Nicola Wealth Management

January 2010 Market Commentary

By Rob Edel, CFA

Markets began the New Year on a negative note in January with the Dow Jones Industrial Average declining 3.5% and S&P/TSX 5.5%. It wasn't just North American markets that were lower, however. Most markets ended the month in negative territory, though losses were tempered somewhat by a weak Canadian dollar.

Why the gloom? Well for starters, China implemented a number of measures to slow down credit growth in the face of growing inflation and a potential bubble in real estate. China reported that Q4 GDP had grown a stellar 10.7% and a respectable 8.7% for all of 2009. Not bad considering they were targeting 8% growth for 2009 and some feared it could be as low as 5%. While a recovery in global trade was a contributing factor, domestic property and infrastructure were the major drivers. The bad news, however, is that consumer prices increased 1.9% in December versus only 0.6% in November, raising fears that inflation, particularly in domestic real estate, might be getting out of control. Construction starts were up 75% from last year and prices of new residential property were reported to be rising at an annualized rate of more than 20%. Wang Shi of China Vanke, China's largest real estate developer, believes China is at risk of a Japan-style property bubble if rapid price gains spread beyond major cities.

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In order to prevent this, Beijing placed further controls on state bank lending by mandating that the Bank of China stop giving loans for the rest of January and increased reserve ratios for large banks by 50 basis points. Normally we (and global capital markets) would care very little about restrictions on Chinese banks or an overheating Chinese real estate market. China, however, is perceived to be the new de facto engine of growth for the world economy and any perception that its economy may slow causes panic on trading desks around the globe. The world needs China and its 1.3 billion consumers to help spend us out of our current debt-laden recessionary woes. To make things even worse, India, representing another 1.1 billion potential customers, followed up and increased the cash reserve requirements for their banks, also citing inflationary concerns. The Reserve Bank of Australia, which has been on a tightening program since last October, surprised everyone in early February by deciding to leave its cash rate unchanged at 3.75%. Apparently, the Bank of China and Bank of India had done their monetary tightening job for them.

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While Asia is concerned about inflation, the rest of the world has been rocked by currency and sovereign debt crises. The World Economic Forum cited unsustainable debt levels amongst the top three risks facing the world in the years ahead (underinvestment in infrastructure and health care costs being the other two) and feel they could potentially lead to social and political consequences. Venezuela would certainly agree, as they devalued the Bolivar 50% in early January. Venezuela, however, is ruled by a mad man (meaning he's crazy, not an advertising executive from the 1960s as portrayed in the AMC television drama "Mad Men"), so the capital markets were not very concerned.

Of more concern, however, is the crisis playing out in Europe with the fiscal spotlight continuing to be shone on the so-called PIIGS nations (Portugal, Italy, Ireland, Greece and Spain). While Greece seems confident that they will be able to trim their current budget deficit (currently about 13% of GDP) back down to a more German like 3% of GDP, clearly no one else is. With credit spreads on Greek debt exploding and government bond auctions looming on the horizon, Greece's options appear few. Either someone (most likely Germany and/or France) bails them out in some fashion or they leave the European Union and devalue. The former is the most likely course of action but creates a dangerous precedent as all the other PIIGS nations will expect similar treatment and will conduct their fiscal affairs accordingly. Surely this will be unacceptable to German central bankers who so clearly remember the hyperinflationary demise of The Weimar Republic. There seem to be no happy endings for this Greek tragedy.

While it might be easy to discount Europe's problems as merely those of the "club med" countries, they are not the only heavy spenders in Europe in jeopardy. As Noriel Roubini and Ian Bremmer stated in a recent Wall Street Journal article, "Though the PIIGS acronym was apparently coined by British bankers, Britain, Ireland and Iceland also smell distinctly of bacon." Even the world's two largest economies, the United States and Japan, are being tagged for potential downgrades by rating agencies if progress is not made on reducing their growing deficits. Ironically, it is the developed economies in general that have seen a dramatic spike in debt as a percent of GDP while the emerging economies have been able to manage their fiscal affairs more prudently.

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Of particular concern to us is the U.S. With Barack Obama's recent 2010 budget calling for a $1.6-trillion deficit, one has to wonder when the bond vigilantes will turn their attention to America. At a post-WWII record of 10.6% of GDP, the U.S. deficit isn't that much lower than Greece's 13% total. What's more, the budget is predicting an increase of $8.5-trillion through 2020, pushing government public debt as a percent of GDP to 77%. And that's his budget! Based on overly optimistic growth estimates, we know how accurate budgets tend to be. Harvard University economist Kenneth Rogoff points out these kinds of debt levels could push the U.S. towards a tipping point where interest rates could soar and the value of the dollar could plunge. Mr. Rogoff points to other countries' experiences to suggest that "going beyond 80% (debt to GDP), you're taking a real chance." Bond rater Moody's Investment Service would tend to agree, saying recently that, based on Washington's spending and debt trends, the U.S.'s coveted AAA debt rating could be at risk. Double-A U.S.A. I can hear the chants now.

Moody's is starting to pay attention, but what about the U.S. government? After losing Edward Kennedy's Massachusetts Senate seat (held by the democrats since 1979) and their filibuster-proof majority with it in a mid-November election, Obama and the Democrats have had to dramatically change their agenda and strategy. The health care reform bill is effectively dead. It's clear that the American people didn't want it and were scared of the potential costs versus the uncertain benefits.

Instead, Obama is shifting his attention to softer targets, like Wall Street. Everyone hates Wall Street right now and bashing fat cat bankers is a sure vote-getter heading into the November congressional elections. Vowing that "never again will the American taxpayer be held hostage by a bank that is too big to fail," Obama is proposing that banks be banned from proprietary trading and using their capital to invest in private equity or hedge funds. The markets and fat cat bankers did not react favourably. Obama has also suggested some modest fiscal restraint by proposing a 3-year freeze on discretionary spending, impacting approximately 17% of the total budget. It's a start, but more is going to be needed. Ironically, the legislative gridlock that could be created from a Democratic defeat in the upcoming November mid-term elections could help perpetuate the budget deficit problem. Republicans are likely to veto tax increases while Democrats veto spending cuts. Now that's a Greek tragedy.

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THE U.S. ECONOMY

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The big news in January was that Q4 GDP grew 5.7%, 1% higher than expectations. While this is good news and reinforces the view that the U.S. economy is on the mend, most of the increase (3.4% to be exact) was due to a slower inventory drawdown. This is not a bad thing. Businesses can't continuously run inventories down to zero. They eventually have to replenish their stockpiles, and when they do, it helps boost economic growth. The concern is that consumer purchases still drive the economy, and unless the inventory replenishment cycle and resulting stronger economic growth translates into stronger consumer activity, economic growth cannot be sustained. Consumer spending contributed 1.44% of the GDP's growth in Q4 with consumer spending increasing 2% versus Q3 versus 2.8% growth in Q2. Okay, but by no means robust.

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Following on with the inventory replenishment theme, manufacturing continues to recover from extremely depressed levels. While overall U.S. industrial capacity declined a record 1% in 2009, not all industries suffered equally. The recession has accelerated the demise of industries that were already in decline before the downturn while growth industries managed to recover fairly quickly. For example, motor vehicle production capacity declined 4.4% last year and the chemical industry shed 1.7% in capacity, the largest such declines since at least 1949. As Huntsman CEO Peter Huntsman said, "the chemical industry is leaving the United States, and it won't be back." Alternatively, the semiconductor industry grew an estimated 10.4%, benefiting from a manufacturing process that is highly complex and requires less human labour. A mobile and flexible work force like the U.S. is well suited to adapt to the dramatic changes taking place in the world economy. Europe? Not so much.

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Overall, the U.S. economy is moving in the right direction and continues to recover. Even the services sector is indicated to be expanding with the ISM Services Index increasing above 50 in January.

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The U.S. lost 20,000 jobs in January… but the unemployment rate decreased 0.3% to 9.7%? The reason for this discrepancy is that the jobs report and the unemployment rate come from two different surveys. The jobs report comes from Current Employment Statistics (CES), which is a survey of 400,000 business establishments nationwide, including the government, while the unemployment estimate comes from the Current Population Survey (a.k.a. the household survey), which is a monthly survey of about 60,000 households. The household survey indicated employment levels were 541,000 higher than previously thought while the labour force increased 11,000, thus resulting in the lower unemployment rate. So who do you believe? In the long run, both surveys should converge. In the short term, we would tend to believe the CES survey was used for the Jobs number. The 20,000 loss in jobs is close to the '-22,000' figure derived from the ADP estimate (which is a subset of payroll processor's ADP's 22 million employee payroll data). The household survey relies on people telling the truth (yes, we are very cynical).

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While the decline in the unemployment rate is good news, the jobs number of -22,000 was a bit of a disappointment with the market expecting losses of only 5,000. But it gets worse. December was revised lower to -150,000 from the -84,000 originally reported and the Labor Department's annual benchmark revision indicated that employment last year was nearly 1.4 million lower than previously reported. Near-term trends are not looking any better with jobless claims for the week ending January 30 increasing to 480,000 versus 434,000 at the end of December. The good news is that there were only 8.3 million workers in part-time jobs that preferred full-time positions versus 9.2 million the previous month, and 52,000 temporary jobs were added in the month. Both are indicators that employers may be setting the stage to hire more workers.

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Yes, the year-over-year numbers are up a bit, but that is only due to a steep fall in energy prices at the end of 2008. The month-to-month numbers remain well under control, as does core CPI. Overall, deflation would seem to be more of a concern than inflation at this point.

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Interestingly, longer-term inflation-protected notes are indicating that inflation will increase to the 3% range in 5 years. With 5-year TIPS (Treasury Inflation-Protected Securities) discounting inflation of 1.8% and 10-year TIPS discounting 2.3%, the implied 5-year inflation rate in 5 years is 2.8%. While this doesn't seem that high, it is on par with inflation rates seen in 2003 and 2004 when (as it has been suggested) the Fed helped fuel the housing bubble. Clearly, not everyone thinks inflation will stay at current low levels.

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Consumer confidence continues to recover and move higher. While the University of Michigan's Consumer Confidence Indicator came in a little worse than expected, the Conference Board's Index came in a little higher. Both increased from last month, which is good.

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Despite improving consumer confidence, retail sales disappointed in December but were still up considerably over the previous year. For all of 2009, retail sales were down 6.2% before seasonal adjustments, the largest drop since records began being collected in 1993. In order to gain an accurate picture, December and November retail sales should probably be looked at in combination. Doing so indicates an improving trend, especially when an early look at January same-store sales are considered. Prudent inventory management and Christmas gift card spending resulted in the liquidation of the little holiday inventory remaining and even put a good dent in the new full-priced spring inventory.

It's still a very tough environment for retailers, however. Consumers continue to retrench and trade down to cheaper products. They are even finding other things to cry into as evidenced by the fact U.S. beer sales volume declined 2.2% last year, the largest annual decrease since the 1950s.

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In another sign that consumers are tightening their belts and staying home to conserve funds, CBS reported that 25.8 million viewers tuned in to watch the Grammys versus only 19.05 million last year. Luckily, the Olympics will provide ample viewing pleasure for the stay-at-home consumer. In an attempt to get consumers to leave their homes, many luxury resort hotels are finding that dropping the word "resort" from their name can result in increased business. After last year's much publicized controversy with AIG planning to host a sales retreat at a posh Californian resort after accepting a $180-billion government bailout, companies are reluctant to risk the appearance of living large while the economy suffers. Loews Lake Las Vegas GM, Dale McDaniel, estimates that dropping the resort label could result in as much as a 10% increase in business.

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Like retail sales, December's housing sales should probably be combined with November in order to get a more accurate picture of current trends. Existing home sales suffered their largest decline since 1968, but it is likely November borrowed some sales from December as home buyers rushed to close deals before the expiration of the homeowner's credit program that was scheduled to end November 30, but ended up being extended to the end of April. Same goes for new home sales. The increase in the inventory of homes on the market was a little discouraging, but prices continued to firm, which is good.

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We remain concerned that the more than 7 million homes that are either behind in their mortgage payments or already in foreclosure will hit the market in the coming months. According to LPS Applied Analytics, the foreclosure process can take more than a year and there are presently 2.5 million homes that are more than 90 days behind on their mortgage payments that haven't even started the foreclosure process yet. The market has stabilized but the recovery will take years.

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While the trade deficit increased in November, most of the rise was due to higher oil prices. Volumes were actually down but the average price per barrel increased over $5 to $72.54, the highest level since October 2008. Higher imports are also a sign that the U.S. economy is strengthening. The decline in the surplus with China was also a good sign, though Japan, Euroland and Mexico all saw their trade surpluses with the U.S increase.

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THE CANADIAN ECONOMY

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November, which remains a lagging indicator for our purposes, had a decent GDP increase. While still down 1.7% versus last November, it puts Canada on track to meet or even exceed the Bank of Canada's Q4 forecast of 3.3% growth. In its Quarterly Monetary Policy Report, the Bank of Canada is forecasting 2010 GDP growth at 2.9% and 3.5% in 2011 after contracting 2.5% in 2009. The IMF is forecasting only 2.6% GDP growth for Canada in 2010 but 3.6% in 2011. While generally more bullish on the prospects for the economy, the Bank of Canada cautioned that recovery depends on debt-cutting measures by advanced nations and countries such as China continuing to stimulate domestic consumption. In other words, if the economy grows less than expected, it's not their fault.

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No disappointments with the Canadian employment report in January with strong job growth and a lower unemployment rate. Most of the new jobs were part-time and wage growth continues to decline, but we are not complaining. The unemployment rate is only 0.1% below year-ago levels, and that's a good thing - the Canadian Labour Congress estimates that of the approximately 2 million Canadians that filed for unemployment insurance in 2009, 500,000 may be close to exhausting their benefits. On average, employment insurance claimants qualify for about 38 weeks or 9 months of benefits.

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The numbers speak for themselves. Inflation is a non-event in Canada.

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Like in the U.S., consumer confidence continues to move higher in Canada. While November retail sales might be a bit of a lagging indicator, they were disappointing. Excluding price changes, retail sales were down an even worse 1.0%. Let's wait until next month when we get a clearer picture of holiday sales before drawing any conclusions.

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While retail sales may have slowed in Canada, the slowdown did not carry over to the housing market. Existing home sales may have declined from December but they were still up dramatically over December 2008. For 2009, existing home sales increased 7.7% versus 2008. The same goes for prices, down slightly versus last month but up versus last year and up 5% for all of 2009. We have added the Terenet National Bank Index to our table in order to get a better indication of the trend in house prices. The Terenet Index is based on prices in land registries of homes that have been sold at least twice and is the Canadian equivalent of the Case/Shiller price indexes. The Terenet Index confirms the strength in the housing market with prices up almost 3% from last year. Inventories of unsold homes increased versus year-ago levels for the first time in a year, but remain at extremely low levels.

So is the housing market in a bubble? Former cabinet minister and author Garth Turner thinks so. Referring to the housing market in Canada, Mr. Turner recently commented that "It's a mania. It's going to end badly." Bank of Nova Scotia economists Derek Holt and Karen Cordes agree, saying recently that "The country is in a price bubble." Average home prices have risen 23% from their trough in January 2009 despite the fact personal income has declined 1% and employment has contracted 1.4% in 2009. Household debt, of which mortgages make up the bulk, hit a record 1.42 times disposable income in Q2 2009. Even the Bank of Canada has expressed alarm, stating in December that if interest rates increase as they expect, by mid-2012 about 9% of Canadians could find themselves "financially vulnerable."

Others make the point that the market is not in a bubble and the high sales activity in 2009 are inflated by unusually low activity the year before and that hot markets like Vancouver tend to skew the national averages. Furthermore, the Canadian Association of Accredited Mortgage Professionals argues that of the 40,000 new mortgages they analyzed in 2009, 86% were fixed-term rather than variable rate and 70% of the fixed-term mortgages were for terms 5 years or longer. Their analysis concludes that only about 4,000 households a year are pushing the envelope in terms of risk. Delinquencies are still low in comparison to the U.S. with 0.44% of mortgage holders 3 months or more in arrears on their mortgages. This is still a 7-year high, however. Our take: if it's not a bubble, it's certainly heading that way. If it wasn't for the weak manufacturing sector in Southern Ontario, the Bank of Canada would have already raised rates.

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November saw Canada revert back to a trade deficit with an improving domestic economy increasing demand for imports. A stronger dollar, while decreasing the cost of imports, also has the effect of decreasing the attractiveness of Canadian exports.