“A nickel ain’t worth a dime anymore”

Yogi Berra

 

Last year was a year of waiting. We waited for Europe to find a way forward and just like the American experience, it was the European Central Bank (ECB) that came to the rescue. The head of the ECB essentially indicated that the Bank was prepared to do “whatever it takes” to back-stop the Euro. As has often been the model since the financial crisis, “whatever it takes” is code for money creation and the ECB used its printing presses to purchase bonds of the most indebted countries such as Spain and Italy. As ECB bond buying kicked into gear, Spanish and Italian bond yields plummeted from over 7% to less than 5%, essentially breaking the “fear fever” that had gripped Europe and the world last summer. In my most recent market letter last June, I indicated that Europe was at a “watershed” moment but that it is in everyone’s best interest to keep moving forward and that is what has transpired.

 

We waited to see if China would achieve a “soft landing” when they purposely tried to dial back their economic growth rate to something more manageable with lower inflation rates. While the world worried about a stalling Chinese economy, I wondered why everyone was so convinced the Chinese would be so inept at managing their economy when they have the ability to instantly change gears without political gridlock. If growth was slowing too fast, they could gear up very quickly and that seems to be exactly what they are doing. The risk of a Chinese recession has subsided and that is good for Canada and the world.

 

We waited for the US election to play out and hoped that it would result in a clear mandate being given to either party so decisions in Washington could be made. After Mitt Romney was made the official Republican nominee, I went on record in expecting another four years for President Obama. I thought Romney was essentially “unelectable” especially after his tax returns showed an effective tax rate of only 15%. The majority of Americans did not blame Obama for the slow economy and realised it took many years to create the problems and it would take more than 4 years to right the ship. American society is tired of the “rich getting richer” and regardless of what he said, Romney represented the ½ of 1% of America where all the wealth has been accumulating for 20 years.

 

Hours after the election results, the media wasted no time in turning our attention to the next “crisis” into year end as the countdown clock to the Fiscal Cliff went live on CNBC. In true Washington form, politicians stayed in the spotlight right up until New Year’s Eve, finally cobbling together enough tax reform to avert the cliff dive. Actually the deal was passed hours after midnight so in reality America actually went over the cliff, defied gravity and scrambling back up to safety in true cartoon style.

 

Now our attention is being directed to the next crisis. Once more, America will bump up against its self-imposed borrowing ceiling this spring as it has 79 times before since 1960. America is the only country that imposes a limit on its government borrowing capacity and one has to wonder who else besides politicians and the media benefits from the exercise as every time the limit is reached, a new higher ceiling is created.

 

This past week however, Washington agreed to extend the ceiling by 3 additional months. In response to this relative calm in the financial world, stock markets have been steadily rising this month while at the same time, bonds have been steadily losing value. The US 10 year bond yield is almost back to 2% from 1.50% last August so perhaps the peak in bond valuations is now behind us. That would be a good thing for stock markets as the money that has been flowing out of stocks and into bonds now for the last 5 years could reverse course and fuel higher stock market valuations from these relatively low levels.

 

Since the financial crisis, I have devoted a fair bit of space in my market letters to write about the threat of competitive currency devaluations and it is starting to become front page news. Many countries have labeled the latest round of Quantitative Easing (QE) by the US Federal Reserve as a blatant effort to devalue the American dollar (in hopes of increasing exports). As 2012 drew to a close, Japan elected a new government who is openly calling for a weaker Yen in hopes of spurring Japanese inflation and exports. No country wants a strong currency when they are saddled with record debts and stagnant economies. One only needs a few fingers to count the number of countries that are still allowing their currencies to truly float without major government intervention. Canada, by the way, is one of them.

 

I still think that currency devaluations will eventually lead to higher levels of inflation which is exactly what every Central Bank wants at this stage. The US Federal Reserve is now targeting a 6.5% unemployment rate as their main policy objective and has openly indicated that it will tolerate higher levels of inflation above the target 2% in the short term. American home prices rose 7% on average last year so it seems the age of cheap money is beginning to have some success. If housing really has bottomed (some 6 years after peak), this bodes well for the American economy. Every 10% increase in home prices brings 2 million homeowners back into positive home equity, allowing them to refinance at record low mortgage rates. This leads to a wealth effect which leads to new car purchases and other expenditures.

 

Corporate net profit margins are at all time highs, as are corporate bank accounts. With all of the uncertainty in the last couple of years, companies have been reluctant to get off their cash. As markets toggled back and forth between being opened and closed last year, companies that wanted to issue debt at record low borrowing costs sat on the sidelines. But if we have relative calm for a few months, I think we will see many companies rushing to issue long term debt at these very attractive borrowing costs. IBM for example raised 10 year money for just over 2%! Companies will use the money to acquire competitors, raise dividends to get higher stock valuations or buy back stock. The dividend yields for many companies are much higher than the borrowing costs for 10 years so it makes perfect sense to take on debt and retire stock.

 

While many have been calling the last 4 years a bull market that is running out of gas, we have to look at the recovery off the panic bottom as simply that and look at the big picture. Markets are cheaper than they were 5 years ago and on much stronger fundamentals. While the US broad markets are being cheered as they hit 5 year highs, they are simply getting back to where they were in 2007 (which sadly is the same level they were at in 2000). Meanwhile, the TSX is still more than 2000 points lower than its all time high and is still about 1500 points lower than its recovery high almost 2 years ago. While we are moving in the right direction, it has been a big “sideways” market now for 13 years! Somewhere out there in the next couple of years, I think we get to a new secular bull market that breaks out and upwards of this long sideways market. I think that inflation will be a factor in this new bull stock market as stocks can navigate moderate inflation much better than “fixed income” that by definition cannot. A big rotation is coming but I am not convinced that it is clear skies just yet. But the sun is peeking out and it is getting brighter!