more defensive posture to compensate for the current lacklustre global growth environment.  Our preference is for high quality, dividend paying companies that have the ability to grow earnings in the current sluggish economic environment.

Bull Market?

The headlines have finally turned in a positive direction. European stability has been enhanced by the restructuring of the Greek debt and the promise of additional short-term financing. Spain and Italy have taken steps to improve their financial situation leading to lower yields on their government debt.  Although Europe is in a mild recession, the US economy is experiencing growth. Employment, industrial production and housing data are all moving in the right direction.  The combination of the resolving Greek debt crisis and US economic growth has led to cautious optimism on the part of investors. In turn, this has resulted in a strong first quarter with the US market appreciating 12% in US dollars and 9.7% in Canadian dollars.

The Canadian stock market also experienced growth, albeit only 3.7%. This is in part related to fiscal interdependence on Chinese economic growth, which declined to 8%. Canadian stocks which are exposed to the commodity sector were impacted by a concern about a progressive decline in the Chinese economy. We continue to believe that Chinese economic growth of 8% will be the norm for the next few years, with a shift away from infrastructure spending to consumer led spending growth. Financial stock strength related to an easing in the European debt crisis and strengthening of the US economy provided some support for the Canadian stock market.

As the US economy accelerated, bond prices experienced a small decline. Bond yields compensated for the price declines, leading to flat total returns. Bonds remain a relatively safe investment, however in light of the current low interest rate environment and the strengthening US economy, we would not be aggressively investing in bonds.

Our last quarterly commentary cautioned that investors may find themselves in the position of chasing a rising market. The last 5 years have seen investors moving into more conservative assets (such as cash or bonds) leaving themselves underweighted in equities. Despite the recent run in stock prices, market valuations remain relatively inexpensive.  We believe the current upswing is likely to continue. This is supported by a reduction in the severity of the global financial crisis, slower but continued growth at 8%  for the world’s second largest economy (China) and a strengthening US economy.

                     S&P 500 Multiple is Still Below Long Term Average

The S&P 500 has increased by over 10% in each of the last two quarters.  While the media remains skeptical,  we believe that we are in the early stages of a bull market for stocks.  Most bull markets tend to climb a wall of worry and there is a multitude of issues for investors to fret about.

It has been a long time since investors experienced a bull market.  The new crop of relatively inexperienced investors may not recognize its return. There has been a notable decrease in both market and individual stock volatility since the beginning of the quarter. The only tell tale bull market characteristic currently missing is a full blown public euphoria.  The longer this bull market remains in stealth mode, the longer the current uptrend can quietly progress.  While we currently do not see anything to derail the continued upward long term movement of the market, we do recognize that there will be corrections.  As the market has largely been a one way trade up over the last 6 months, it would not surprise us if there was a pull back in the short-term.  As short and rapid corrections are all part of an uptrend, a short market decline will not change our preference for stocks over bonds for 2012.

US Housing Market

American home values have declined by $6.5 trillion since 2008. The housing market remains depressed despite the current economic recovery.

New home starts and increased renovation activity typically provides the biggest boost to job creation after a recession. The almost non-existent housing recovery (chart 1) is atypical for this stage of an economic recovery. This has resulted in a lower level of job creation and a subpar economic recovery.

Chart 1: New Home Starts

There are signs that after 4 years of historically low levels of housing activity, we may be nearing a bottom. Recent delinquency reports (households delinquent on their mortgage payments) have fallen to their lowest levels since 2008, potentially signalling that the housing market is stabilizing. The rate of home price declines is showing signs of moderation, providing another hopeful sign. During January, half of the cities surveyed showed flat or sequential prices increases on a seasonally adjusted basis. Sales of previously owned homes (chart 2) rose to their highest levels in almost two years in January. This activity was sustained through February.

                                  Chart 2: Existing Home Sales

Homes listed for sale (Grey line in Chart 3) is also declining as is the inventory of unsold homes (blue line in Chart 3) which fell to a 5 year low at around six months supply of existing homes for sale. A reading of 6 months or less is generally considered an indication of a healthy housing market where there is a balance between supply and demand.

                   Chart 3: Inventory of Existing US Homes

It is increasingly likely that a bottom for both home price and housing activity will be achieved sometime in 2012. This does not necessarily mean that home prices will materially appreciate for a number of years or provide near term relief for the millions of home owners who owe more on their mortgage than their house is worth. With the enormous backlog of bank foreclosures (2 million loans), there is still an ample supply of homes waiting to come to market that will limit a rebound in prices this year. Even though we are discussing national trends, real estate remains a local market. While home prices will bottom nationally sometime in 2012, prices will vary locally with the bottom occurring at different times in different markets.