Manager Views

When autumn leaves begin to fall

Mackenzie Chief North American Investment Strategist Norman Raschkowan discusses the European debt crisis, the economy and where the markets may be headed.

Financial markets experienced a turbulent summer as investor confidence was
undermined by ongoing debt problems in Europe, the debt debate in the US Congress
and evidence of slowing economic growth in Europe and North America. Indeed, to
focus on the 4.0% decline of the S&P/TSX composite over the July-August period, or
the 19.2% fall of European markets hardly does justice to the dramatic day-to-day
swings experienced during the period.

In the wake of such an unsettled season,
it seems appropriate to review economic prospects for 2012 and attempt to gain a
better perspective on uncertainties and opportunities that may be ahead of us.

Solid corporate earnings and reasonable valuations

The correction in equity markets occurred even as companies were reporting strong
results. In the US, second-quarter S&P 500 earnings were up 12.5% from the previous
year, and were forecast to grow 14% in 2011, to about $97.50. Companies reported
that order trends remained firm, with the obvious exception of businesses tied to the
housing sector. As companies may find it more difficult to achieve further savings
in operating margins, we believe earnings growth in 2012 will likely be less than the
12% consensus forecast. However, at a level of 1200, the S&P 500 is discounting a 12%
decline in earnings for 2012, based on its long-term median price-to-earnings multiple
of 14 times earnings.

In Canada, the situation is much the same. Earnings for the S&P/TSX are forecast to
rise 25% this year and a further 16% in 2012. Higher commodity prices are a major
contributor to this anticipated growth, but even the non-resource segment is expected
to post earnings growth of 15% in 2011 and 12% in 2012. Applying the long-term median
price-to-earnings multiple of 15.0 times earnings for the TSX suggests that investors
expect earnings to slip 2% in 2012.

A slip back to recession in 2012?

Weakness in equity markets and a rally in government bonds reflects mounting fears
that the global economy may slip back into recession in 2012. These concerns have been
fed by revised economic data in the US that indicate the 2008-2009 recession ran much
deeper than previously believed, and that the economy has not yet recovered to prerecession
levels of output.

In addition, the US economy grew at only a 1.0% annual rate while Canada’s economy stalled in the second quarter. Manufacturing surveys for the US, Europe and China also softened. However, these slowdowns could also be attributed to global economic disruptions from the earthquake and tsunami that knocked Japan into recession. More recent reports that Japan’s industrial production jumped 6.2% in June, and a further 0.6% in July, suggest that the world’s third-largest economy may actually be poised to once again contribute to global growth.

Certainly, a more subdued rate of growth helps explain why US unemployment levels have remained high. And we expect the employment picture to remain challenging in the coming months, given the layoffs announced as companies reacted to the recent economic slowdown.
However, it is worth noting that employment growth remains positive and that incomes continue to grow at a 2.3% rate, supporting consumer spending. Whether we are to face an extended period of sluggish growth of 1% to 2% or a return to recession may ultimately be determined by consumer and business confidence. 

As in 2008, capital markets are being roiled by credit concerns. The focus this time around is on sovereign debt and government deficits rather than on residential mortgages. Unfortunately, the political theatre associated with Greece’s second bailout and the US debt limit debate has only served to erode consumer, business and investor confidence. Ironically, there are solutions at hand – the only thing lacking may be the political will to make tough decisions.

Europe: Sorting out a sovereign debt dilemma

The second Greek debt bailout package lacks credibility, as suggested by two-year Greek
bonds that yield over 60%. This indicates that capital markets still expect a default, since the deal would still leave Greece with a debt-to-GDP ratio of about 150%. In addition, large losses reported by the Royal Bank of Scotland and two French banks, BNP and Société Générale, on their Greek debt positions have highlighted the vulnerability of the European banking system to the sovereign debt crisis.

The failure of European leaders to bolster the European Central Bank’s (ECB) ability
to provide emergency support beyond its present 440 billion euros has increased
concern that the ECB lacks the resources to prevent contagion. A heavy calendar
of sovereign debt maturities in 2012 thus increases probability that European consumers and businesses may find access to credit constrained, which could trigger a recession in Europe.

It is encouraging that the new head of the International Monetary Fund  (IMF), Christine Lagarde, has advised that additional capital should be injected into major European banks. Such a European program, similar to the US Troubled Asset Relief Program (TARP), would allow Greece to write down its debt by 50% and address fears of contagion. Unfortunately, politics will likely prevent timely resolution of this problem – Spain faces a general election in November, and France has elections in April and June 2012.

The US budget challenge

The heated debate in the US Congress over raising the federal debt ceiling illustrates the challenges faced in getting US budget deficits under control. The debate confirmed that future economic growth will
be tempered by some combination of tax increases or spending cuts. In fact, politicians do have a number of options open to them that would not necessarily have to undermine the present economic recovery:

• Entitlement programs (such as Medicare, Medicaid and Social Security) need to be addressed to achieve long-term progress in reducing the deficit. The US could introduce claw-backs, as we have done in Canada, or could opt to postpone entitlements for future beneficiaries to age 65.
• Excise taxes on gasoline, alcohol or tobacco could be increased, which would raise taxes and promote social welfare.
• A national value-added tax could be introduced – the US is one of the few developed nations without one.

Unfortunately, as 2012 is an election year, it is unlikely that a long-term solution will be forthcoming. In the short term, the agreement to enact $2.5 trillion of spending cuts over the next decade, combined with
tax increases already scheduled for 2012, suggests that fiscal policy will be a drag on growth. However, unlike the situation in Europe, this political paralysis may not portend a recession in the US, where bank credit is still readily available to corporations and consumers.

Looking ahead – modest growth, modest returns, heightened volatility

We expect to see continued expansion of the global economy in 2012, led by China and other major emerging economies like Brazil, India and Indonesia. Growth in North America will likely be more subdued, at a rate of 1% to 2%, while Europe may fall into recession. This modest growth will likely translate into only a slow improvement in unemployment, but it is likely to also limit the risk of inflation.

Unfortunately, such modest growth leaves little margin for error. In the context of ongoing sovereign debt concerns, this suggests that capital markets may remain unusually volatile. It is impossible to know whether equity markets have bottomed;  certainly, seasonal factors suggest equity markets will remain vulnerable through the fall as earnings forecasts for 2012 are likely to be revised downwards. However, equity markets seem fundamentally attractive at current levels. Corporate balance sheets remain solid, with low debt levels and cash levels now estimated at over $1.3 trillion for the S&P 500 companies available to fund corporate acquisitions, share repurchases and dividend increases. The dividend yield of the S&P/TSX composite now exceeds the 10-year Canada bond yields which, when considered together with the long term earnings growth of 7.7% per year and in the context of reasonable valuations, makes the long-term case for equities compelling.

Mackenzie fund families take their positions

Thus, we continue to favour equities within our balanced portfolios versus bonds, and are holding above-average cash reserves to take advantage of opportunities presented by the increased market volatility.

Within our fixed-income funds, we continue to prefer corporate bonds due to their attractive yields and the continuing improvement in corporate credit quality, and the Mackenzie Sentinel portfolios are positioned accordingly. Within equity portfolios, the shares of quality, large-cap companies with rising dividends and earnings are favoured by our Ivy, Maxxum and Universal teams as they should fare well in this unsettled
environment and are attractively valued.

Value stocks, the focus of the Mackenzie Saxon team, should benefit from rising multiples over time as investor confidence returns..

The Mackenzie Cundill team will likely enjoy an increase in deep value opportunities thanks to the wider fluctuations in business conditions and investor sentiment.

After their recent correction, the valuations of resource shares appear compelling given the prospects for future commodity demand growth. Investors who have invested in gold as insurance against market volatility might want to consider rebalancing their holdings and “cashing in” on this insurance after the recent surge in bullion prices; in the long run, bullion prices will likely continue to be driven by sentiment regarding the US dollar. We expect commodity prices to fluctuate within an upward-sloping band, strengthening our conviction that resource funds retain an important role within well diversified
portfolios