The purpose of this quarterly commentary will be the same as the past: to communicate with you about our thoughts on the markets, provide some snap-shots of market metrics, and provide an overview of topical issues; however, it will also be married with some aspects of our recently initiated monthly commentary, in order to provide you with a succinct update of our views on the market, without the need for two separate communications. I hope you enjoy this information, and that it allows you to better understand what we see going on in the market place.
“If you’re prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won’t get bored.” – Peter Lynch
Following a period of multiple years in which markets had not declined by over 10%, the oft-forecasted correction finally manifested itself across most major markets; starting in approximately the middle of September, before markets began to rebound by the start of the fourth quarter in mid-October.
The reason why this correction was forecasted on such a consistent basis was the stark contrast between economic activity levels and stock market performance. For example, since the 2009 market bottom, the S&P 500 has more than tripled; meanwhile, economic growth, as measured by Gross Domestic Profit, has been anemic, and the jobs lost during the recession have only recently been regained. The difficult part, of course, was forecasting at which point the market would check back. Although moderately over-valued equities were not enough to trigger a correction by themselves, it would seem that mounting geo-political tensions, in tandem with lagging international economic data and the imminent erasure of Quantitative Easing, were enough to spook investors.
Despite a strong start to the quarter, the market return data, located below, exemplifies the effect that this correction had on quarterly returns. Of particular note, is the damage dealt to the TSX Venture and Russell 2000 indices; these particular indices house listings for smaller companies, which are typically the first stocks to be sold in a negative sentiment environment. By many, this correction was described as being a key characteristic of a healthy market; the overall mindset being that a market that never goes down can be much more terrifying than one that goes in both directions. Although they have remained above their respective long-term averages, most valuation metrics were actually deflated to slightly more realistic levels. See below for a chart detailing a variety of major metrics at quarter end.
For the first half of the year, the primary geopolitical focus was centered around the Israel-Gaza conflict and the Ukraine crisis; during the third quarter, as well as moving forward, although these issues persist, there have been a few new issues dominate the headlines: the advance of the Islamic State, or ISIS, and the largest outbreak of Ebola in history, which is currently devastating West African nations. Although the actual economic implications of these events are debatable, the more upheaval in the global community, the more erratic the financial markets tend to be.
The thematic that overwhelmingly dominated the headlines for North American markets during the third quarter was undoubtedly that of falling oil prices. The price per barrel for West Texas Intermediate (WTI) oil, which is the bench-mark used for American oil prices, dropped from over $100 at the beginning of the quarter, to approximately $90 by the end of it. Following the end of the third quarter, oil has continued its downward descent, and currently sits in the low $80 range. This downward trend in oil prices was exacerbated in Canada, as the Canadian oil benchmark, known as Western Canadian Select (WCS), dropped from the low-$80 range to the low-$70 range. Canadian oil typically fetches lower prices in the open market than its American counter-parts due to its increased refining and transportation needs. Additionally, due to the explosion of fracking technology and therefore American oil production, our largest trading partner has also significantly reduced their Canadian oil demand, which has further damaged our Canadian oil prices.
This downward trend in global oil prices, to some, has been puzzling, specifically due to the amount of turmoil currently existing in the Middle East. Typically, an average investor tends to associate Middle Eastern conflict with a spike in oil prices, but the recent trend has been quite the opposite. The logic is simple: the countries in the Middle East account for a large portion of global oil supply, conflict reduces their capacity and ability to export oil, therefore global supply should drop and oil prices should rise. Why, then, are prices falling in such a drastic fashion?
For one, despite conflict in the Middle East, supply out of the Organization of the Petroleum Exporting Countries, or OPEC, has actually increased substantially. Although supply has been slightly pared back out of member countries such as Iraq, who is currently undergoing an assault by the Islamic State, the deficit has been more than compensated by improving production in Libya, as well as a ramping up of production in Saudi Arabia. This has resulted in OPEC reaching a level of supply which has not been obtained since November 2012. The chart below shows the monthly export data for OPEC, together with a transposed chart of recent Brent oil price activity. Brent oil is used as a benchmark for European-produced oil.
Countries such as Saudia Arabia, due to their large oil inventories and cheap extraction cost, have stated that they are comfortable with the current ~$80 price of oil, and would be fine with oil prices trending downwards to the $70 range. Other countries, OPEC and non-OPEC members alike, are not so supportive of the prospect of lower oil prices, namely Iran, Russia, and even the United States. A large portion of the American’s supply comes from fracking technology, which is typically more expensive to utilize than regular operations, and therefore requires higher oil prices. There has been speculation that Saudi Arabia’s increase in production is a direct attempt to fight against American competitiveness in the global market, but this theory lacks concrete evidence.
In conjunction with increasing supply, another reason for lower oil prices seems to be slowing global growth. The U.S. economy seems to be the lone bright spot in the global economy. A primary example of international economic weakness is the Eurozone, which will be detailed below.
The landscape of the European economic situation during the third quarter saw a swing of the proverbial pendulum back towards worrisome territory.
The Eurozone, which at one point seemed to be firmly recovering from the 2008 Greek debt crisis, has shown its cracks, and continued to exhibit weak economic data over the third quarter of 2014. GDP growth for the entire region was flat in month-over-month terms, according to the most recent report, the total unemployment rate remains at 11.5%, and Italy recently announced negative GDP growth for the second quarter of the year, which means the country has returned to recession, joining Cyprus, Finland and Greece. Germany, who has previously been the strongest member of the area, even reported negative growth during the second quarter, and early estimates believe they have the possibility of entering a technical recession upon the announcement of third quarter data.
Many analysts have noted that this recent economic weakness is a sign of the severe impact of the ongoing conflict between Russia and the West, and more particularly, their resulting economic sanctions.
Inflation data has also remained weak, as the Consumer Price Index for the European Union was reportedly up only 0.3% in September. The absence of inflation – as well as the fear of deflation – has caused the European Central Bank to further trim their key interest rate to 0.05%, as well as outline additional plans for stimulus. This procedure is hoped to encourage European citizens to spend, and banks to lend, which would stimulate the economy. This initiative, albeit on a smaller scale, is similar to the recently-extinguished Quantitative easing program in the U.S.
However, despite accommodative policy, Europeans are remaining tepid with their funds, and are heavily refraining from investing in an equity market which caused serious damage to their wealth in recent history. As a result, many funds are either transferring out of
euro-denominated investments, and into U.S. dollar investments, or into government debt. Evidence of the former can be seen by the recent drastic devaluation of the euro in relation to the dollar, whereas evidence of the latter can be seen in the chart below.
This chart shows 10-year yield levels for several international governments. In this chart, it can be seen that a 10-year U.S. government bond currently pays more than a comparable bond issued by France. Although not pictured, Italian yields, despite recently re-entering recession are also yielding below American levels. Put simply, European investors are not confident enough to spend money, and are attempting to achieve yield by whatever means necessary.
As is usually the case, international attention outside of North America and Europe was firmly placed upon China during the third quarter. Due to its size and continually growing economic clout, China remains an integral part of the global economy, and has recently been the subject a high level of uncertainty. Persistent questions surrounding the validity of the country’s economic data, strict government rules and restrictions, an over-active real estate market, and swelling municipal debt levels have caused the Chinese growth story to remain an enigma, with data maintaining a certain level of ambiguity until it has actually come to fruition; this situation creates an inherent level of volatility in many aspects of the global economy, the most specific area being commodities, due to the fact that China is the main consumer of many of them.
To deal with the aforementioned issues, the Chinese government has initiated a multi-pronged program, which involves a variety of policy and regulatory changes, an increase to government stimulus aimed at developing affordable housing, as well as a tighter monetary policy which is aimed at taming municipal debt levels. At face value, these various initiatives tend to be seen as contradictory, which is a main reason many market participants have voiced concern over China’s ability to meet its growth target of 7.5% GDP growth. Increased regulation is typically seen as contractionary, as is tighter monetary policy, whereas increased government stimulus is seen as expansionary. In order to meet its growth target, the Chinese government will need to be able to execute their plan extremely delicately.
The graph below is effective in illustrating the importance of the Chinese economy, particularly when it comes to commodity markets.
This chart shows the percentage of the market attributed to China, with respect to both imports and consumption, for a variety of major commodities. The axis on the left represents the percentage of total global figures. From this, we can easily extrapolate not only the importance of China to the overall economy, but also the rippling effects that uncertainty surrounding the country will cause. This ambiguity, as well as relatively weak import trade data, was a large reason why commodity prices lagged significantly over the quarter, with oil and bulk commodities such as iron and coal leading the way.
The overall themes experienced during the third quarter, in our opinion, seem to be indicative of what’s to come in the near future. Oil prices will likely remain under pressure, international markets will likely remain plagued with uncertainty and struggle to regain growth, and the U.S. will likely lead the recovery as the strongest economy and stock market readily available. This will likely translate into a stronger U.S. dollar compared to most other major currencies. To capitalize on this trend, we have taken the approach of targeting Canadian companies which have high exposure to U.S. revenues. As the USD increases, the revenue these companies receive will become increasingly valuable, while their expenses, which are paid in Canadian dollars, get cheaper on a relative basis.
It would also seem that, on a wide-spread basis, the recent correction in the market was a temporary, healthy check-back. We do not believe that an imminent threat exists in the market that is able to completely derail the stock market. That being said, we will always remain cautious of all potential risks.
MacNicol & Associates Asset Management: October, 2014