Third Quarter 2015

Market Review Quarter 3, 2015


Third Quarter

Equity Markets                                      % Change (in Cdn$)

S&P/TSX Composite                                                  -8.6%

S&P 500                                                                    -0.1%

MSCI/Europe                                                             -2.4%

MSCI/Far East                                                           -7.0%

TSX Energy                                                             -18.0%

TSX Financials                                                          -4.0%


Interest Rates                                  September 2015              June 2015

Cdn 91 day T-Bills                                            0.41%                          0.58%

U.S. 91 day T-Bills                                           0.02%                          0.02%

Cdn 10 year Bond                                             1.45%                          1.69%

U.S. 10 year Bond                                            2.04%                          2.35%


Commodities (in U.S.$)                   September 2015              June 2015

Oil                                                                  45.40                           47.64

Natural Gas                                                      2.52                              2.82

Gold                                                           1114.10                         1172.10


Portfolio Management Strategy


What Worked                                                                                      What Didn’t

– Bonds                                                                                               – Commodities

– Utilities                                                                                             – Preferred Shares

– U.S. Dollar                                                                                        – Canadian Dollar


A Preferred Opportunity – NL

Investors in most of the world had difficulty making money during the second quarter in both fixed income and equity markets.  In the third quarter, bond investors actually did okay as the long-awaited increase in short-term interest rates by the Federal Reserve (Fed) in the United States was once again put off until some unknown date in the future.  As such, Janet Yellen, Chair of the Fed, is getting a reputation as The Great Procrastinator.  In Canada, the Bank of Canada not only didn’t raise rates as most investors had hoped, but instead cut interest rates for the second time in 2015, hoping to stimulate the economy by lowering the value of the Canadian dollar and thus making our exports more attractive.  The result was lower bond yields, which translates into higher bond prices.  Investors in equities, however, did not fare as well, with stock markets around the world showing negative returns almost universally.  As the front page of this publication shows, the S&P/TSX Composite index declined 8.6%, led largely by a significant drop in the price of most commodities.  That said, even Canada’s beloved bank stocks were down 3.4% for the quarter, bringing their year-to-date slide to 8.6%.

Canadian investors in the U.S. benefitted greatly from the continued drop in the Loonie as the S&P 500 was essentially flat when measured in Canadian dollars.  Painful as it has been to watch our dollar sink for most of the year, Canadians should take some solace in the fact that the U.S. dollar is the strongest currency in the world and we have fared about the same as our European cousins and better than many other commodity-based currencies.

One area that has continued to be hit quite hard is the preferred share market.  More precisely, the Rate Reset and Floating Rate sectors of the preferred market.  Investors had been pouring money into these two areas in the expectation that they would make a lot of money as interest rates rose from historically low levels.  Unfortunately, as noted above, not only have rates not risen but they have in fact declined.  This has led to significant losses by those owning these securities.  Year-to-date, Resets are down 30% and Floaters are down 36%.  Investors have been bailing out of their holdings willy nilly, as if interest rates will never rise again, and tax-loss selling will no doubt exaggerate this effect.  Mindless, wholesale, and fearful selling generally creates opportunities and we believe this is no exception.  Eventually, investors will realize that not only do these preferreds now offer very attractive yields, but also the potential for capital appreciation once interest rates do begin to head higher.  We have no idea when interest rates will start to rise but we will be looking very closely at this market over the next quarter for investment opportunities.


Some Perspective On ChinaDS

China’s slowdown has weighed heavily on the markets and the TSX in particular.  Analysts, particularly in Anglo-Saxon nations, have effectively written off the historically fast growing nation.  Capital is flooding out of Asia creating a number of attractive valuations.  Fund flows now favour the slow growing and heavily debt laden U.S.  Europe with its Quantitative Easing (“QE”) program now in full swing is also an attractive investment destination as market commentators are predicting (like the U.S. QE experience) substantial asset inflation and, unfortunately, a major increase in the supply of money.  When Alan Greenspan, the former Chairman of the Federal Reserve, commented on the ultimate ramifications of QE, he noted nations cannot run the (money) printing press at full steam for an extended period of time and not experience substantial inflation.  Anecdotally, we have recently seen a substantial fall in the share prices of major U.S. multinationals in conjunction with a slowing of U.S. QE.  While, the strength of the U.S. dollar is clearly a factor one does wonder if the QE experience will ultimately end badly for those nations that embraced it.  In light of the above challenges, why China with its annual 7% GDP growth rate or even other fast growing parts of Asian warrants such negative market sentiment is a wonder.

Perhaps the answer to the China slowdown fears lies to some degree in a lack of understanding.  Having previously lived in Taiwan for five years and having traveled extensively throughout the region has given me a different perspective than most of my peers.  For my view of economics across the region I tend not to draw upon the Wall Street Journal or the Financial Times but rather talk with management teams operating in the region.  I read China-based, foreign economic and market commentators fluent in Mandarin with substantial experience living and working in China.  These individuals typically have deeper more rounded perspective than nonresident or visiting China commentators.  I tend to stay away from China-based, Chinese analysts as they appear “too close” and I feel they lack the appropriate level of detachment to make the correct calls.  Perhaps the final point to note on the economists and market commentator community in general: they seldom agree and, unfortunately, for investors, when they do they are almost always proven to be wrong over time.

China’s executives have been keen observers of Singapore, under the leadership of the highly regarded and now departed Lee Kuan Yew [1], and of Taiwan.  Both of these Chinese nations have historically been heavily export oriented but more recently have been transitioning into more domestically oriented economies.  Singapore is more advanced on this transition and is currently home to the highest number of U.S. dollar millionaires per capita.  Taiwan, while almost a first world nation, still has work to do on its domestic economy transformation as it currently remains too reliant on the U.S.  I believe these two nations ultimately offer a better insight into what China’s executives hope China will eventually become.

Growth is nonlinear.  Unfortunately, an overwhelmingly large number of China analysts had assumed an uninterrupted high single digit growth trajectory.  Clearly, they were wrong and growth expectations now need re-calibrating.  Naturally, when your trading partners slow to a crawl you must follow suit.  Along that line of thinking, a 6% annual GDP growth rate is very high vis-à-vis most developed OECD nations.  Based on 2014 data, at USD7,000 income per capita, a 6% Chinese growth rate is equivalent to USD420 in new income per head.  On a per capita base of 1.5 billion people this annual growth will translate into a staggering USD630 trillion of new wealth creation per year.  In a relative context, that would equate to building an economy 20% larger than Switzerland on an annual basis!

It is problematic most market commentators broadly accept China’s policy statements as a fact.  When China stated “we will transform into a more domestically driven economy” at its ten year economic planning session held in 2013, the appropriate question should have been how will this be achieved, not just a benign acceptance of a new reality.  Many economists have noted the complexity of transitioning an economy.  Here in Canada, federal election hopeful Thomas Mulcair publicly lamented the undiversified nature of our economy.  He stated, we can transition away from commodity products into a value-added higher margin economy.  However, when you think of the number of national champions capable of progressively generating value-added growth, Bombardier, with all its troubles, and a couple of other Canadian companies spring to mind.  Consequently, I am skeptical in the near term that China’s development of its domestic economy will be anything but pedestrian.  Rather, I expect progress at the margin on its domestic economy transformation with the export sector remaining the major engine of its economy.

China is slowing down.  This is a fact.  The slower growth rate is a natural consequence of the slow growth of its trading partners.  China has doubled its economy since the onset of the Global Financial Crisis, a feat no other sizable or developed nation can lay claim to.  Looking forward, the next major phase in China’s evolution will be the development of an export-oriented car industry.  China has an auto sector but it is domestically focused.  Local content rules and the acquisition of the Volvo car brand (now owned by Zhejiang Geely, which is listed on the Hong Kong market) do make one wonder when China will begin exporting autos.  Clearly, an export-oriented car industry would be a major wealth generator for China as the Auto Pact (now NAFTA) has been for Canada and as the German auto sector has been for Germany.

China has begun liberalizing its financial markets and has ambitions to turn the Renminbi into a major global currency. Hong Kong will be a key cog in that process.  Hence, the 2014 China Connect process, which cross-listed the top 300 Chinese companies on the Hong Kong Exchange, provided non-Chinese residents with unrestricted access to blue chip Chinese equities for effectively the first time since Mao took control.  The Chinese portion of Connect allowed Chinese residents to buy securities on the Hong Kong Exchange and they did so in massive volumes.  Looking forward, a Connect program expansion has immediate implications for Singapore, and probably Taiwan, and for most major global indexes over a longer timeframe.

In summary, China has become a substantial portion of the global economy.  Its share of Global GDP will continue to rise.  However, the pace of growth must surely slow as sustained high single digit annual GDP growth from a $7,000 income per capita base will become increasing difficult to achieve i.e. the inability to continue building ever larger versions of the Swiss economy on an annual basis.  Historically, exports were the major driver but for China to continue growing its per capita income, it will need to embrace new economic policies. These policies will take at least a decade to implement, probably longer. The growth of the domestic economy, the development of comprehensive pension and healthcare systems and the use of its financial resources on the international stage will all be pillars of this new strategy. In the recent past China was the main target for our commodity sectors. Moving forward, we as a country will need to target its financial sector, its service industry and its manufacturing base. Our success or not with these endeavors will have major implications for the standard of living we currently enjoy here in Canada. For Canadian investors, we too must engage with China but we must do so in a rational and prudent manner.


Can You Expect The Unexpected?RD

Donald Rumsfeld, as George Bush’s secretary of defense said ‘As we know, there are known knowns; there are things we know we know.  We also know there are known unknowns; that is to say we know there are some things we do not know.  But there are also unknown unknowns – the ones we don’t know we don’t know.’

We have been musing for a while now about all the time and attention spent on the timing of when the U.S. Federal Reserve would begin to raise the federal funds (interest) rate after more than 6 years at close to zero.  We have instead been pondering on how little value we were finding in the market, hence the rise in cash positions over the course of the last 12 months.  We observed that analysts were spending so much time speculating on the exact date of the interest rate rise that we couldn’t help but think that with all eyes focussed there, it would largely be a non-event (it is reasonable thinking that higher interest rates lower stock prices, especially if interest rate increases are large).  We instead were getting nervous that something else, something as yet unknown, would create a stock market moving event.

The 3rd quarter was fascinating as the cup runnethed over with out of the blue, black-swan like events. The concept of a black swan event was popularized by the writer Nassim Nicholas Taleb in his book, “The Black Swan: The Impact of the Highly Improbable”.  Mr. Taleb is a finance professor and former Wall Street trader.  He suggests that the world is severely affected by events that are rare and difficult to impossible to predict. Black swan events are not in any model because no one expects it to occur.

The fact that high valuations eventually come back down to earth is not a black swan event.  For example, with interest rates low, investors looking for yield, are confronted with limited offerings.  Less supply and more demand has bid up the stock prices in high dividend yielding stocks.  This makes them vulnerable to an interest rate increase that would potentially open up more options for the yield seeking investor.  When demand wanes it won’t be a black swan event but rather a reversion to more normal valuations.

However, in the 3Q alone we saw China devalue its currency and then try to strong arm its own stock market by prohibiting trading in some of its major listed stocks.  Did anybody really see those extreme events coming?

We reduced our weight in healthcare last year but then that sector went on to be one of the best performing sectors for this year.  That is until in September, a tweet from Hilary Clinton commented on an egregious 5000% price hike by Turing Pharmaceutical on a drug it produced to treat a life threatening infection. This is not the first time that there has been a massive overnight price increase on a drug but this was the first tweet about it from a high level politician.  The healthcare sector tumbled and lost its 10% relative outperformance with respect to the U.S. market so that year-to-date that sector’s performance is also in negative territory.  Canada’s darling (cough) Valeant Pharmaceutical and other highly valued biotech stocks fell significantly.  Highly valued stocks suffer most from these unexpected events.

And then there is Volkswagen.  Could there be a more shocking case of deception and fraud?  Well yes, so this is not technically a black swan event either but that is no comfort to investors.  Almost 20 years ago the U.S. government sued heavy engine manufacturers Caterpillar, Mack Trucks and others for virtually the same engine emission rigging shenanigans.  As Mark Twain said ‘history may not repeat itself but it sure rhymes’.  Those firms settled for USD 1 billion back in 1998.  In today’s even more environmentally conscious world, they will be made to pay dearly.

Stuff happens, unpredictable stuff, despite regulations being in place to prevent the stuff we have actually considered.  As always, we let our diversification and value doctrine lead the quest to weather the next unknown.











October 2015

[1] The founding father of Singapore. He advanced a pro-business single party political system that has transformed a post-colonial backwater into one of the most affluent countries in the world. His legacy continues under his grandson Lee Hsien Loong, the current Prime Minister.

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