Another Summer of Discontent?
So far, 2012 has followed what is becoming an all too familiar pattern. After a great start to the year in North American equity markets the S&P/TSX Composite had given back its gains by early April and continued lower still in May. The US markets, while still positive year to date have followed much the same path. On the other hand, “safe haven” investments such as US and Canadian government bonds are offering the lowest yields in decades. Resurgence in the European sovereign debt / banking crisis and slowing economic growth in the rest of the world has investors squarely in capital preservation mode.
Economic uncertainties take centre stage
The European debt crisis has again taken centre stage with soaring bond yields continuing to pressure all but the strongest Eurozone nations. While several countries have already been “bailed out” the list of the needy keeps growing with Spain the latest to request external aid. The austerity measures enacted by many European countries with the aim of reducing deficits and ultimately bringing down debt loads threaten to have exactly the opposite effect as growth is falling faster than debt levels. With populations reeling at the extent of the austerity people are looking for another way and rewarding politicians promising a renewed focus on growth. For this to be a positive for equity markets any efforts towards stimulating growth will need to be accompanied by a credible plan to bring down debt levels over the medium term. As time goes on the bar for “credible” will continue to get higher and higher as investors tire of weak, half-hearted attempts at tackling the core issues of trade imbalances, undercapitalized banks and public debt levels.
While bond yields in Portugal, Spain, and Italy are clearly pricing in distress we do take some solace from the fact that financial conditions in Europe, as measured by the Bloomberg Financial Conditions Index, remain better than last spring. This indicator looks at money markets, bond yields, equity markets and volatility and compares where markets lie relative to the 10 years leading up to 2008. While conditions have deteriorated over the last few months they remain much better than those we experienced last spring and summer.
Figure 1: Bloomberg European Financial Conditions Index
Slowing global growth leads to policy action
As figure 2 demonstrates, economic momentum within the major counties has been waning since the 4th quarter of last year with more economic reports missing estimates than beating them since early in 2012.
Figure 2: Citigroup Major Economies Economic Surprise Index
While falling growth rates are not positive for investors in the near term they have coincided with a drop in inflation which in turn has opened the door to more policy action on the part of central banks.
As figure 3 illustrates the Chinese Consumer Price Index has dropped to 3% from over 6% less than one year ago. This drop in inflation has allowed the Chinese government to loosen the monetary spigots and adopt a more accommodative policy stance.
Figure 3: Chinese Consumer Price Index
Last week China surprised markets by cutting its benchmark lending rate for the first time since 2008. While the negative interpretation of this move is that growth is slowing so rapidly in China the central bank was forced to act, a more optimistic view would see this as a move to support continued growth at or above the stated 7.5% GDP growth target. There have also been fiscal moves supporting these monetary actions such as the expedited approval of several large infrastructure projects. A reacceleration in Chinese growth or even increased optimism towards a soft landing would be a positive for equity markets with resource stocks large potential beneficiaries.
The European Central Bank has resisted providing further monetary support before elected officials make progress in dealing with European structural issues but may be willing to “reward” progress with further actions. In the US expectations are growing that some form of additional monetary action will be announced at the next Federal Reserve meeting, which ends on June 20th. Speculation ranges from an extension of “operation twist” to another full blown round of balance sheet expansion. Equity markets may well react negatively if nothing new is announced while the strength of any positive reaction will be interesting to watch given the ephemeral rallies produced by earlier unconventional actions.
“Safe-haven” investments remain expensive
Massive uncertainty in Europe combined with a slowing global economy has investors seeking shelter from the storm. While this is intuitively reasonable, the price of this shelter is historically very expensive. The top pane of figure 4 shows the relative PE differential between North American cyclical stocks and the market which is well below the average level since 1972, although not quite at the lows seen in 2000 and 2008. This middle pane illustrates the relative PE differential of defensive stocks relative to the market which are at all-time highs. A look at cyclicals relative to defensives in the bottom pane shows this relationship at all-time lows. So both government bonds and defensive stocks (staples, healthcare, telecom and utilities) are quite expensive, historically speaking.
Figure 4: Relative PE Differential of Cyclicals to Defensives
While the dangers facing the global economy do warrant caution on the part of investors good long term returns have rarely come from buying very expensive areas of the market. Short of an uncontrolled breakdown of the Eurozone investors appear to be pricing in a very negative growth environment. This stance may be correct however it is not inevitable. There are potential catalysts to change the current pessimistic view. For instance, further monetary accommodation on the part of the Federal Reserve, a tangible move towards a greater degree of fiscal cooperation in Europe, and/or further monetary and fiscal stimulus in China could all lead investors to adopt a more optimistic view on equities.
Within the funds, we have recently raised cash levels, added some small positions in gold producers, reduced exposure to the US dollar and started scaling into positions in more cyclical companies that have seen their valuations become attractive as the markets have sold off. We remain focused on dividend paying companies that we feel can grow their earnings and dividends over time. While we do agree that the high level of global uncertainty calls for caution we also feel that there are risks to having no exposure to out of favour areas that will benefit in the event of an upside surprise.