More Than Just Resources

Canada has not gone unnoticed by investors abroad. A report last week indicated that Canada has benefited from record net inflows of foreign investment in Canadian securities.

By extension, demand for the loonie has also increased, and this is one of the reasons why the Canadian dollar currently sits near parity with its U.S. counterpart.

Foreign investors purchased $109 billion worth of Canadian securities in 2009, and another $11.8 billion in the first month of 2010. They were particularly keen on Canadian corporate bonds in 2009, purchasing nearly 80% of net new corporate issues. Meanwhile, Canadian investors were noticeably more conservative – nearly all bonds issued or backed by the Government of Canada stayed in Canada.

Why Canada?

There are good reasons for this renewed interest in Canadian investments. Canada has a highly educated workforce, a rock-solid financial system, and one of the strongest economies in the developed world. What’s more, the Canadian stock market has delivered some of the best returns in the world over the past 10 years. (Could this be a warning sign though?)

All of these points underscore the importance of having Canadian exposure as a core holding in a well diversified portfolio.

The following are three high-level economic data points that we can use, along with our other tools, to further assist us determining our views on equity market investments.

1.) U.S. Housing

As the root of the credit crisis, healing in the U.S. housing market is a precondition for sustainable recovery. Recent data has confirmed that the worst is behind us and the residential real estate market is stabilizing.

The inventory of unsold houses while still high is heading in the right direction towards clearing and sales of existing homes have recently turned positive on a year-over-year basis. And an index which measures year-over-year price changes of houses in 20 major U.S. cities (the S&P/Case-Shiller Home Price Index) plunged 33.6% from its June 2006 peak to the April 2009 trough, but has now climbed 1.9% over the past two months.

2.) The U.S. Consumer

The resurgence of the U.S. consumer will be key to watch as recovery unfolds since consumption is 70% of the American economy. Despite the ‘hit’ that the housing crisis has exacted on their net worth, American household balance sheets are still in relatively better shape than they’ve been in the past due to the tremendous growth net worth over the last decade.

However, the process of deleveraging (winding down debt) has begun and this will impact spending patterns in the near-term.

3.) The U.S. Manufacturing

The level of manufacturing has historically followed an inverse path to the Fed funds rate but on a 6-month lagged basis – as the fed funds rate drops, six months later, manufacturing activity picks up.

However, in fall 2008, although rates declined to historically low rates, the credit crunch intensified and that typical relationship between low interest rates and increased manufacturing activity did not materialize. More recently, credit channels have opened up and the ISM (gauge of manufacturing activity) has improved, indicating the economy is finally responding to massive stimulus after a long lag.

And further improvement just yesterday with the latest ISM level better than expected at 52.9 – the first reading above 50 since January 2008 and hit the highest level since June 2007. This is further indication that while not yet normal, the economic environment is normalizing.

These are three key areas of the market to watch when assessing the high-level economic situation and it’s relationship to the stock market trends and valuations.

Of course this isn’t the be all and end all of data you should include in your due diligence, but it certainly plays a role as you calculate your risk tolerance moving forward.

Here’s a summary of market action and key developments from last month, including monthly benchmarks.

• Investors saw more data indicating that healing is underway in the global economy. Increased optimism paved the way for a fifth consecutive month of gains across world markets.
• International stocks advanced. The MSCI World Index returned 8.4% (in $US terms). Since March 9th, the MSCI Asia Index has risen about 58% in local currency terms.
• Commodity prices rose. Copper is up more than 80% year-to-date supported by increased demand from China. The S&P/TSX Composite Index benefited, adding 4%. The S&P/TSX has climbed 45% since hitting a five-year low on March 9th.
• In the U.S., stocks made up more ground. The Dow Jones Industrial Average (DJIA) had its best month since 2002, up 8.6% . The S&P 500 Index advanced for the fifth consecutive month (the longest streak since 2007) gaining 7.6% . The S&P 500 is now up more than 40% since March 9th and Monday, it closed above the 1,000 level for the first time since November 2008.
• Volatility continued to be a key theme in currency markets. After falling more than 6% against the U.S. dollar in June, the Canadian dollar appreciated by 7.4% versus its U.S. counterpart in July. This cut into returns on investments denominated in $US. Case in point, the 7.4% gain on the S&P 500 was essentially wiped out when converted back to C$.

With much of the latest economic news continuing to look less bad (over 70% of companies beat expectations last quarter and it appears US housing may have found a bottom), the economy looks to be on the mend.
However, we must realize that the rate of recovery that we are seeing is not normal and likely cannot be maintained long-term. That said, as an investor looking out 5+ years I belive valuations in the equity market are still low and the potential remains for double-digit returns heading forward over a 5+ year horizon.

1. An investor’s choice of asset allocation is the single largest factor that will influence the probability of long-term success. Historical evidence suggests that cash investments return the least amount over the long run.
2. There is significant upside potential in equities for long-term investors right now. Stock valuations are, despite Q2’s rebound, well below their highs and have a long way to go to be back in line with what we consider to be fair value.
3. Sustained low interest rates and dramatic increases in money supply combined with increased deficits have many fearful of the inflationary impact once economic recovery takes hold. Money market investments, non-market linked CD’s and high interest savings accounts offer little protection against the wealth eroding effect of inflation.

That is not to say that there is no downside.  In fact, there is an inherent risk when investing in equities.  However, I beleiive the risk vs. reward payoff  still favors the equity investor at this time.

Below are a few summary points including a couple of references to the ‘less bad’ concept.

U.S Housing

Real estate, which has been at the root of the credit crisis, needs to stabilize before a sustainable recovery can happen. Here are some things to consider with respect to the current situation:

• Housing to Income ratio: At its peak, the ratio of house prices to household incomes in the U.S. was 27% above its long-term average. It is now down 30% from that peak. While seemingly ‘ugly’, this has brought housing prices back to their equilibrium level. That in itself doesn’t generate new buying, but it does create “capacity” – something that’s important for recovery. With housing affordability at its best level in a generation, once household balance sheets are restored and confidence returns, people will then take advantage of this more ‘normal’ house price to income relationship and go back to buying houses.
• Housing Sales: Although existing housing sales are still falling – they are falling at a much slower rate compared with last year, which suggests that the situation is getting ‘less bad’.

Corporate Balance Sheets

One of the bright spots in the decline of the economy until now has been the health of corporate balance sheets – things like corporate debt to equity ratios and ability to cover interest payments on outstanding debt. With continued contraction in the economy, we are now starting to see meaningful erosion in corporate balance sheets as business profits continue to come under pressure. However, despite this erosion, corporate balance sheets are still relatively healthy.

Manufacturing

The U.S. manufacturing index (ISM) tends to respond favorably six months after interest rate cuts. This is because manufacturing orders are dependent on consumer demand, which is stimulated by low interest rates. Although possibly a long way off, there’s some evidence that we may be seeing a positive response to historically low interest rates.

Earlier this year, the manufacturing index in the U.S. (the ISM) was moving sideways instead of falling and yesterday, data showed that the ISM improved modestly in March. While the ISM data was still weak, recent trends suggest that the health of manufacturing is not getting any worse (i.e. the situation is ‘less bad’ than has been previously been the case).

Inflation

Although inflation may likely have to be dealt with longer-term, it’s not a near-term issue for policymakers. There is risk of “transitory/temporary deflation” (the opposite of inflation and a situation where prices of goods are declining over time) but we believe it is unlikely to develop into a sustained period of falling producer/consumer prices. As the credit crunch and deepening recession continue to dominate policy, rates are expected to hold at rock bottom levels.