March 2011
“Blue skies
and stormy weather”
Improving economic conditions in the US have led to forecasts of another solid year for equities. In particular, manufacturing is recovering. Potential storms may arise from inflation, and the efforts of emerging economies to control it. Food inflation has been significant, and has a greater proportional effect on emerging countries. To the extent that they become inflation fighters, this affects prospects for both their growth and growth in commodities prices.
Equity investors have been enjoying nothing but blue skies in recent months, thanks to a combination of favourable economic data and strong corporate earnings. Bond investors have encountered some stormy weather, as this same economic data, combined with mounting price pressures, has pushed interest rates sharply higher. Capital flows, featuring asset mix shifts from bonds to equities, have only served to accentuate these fundamental market trends.
The economy – optimism now reigns
Concerns that the US economy would fall back into recession have been quelled in the wake of favourable data released over the past three months. The US economy grew at a steady 2.0% rate in the third quarter, and the November Institute of Supply Management (ISM) survey index at 56.6 shows the positive growth trend remains intact. Of greater significance, however, is the rebound in Consumer Confidence to 54.1 in November, a five-month high, which is confirmed by the solid 2.6% growth in consumer spending. Data related to the housing sector has also turned from "dire" to "mixed"; while housing starts remain moribund at a 519,000 annual rate (onequarter their level at the peak of the credit bubble), mortgage applications for homes have recovered to a six-month high. Equity investors have been further cheered by strong earnings reported for the third quarter, with 76% of S&P 500 companies exceeding consensus estimates, and profit margins for non-financial companies back to their 2007 peak levels.
The US economic recovery is now well established. US GDP grew at a 3.2% annual rate in the fourth quarter of 2010 and with the January Institute of Supply Management (ISM) survey index at 60.8, consumer confidence rising, and commercial and consumer credit growing, the economic outlook is bright. Indeed, the additional tax cuts and spending initiatives passed by US legislators in December, and the additional stimulus from the Federal Reserve's "QE 2," provide additional assurance that the US economy will enjoy a solid 2011. This should ensure that job growth begins to improve, bringing down the unemployment rate from its still painful 9.0% level.
The favourable US outlook was one factor that prompted the International Monetary Fund (IMF) to increase its forecast of global economic growth to 4.4% for 2011. Equally important were the economic trends in Asia and Europe. The Purchasing Managers' Index for Europe rose to 57.3 in January, while the UK index jumped to an 18-year high at 62. China's index remained firmly in "growth" territory at 52.9. Also noteworthy was the fact that Spain's consumer confidence index jumped to 70.7, and that the index of European investor confidence jumped to its highest level since 2007. Growing optimism in Europe has been aided by signs that the European Central Bank has contained the sovereign debt problems that threatened to destabilize credit markets. Spain and Portugal have both conducted successful debt issues at lower than anticipated interest rates.
A strong economy = strong commodity prices and corporate earnings...
The buoyant economic environment has been reinforced by strong corporate earnings. Over 70% of companies have reported earnings for the fourth quarter that exceeded investor expectations, and earnings forecasts for 2011 have been revised upwards as well. Investors now anticipate that the S&P 500 will post a 14% earnings gain this year, while a 27% earnings surge is expected from companies in the S&P/TSX Composite. Canada's profit growth relies on strength in commodity prices, which in turn rely on a robust global economy; at the end of January, the Commodity Research Bureau (CRB) price index stood 22% above its average 2010 level, helped by gains in the price of oil (+15%), nickel (+24%) and copper (+28%). Strong commodity prices are forecast to generate a 48% gain in profits from the Energy and Materials sectors, with the balance of the Canadian market posting still solid earnings growth of 13%.
Growing investor confidence helped drive global equity markets up by 6.9% (in Canadian dollar terms) in the December–January period. A 9.7% gain was posted by the European markets, where improving economic prospects bolstered investor confidence that the European Central Bank would be able to manage the sovereign debt crisis. In the US, the S&P 500 rose 6.7%, while the small-cap Russell 2000 index was up 5.1%. In Canada, the S&P/TSX Composite index was also up 5.1%, led by the 12.8% advance of Energy issues and the 7.3% gain by the Industrials; small-cap issues continued to post strong returns, rising 6.1%.
The renewed stresses within the eurozone have given rise to renewed speculation that the euro itself may be abandoned by Germany. However, as we highlighted in the spring, the German economy has been a key beneficiary of the weak euro, and the €550bn exposure of German banks to the sovereign debt of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) should provide sufficient incentive to work towards a solution. The support program, once established, will likely stay in place for some time since European banks have about €2 trillion of debt maturing to be refinanced through 2013.
...and rising inflation
However, the strong economic backdrop has been accompanied by mounting inflation pressures within a number of economies. Whereas 18 months ago, 30% of the countries surveyed by The Economist were experiencing consumer price deflation, the latest survey shows all countries witnessing rising consumer prices. The change has been particularly acute in some emerging economies.
Argentina has reacted to private estimates of inflation of 25% by threatening economists with $125,000 fines or jail. The central banks in Brazil, China, and India have responded in a more traditional fashion, sharply increasing shortterm interest rates in an effort to slow economic growth and temper inflationary pressures. This has resulted in an inversion of their yield curves. Historically, this has not been a condition favourable to equity markets, which helps explain why theMSCI Emerging Markets index gained only 1.5% while European and North American markets surged.
Food price inflation hits emerging nations harder
Unfortunately, these central banks face a daunting task in combating inflation because of the contribution from rising food prices. The United Nations' World Food Price Index hit an all-time high in January; sugar prices are at a 30-year high, and wheat and corn prices are about 50% above their 2010 average prices! Food prices have a proportionately greater impact onconsumer prices in emerging economies than in developing nations. There is little that authorities can do to temper rising food prices in the near term, and some of the actions they take, such as hoarding, in fact exacerbate the problem. Dramatic increases in food prices are also of concern because they can promote social unrest, as witnessed recently in Tunisia. Fortunately, food price shocks tend to be short-lived because production responds relatively quickly.
Inflation pressures have also been evident in the developed economies, with the UK reporting Consumer Price Index (CPI) inflation at 3.7% for 2010 while the European Union experienced price increases of 2.2%. While consumer prices in Canada are up only 2.4% over the past year, the mounting fears of inflation have been evident in the bond market: the 10-year Canada bond yield has jumped 80 basis points (0.80%) since early October, and the DEX Universe Bond index has lost 1.4% in three months. Bond investor angst has been accentuated by proposals from some US officials that inflation be targeted at 4% rather than 2%. Such proposals ignore the fact that inflation preys on the weakest members of society – those on fixed incomes and those who lack the power to negotiate for higher wages – and undermines the incentive to save.
Looking ahead
We remain optimistic about prospects for equity markets in 2011, recognizing that the generally positive trend will remain subject to periodic event risk. It is worth noting that the consensus ranking of asset class performance for 2011 is identical to the relatively successful forecast made for 2010:
We agree that prospects for North American equity markets appear robust, buoyed by continued improvement in corporate profits, rising dividends and merger and acquisition ("M&A") activity. We expect interest rates to rise further as the economy grows. As investors who sought safety in government bonds start to see negative returns, they will seek refuge in income alternatives that are not penalized by growth, such as corporate bonds and dividend stocks. The resulting flow of capital into equities that we anticipate as large institutional investors rebalance their portfolios further enhances the favourable fundamental outlook for equities, and for large-capitalization shares in particular. However, where our 2011 outlook differs from the consensus is that we expect US equity returns to rank ahead of Canadian returns due, in part, to the ongoing efforts of central banks in the emerging economies to combat inflation. These efforts to dampen economic growth rates are of particular importance to the outlook for commodity prices, and thus the Canadian equity market, in the coming year. The most likely outcome is that we will see commodity prices fluctuate within an upward-sloping band, without the surge necessary to support forecast earnings growth. Of course, under this scenario emerging markets are unlikely to lead the pack in 2011.
Corporate bonds should continue to hold their own even as rates start to rise, thanks to their attractive yields, and our Sentinel team's portfolios are positioned accordingly. This environment should also benefit the shares of quality businesses that pay dividends, like those favoured by the Maxxum team. Attractively valued stocks, the focus of the Saxon team, should benefit from rising multiples given the positive economic environment. The shares of quality companies with competitive advantages that yield superior revenue and earnings growth, the focus of our Ivy and Universal teams, are currently available at attractive valuations. Finally, Canadian investors will likely be well served by foreign diversification. Our Cundill team is well positioned to take advantage of opportunities around the globe.