Video - Market Trends May 2015
Here is the May 2015 webcast, covering topics such as oil inventories, the resource boom, euro zone surprises, the healthier U.S. economy and, of course, various asset allocation recommendations.
Michel Doucet, B. Sc., CIM®, Vice-President and Portfolio Manager, Portfolio Advisory Group;
Anne Perreault, M. Sc. Finance, CFA, Portfolio Manager, Portfolio Advisory Group;
Jean-René Ouellet, MBA, CFA, Portfolio Manager, Portfolio Advisory Group.
Market Trends – May 2015
Hello, and welcome to your Market Trend webcast which will enable you to learn more about financial market trends. My name is Michel Doucet and I would like to introduce my colleagues, Anne Perreault and Jean-René Ouellet. Anne, there’s one subject that is keeping us awake at night, oil prices. They’ve dropped to a low of $47 in March, they’ve since come back to $57, an increase of 25%. What’s up? Where are we going? What can we expect?
Yes, Michel. We’ve seen improvement in the various fundamental data. Among other things, U.S. oil production is stabilizing. The rig counts in the United States fell once again last week for the 20th consecutive week. What’s more, the rig counts in key basins is down close to 50% from the 2014 high. This slowdown in drilling activity points to an eventual decline in production.
However, crude oil inventories continue to rise and are at unprecedented levels which could limit a price recovery. We may see a decrease in inventories in the next few weeks as refinery activity picks up before summer. Nevertheless, the market will remain well supplied compared with historical standards. Another factor that could impact the price of oil is the lifting of economic sanctions against Iran, which can then export about 800,000 additional barrels per day, but even if an agreement is reached, Iran could face some challenges to restore the production capacity of its deposits.
All things considered, market conditions have changed with the decreased influence of OPEC and new production capacity in North America. This new reality should push production costs down and will probably result in greater oil price volatility, due to OPEC’s weaker influence. At present, the ceiling for oil prices appears to be around $70 as there is plenty of oil that can be produced at a price of $65 to $70 U.S. At these levels, companies could review their capital spending and start drilling again, in which case we could see a return to production growth.
Michel, we’ve seen the Bank of Canada worried about the decline of oil prices. What about that?
This story seemed to have changed over time. The Bank of Canada was really worried about the Canadian economy if you go back late January, when they surprised the market with a 25 drop in the key interest rate, but since then, the Bank of Canada seems to be more relaxed with the current economic backdrop, with interest rates poised to stay put for the time being, at least for the next quarter or more. Besides the household debt burden which is currently running at a record high and the housing sector that is starting to show some signs of stabilization, one thing that will be key to watch for the Canadian economy is the value of the Canadian dollar which has lost quite some momentum over the last couple of months or since the Bank of Canada surprised the market with a key rate drop.
Jean-René, we’ve seen the same thing in Europe where you saw the euro move from 1,40 to 1,08. What should we be looking at?
Yes, I won’t try to convince you that Europe is great at the moment. It’s nothing close of that but the euro area is clearly one of the most – the biggest beneficiary of the decline in oil prices. It is a net importer of almost all its energy. So the drop in energy prices is of huge support for the consumer sector. While talking about things that are going not well, but better, we see increases in retail sales. Retail sales in Spain were up 6.5% last week alone. So good numbers, but we have to understand that we’re starting from a low level, but still, we’re increasing. The euro area is probably where the United States were in 2010, when the Federal Reserve stepped in saying that they won’t let it go, they would do anything or everything they need to support their economy. The ECB has reached this point as well. So we see good retail sales and we see good sales of cars as well. Confidence is increasing, consumer confidence is getting better. Credit is starting to flow again.
So things aren’t great in Europe, but they’re trending better and as Michel was saying, the decline in the euro is a factorvery very good and positive for earnings to be reported by European companies. Every dollar of business they do earn or profit they earn in U.S. dollars once shown in euro terms will just be higher. So we could be expecting nice surprises from the eurozone and their companies.
In the U.S., well over the last few years, it’s been a deleveraging story. It’s well advanced assets that the households have stabilized or increased again. Home prices have moved higher, pension funds have turned better, deposits have increased again as people started saving again and financial assets are also higher. So the net worth of U.S. citizens is at record high. Financing costs are at record low. Job openings are at many years high while the jobless claims are at 15-year lows. So we see a better job market going forward.
Yes, economic statistics have been kind of weak for the first quarter due to strikes in the west coast ports or difficult weather in the winter season, but things should improve again just as they did last year in Q2 and Q3. So we’re expecting a good momentum in the U.S. to keep pushing us higher.
Michel, all that being said on the economic front, what would be the best investment strategies to adopt here?
Jean-René, if I could just recap here, take a breather. No. 1, the Canadian economy is trending along. The resource sector will be keeping back the Canadian economy, as much as household debt burden will be keeping back the economy also. The U.S. economy, yes, it’s the strongest economy in the world, sure. Europe, Europe will surprise us on the upside. What – what do we do in the portfolio? That’s key to investment strategies this year will be to manage the asset allocation. Right now, we’re considering having an overweight position in cash and equities and a underweight in fixed income. When it comes to the fixed income strategy, investors will need to be very meticulous in their maturity and issuer mix.
When it comes to maturity, we’ll be out of the box in our strategy. Currently, investors are preferring to be short duration in a portfolio. We’re not. We’re – right now, we’re recommending that investors have a equilibrium weighting in maturities, meaning at the end of the day that the duration of portfolio will be between five and eight years. Where are we going to find returns in the fixed income market? Quite simply by managing the issuer mix, where we’ll be favoring a provincial bonds, municipal bonds and corporate bonds. When we get to the corporate bonds, Anne, we like to split corporates and preferred shares and preferred shares have been hit quite severally since last September, meaning by severally, what I’m saying is they’ve dropped between 7 and 10%. We’ve seen investors capitulate on preferred shares. What should we be doing?
Okay, so let’s start with the cause of the decline. The first leg of the decline was caused by the drop in five-year bond yields, which hit a low of .69% in February of this year. In this context, investors revalued fixed reset preferred shares according to the new dividend yield– they would obtain at the reset date. For some issues with a reset date in 2015 for example, the new yield could be around 2.2% versus yields of 3.6 to 3.7% on some recent issues. So prices were adjusted accordingly. However, prices continued to fall in April. Some investors were disillusioned with the overall performance of preferred shares and sold all their positions in a very illiquid market with few buyers. In this environment, moves to the downside tend to be amplified.
The tide seems to be turning now with a slight increase in five-year bond yields, right now, around 1%, as buyers step in to take advantage of current prices. Of course, five-year bond yields will affect the prices of these issues in the coming months. Consequently the prices of preferred shares with an imminent reset date could remain volatile.
But Jean-René, ultimately, how should an investor position his portfolio? Which country do you prefer right now?
Yes, thanks Anne. Within the equity allocation of a portfolio, first we’ll look about the geographic allocation. First of all, as we’re Canadians, sad to say, but we’re underweight – we’re recommending to underweight the Canadian market within a global portfolio for essentially two reasons. First, Michel told us about the weak momentum of the Canadian economy, first and second, out of the resources sector, many Canadian companies are trading at very rich multiples compared to their global peers. So we would say effectively underweight the Canadian market within our exposure.
We’re now neutral on the U.S. market. We’ve been overweight in the U.S. market for many years. Now, what led us to decrease our weighting to the U.S. market? Well, we’ve posted five years of 25% – well, the U.S. market generally has 25% per year return over the last five years, so those returns were terrific. They’re abnormal by nature and the market was cheap. So the valuation is more adequate. It’s also possible that the U.S. market goes from 18 times earnings to 20, 22 times, but then it will just become more risky. So we want to stay neutral on the U.S. market.
Where we would go then? We would be moderate overweight on the European market. As I was saying, the European market has lagged the global market. It has a slightly better valuation. It has a better momentum in terms of expected earnings going forward, so we could get some surprises there and regarding the emerging markets, we would adopt a new tool holding ,but let’s put things into perspective. The emerging markets could represent about 10% of a global equity market, meaning about 5% of a well-diversified portfolio. So it’s not that significant, but within the emerging market, we would remain out of the resources’ producers such as Brazil, Russia, etc. and we would rather focus on product producers such as India, China, Hong Kong, Korea and so on and so forth. So this is for the geographic allocation. So we would next take a one step deeper within the sector allocation. Anne, can you tell us how we should get involved into the Canadian market?
Yes, sure, Jean-René. In the Canadian market, we’re maintaining a neutral position in consumer stocks. Although their valuations are high in both historical and relative terms, the outlook for this sector remains favorable. Retailer revenues and earnings are getting a boost from increased consumer purchasing power, thanks to lower gasoline prices. In addition, Canadian multinationals with a large proportion of their sales in the U.S. are benefitting from both a pick-up in economic activity south of the border and the stronger U.S. dollar.
We’re also overweight in industrials and technology. The technology sector should maintain its momentum, driven by renewed demand for IT consultation services and specialized software as North-American businesses start to invest again. Engineering firms which were affected by the slowdown in investment in the oil and mining industries are now attractively valued and could rebound on the announcement of major projects in other sectors, infrastructure for example.
As far as interest-sensitive stocks are concerned, we recommend a moderately overweight position in the banking sector. The banks are trading at less than 11 times expected 2016 earnings per share. These multiples are attractive relative to the overall market. In fact, the discount is close to 40% versus an average discount of about 22% for the past ten years.
A rise in interest rates would have both positive and negative effects for the banks. First, financial intermediation margins would widen which is positive. However, loan growth will slow and non-performing loans will increased, but most mortgages are insured by the the Canada Mortgage and Housing Corporation which reduces the risk associated with excessive household debt and the residential real estate bubble. Also since the late 80s, Canadian banks have diversified by investing in wealth management, insurance and capital markets and also by acquiring foreign subsidiaries. Among the other subsectors we also recommend overweighting insurers. These companies will benefit from a rise in interest rates which will generate higher revenues to finance insurance payouts.
And finally, in the resources sector, we’re maintaining an underweight position. We underweight, oil producers as many of the majors are discounting oil prices in the $70 to $75 range. In this environment, we prefer integrated producers with solid balance sheets and relatively low operating costs. The refining operations and the distribution networks of these companies will benefit from increased demand for fuel.
Jean-René, in the U.S. which sector do you prefer?
In the U.S., we’ll adopt a slightly different tone but with similarities to the Canadian exposure. First, we’ll also overweight the industrial and technology sector. First of all, it’s much bigger and diversified than in the Canadian market. So from a Canadian perspective, it’s a very good diversifier. Also I told you about the valuation of the market. When we look at technology companies, let’s say ten years ago, they were considered as being very aggressive on risk investments, but today when you look at the balance sheet of Google and Apple, Cisco and so on and so forth, we find very good defensive metrics within the technology area, plus they face a better momentum in their top line and earnings where we are in the cycle, so many good ideas there and a decent valuation. So it’s still an attractive sector.
Within the consumer space, we’ll adopt a neutral stance, but we would favor the consumer discretionary rather than the consumer staples. For example, when we look at big consumer staples companies such as Procter and Gamble for example, they have huge international exposure. So the U.S. will weigh big times on their earnings, on their coming reported earnings and they also face very very
muted growth, but they do have a premium valuation, much higher than the rest of the market. So paying 20, 22 times earning with – that aren’t growing is kind of rich and difficult to justify, but when you look in the consumer discretionary space, sometimes you can, let’s say, look at the automotive space, you have parts manufacturers that will show good growth based on the increased components within vehicles of let’s say dynamic safety, fuel economy, connectivity of the vehicles. So there are many growth aspects there that could help these companies post better results. So You’ll have to be very very selective within the consumer space.
In the interest-sensitive, we would avoid the utilities, favor the financial world, but we’ll be let’s say more neutral on the banks and a slight overweight within the life cos., because life insurance companies will be a prime beneficiary when interest rates do rise again. So we’ll stay tuned there and just like in Canada on the resource space, we want to be underweight in our exposure here.
So if I sum things up, let’s say on the big level, cash, stock, bonds, right now, we’re currently comfortable to have a slightly overweight in cash due to a slight underweight in fixed income products and we will have a small to moderate overweight within equities. On the geographic front, we’re as I said underweight in Canada, neutral on the U.S., slight overweight in the European market and neutral on the emerging markets. So with all that being said, Michel?
Thank you, Jean-René, thank you, Anne. In the end, investors will want their investment portfolio to be aligned with their long-term investment objectives and to reflect their investor profile and their risk tolerance. Portfolio rebalancing to restore target weighting is a way to combine rigor, discipline and risk control. A long-term view together with investment diversification and portfolio rebalancing is a good way to add value and weather periods of volatility. Resisting the temptation to react impulsively and acting when opportunities arise is part of a management process that has proven itself over time and through various investment cycles.
We thank you for your attention and we hope the topics covered in this webcast were of interest to you. Should you have any question, don’t hesitate to contact investment advisors who will be pleased to answer them Please join us for our next webcast three months from now. Thank you and have a good day.