A Tale of Two Hemispheres


Highlights This Month

Read this month’s commentary in PDF format.

The NWM Portfolio

Overall, we remain more cautious on the Canadian economy and more constructive on the U.S. economy. Having said this, economic results in March were incrementally better for Canada and worse in the U.S.

Of the three (or more) threats we are watching, China was more of a concern and Europe looks to be headed for more volatility, with 10-year bond yields in Spain and Italy headed higher. Oil prices look contained for now and nothing new on the U.S. deficit.

Bonds were mainly unchanged, though high yield bonds had another positive month in March. If interest rates increase, there is limited duration risk (about four years) and credit spreads should narrow.

We view the recent RBC lawsuit and “wash trade” controversy to be a non-event. We have begun selling certain positions, finding defensive ways to play an improving North American economy.

We also continue to look for opportunities to increase our U.S. holdings and added to our technology position last month, which continues to look attractive along with health care. We plan to also plan to look more closely at the industrials sector as we would like to gain more exposure to a rebounding U.S. manufacturing industry.

March in Review

By Rob Edel, CFA

Equity markets were mixed in March with the S&P/TSX losing nearly 2%. The S&P 500 and Dow advanced 2.6% and 2.0% respectably, but most of the gains were made earlier in the month and both indices were heading lower in early April.

The weakness, especially for the Canadian market, was mainly due to concerns of slower economic growth in China.

The HSBC Purchasing Manager’s Index for China fell to 48.1 in March, below 50 for the fifth month in a row, thus indicating a contracting manufacturing sector in the Middle Kingdom. This, in conjunction with a reported $31.5-billion trade deficit in February, the largest monthly deficit since at least 2000, has many concerned China’s economy is headed for a hard landing.

While this might turn out to be the case, we would point out China has a lot of levers they can pull and much of the recent slowdown is self-induced and part of efforts to keep inflation in check.

We are still in the soft landing camp.

 

Perhaps more interesting, was the gyrations of the bond market in March.

Yields started to move higher mid-month, prompting many to wonder whether the great bond rally of the past 30 years had finally run its course. Positive U.S. economic numbers provided the setting, but comments by the Fed regarding the strength of the economy and reduced likelihood of another round of quantitative easing supplied the catalyst.

This also led to a correction in gold bullion and stocks, which further contributed to the weakness in the gold-heavy S&P/TSX index (gold is almost 11% of the S&P/TSX).

No fear, however, a sub-par U.S. employment number and more trouble in Europe prompted bond yields to retreat back to their recent lows. Bond yields will rise sometime, just not this month.

 

Higher interest rates aren’t necessarily a bad thing for equity markets, yet stocks seemed to react poorly and moved lower in early April. If rates move higher because the economy is growing faster, this should be good for stocks, right? (Though perhaps not for earnings, as we discuss below.)

Even after spiking to just over 2.3%, 10-year government bond yields are still absurdly low. The last time the S&P was at current levels, in mid-2008, 10-year U.S. Treasuries were over 4% – a level HSBC believes is needed before corporations begin curtailing investment.

With rates back down to around 2%, we are miles away from levels that would needed to constrain growth.

So why did the equity markets pull back? Some postulate the real driver behind the recent equity market rally hasn’t been the improving economy, but rather the liquidity being provided by the Federal Reserve.

Yes, job growth has picked up of late and manufacturing is showing some promise, but let’s face it: the recovery has been underwhelming so far.

Liquidity, however, has provided a backstop for traders who have long learned not to fight the Fed. This is why when the Fed dashed hopes that more liquidity was forthcoming, some took this as a signal to sell, both stocks and bonds.

Perversely, under this line of thinking, slower economic growth could lead to better equity markets if traders believe the Fed will be forced to undertake more quantitative easing.

Apart from a tighter monetary environment, analysts are also concerned corporate earnings growth is slowing, even in a growing economy. Profit margins have soared since the recession ended and are arguably at unsustainable levels.

One of the reasons for this is that companies slashed payrolls to the bone during the financial crisis and have been reluctant to hire back. In 2007, The Wall Street Journal estimates U.S. companies generated average revenue per employee of about $378,000 compared to $420,000 last year.

Once companies feel more confident that the recovery is sustainable, they will start to invest in the resources needed to facilitate sustainable future growth, and hiring additional workers is a big part of this. Current trends in the employment market indicate this may already be starting and could result in slower productivity growth and lower profit margins in the short term.

Analysts are estimating profit margins for non-financial companies will drop to 8.4% in in Q2, a two-year low. Already, analysts have started to lower earning estimates in both Q1 and full-year 2012. And according to S&P, only three of the S&P 500’s 10 sectors are expected to deliver positive earnings growth in Q1.

Backing this up, Morgan Stanley reports companies pre-announcing negative Q1 earnings have out-paced positive pre-announcements by the largest margin in two years. On the positive side, valuations are still very reasonable, and with interest rates as low as they are, stocks should more than hold their own against fixed income alternatives, even if profits slow.

We still are becoming more constructive on the equity markets, especially in the U.S. It won’t be a straight line up, but barring any future financial crises, a stronger economy should provide a favorable backdrop over the medium-to-long term.

Of course one can’t talk about potential financial crises without mentioning Europe. The Federal Reserve wasn’t the only central bank indicating that further monetary stimulus is unlikely.

President of the European Central Bank (ECB), Mario Draghi, recently dashed hopes of further central bank help, citing concerns about inflation. Evidence that interest rates are already too low can be seen in German property prices, which are up 5% over the past year.

Memories of the hyperinflation in the 1920’s and fears inflation is on the rise has resulted in ordinary Germans flocking to the perceived safety of real estate. 

The Germans and the ECB believe austerity and long-term structural reforms are the keys to Europe’s salvation and are putting the onus on national governments to stimulate growth through structural changes to their labor markets.

Germany (and apparently the ECB) argues controlling government debts today will lead to higher economic growth in the future as consumer and corporate confidence increase knowing the country is on a sustainable fiscal path.

Of course austerity and higher interest rates are easier to bear for countries like Germany, where wages grew 3.7% in Q4 2011 and the unemployment rate is holding steady at a low 5.7%.

Not so much for the Mediterranean periphery, where economic trends are looking anything but sustainable and government bond yields are beginning to move higher again. Additional austerity is only driving the economies of Spain, Italy, and Portugal deeper into recession, which in turn is resulting in even higher fiscal deficits.

With even Germany flirting with recession, more central bank help will be needed to support bond market demand, or Greek-style bailouts will become the norm. We are not sure if Europe has the luxury of tighter monetary policy, despite what is happening to German housing prices. If bond yields in Italy and Spain keep moving higher, the Euro is doomed.

As for Portugal, rates are already beyond the point of no return. Stay tuned for a bailout.

The U.S. Economy

The U.S. economy is again the engine of growth for the global economy, for the time being anyways. Even the gloomy Federal Reserve is more upbeat, projecting “moderate” growth in their March statement as opposed to “modest” growth in January.

In “Fed-speak,” moderate is deemed by analysts to be slightly better than modest. We’ll take their word for it.

A warmer than normal winter certainly helped thaw the Fed’s view with the National Oceanic and Atmospheric Administration claiming the U.S. experienced its fourth warmest winter since records began being kept in 1895.

J.P. Morgan economist Robert Mellman estimates the balmy weather could have added an extra 45,000 jobs a month to payrolls over the past three months while Gluskin Sheff’s David Rosenberg believes U.S. consumers saved about $30-billion in heating costs.

While GDP growth of 3% in the fourth quarter of 2011 is the fastest quarterly growth rate in a year and a half, it’s still pretty modest (which isn’t as good as “moderate”) given how much the economy contracted during the recession.

Gross domestic income, which measures income generated by economic activity rather than the value of goods and services, pegs the economy’s growth at a more robust 4.4% in Q4. If this is the correct measure for gauging the growth of the economy, we would be, shall we say, “moderately happy.”

Manufacturing continues to be the unsung hero for U.S. economy, increasing in March for the 32nd straight month. While European and Chinese purchasing manager indexes decline, indicating a contraction in manufacturing activity, U.S. indices continue to expand.

As a percentage of GDP, manufacturing hit a meager 11% in 2009 before rebounding to 11.7% in 2010, the largest year-over-year increase in more than 50 years. The U.S. manufacturing sector is making a comeback. Yes, wages in emerging markets are still cheaper, but they are moving higher, quickly.

In addition, higher oil prices makes shipping goods back to the U.S. expensive and a weaker U.S. dollar over the past decade (the U.S. dollar is down nearly a third versus the UK pound and Japanese Yen) means U.S. manufacturers are more competitive.

Also, low natural gas prices are helping domestic factories compete by supplying them with cheaper feedstock and rock bottom electricity prices. Yes, a warm winter has helped, but it’s not the whole story.

This manufacturing industry renaissance looks to have legs.

 

After three straight months of 200,000-plus jobs growth, the U.S. reported a mere 120,000 new jobs in March. This was a major disappointment, especially since the ADP private payroll report indicated 209,000 new jobs were created.

The good news is wage growth accelerated and the unemployment rate ticked down one tenth of a percent to 8.2%.

Rather than question why employment growth was lackluster in March, many are questioning why it’s been so strong the past few months. With the economy growing a mere 1.7% last year and potentially struggling to top 2% in Q1, the last three months has seen the U.S. add an average 245,000 new jobs each month.

According to Okun’s rule, which draws a relationship between the unemployment rate and the economy’s under or over-performance relative to its long-run trend, GDP growth should have been more like 4 to 5% last year.

Why the discrepancy? Most likely because the relationship first broke down in the other direction during the recession, as employers overreacted to the financial meltdown and cut jobs at a quicker pace than in normal economic cycles.

If this is the case, some argue the 245,000 new-job average experienced the previous few months might be just a catch-up adjustment and monthly job gains like we experienced in March could be more likely the norm.

Perhaps corporate profits are strong and profit margins are at historic highs partially because companies have trimmed payrolls so aggressively. Also, as mentioned above, if gross domestic income is used to measure economic growth, the employment growth above 200,000 jobs a month might be just about right.

 

 

Inflation remains elevated, but palatable. Higher gasoline prices are the main concern with the Wall Street Journal estimating a $126 hit to consumer pocket books over the past six months. Fortunately, lower natural gas prices have reduced heating costs to the tune of an estimated $9-billion, or $76 per household.

Despite some talk to the contrary, the Fed is not concerned about inflation. If the job market loses momentum, QE3 will be become a reality.

 

Consumer confidence remains strong with a recent Wall Street Journal survey finding 37 out of 50 economists believe higher oil prices have not yet had a negative impact on economic growth. As to what price would be required for the economy to begin to feel the effects, estimates ranged from $115 (close to current prices) to $250 a barrel.

The magnitude of price change will not be the sole determinant, however. The same economists believe the speed of the increase, the reason for the increase (supply issues are perceived to be more negative than demand), and the strength of the rest of the economy will also determine how much of an impact oil will have on the economy if it continues to move higher.

 

 

Retail sales continue to trend higher with February sales at their strongest level since September 2011 and March same store sales pointing towards another strong month.

March sales benefited from Easter falling two weeks earlier than last year, but this will probably result in a slow April. Easter is an important holiday for merchants. Not only is it traditionally the third largest spending season after Christmas and Valentine’s Day, it is also the one time of year consumers generally accept paying full price.

Also helping sales has been exceptionally warm weather that is, so far, carrying into April. We are a little nervous about the personal savings rate continuing to trend lower. It’s good for the economy that consumers are spending, but let’s not forget what got us into trouble in the first place. Consumer deleveraging still needs to run its course.

 

  

We continue to be more constructive in our view of the housing market with hopes prices may soon find a bottom.

Though sales of existing homes in February declined versus the previous month, sales in January and February were still at levels not seen since 2007. The inventory of unsold homes also deteriorated slightly from January, but at just over 6 months, remains at levels historically deemed indicative of a balanced market.

Not surprisingly, new construction and renovation activity has started to pick up. Investment in real estate, in fact, had a net positive contribution to U.S. economy in Q4 2011, the first time this has happened since 2005.

The one fly in the proverbial ointment is prices, which continue to remain weak.

With Moody’s Analytics estimating 3.7 million foreclosed homes or soon-to-be-foreclosed homes are sitting on lenders’ books waiting to hit the market, many are concerned prices have not yet reached a bottom.

The good news is 30 and 60 day delinquent mortgages have declined dramatically and housing affordability has soared. Low prices have caught the eye of institutional investors, who have been accumulating portfolios containing hundreds of homes with the intention of creating large rental pools.

Many potential new homeowners are actually finding it hard to buy in this market and are being out bid by savvy Wall Street investors armed with spreadsheets and deep pockets. Goldman Sachs calculates rental pools can generate a nationwide average yield of 6.3% and a yield upwards of 8% in some depressed markets.

Fannie Mae and Freddie Mac (the US’ government sponsored home mortgage companies), who are estimated to hold approximately half of all foreclosed homes, are presently testing bulk sales and might consider keeping an interest in some of the rental pools.

The result could not only help clear the dreaded “shadow inventory” quicker than expected, but it could also help keep rental rates in check. It’s much more efficient for the banks to sell hundreds of homes to an institutional buyer than go through the painful process of haggling with Joe Six Pack.

Balanced and stable housing is important for the economy for two reasons. One, it would speed up the deleveraging process and reset the bar for consumers and lenders, and two, it would enable simulative monetary policy to be more effective.

Low interest rates do nothing if consumers are in no position to borrow, no matter how low rates are. In a normal housing market, low interest rates entice consumers to consume. Higher consumer spending leads to increased corporate investment, and so on.

The quicker we get consumers deleveraged and the housing market balanced the better. Institutional investment might be the key making this happen. There’s a clearing price for every asset and America is historically very adept at finding it.

 

Bad news for the trade deficit is probably good news for the global economy. While higher oil prices certainly contributed to the increase, a stronger U.S. dollar in combination with a re-energized U.S. consumer helped move the deficit higher.

The higher deficit with China and the fact that exports (while still increasing less than imports) still increased, are indicative of a stronger domestic economy.

The Canadian Economy

 

GDP growth in January was a disappointing 0.1%, but we are encouraged by stronger leading indicators and manufacturing indices. Manufacturing, in fact, increased for the fifth month in a row and helped offset a weak oil and gas extraction sector. With natural gas prices so low, exports to the U.S. have plummeted.

A huge rebound for the Canadian job market. At over 80,000, monthly job growth reached its highest level since 2008. The quality of the increase was also high, with 70,000 full-time positions created and nearly 43,000 coming from the private sector.

Wage growth was also stronger, though still barely keeping pace with headline inflation. Overall, a great month; especially given the disappointing growth in January and February.

Inflation continues to move higher, with higher energy prices the main culprit. Despite remaining above the Bank of Canada’s desired 2% target, inflation does not appear to be a concern to policy makers presently.

Consumers, well they may have a different view. Expect the Bank of Canada to raise rates sooner than the Federal Reserve, but don’t expect either to happen any time soon.

  

Consumer confidence soared in March, though most of the increase was due to favorable intentions towards major purchases. Canadians appear to be walking the walk in this regard and making major purchases.

Household debt levels in Canada continue to move higher, though an increase in personal income meant the household debt-to-disposable income ratio actually moved slightly lower in Q4 2011.

Retail sales were positive, but lower than expected. Excluding auto, retail sales were actually negative 0.5% in January.

The housing market remains in good shape. Housing starts and permits were down sequentially, but were up against very tough comparables.

Canada’s trade balance remained positive in January with both exports and imports declining. The strong Canadian dollar was a major contributor to the declines as volumes were strong. Helping exports were robust U.S. auto sales, of which Canadian manufacturers contribute to.

We may have written off the Canadian economy too soon. Strength south of the border, especially in the auto sector is helping create Canadian manufacturing jobs. That being said, we are still uncomfortable with high consumer debt and regional housing bubbles (Toronto and Vancouver).

No big news from the budget, other than the demise of the penny and the dreams of retiring at 65.