Market Review Fourth Quarter, 2012
(% Change in Cdn$)
Calendar Year 2012
Cdn 91 day T-Bills
U.S. 91 day T-Bills
Cdn 10 year Bond
U.S. 10 year Bond
Commodities (in US$)
Portfolio Management Strategy
Year over Year 2012
Life Insurance Stocks
– German Stocks
– Forest Products Stocks
– Small Cap Stocks
– Chinese Stocks
– Commodity Stocks
The End of an Era – NL
Despite the negativism one constantly hears, stock markets around the world finished 2012 almost universally in positive territory. In fact, I could not find a major world market that declined during the year. Surprises abounded. The top performing major markets were Germany, Japan, and Hong Kong while the worst (although still positive) were China, Canada, and UK
European equity market results are the ones, I believe, that will shock most investors. Last year they suffered as headlines would have had you believe the continent was headed for economic breakup and bankruptcy. Not only that, but European-based companies were going to follow the continent down, even those that had the majority of their sales and earnings outside Europe.
Yes, much of Europe is or will be in recession in 2013 but corporate valuations were punished to bargain levels by panicky investors who just wanted out. As usual, this brought opportunity and investors took advantage of those bargains. Japanese markets responded to both an expected change in government and the fact that the new government was going to print more money, hoping to both awaken its moribund economy and cause the Yen to fall in value, therefore stimulating exports. Not surprisingly, exporting companies led the charge. Finally, Hong Kong stocks did well as investors realized their worries over a slowing Chinese economy were overblown
That said, the Shanghai market was the weakest major market last year. What gives? While the Hong Kong market has Western-style corporate governance, Shanghai is still the Wild West. Sino-Forest was not an isolated incident and investors want protection. Investing in Chinese stocks traded in Hong Kong gave them the best of both worlds. Canadian markets once again underperformed as commodity demand and pricing largely remained under pressure. Finally, stocks in the UK suffered due to a weakening economy coupled with an overvalued currency.
The great bond market rally, which began with the peak in interest rates in September of 1981 has, we believe, finally run its course. Oh, how we dream of having bought 30-year Government of Canada bonds yielding over 18% and holding them to maturity. What I do actually remember is renewing the mortgage on my first house at 19.5% for one year. Something I will never forget! Over that thirty-one year period, it would have been almost impossible to lose money in the bond market if one held bonds for any reasonable length of time. It was like shooting fish in a barrel. The barrel, however, is springing leaks and the fish are starting to escape. Five-year Canada bond yields bottomed in July of this year at 1.16% while long bonds bottomed the same month at 2.22%. At time of writing, those same five-year bonds are yielding 1.5% and the long bond is yielding 2.5%.
There are two main reasons why we believe the great bond bull is dead or at least dying. First, we expect economies, especially in North America, will be stronger than what most economists are currently forecasting. Three important industries are behind this optimism: housing, automobiles, and aerospace. The recovery in the U.S. housing market is in its infancy. In many markets, housing prices have not only stabilized but are finally increasing, albeit from an extremely depressed level. Additionally, new home construction is on the rise. This has implications not only for labourers who are involved in building the houses but, also all the suppliers from lumber producers (lumber prices are already at multi-year highs) and other building material companies to real estate salespeople through mortgage providers to auto companies making the pickup trucks that bring supplies to construction sites. These are all labour intensive, good paying jobs. Speaking of auto companies, North American auto production is booming and there is talk of new plants being built to handle the increased demand. The current age of the fleet on the road is at an all-time high and it is in the process of being replaced. This bodes well not only for assembly workers but also tire and parts manufacturers as well. Once again, labour intensive well-paying jobs. Finally, despite the teething problems Boeing is currently having with its new Dreamliner, demand for aircraft is extremely strong as air travel is up and airlines are scrambling to replace their old fuel guzzlers with more modern fuel sippers to maximize their profitability. Yes, aircraft and parts manufacturing is labour intensive and good paying. These three industries alone should contribute to stronger economic growth, higher employment levels, and increased inflation due to growing demand for goods and services. A booming economy? No, but stronger than most expect. This will lead to higher interest rates and lower bond prices.
Second, we think the jig is up for the free ride given to profligate governments in both Canada (mostly the provinces) and the U.S. Investors have ignored fiscal woes and constantly increasing borrowing levels as fear has pushed them away from volatile stocks and into safe bonds. This has enabled governments to borrow vast amounts of money at ridiculously low interest rates. Investors, however, are just now starting to be drawn back to stocks and away from bonds. The TSX Composite Index currently yields 3.0% versus 1.5% on Canada five-year bonds. Ten-year bonds are still under 2%. Dividend payments from top companies tend to grow over time, increasing one’s yield. Also, for Canadian stocks in taxable accounts, the dividend tax credit makes dividend income far more attractive than interest income. Pension funds cannot come anywhere close to meeting actuarial assumptions with bond yields at current levels. Individuals cannot fund their retirements with most of their savings in bonds. As investors seek growth and higher yields, they will increasingly be moving money from bonds to stocks. While we do not expect a large jump in interest rates, it is a larger relative percentage change when interest rates move from 2% to 3% versus when they go from, say, 7% to 8%. The effect of rising rates on bond prices can be devastating at these levels. We think the risk/reward ratio now favours equities instead of bonds. The chances of rates moving from 2% to 3% or higher are far greater than them moving down to 1.0%.
While we do not believe, as noted above, that rates will rise quickly, we do think that interest rates in the bond market (as well as yields on preferred shares) will be higher a year from now. In anticipation of this move, we expect to reduce our exposure to fixed income and increase our exposure to stocks as the year progresses. In addition, as I have mentioned in previous issues of Commentary, the longest bond maturity we own for our clients is currently eight years and we may reduce that further if we see rates rising faster than we expect. All good things must come to an end.
Changing Winds – FB
During my 22 plus years at Portfolio Management we have consistently held significant positions in the fixed income markets, primarily bonds issued by the Government of Canada and various Canadian provinces, for client portfolios. Those investments offered stability, safety, reasonable income and as interest rates fell over time they also provided some attractive capital appreciation. As always the future will hold different challenges and we will experience different interest rate environments. The next 22 plus years will almost assuredly not provide the same smooth ride as rates can’t experience the same decline in the future.
The primary driver of a bond’s price is the interest rate the borrower must pay to the lender to attract capital. That pricing mechanism, the rate of interest, has in turn two determinants: inflation and credit quality. So it follows that where inflation and credit quality lead, bond prices will follow.
Inflation, meaning the rise in price of consumer goods and services, erodes the future purchasing power of a dollar. If an investor believes that inflation will average 3.5% during the period he holds a bond, and if he wants a 3% return during his holding period, then he must purchase a bond such that he will earn 6.5% before inflation.
Credit quality, the other primary determinant of interest rates, has been largely forgotten and dismissed by lenders over the past 4 or 5 years, at least as far as their lending activities in North America go. It seems illogical to me that rates on U.S. government debt, commonly called U.S. Treasuries, are at generational lows at the same time the U.S. government is further in debt than ever before.
The markets are starting to fret about a recovering U.S. economy producing inflation. Personally, I’m not as concerned about inflation as I am worried that the risk reward for bonds has become much less attractive due to large and increasing government deficits and massive government debts. Add in pension obligations, health care obligations and the situation is tenuous at best. In short, something has to give. The most likely candidate for revision is a reduction in the credit worthiness of governments and if that were to happen interest rates would rise dramatically.
All the above suggests that it seems to us that the risk return equation in the North American debt markets is becoming less and less favourable to the lender with each passing week. Our response is that we will not be emphasizing bond investments unless and until we see an expectation of a reasonable future return given the then existing risk(s) imbedded in the market
Another twelve months has slipped by and our firm had a successful year. It’s my pleasure to extend a thank you to all clients, readers of our commentary and friends. On behalf of my partners and our wonderful staff please accept our thanks. We haven’t, and I hope never will, take your support for granted. And to those of you who referred friends and relatives another thank you. Those referrals turn into a significant portion of our new business each year and for that we are most grateful.
Who We Are – NL
I would be remiss if I did not address something that many clients and prospective clients ask us frequently: What is the main difference between an investment counsellor and a stock broker (or investment advisor or financial consultant or whatever fancy name their firm gives them) or a mutual fund salesperson? I will offer two answers. One is my own and the other is from the CFA Institute.
To me, the main difference (please note that in the past I worked for two different stock brokerage firms for close to ten years) is that stock brokers and fund salespeople are generally salespeople who happen to be in the investment business. Investment counsellors are primarily investment professionals who have to sell in order to eat but who would rather just invest.
To the CFA Institute (The CFA Institute is the global association of investment professionals that sets the standard for professional excellence), the difference has to do with different standards. “In order to have fair and transparent markets, all investors must feel confident that the investment advice, products, and services offered by investment professionals are not only suitable for them but also in their best interest. Clients want to be assured that investment professionals are placing the clients’ interests ahead of their own personal interests or those of their employers.” Investment counsellors have fiduciary standards, brokers have suitability standards. “Under a fiduciary standard, investment professionals owe a duty of loyalty and a duty of care to their clients. This requires that they act in the best interest of clients, disclose all conflicts of interest, and have a reasonable basis for making investment recommendations. In other words, investment professionals must provide suitable and reasonable advice to their clients based on their investment objectives and financial circumstances. Under a suitability standard, investment professionals are required to have a reasonable basis for recommending products and services after considering the client’s investment objectives and financial circumstances. However, they are not required to recommend products that are in the client’s best interest.”