October 24, 2011

Market Update - Q3 2011

Financial market performance in the third quarter was dominated by slowing global economic growth.  Market volatility was driven by concerns of financial contagion in Europe, slowing growth in emerging markets and political mismanagement out of the United States.

The epicenter of financial market strains is Europe.  The market is now pricing Greek debt as though it is likely the country will need to default.  Greek debt with maturities longer than 3 years are trading at 30-40 cents on the dollar.  The market has also placed a substantial risk premium on Spanish and Italian sovereign debt.  Italy’s borrowing costs are now 3.5 percentage points above those for Germany.  European banks are feeling the repercussions from the devaluing of these bonds.  The core of the problem is the high levels of sovereign debt held by banks in many European countries, which has not been marked down to market prices.  The policy making process in Europe has done little to calm these concerns.  The creation of a European stabilization fund is positive but the fund’s mandate has been constrained and its size restricted to appease both its participants and its opponents.  In the meantime, the elevated costs of  borrowing for banks and some governments is having an impact on economic growth.  Even the industrial heartland within Germany, that to date has been immune to periphery problems, has begun to shows signs of slowing. 

Over the last several years, emerging economies have gained in strength and prominence and helped the world recover from the last recession.  Unfortunately, the high pace of growth and easy credit conditions have led to inflation in many of these economies.   To combat inflation pressures, we have seen a tightening in monetary policy over the past year and the early signs of economic slowing.  China has begun to slow loan growth and is showing preliminary signs of manufacturing slowing.  In Brazil, new concerns around weaker global growth caused the central bank to reverse previous hikes and move to cut interest rates.  The impact of this slower growth has been a softening in commodity prices as emerging markets are the main source of incremental demand.

Finally, amidst these global concerns, U.S. policy makers dealt themselves a self- inflicted wound to confidence by mishandling the increase of the debt ceiling. The follow-on impact from a debt rating downgrade was felt more in stocks than bonds and led most economists to significantly revise down their expectations for second half growth. To help support the economy, the Federal Reserve took two unconventional steps this quarter.  In August, they announced they would attempt to hold the federal funds rate in the 0%-0.25% range until the middle of 2013. At the September meeting, they announced an intention to sell $400 billion in short term bonds to buy longer term debt.  Both of these measures were intended to lower longer term interest rates further and provide a more favourable environment for refinancing mortgages and long-term corporate debt, in order to stimulate personal and corporate spending.

Canada has not been immune to these effects.  Canadian stocks and commodity producers in particular are pricing in much slower global growth expectations.  Over the quarter, the Canadian stock index declined just over 12% and the Canadian dollar weakened close to 9%.  Canadian interest rates have declined in sympathy with US rates and have provided positive capital gains in the bond market. 

Outlook

It’s difficult to see how the challenges in Europe can be resolved quickly.  Even with the emergency stabilization fund, another restructuring for Greek debt is likely.  In addition, there are two key structural problems that need to be resolved within Europe.  First, social programs and pension plans have created structural deficits that need fundamental reform rather than just improved financing liquidity.  Second, its not clear that currency unions can be effective without mechanisms for transfer payments to smooth out regional disparities in economic performance.  These fundamental problems are not new, but what is new is investor’s lack of willingness to provide financing at interest rates that ignore these problems.  In the case of the Eurozone, they may not be able to avoid a significant slowdown or potential recession. 

For emerging markets, we have begun to see a reversal of the tightening of policy that has dominated this past year.  Though inflation has not been tamed, recent commodity declines will remove some of the near term pressure.  In addition, emerging markets have much more flexibility than developed economies to provide monetary and fiscal stimulus as well as improved credit conditions. Emerging economies will likely continue to lead global economic growth.

We believe a US recession is unlikely. We are most likely in an environment of 0-2% slow growth. The Federal Reserve has been much more aggressive in providing liquidity than in Europe and excesses in terms of inventories and capacity have not built to levels that have generally preceded recessions in the past.  However, we remain concerned around the potential impact from further budget negotiations and a slowing Eurozone economy.

We are most likely in an environment of continued lower interest rates in Canada over the next 12 months.   We anticipate that the Bank of Canada will need to take further steps to normalize rates but that these steps are probably delayed given the global uncertainty.  Over a longer time horizon, we expect short term rates to normalize in the 2-3% range with long-term bonds in the 3-5% range. 

Given this, it is not surprising that some investors are losing faith in equities. However, now is not the time to be selling. While we can not predict the timing of a market recovery, we know there will be one. There is also no telling what form of catalyst could emerge to provide a market rebound. It could be a European debt restructuring, better than expected economic growth in emerging countries or the United States or it could be something that no one is expecting. Financial markets will often rise before the economic statistics and popular media tell us a recovery is taking place.

We believe large market declines provide an opportunity to add to our companies where expected returns over the next 3-5 years have improved further, and where we have high levels of confidence that the business models can weather and even grow stronger during periods of uncertainty. For example, CN Rail and Saputo are both selling for 10% cheaper than they were at June 30^th, yet both companies enjoy strong cash flows in good times and bad and their management has a demonstrated ability to reinvest those cash flows profitably.

Even in an environment of 0-2% economic growth environment, we still believe our stocks can provide returns in the range of 6 to 8%. This is attractive in an environment where bond yields have fallen well below 3%. Stocks have disappointed investors lately, but are poised for outperformance relative to bonds, from these levels.

The article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.