Manager Views

A troubling backdrop, but the markets are buoyant

Mackenzie Chief North American Investment Strategist Norman Raschkowan
on where we're headed in 2011

Canadian investors have seen share prices rise steadily since mid-August 2010. Markets have remained sensitive to “headline risk” which, ironically, has featured the same protagonists as before the summer: easing by the US Federal Reserve, a sovereign debt crisis in Europe and concerns about Chinese authorities tightening monetary policy. While the dominance of macro factors has presented investors with a sense of déjà vu, the impact on markets this time around has been more transitory than in the summer, and has failed to disrupt the generally buoyant tone to equity markets associated with the waning of concerns of a double-dip recession.

The economy: Mounting evidence of a sustained recovery

Concerns that the US economy would fall back into recession have been quelled in the wake of favourable data released over the past three months. The US economy grew at a steady 2.0% rate in the third quarter, and the November Institute of Supply Management (ISM) survey index at 56.6 shows the positive growth trend remains intact. Of greater significance, however, is the rebound in Consumer Confidence to 54.1 in November, a five-month high, which is confirmed by the solid 2.6% growth in consumer spending. Data related to the housing sector has also turned from “dire” to “mixed”, while housing starts remain moribund at a 519,000 annual rate (one quarter their level at the peak of the credit bubble), mortgage applications for homes have recovered to a six-month high. Equity investors have been further cheered by strong earnings reported for the third quarter, with 76% of S&P 500 companies exceeding consensus estimates, and profit margins for non-financial companies back to their 2007 peak levels.

Europe: To have and have not

The collapse of Ireland’s banking system focused investor attention once again on European sovereign debt. While the event was not a total surprise to investors, as evidenced by the steady upward drift in credit spreads during the summer months, it came only four months after 84 of 91European banks (including all the Irish banks) passed their highly publicized stress test.

Ireland’s need for financial support raised concerns about the adequacy of the €750bn support package put in place by the European Central Bank and the International Monetary Fund (IMF) when Greece faced default in May. The resulting contagion quickly drove yields higher in Portugal and Spain. In contrast to May, investors differentiated between countries as it became clear that the economic conditions within the “have” countries remained solid, while the fallout of the credit crisis was weakening the “have not” economies.

This was evidenced by the European ISM data; while the overall index was a solid 55.3, it was 58.1 for Germany and 58.0 for the UK, but only 52.0 for Italy, 50.0 for Spain and 43.9 for Greece.

Speculation surrounding the euro grows
The renewed stresses within the Eurozone have given rise to renewed speculation that the euro itself may be abandoned by Germany. However, as we highlighted in the spring, the German economy has been a key beneficiary of the weak euro, and the €550bn exposure of German banks to the sovereign debt of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) should provide sufficient incentive to work towards a solution. The support program, once established, will likely stay in place for some time since European banks have about €2 trillion of debt maturing to be refinanced through 2013.

The US Federal Reserve floats QE 2
A second round of quantitative easing by the US Federal Reserve, dubbed “QE 2”, was launched in the fall. This undertaking to buy US $600bn of US Treasury bonds over an eight-month period was intended to flatten the yield curve by bringing down longer-term bond yields, and reaffirmed for equity investors the Federal Reserve’s commitment to promoting a sustained economic rebound.

 In Canada, the S&P/TSX Composite index rallied 9.4% in the September-November period, with small-cap stocks surging 17.3%, the materials sector rising 11.8% and energy issues up 10.8%. The commodity-heavy Australian market also reacted strongly, posting a 9.2% ($Cdn) gain. The bond market’s initial response to QE 2 was favourable, with 10-year US Treasury bond yields falling almost 50 basis points in anticipation of its launch. However, yields reversed course in early October and the early gains were lost.

The back-up in rates reflected the improving economic outlook, and the associated evidence of mounting inflation.  Indeed, of the 43 countries tracked regularly by The Economist, only Japan has a negative CPI over the past 12 months. A year ago, 15 countries were experiencing deflationary pressures.

The Canadian bond market thus provided investors with a negative return in November, and for the last three months. Corporate bonds fared slightly better than government issues, thanks to their shorter average term and a narrowing of credit spreads. The difficulties in Europe are prompting a “flight-to-safety,” with increased demand for US and Canadian government bonds that should help the bond market stabilize in the near term.

What’s ahead?
As we headed into the home stretch of 2010, investors focused on events in Europe, and their implications for growth and capital markets. However, it is likely that events in China and other emerging economies will be of far greater consequence to Canadian financial market returns in 2011.

China’s economic growth remains strong, with its latest ISM reading at 55.2 and GDP growth of 9% forecast for 2011. However, authorities are also facing accelerating inflation, with consumer prices up 4.4% over the past year, and food prices up 10.1%. Brazil, where inflation is running at a 5.2% rate, has seen its ISM reading fall below 50.0. India is witnessing consumer price inflation of 10.1%, and its industrial production growth has slowed to a 4.4% annual rate. The extent to which efforts to subdue inflation pressures in these, and other, emerging economies dampen economic growth rates is of particular importance to the outlook for commodity prices, and thus the Canadian equity market in the coming year.

Commodities could trade in a narrow band
The most likely outcome is that we will see commodity prices fluctuate within an upward sloping band. The overall outlook for North American equity markets appears robust, buoyed by continued improvement in corporate profits, and an anticipated increase in money flows into equities. We expect it likely for interest rates to resume their upward course as the economy continues to grow. As investors who sought safety in government bonds start to see negative returns, they may seek refuge in income alternatives that are not penalized by growth, such as corporate bonds and dividend stocks.

Corporate bonds should continue to do relatively well even as rates start to rise, thanks to their attractive yields, and the Sentinel portfolios are positioned accordingly. This environment should also benefit the shares of quality businesses that pay dividends, like those favoured by the Maxxum team; dividend-paying stocks have actually underperformed the market this year, but the divergent market performance in Europe suggests that “quality” may once more be coming into favour. In a moderate growth economic environment, investors should begin to apply premium valuations to quality companies with competitive advantages that yield superior revenue and earnings growth, the focus of our Ivy and Universal teams. Finally, Canadian investors will likely be well served by foreign diversification given the superior growth from emerging economies, and the values presented by restructuring businesses in developed nations: Cundill provides you a window on both.