With the introduction of our monthly commentary, the format of the quarterly commentary this quarter will be slightly changed. The purpose will be the same as the past quarterly commentaries: 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.


“You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time.” – Abraham Lincoln.

Following a brief correction to momentum stocks during the first quarter of 2014, many market participants scrambled to safety, thrusting second winds into previously lackluster asset classes such as the precious metal miners, and defensive areas of the market such as utilities and health care; the second quarter saw a continuation of this trend, as a whole, with a key difference – the dominance of the energy sector. A renewal of geopolitical upheaval in Iraq, as well as continuation of the Ukraine-Russia crisis caused both West Texas Intermediate (the benchmark for U.S. oil) and Brent Crude (the bench mark for European oil) to soar, bolstering the prospects of energy production companies, leading to a strong return of approximately 12%1 for North American energy producers over the quarter.

Defensive sectors such as Health Care and Basic Materials also performed well for the second quarter in a row. Financial stocks were the main laggards during the period, although they were still able to gain ground.  quarterly 1This out-performance of the energy sector allowed for another strong quarter for the TSX/S&P composite, which gained 5.7% during the quarter, largely due to its extreme weighting of energy stocks. The NASDAQ and S&P 500 also performed well over the quarter, producing returns of 5.0% and 4.7%, respectively. The Dow Jones underperformed its major peers, but remained able to finish the quarter 2.2% above where it started.


“The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.” – William Arthur Ward

Despite developments in Iraq, a downward revision of U.S. first quarter GDP to an annualized rate of -2.9%, and a U.S. Consumer Price Index reading above the Federal Reserve Bank’s target rate, most equity indices were able to finish the quarter with gains. Ongoing global accommodative monetary policy is partially responsible, as is a renewed strength in Emerging Asia. Propelled by a definitive election in India, the emerging markets, and particularly emerging Asian countries, produced the strongest growth and garnered the most investment over the quarter.


For additional information on the developments in Iraq, the Ukraine crisis, or the elections in India, I would strongly suggest visiting our blog, which we operate through our website; we have dedicated posts to these issues – among others – in order to provide a brief overview and understanding of these important developments.


Deflated Inflation


As stated above, one of the headline stories during the last quarter was the May Consumer Price Index (CPI) reading in the U.S., which was recorded at a 2.1% gain, the highest it has been in 15 months. The CPI is largely heralded as the primary measure of inflation, and it carries with it a special significance in the current era of monetary policy. The reason is due to the Federal Reserve Bank’s Quantitative Easing program, which has been utilized to support a fragile American economy for the past 5 years, and whilst doing so, has quintupled the U.S. dollar monetary base from $800 billion to approximately $4 trillion. The key consideration is that, although the amount of money in the system has exploded, this has not translated to inflation; part of this is due to the fact that the big banks have not been lending the money out, and the other part is the fact that American citizens have been primarily focused on paying down their current debt levels, and have not been eager to take out additional debt. The fact that the increased monetary base has not, as of yet, translated to inflation, has acted as a ‘green light’ for the Fed to continue its Quantitative Easing program. This has allowed them an opportunity in the future to reduce the monetary base before the money is transferred to consumers and spent, which is what ultimately drives up the price of goods. The Fed has used a 2% growth rate in the CPI as a target for their desired inflation rate, and thus a reading above this level has added to the worry that the explosive growth to the monetary base has begun to finally translate into inflation. Current Federal Reserve Bank Chair Janet Yellen discounted the reading as a product of market ‘noise’2, and argues that rising prices are not a concern at the current time.


“Experience is a hard teacher, because she gives the test first, the lesson afterward.” – Vernon Sanders Laws


Yellen’s assertion is a controversial topic for a variety of reasons, as some Analysts argue the contemporary state of the CPI has limited value as a true measure of inflation, and others argue that there are significant prevailing forces in the near-term that result in inflationary worries being a real concern.  When the CPI was created, its purpose was to be an index which measured the growth in income required in order to maintain an individual’s current lifestyle; a basket of goods was collected, based upon thousands of surveys of households, which was meant to represent the most commonly purchased goods, and each subsequent CPI reading was interpreted as the change in price for that same amalgamation of goods, using prevailing prices. The chart below provides a simple summary of the types of goods included, and what proportion of the ‘basket of goods’ they represent.  quarterly 2As is readily discernable from the above chart, housing costs constitute the largest portion of the basket, followed by transportation, and groceries.  Much like other economic metrics, it was quickly discovered that the CPI was not exactly perfect at measuring the effects of rising prices on households, for a variety of reasons.


The most commonly cited criticisms of the CPI, some of which have been adjusted for, are:


  • Difficulty adjusting for price increases tied to an increase in the quality of a product.


  • Accounting for ‘substitution bias’, where consumers shift consumption between two substitutable products based on which is more expensive at the time.


  • The method for calculating the cost of housing.


“You leave yourself an enormous margin of safety. You build a bridge that 30,000-pound trucks can go across and then drive 10,000-pound trucks across it. That is the way I like to go across bridges.” – Warren Buffet

In order to adjust for changes in quality, a method known as ‘hedonic pricing’ was added to the CPI construction process in the 1980’s. This method effectively lowered the reported rate of inflation, as part of the rise in prices was designated as being justified due to the increase in quality of that product, and was not included in the reported figure. An example of this would be saying that an increase of $100 to the average price of a Personal Computer would not be included in the CPI reported figure, as the increase in price was justified given the advancement in the technology. Although this intuitively makes sense, it marked a shift in purpose for the CPI, as it moved away from being a true measure of out-of-pocket expenses for the average consumer.In order to adjust for what is known as ‘substitution bias’, in the 1990’s, the CPI became a geometric average of prices, rather than an arithmetic or common average. This technique places lower emphasis on goods which rise in price quickly, based on the assumption that consumers will defer their spending towards cheaper goods as the prices of certain substitutable goods rise. This decision shifted the purpose of the CPI once again, as it became more of a ‘cost of survival index’ than a cost of maintaining a certain lifestyle.The final area of the CPI which has been heavily debated is the manner in which shelter – which accounts for 40% of the CPI – is measured. The original method, which simply measured the amount it cost per month to finance a residence, was deemed misleading due to the fact that it included properties held for the purpose of investment. The reason this was deemed misleading was due to the idea that current mortgage or financing costs for those residences which were held for investment were not necessarily indicative of the rent, or cost, which would be required to be paid by a true resident. The ‘corrected’ measure, that is currently used, is known as ‘owner’s equivalent rent’, and inquires the price at which a home-owner would be willing to rent their residence for in the current market. This method, however, has also been heavily criticized, as it was unable to predict the incredible inflation of home prices during the housing bubble. Some argue that the measure is a function of interest rates, rather than rising prices, as the price home-owners are willing to rent their homes for is directly correlated to their current mortgage rate, not necessarily the price of their home. Due to the elongated period of zero interest rates as of late, many believe that this large portion of the CPI remains artificially depressed.John Williams, an economist whom we follow closely, has been a vocal advocate against the current headline reports of CPI and inflation; he argues that the CPI is not indicative of the current price environment for the average consumer, and that inflation is much higher than the mainstream media would have you believe. Below is a chart, taken from his site ‘Shadow Government Statistics’, which displays the mainstream media’s announcement of CPI (red line), versus what the unadjusted CPI (blue line), which represents what the CPI figure would be if the controversial adjustments previously outlined were not implemented.3  quarterly 3The aggregate difference between the two figures is approximately 7%, which is the driving force behind Mr. William’s disbelief of the currently popular view that inflation is of no concern.There is also a strong argument behind the idea that, regardless of the current rate of inflation, strong conditions are currently present which could put upward pressure on prices. As stated previously, the most basic force behind inflation is consumer expenditure; as such, the strongest argument for imminent inflation surrounds the current pressure on corporations to raise stagnant wages.The most visible example of the demand for wage increases has been the high profile debate over the level of minimum wage, which, after being adjusted for headline inflation, is at a lower level than that which was in place in the 1960’s4. However, minimum-wage-earners are not the only ones battling for increased wages, and companies are starting to concede.As the chart below shows, a survey of a number of corporate CFOs indicates that an increasing amount of companies plan on increasing wages and salaries over the next 12 months.  quarterly4In conjunction, the recent financial crisis has necessitated companies to pursue lean operations, find savings and depress investment; this will decrease their ability to absorb the additional wage increases without cutting into profits. As a result, the chart also shows that most of these companies are planning on increasing their own product’s prices over the next twelve months as well.Along with corporate management, employees also have history on their side of the argument for higher wages, as labour compensation, as a percentage of GDP, is at the lowest level that it has ever been. The chart below shows a small rebound to the downward trend, which may be an indication that the trend has already begun.quarterly5In summary, although global central banks have advocated deflation and falling prices as the primary enemy, the stage is set for an inflationary environment, and the argument that it is already upon us is rather strong. As it is typically regarded as a leading indicator for inflation, gold is an attractive asset to hold in such a scenario5.  If inflation is indeed upon us, and wages continue to rise, we would expect for investors to flock to the tangible value of gold, and precious metal-related stocks would likely benefit as a result.

Despite the level of geopolitical upheaval or economic uncertainty, the markets are somewhat paradoxically calm.

The VIX, which is used to measure the expected amount of volatility in the options market, is currently at its lowest level since pre-crash 20076, and this low level of observable fluctuation is not only present globally across differing countries, but also across most primary assets. As Ramin Nakisa, volatility expert at UBS notes: “Volatility is the digestive noise of the market, and if it is not rumbling, it is because there is no new information; there are no shocks to make volatility spike; there are no directional changes in the markets.” This is partially a product of global easy money policy, which has allowed for cheap credit for both individuals and sovereign entities, but also, in our view, due to an absence of investor conviction. Many investors are unsure which direction the market will turn in the near term, and are looking for a key piece of information to convince them either way. Two pieces of key data which will be pivotal in the development of investor bias will be the upcoming releases of second quarter U.S. GDP, and the next release of CPI data. The horrible GDP figure exhibited by the U.S. during the first quarter was largely attributed to poor weather, which has added emphasis to the importance of a strong figure in the second quarter. If this release disappoints, as John Williams from Shadow Government Statistics predicts it will, the market may enter a panic and begin to seriously debate the legitimate strength of the economy. In addition, as Fed Chair Janet Yellen has dismissed the recently elevated CPI figure as being due to market ‘noise’, another data release above 2% would also cause investors to re-examine their positions on the presence of inflation. Global stock markets have consistently outpaced the strength of economic data that is being reported, and we are remaining wary of any shock that may emerge to remind investors of this weakness. The source of the tipping point is unknown to any single investor, but it is our view that it is better to be safe than sorry.


For a sample of content which we are regularly publishing on our blog, please see below:


Close your eyes and imagine it is the year 1978. Pierre Trudeau was the Canadian Prime Minister, Saturday Night Live had just entered its third season, and the Toronto Maple Leafs’ Stanley Cup drought was only 11 years young. In the same year, China had 180 million people living in urban cities; fast forward to present day, and this number has grown to 700 million. This serves as a dramatic example of the urbanization process that is currently impacting the world. By 2050, the world’s urban population will grow from 3.9 billion to 6.4 billion people. This process will strain both local and national infrastructures, pressure urban real estate markets, and pose severe environmental challenges. This movement is occurring globally, but not uniformly. In recent times, Toronto has witnessed an expansion to its suburbs. The city has a population density of 4,150 people/ km2; comparatively, Manhattan has a density of 27,000 people/ km2. Toronto is a city that is sprawled out, but will soon see the end of suburb expansion and the move towards further urbanization. To cope, Toronto desperately needs to fix its decrepit infrastructure, which currently has Torontonian’s commuting for a longer time on average than both New York and Los Angeles. It will also have to build vertically, instead of horizontally. This dynamic will increase the value of existing single family homes in desirable and convenient locations, and put pressure on the influx of condos ready to hit the market.

To read more about the implications of urbanization, both globally and locally, please visit our blog on https://macnicolasset.com/toronto-urbanization-and-the-future/