“It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.” – Robert Kiyosaki
The purpose of this quarterly commentary is 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. We hope you enjoy this information, and that it allows you to better understand what we see going on in the market place.
At the close of 2014, swirling conversations constantly debated a few specific concerning developments; namely, a rapidly dropping oil price, weak corporate earnings estimates, deflationary pressure, weak global economic growth, and the possibility of rising interest rates. All of these individual developments, respectively, represented a material threat to the stock market, however, disagreement was prevalent in regards to how, when, and if all of these issues would affect market indices. Now, with the close of the first quarter of 2015 – and with the benefit of hindsight – we can see that these factors have collaboratively worked to subdue market returns in the near term. Chart 1 displays a summary of performance for all major U.S. indices and a few select sectors. This chart was obtained from a Raymond James publication. For comparison, the TSX grew by a mere 1.85% over the same period.
Underwhelming corporate earnings and low earnings growth estimates have also caused valuation levels to stretch beyond where they were a year prior. A summary of current valuation data for the S&P 500 can be seen below in Chart 2.
The Effect of Falling Oil Prices
After the price of oil’s precipitous decline into the end of 2014, the first quarter of 2015 represented an opportunity to assess the effect that lower commodity prices are having on both oil and gas equities and the stock market as a whole.
Near the end of 2014, the initial consensus seemed to be that, while lower energy prices will undoubtedly harm the results of oil and gas companies, these lower prices will be a boon to consumer spending and industrial companies who have large energy input costs; it was hoped that these effects would off-set, leading to a marginal net effect for the overall stock market and economy. The reality of the situation, so far, has been that earnings estimates across the board have been coming in at a rate that suggests a 10% year-over-year decline from the same quarter last year. Although these results have been heavily hampered by a 56% drop in oil and gas corporate earnings year-over-year, it seems that lower energy prices have not yet visibly improved other areas of the economy. For the TSX, earnings estimates for the first quarter of 2015 have been revised down farther than the U.S. indices, dropping 14%, which is a function of a higher exposure to oil companies. These results represent a continued decline from the fourth quarter of 2014, where earnings fell 3% on a quarter-over-quarter basis, which represented the largest drop since 2011. These weak earnings results and growth estimates have resulted in most major equity indices trending sideways for the first quarter of the year, which can be seen on the previous page in Chart 1.
Despite their significant decline as of late, we continue to monitor the situation for oil and gas equities, and do not believe that the current environment warrants a re-entry into the space. The opinions on oil prices moving forward appear to be fairly evenly split amongst those who believe that prices will rebound, fall farther or stay the same, respectively; we tend to align with the camp that believes oil prices will likely remain range-bound for at least the remainder of 2015.
The main developments which we believe will serve to limit any near-term upside in the price of oil are:
- Iran’s deal with the U.S., which will allow them to rid themselves of austere sanctions and allow them to significantly increase their oil production. Western sanctions have severely depressed the amount of oil Iran has been able to export, and due to their fiscal reliance on the commodity, they are likely to significantly increase their production once these sanctions are removed or slackened.
- Saudi Arabia recently announced that they will increase the amount of oil that they are providing, in an effort to increase their global market share and, perhaps, as a prospective defense against an incoming influx of supply from Iran.
- Total oil storage facilities in the U.S. are currently at 70%, compared to 48% a year ago. If these storage facilities were to reach near-full capacity, excess supply may have to be sold at depressed prices, adding downward pressure to global oil prices.
- Global economic growth – which is highly correlated to oil demand – remains depressed for much of the world, specifically in Europe, China, Japan, and many emerging markets. In conjunction, a strong USD makes it more difficult and expensive for these economies to purchase large amounts of oil, which is denominated in the currency. Global oil demand is currently weak, and the most recent statistics suggest that global supply outstrips global demand by 1.5M barrels per day – a significant gap.
We believe that, as long as these trends persist, oil prices will remain range-bound and continue to negatively affect the results of oil and gas companies. Due to their importance and weighting in major stock market indices, we also believe that these poor corporate results will have a negative effect on the annual returns of most major stock market indices, especially the TSX.
Slow Global Economic Growth:
As stated previously, global economic growth remains relatively subdued across the world; even the United States, who are currently the strongest market in the world, have experienced economic weakness as of late. Weak global economic growth, combined with sideways stock markets, has served to widen the gap between economic growth and equity performance, and, in our view, enhanced the possibility of near-term corrective movements in the markets.
During the beginning of 2015, many American economic data reports have disappointed, with weaker-than-expected reports out-numbering stronger-than-expected ones at a ratio of 5-to-1. This has caused the Citibank Economic Surprise Index, which measures the ratio of economic reports that are above expectations, to fall to levels similar to 2008. Chart 3 below shows the recent quarterly trend of this index.
It should be noted, however, that assessing the long-term behaviour of this index shows that the figure is inherently volatile, and we do not believe that the absolute figure provides significant predictive power. The chart and data, however, is useful for visually portraying the current situation and trend of economic data.
One peculiar aspect of economic weakness in the U.S. has been consumer spending, which is vitally important to GDP, accounting for 70% of the total figure. As stated previously, it was believed that lower oil prices, and as a result, lower retail gas prices, would result in additional consumer disposable income which would serve to bolster consumer spending. However, retail sales have now fallen for 3 months in a row, as the individual savings rate in the U.S. has jumped to 5.5% from 4.5% and consumers continue to pay down debt. Instead of spending their extra disposable income, individuals are increasing their savings or paying down debt, which does not serve to improve the economy nearly as well.
This development of subdued consumer spending is not unique to the U.S., as global Consumer Price Index levels continue to drop. The Consumer Price Index, which serves as a measure for inflation and is highly correlated to the level of consumer spending, is now falling in 15 out of 34 major economies that belong to the OECD. When accounting for volatile food and energy prices, 7 of these country’s CPI levels are dropping. The result of this situation is a persistent global fear of deflationary pressure, which has negative consequences for economic activity. The major impact of a deflationary environment is the tendency for consumers to delay purchases of goods, due to the expectation that prices will be lower in the future; as an example, this has been a prevalent trend in Japan through recent years which has hindered their economy. Central banks around the world continue to pursue quantitative easing activity as a tool to combat this development, but inflation still remains absent from most economies. This central bank activity has had the effect of lowering global yields on sovereign debt, which in conjunction with deflationary activity, results in the fact that 16% of the world’s government debt now have negative real returns. Effectively, this means that consumers in many markets are losing money in real terms by placing their investments into government debt. As a result, this has led to international money flowing into U.S. treasury bonds and bills, where yields are at least positive, which has served to bolster the demand and therefore strength of the USD.
China economic activity continues to cause concern and weaken, with industrial output slowing, housing sales dropping 16.7% on a year-over-year basis, and weak consumer sales data. Japan’s industrial activity has also recently fallen by double expectations, and companies have reduced their capital expenditure. Many believe that Japan’s central bank will likely increase their quantitative easing activity.
With this economic backdrop, as our colleague, Ross Healy, noted in his recent market commentary, “This is a momentum driven market, not a value-driven market, and they are the hardest ones to deal with, in our experience.” Stock indices have not performed well over the first quarter of 2015; however, they have still performed better than the underlying economic data. For this reason, we believe that stock picking and active management will be more beneficial than ever. Investors who closely follow stock market indices are likely to perform poorly for the duration of 2015. In order to add value in such an environment, we have plan on utilizing our ‘Barbell Portfolio’ technique, which involves a careful balance of ‘low-risk’ and ‘high growth’ investments. Please refer to the last page of the commentary for further explanation. Additionally, as ‘portfolio insurance’, we continue to believe that an allocation to precious metals, as well our Alternative Asset Trust, will allow investors to preserve and sustainably grow capital through the near-term uncertainty.
The Outlook for Interest Rates:
Perhaps the most contentious issue of the contemporary market has been concerning the Fed raising interest rates. Here, briefly, we wish to outline the pros and cons of a higher U.S. Fed Rate.
- The Fed’s interest rate policy remains heavily dependent upon both current economic activity and economic prospects. Therefore, if rates were to be raised, it would mean that the Fed sees economic strength in the U.S.
- With record low interest rates, the Federal Reserve does not have many tools with which to handle economic weakness. If they are able to slowly and successfully raise interest rates, this will re-equip the entity with its key tool to fight economic weakness.
- Higher interest rates would likely contribute negatively to threats of deflation and a strong USD, which both would hurt the U.S. economy. Higher interest rates tend to hurt consumer spending and also strengthen the USD, which hurts export activity.
Given the potential negative impact of higher rates and current prevalent concern over deflation and a strong USD, we do not believe that the Fed will drastically raise interest rates in the near term. However, given current rock bottom levels, interest rates are very likely to be higher than the status quo in the near future. In our view, this has decreased the appeal of fixed income investments. As their values are negatively correlated with the level of interest rates, we believe that investments in fixed income are likely to lose money in an environment of inevitably rising rates moving forwards.
MacNicol & Associates Asset Management Inc. April 2015
The Barbell Portfolio
To expand further upon our approach to portfolio management, we have recently created a graphical representation that we describe as ‘The Barbell Portfolio’.
The Barbell Portfolio is an articulation of what we believe to be an optimally balanced portfolio; low-risk value names provide solid capital preservation, high growth names provide high growth prospects and catalyze out-performance, while our MacNicol Alternative Asset Trust serves as the fulcrum, balancing the entire portfolio and acting as a bridge between low-risk and sustainable returns.