June 2011
Waiting for . . .
the end of QE2
Significant world events have done little to undermine investor confidence. However, some caution is warranted when extrapolating recent strong corporate earnings growth in the US into higher forecasts for this year and next.
Investors have enjoyed a relatively benign environment in recent months. Indeed, capital markets have shown remarkable resiliency in the wake of floods in Australia, social and political upheaval in Libya and across the Middle East, another sovereign debt casualty (Portugal), and the catastrophic earthquake, tsunami and nuclear accident in Japan. Oh, and lest we forget, the US Government almost shut down because of a budget impasse, and Standard & Poor's put the AAA credit rating of the United States on notice for a possible downgrade. Yet, today the CBOE Volatility Index (VIX), an indicator of perceived riskiness of the US equity market, is at 14.81, the lowest since mid-2007. Does this represent well-placed optimism, or complacency on the part of investors?
An uninterrupted upward trajectory...
Global economic prospects remain encouraging, with the International Monetary Fund (IMF) forecasting growth of 4.4% for 2011 and 4.5% in 2012. The continuing strength of the US consumer supports this outlook, as retail sales rose 2.4% in the first quarter (+7.1% year over year), the unemployment rate fell by 1% to 8.8%, and job openings improved to their best level since August 2008. These favourable trends helped boost US consumer confidence despite a soft housing sector, where foreclosures continued to rise and prices continued to slip. The robust business sector has been reflected in the Institute of Supply Management (ISM) survey index holding above 60 through the first quarter, the sharp rise in business confidence, and strong corporate profits. These factors bode well for capital investment and job growth, and provide a solid base for US economic growth.
Economic trends overseas have also been buoyant, a welcome surprise in light of renewed sovereign debt concerns within the European Union. The Purchasing Managers' Index for Europe has risen steadily, to 57.8 in March, while China's economy grew at an impressive 9.7% annual rate in the first quarter despite actions by its central bank to tighten monetary policy. Even Japan's economy appeared to be on the mend until the devastating tsunami at the end of March; it is now expected to be at least a couple of quarters before growth resumes in Japan.
...drives corporate profits higher
The buoyant economic environment has been instrumental in driving corporate profits, and stock markets, higher. The S&P 500 and Dow Jones indices surged to new two-year highs in April, and NASDAQ rose to a 10-year high, as over 70% of companies posted first-quarter earnings that exceeded consensus estimates, and projected 2011 earnings growth for the S&P 500 improved to 15%, with a further 12% profit gain now forecast for 2012. Although the S&P/TSX Composite index lagged the major US equity indices, it too attained new two-year highs in April as higher commodity prices reinforced consensus expectations of 28% earnings growth in Canada. European markets continued to post the strongest gains, despite the sovereign debt problems, thanks to expected earnings growth of 15% and strong employment trends in Germany, which saw unemployment fall to its lowest level since 1992. The strength of the Euro through April meant that European equities provided double-digit returns for Canadian investors. Emerging markets continued to struggle, posting only modest gains as their central banks pursued tighter monetary policies.
Inflation pressures spread
The global economic recovery witnessed over the past two years has been accompanied by mounting inflation. Initially, these price pressures were limited to industrial commodities like oil, copper and iron ore. Then, food prices started to surge and this triggered mounting social unrest throughout the developing world where food still represents over 30% of consumer expenditures. Authorities in major emerging economies have endeavoured to slow wage and price pressures, without success; officially, China's inflation rate has jumped to 5.4%, but anecdotal evidence suggests that prices are rising much more rapidly.
Inflation pressures are now becoming more apparent in North America and Europe. Consumer Price Index (CPI) inflation in Canada was 3.3% at the end of March, and prices in the US have risen at a 3.6% annual rate over the past six months. The European Union saw prices rise at an annual rate of 3.1% to the end of March, which prompted the European Central Bank (ECB) to increase its target interest rate by 25 basis points (0.25%) despite the ongoing sovereign debt problems. Growing inflation concerns amongst investors has generated strong demand for real return bonds, the bestperforming category of government bonds during the past year, and widened the implied "break-even inflation rate" between fixed-rate government bonds and real return bonds to 2.63% at the end of March, its highest level in almost three years.
European sovereign debt – Problems persist
As the New Year beckoned, there was renewed hope that the European Central Bank had contained the sovereign debt problems that threatened to destabilize credit markets. Unfortunately, this optimism proved premature as Portugal became the third EU member to request assistance with its debt, and Ireland confirmed that more capital would be required to shore up its banking system. The situation in Greece became particularly dire as its fiscal deficit was revised to 10.5% of GDP, and its economy contracted, convincing investors that a restructuring of its debt was inevitable. As a result, yields on Greek government bonds surged to over 24% for two-year notes, and to around 16% for 10-year maturities. German and French banks remain the largest holders of Greek bonds, and thus face potentially sizable losses should Greece default or restructure its obligations.
Looking ahead
We expect further gains from equity markets through the balance of 2011, thanks to higher corporate profits, rising dividends, merger and acquisition (M&A) activity, and increased demand from investors rebalancing their portfolios as bonds disappoint and they pursue income alternatives that are not penalized by growth. Although equities may only yield mid-single digit returns, this will be attractive relative to expected returns from bonds or cash. However, these stock market gains will likely be achieved in an environment of heightened volatility, suggesting that risk levels should be pared back.
A new, and unquantifiable, risk is the pending conclusion of the Federal Reserve's second round of quantitative easing (QE2). The Fed's monthly purchase of $75 billion of US government debt has provided significant liquidity to the financial system, helping to keep interest rates low even as economic growth has accelerated. This initiative will end at mid-year, with a very real prospect that interest rates could then start to rise towards more "normal" levels.
Another concern is the complacency apparent in how analysts have extrapolated the recent strength in US corporate earnings into higher forecasts for this year and next. While we have been amongst the more optimistic regarding earnings for this year, we acknowledge that the positive earnings "surprises" owe much to low interest rates, foreign exchange gains arising from the falling US dollar, and tax incentives introduced to stimulate capital spending in 2011. Looking ahead into 2012, we would argue that:
- interest rates will likely be higher,
- the US dollar might stabilize,
- profit margins may decline as firms run out of ways to offset rising input costs, and
- capital spending will slow because 2011 borrowed from 2012.
All these factors suggest that US earnings growth in 2012 could be quite subdued. Canadian corporate profit growth already faces a headwind from mounting cost pressures and the strength of the Canadian dollar. In addition, should inflation pressures persist, equity valuations will come under pressure. This, again, supports a more modest estimate of investment returns over the coming months.
While we are more cautious than a few months ago, our tactical views have not changed materially. Within fixed-income funds, we still expect corporate bonds to hold their own even as rates start to rise, thanks to their attractive yields, and the Sentinel portfolios are positioned accordingly. Within equity portfolios, we still prefer the shares of quality businesses with rising dividends and earnings, like those favoured by our Ivy, Maxxum and Universal teams. Attractively valued stocks, the focus of the Saxon team, should benefit from rising multiples given the positive economic environment, although small-cap shares may experience a period of underperformance after the stellar returns of the past two years.
The resource sectors offer a unique challenge. Ongoing efforts of central banks in the emerging economies to combat inflation could ultimately dampen economic growth rates, and thus the demand for industrial commodities. However, this may be offset by continuing investment demand, since commodities also offer a means of inflation protection to investors. The most likely outcome is that we will see commodity prices fluctuate within an upward sloping band, suggesting that resource funds will retain an important role within welldiversified portfolios.
Canadian investors will likely be well served by foreign diversification, which can now be achieved with the dollar at $1.05 US. We still find US and European multi-nationals appealing. They provide access to the growth of emerging economies, at attractive valuations. While emerging markets may continue to struggle due to monetary tightening, the Cundill team is well positioned to take advantage of attractive opportunities as they arise in these markets, or anywhere around the globe.