January 2016

January 31, 2016 | Derrick Lahey


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“2015 was another year of serial disappointment.”

Bank of Canada Governor Stephen Poloz

 

“It is tough to make predictions, especially about the future.”

Yogi Berra

 

For the fifth year in a row year, the Canadian stock market underperformed the US market in 2015 by dropping about 10% during the year. To put this into context, there has only been one other time since 1927 that Canada has strung together 5 consecutive underperforming years and for what it is worth, there have never been 6 consecutive years. Records are made to be broken and this one may fall, but this “sell Canada” sentiment is getting very old. And it is not just the Canadian oil and commodity stocks that have been suffering as all sectors have been beaten down. It is worth acknowledging that the only developed markets that performed worse than Canada last year were Singapore and Greece!

 

And it really wasn’t much better in the US markets either. There were just a handful of “mega-cap” stocks that propelled the broad indices to about “even” on the year. If it wasn’t for Netflix, Amazon, Facebook, Microsoft and Google (now called Alphabet) and just a couple of others, the US markets would have been down single digits on the year. In fact the only saving grace for Canadian investors was U.S. portfolio exposure that benefited from the rising USD. In C$ terms, most portfolios were fairly flat on the year but it certainly felt worse as the vast majority of holdings were marked down. And the first weeks of 2016 have been unrelentingly hostile to investors. What is behind all the pessimism?

 

There are a couple of issues that the market is grappling with and they are hardly new. We all know Oil is having a hard time finding a bottom as it trades through all reasonable cost levels and to 12 year lows. If there was one variable to predict the direction of the markets in any given day it is the price of oil as there is almost a 100% correlation between oil and the stock markets (as well as the C$). When oil is down in price, stocks are also down and this has been the case now for a couple of months. The markets are interpreting lower oil prices as being universally bad (which is not the case) and foretelling a sharp slowdown in global growth (or maybe even a global recession). On a daily basis we are told the world is drowning in oil which is a supply problem but the markets are increasingly acting like they are worried that low oil prices are a reflection of weak demand. We seem to be in a negative feedback loop with lower oil prices feeding fears of slower global growth and therefore justifying lower stock prices. Also as oil goes lower, the risk of loan defaults rises and markets are increasingly worried that this could lead to another 2008 style credit crisis. While anything is possible in today’s complex financial system, we think the chances of this are extremely remote. Firstly the banking sector does not have the same exposure to the energy markets as it did to the housing market in 2008. Secondly, new regulations that have been implemented since the credit crisis have curtailed many of their riskier practices while at the same time requiring better balance sheets to improve stability.

 

Banks are stronger today and have more capital backing their activities than they did in 2008. So a freezing up in the financial markets like we had during the credit crisis seems very unlikely and in fact credit spreads and other indicators are not signaling the same degree of stress.

 

While it is foolish to try to predict when and at what price oil will bottom, we know markets always trade through “fair value” and this is certainly the case with oil anywhere near $30. There are very few companies that make money selling oil for $30 per barrel and no country can sell oil at these prices and hope to balance their budgets. Most production requires closer to $60 just to break-even (the so-called “all in sustaining cost” which includes land leases, exploration, development etc.). And while Saudi Arabia claims to have a cost of $10, it needs closer to $80-90 to balance its budget (hence the country has issued debt twice in the last year). While it is illogical to keep producing at a loss, companies keep doing so to service debts because bankruptcy is an unattractive option. The Financial Post recently reported that the average U.S. producer was using more than 80% of its cash flow to service interest payments when oil was at $50 so at $30 there isn’t any cash left over for anything else like development. Since the average American oil well produces about 30% less after a year (with some shale production experiencing decline rates as high as 70% per year) production drops off pretty rapidly over time. With all of the reduction in spending going on, we are setting up for an inflection point that will take prices much higher at some point. Just as it has taken time for production to decline, the supply response will be slow when prices do eventually recover. I suspect Saudi Arabia wants to see some blood on Wall and Bay Streets to teach everyone a painful lesson (and as we know, the degree of pain and the strength of memories directly correlate). I am pretty sure this is what Saudi Arabia and OPEC expect as they tolerate “short term pain for long term gains”.

 

China is the next big worry. Last August China devalued their currency against the USD (like every other country has done) and the markets interpreted this as the first of many adjustments to come. In fact, China devalued again by a small amount in early January and this has caused more capital to leave China and is no doubt contributing to global market volatility. Some view these devaluations as proof that the Chinese economy is collapsing but again, I don’t know how this is a logical conclusion. Every country wants to export more and devaluing currencies is a logical step so why should China be any different than Canada, Japan, Europe and others? And while nobody believes the published Chinese 2015 GDP growth rate of 6.9%, even the most negative observers acknowledge that China is still growing. And as their economy has doubled in size over the last 10 years, even if growth is half of what it was 10 years ago, the economic output is the same as 10 years ago which is second only to the American economy. Worries about China will no doubt continue but hopefully the market starts to put them into some perspective. Not to downplay China’s importance from a global perspective but it accounted for only 8% of U.S. exports in 2014 which was less than 1% of U.S. GDP. It certainly matters but the strength of the American economy is of paramount importance and that economy is doing reasonably well. U.S. recessions don’t usually start with solid employment growth and one tentative interest rate increase.

 

The last big worry that markets are ruminating on is the chance of a Federal Reserve policy error. For the first time in 9 years, the Federal Reserve raised their overnight lending rate by ¼% last month and signaled as many as 4 more to come this year. The anticipation of this tightening cycle (the only one in the world currently underway) has caused the USD to appreciate and with it, global financial stress. While markets are worried that the Federal Reserve will continue to raise rates irrespective of global conditions, this seems very unlikely. The Fed is attuned to global markets and delayed the first expected increase from September to December because of global market volatility at the time. So it will be “data dependent” and at the moment, there is no data suggesting that they should rush to implement additional rates increases. This should moderate the continued USD strength and in turn, help to stabilize commodity prices and emerging market economies. Even Goldman Sachs proclaimed that a new commodity bull market will start this year which certainly lines up with an end to Canada’s long losing streak.