Quarterly Comment

Fourth Quarter 2013
Market Commentary
Picton Mahoney Asset Management
Investment Outlook
“Still Upside in Equities, but …”
Over the past year capital markets and the global economy have come a long way. 2013 began with a
“fiscal cliff” resolution that marked the “the peak of uncertainty”. We then settled into a “Goldilocks”
growth phase, weathered Quantitative Easing (QE) “taper” discussions, and most likely witnessed the
cycle lows being set in U.S. Treasury yields. Debt ceilings were debated, economic growth slackened
from the subsequent U.S. government shutdown, and for the grand finale, closed out the year with strong
economic re-acceleration. While bond markets suffered their worst annual loss in 19 years, equity markets
surged, marking new all-time stock market highs in the U.S., Germany, Norway, Israel, Mexico, India,
Malaysia, Indonesia, Philippines and South Africa. Meanwhile gold prices, a classic measure of economic
uncertainty, were down a whopping 28% for the year. The MSCI World Index was up 8.1% during the
quarter and finished the year up 27.4% (or 36.1% in Canadian dollars). The S&P 500 Index gained 10.5%
in the fourth quarter and 32.5% (in U.S. dollars) on the year. While the S&P/TSX Composite Index rose a
solid 7.3% in the final quarter, its total annual return of 13% still lagged well behind global market
returns. The best performing Canadian sectors in 2013 were healthcare, industrials and consumer
discretionary.
As we kick off 2014, the global economy has moved from the modest recovery pace of the past three
years to a stronger growth phase. Investors have started to move money from bond markets to equity
markets as part of “The Great Rotation”. While stock markets may be extended in the short run and
investor bullishness is higher than we would like, we continue to find equities the most attractive asset
class and anticipate bond markets will remain vulnerable to rising/normalizing interest rates. We would be
buyers of equities on near-term weakness although we could become sellers on strength later in the year
should bond yields rise too quickly to levels unpalatable for the stock market.
Our Economic Acceleration scenario is playing out
Much has been written about the de-leveraging cycle since the “Great Recession” and its negative impact
on the economic recovery, especially compared to previous cycles. Various headwinds from consumption
to housing to corporate spending to fiscal restraint have contributed to restrained economic growth, even
in the face of unprecedented monetary stimulus from the U.S. Federal Reserve and other central banks
around the world. Debt related imbalances continue to exist around the world and will haunt economies
for years to come. However, former gale-force headwinds have been quelled one by one and are
realigning to form a synergistic cyclical tailwind. In the U.S., the Fed’s wealth creation strategy has
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Fourth Quarter 2013
Market Commentary
boosted spending power for U.S. consumers and this spending is gradually being augmented by better
jobs growth as well. Housing activity has surged off its lows and despite recent softness is poised for
further growth. CEO confidence is high and capital spending is finally on the rise. With the U.S. “fiscal
cliff” tax hikes and “sequester” spending cuts already mostly implemented, fiscal drag will soon start to
ease as well. We expect U.S. real GDP growth to accelerate in 2014, and would not be surprised to see it
reach a more robust 3.5% rate for the year.
At the same time, other developed market economies are gathering steam. As of December, 24 of 30
developed countries had recorded Purchasing Manager Indices (PMIs) above 50, indicating their growth
prospects are improving. The Eurozone’s PMI remains firmly above 50, and according to consensus
forecasts, real GDP growth is expected to go from essentially zero in 2013 to 1.6% in 2014. The European
Central Bank (ECB) also seems to have become more willing to use further monetary policy to stave off
deflationary forces, especially given the recent strength in the euro. Of course, there is still plenty left to
be done to sort out imbalances in many European countries, but conditions have certainly improved
dramatically since the ECB’s announcement of the Outright Monetary Transaction (OMT) program in
2012.
Japan continues to have positive near term economic momentum as well. There are “three arrows” in
Japan’s new growth strategy (monetary easing, fiscal stimulus and structural reforms), with monetary
policies having been the most effective thus far. Japan’s massive QE strategy has helped contribute to a
25% depreciation of the yen over the past year. This devaluation has been the primary driver of the recent
acceleration in Japanese corporate profits. Falling inflation expectations have finally stabilized and have
even picked up recently, although much of this is a result of higher commodity import pricing. As an
export nation with a high cost base, Japan should benefit disproportionately from the re-acceleration in
global GDP growth that we expect. Of course, Japan has no choice but to take drastic action to address its
growth issues because its fiscal problems are significant. Only good growth and negative real rates will
skate Japan’s fiscal situation back on side. However, monetary policy can only do so much and could
eventually become problematic should inflation rates accelerate too quickly. There will have to be
significant structural reform to improve the long-term outlook for Japan but, so far, this “third arrow” has
been rather underwhelming. For instance, planned labour market reforms have had to be delayed due to
political resistance, the challenge being that one half of Japanese voters are over 60 years of age and
continue to support full pensions, seniority based pay, and lifetime employment. Lack of progress on
these issues should not derail near term growth expectations or market returns, but significant work
remains to be done to avoid grave longer term consequences for both.
Emerging Markets Remain a Wild Card
This past spring’s U.S. QE “taper” discussions prompted a large outflow of funds from emerging market
debt markets. This, in turn, led to sudden currency declines and even current account crises in countries
heavily reliant on external financing. Countries such as India, Indonesia, Brazil, South Africa and Turkey
that have borrowed excessively and rely on foreign capital are certainly in a position of weakness.
Fourth Quarter 2013
Market Commentary
However, countries such as Korea, Taiwan and China with current account surpluses, high foreign
reserves, low inflation, and ties into global trade are better positioned to withstand increases in longerterm interest rates. The postponement of the QE taper in the U.S. bought time for emerging economies to
at least partially address their vulnerability to rising U.S. rates by tackling their weak current account
issues and /or enacting more prudent monetary policies. For now, markets have calmed down and fears of
a 1998-style emerging market crisis have dissipated. Hopefully, the current situation will end up similar to
1994 and 2004 where emerging economies generally benefitted from higher exports and capital inflows as
a result of higher consumer demand from accelerating developed economies.
The largest emerging economy, China, is in a period of transition from its “old” export-based model to a
more internal consumption-based economy and simultaneously confronting past excesses including a
significant build up in debt. Thus far it would appear that China’s aggressive policy reform is working.
The Chinese are showing commitment to stability and continuity in their macro-economic policies, while
pushing forward currency and interest rate reforms. Chinese growth may not accelerate, but its new
slower trajectory will be higher quality and likely more sustainable than its growth in the heady export
driven days of the past decade.
Stocks are still undervalued compared to bonds
Our belief is that if the economic recovery starts to resemble a more “normal” mid-cycle acceleration,
then bond yield versus equity earnings yield relationships should continue to converge toward a more
“normal” level as well. This implies that some combination of increasing stock prices and increasing
interest rates will occur this year in global capital markets.
Historically there has been a fairly consistent relationship between bond yields and earnings yields. One
of the intentions of the Fed’s QE program was to reduce (repress?) bond yields through massive bond
purchases. In an environment where markets were concerned about “secular stagnation” in economic
growth, QE helped open up a much larger gap than normal between traditional comparisons of bond
yields and stock market earnings yields. As the economy strengthens and capital markets are slowly
weaned off the QE morphine, we expect this gap will narrow considerably.
Relatively underpriced equities aren’t limited to the U.S. market. For example, even after the TOPIX
Equity Index gained 54% in 2013, stocks in Japan are still relatively inexpensive. All of the 2013 gains
came from earnings growth rather than multiple expansion. Japan and Europe remain overweight in our
global portfolios.
Mid cycle re-accelerations start off positively for equity markets but interest rate increases can
eventually undermine stocks
We have identified five mid-cycle re-acceleration phases since 1980 where leading indicators were
generally consistent with recent data in this cycle. These periods are listed in Chart 1 below.
Fourth Quarter 2013
Market Commentary
Chart 1:
Start
End
July 31, 2013
Current
November 30, 2005
May 31, 2006
April 30, 1999
January 31, 2000
June 30, 1996
April 30, 1997
November 30, 1993
October 31, 1994
November 30, 1985
March 31, 1986
Chart 2:
Fourth Quarter 2013
Market Commentary
Of course each of these cycles had differences, but there was a reasonably consistent trend in capital
market performance in each of them. These trends are displayed in Chart 2 and are consistent with our
views for the upcoming year. Mid-cycle re-accelerations start off positively for equity markets, especially
those with higher sensitivity to economic growth such as emerging markets or commodity centric markets
like Canada. Bond markets typically do not fare very well in these environments and historically, U.S. ten
year bond yields have gained 80 basis points on average over the next three quarters. Chart 2 also shows
that equity / bond valuation spreads tend to tighten in the first year of a mid-cycle re-acceleration but then
bottom and start widening out during the second year as a result of interest rate increases improving the
attractiveness of bonds while also contributing to an eventual slow-down in economic and corporate profit
growth which undermines the relative strength in equity prices.
Overly bullish investor sentiment levels are a near term concern
Markets have reflected at least some of our views given the surge in equities and weakness in government
bonds since the initial taper related pullback in mid-2013. Many measures of shorter term investor
sentiment appear quite optimistic as evidenced by Ned Davis Research’s Crowd Sentiment Poll in Chart
3. Investor sentiment has recently spiked to the highs of the past decade.
Chart 3:
Normally these types of bullish readings act as contrary indicators signalling stock markets may be due
for some sort of near term correction. While a pull-back is certainly possible, there are other sentimentrelated factors that suggest “The Great Rotation” still has significant room to run and that there is ample
powder available to buy equities on any pullbacks. While Trimtabs has calculated that investors moved
$86 billion from bond funds in 2013, this is still well below the $750 billion that Empirical Research
Fourth Quarter 2013
Market Commentary
Partners suggests went into bond funds after treasury yields fell below 3%. Many of these bond investors
likely didn’t realize that their seemingly low volatility bond funds could actually lose money as rates rose.
We think that the 2008/2009 stock market collapse also made many investors much more risk averse than
they traditionally have been. A recent Barry Ritholtz opinion piece written for Bloomberg asked the
following question:
"How can we have a stock bubble -- irrational exuberance, animal spirits, whatever -- when the
biggest, most affluent investors are so scared they are sitting in that much cash?”
For instance, BlackRock found 56% of affluent investors have "substantial" amounts of cash, with 35% of
their assets in cash or savings accounts. They also surprisingly suggested that 32% of affluent investors
globally expect to increase cash positions and savings account deposits over the next 12 months, versus
17% who expect to reduce cash. UBS Wealth Management noted that 28% of client assets remained in
cash in the third quarter of this year. In spite of bullish sentiment readings, risk aversion for many
investors with large amounts of money remains high. The Financial Times noted that 49% of global
affluent investors “did not want to take any risk with their money.” This risk aversion was lowest among
affluent Americans (34%) and highest among the French and Italians (64% and 59% respectively). With
the U.S. Fed signaling that short term interest rates will be kept low for some time to come, the S&P 500
Index’s 2% dividend yield, 3% net buyback and 5% plus earnings growth might prove enticing enough
for at least some of these risk averse investors to spend some of their cash buying stocks. The deployment
of even a modest portion of this cash along with the reallocation of assets from money losing bond funds
into equities could help fuel another big up-leg in stocks. One possible off-set to this potential buying
could come from de-risking of portfolios in the pension fund community. Mercer reports that pension
plan funding ratios of S&P 1500 companies ended 2013 at 95% which is a massive 21% improvement for
the year. This is the highest year-end result since 2007, and given what transpired in 2008 it wouldn’t be
surprising to see some plan sponsors rebalance portfolios by selling stocks to lock in gains while boosting
bond weightings as interest rates increase.
We expect a solid start for equities in 2014 but with concerns mounting through the year
Although we expect solid returns for equities in 2014, there is a possibility that these returns could be
more front-end loaded and then followed by increased volatility. There are a myriad of influences that
could sprout in the spring, grow like weeds through the summer, scare us for Halloween and even threaten
some darker days next winter.
Our biggest concern for later this year is that bond yields rise more quickly than markets expect, to levels
that become untenable for equities. Central banks have acted aggressively to counter the threats of
deflation and persistent recession. They seem to have staved off unwanted deflationary risks (for now, at
least) and maybe even hope to create some inflation in the system. However, while creating inflation is
one thing, controlling where it goes to, or how quickly it gets there, may prove to be a whole different
kettle of fish. It cannot be ruled out that there may be less of an output gap in the global economy than
investors presume, especially in the United States. Global synchronous growth could result in a more
Fourth Quarter 2013
Market Commentary
sudden than expected lift in inflation, especially given the massive amount of monetary stimulus in the
system. Central bankers appear willing to wait for evidence of inflation to emerge before acting, instead
of anticipating when it might occur and tightening in advance of it. Longer term interest rates could
abruptly overshoot higher in an inflation scare, causing an accident in all risk assets. We certainly don’t
expect inflation to emerge in the near-term. However, we do think investors should become more mindful
of this risk as the economy accelerates.
Of course, the Fed and other central banks have somewhat hijacked the natural clearing processes of
various markets, driving the prices of interest rate related assets higher than they might otherwise be.
While the QE process has given the global economy time to heal, it has also created a hunt for yield that
has lured investors into increasingly higher risk investments. QE has enabled problematic behaviours that,
in some cases, are similar to the pre-2008 risk-taking that precipitated the financial collapse. Last quarter,
the Bank of International Settlements (the Swiss-based “bank of central banks” and central source of
economic research) suggested that global credit excesses have reached or surpassed levels seen shortly
before the Lehman crisis. QE-induced credit bubbles are a major concern and sharply higher interest rates
would exacerbate bubble-popping losses. There remains a distinct possibility that the world has
handcuffed itself to a cycle of stimulus and ever falling interest rates, and has much fewer options if the
system were to buckle again. We will repeat our refrain that the economy and risk assets cannot fully be
declared off life-support until the artificial bid of central banks has been removed from interest sensitive
markets. The QE “taper” has begun, but there is no experience to draw on which shows how this process
should work and how it will impact markets and the economy as it occurs.
Conclusion
The impact of QE-related inflation or credit bubbles could eventually become an Achilles heel for our
constructive equity market outlook. Nonetheless, we don’t expect these to be a factor in the near-term.
The market has reacted much more constructively to the recent implementation of the “taper” compared
to the way it did to the mere murmurings about it this past summer. This suggests that markets are starting
to believe in a more self-sustaining economic recovery and that any near-term pull-backs in equities are
buying opportunities. However, as the year progresses improving economic numbers may become less
bullish and more problematic as investors become more concerned about building inflation expectations,
the removal of monetary stimulus and/or ultimately higher long-term interest rates. Our portfolios are
aligned for an auspicious start to 2014, but we will be closely monitoring data for mounting risks as we
move further through the year.
Fourth Quarter 2013
Market Commentary
Global Sector Outlook
Our investment process continues to favour companies and sectors with cyclical earnings leverage over
more defensive, yield related areas of the market. Interest sensitive equities had been big beneficiaries of
aggressive central bank stimulus policies and were excellent performers as interest rates were driven
lower. However, an inflection point was reached in mid-2013 and these types of equities have been
substantial underperformers since then as a result of their same interest rate sensitivity combined with
their lofty valuations and lack of earnings growth. Entering 2014, our preference remains for companies
that have had a history of generating solid growth regardless of the economic environment but that also
have cyclical upside should the economy improve in line with our outlook. We have also increased energy
and material exposures as a tactical response to better economic growth prospects.
Consumer Discretionary
In 2013, consumer discretionary stocks re-rated higher around the world and outperformed significantly
versus the broader markets. With the group trading at a large premium to global indices, further
outperformance will largely be dependent on earnings growth. Magna International Inc. remains a core
holding in our funds and should continue to generate earnings growth as global auto sales strengthen even
further and the company’s margins continue to improve. We expect favourites like Gildan Activewear
Inc. and Canadian Tire Corp Ltd. to continue creating shareholder value by putting their strong balance
sheets to work, whether through share buybacks or accretive acquisitions.
Industrials
Industrials fared very well in 2013, especially since the start of the third quarter earnings season. The
group’s core earnings growth of 3% last quarter came in at the high end of expectations, and guidance for
2014 suggests an improving macro backdrop. The European recovery will be a new tailwind for the sector
along with improving pension obligations. The outlook for non-residential construction is also
strengthening and there is significant pent-up demand in this area to drive future earnings. Valuations are
higher than they have been, but we think there are a number of attractive earnings acceleration prospects
in this sector. We continue to favour Canadian National Railway Company, our top Canadian holding in
this sector, which has been a source of steady growth in a sluggish economy but that has significant
leverage to economic improvement.
Technology
We are selectively optimistic on the technology sector heading into 2014. Enterprise demand should
stabilize as the macroeconomic outlook improves and CIO’s gain comfort around their IT infrastructure
needs in cloud computing, mobility, real-time analytics, and social media. The anticipated IPO of
Alibaba, which we consider the Chinese equivalent to Amazon, eBay and Google combined, likely gives
a sustained bid to the Internet group. In Canada, CGI Group Inc. remains a core holding given solid
execution and the potential for capital initiatives.
Fourth Quarter 2013
Market Commentary
Energy
We have made some significant changes in our energy holdings, based on our belief that the North
American light oil market may have become saturated with light crudes earlier than markets expected.
This potentially creates a long-term structural situation where the North American crude market
completely dislocates from the global crude markets (similar to the situation we have today with North
American natural gas pricing). In such an instance, large crude price differentials (vs. Brent) become the
norm, the type and location of produced crude gains in importance and integration (or pure refining
exposure) becomes more critical. We have added to positions in Suncor Energy Inc., Husky Energy Inc.
and Vermillion Energy Inc. to take advantage of these trends. We also believe that natural gas
fundamentals are showing early signs of improvement and expect steady price increases into 2015. Arc
Resources Ltd. and Peyto Exploration and Development Corp. are two of the lowest cost, growing
producers in Canada and we own them in our portfolios.
Materials
On the heels of a global manufacturing acceleration and signs of a non-residential upturn in the U.S., we
have increased our exposure to materials stocks with new positions in copper, steel, aggregates and
industrial gases. While steel remains oversupplied in some markets, utilization rates are clearly increasing
as demand improves and the inventory overhang in China shrinks. Although copper mine concentrate
supply is indeed increasing in 2014, a visible Chinese crackdown on polluting industries is likely to keep
smelters from expanding aggressively, thus maintaining a tight refined copper market. We remain
constructive on chemicals as improving utilization rates will likely continue to drive commodity chemical
pricing higher in 2014. Evidence of a non-residential construction recovery has finally arrived with major
U.S. aggregates producers reporting a sharp volume recovery in the third quarter. We added Praxair Inc.,
a major producer of industrial gases, to portfolios this past quarter. Praxair weathered the global recession
much better than most materials-related companies, while the company’s excess capacity provides
cyclical exposure to non-residential construction and general manufacturing increases.
Financials
We are constructive on financial services and are focused on regions like Japan and Europe where
fundamentals are improving and central bank policy is easing, yet tail risks are still reflected in share
prices. The Canadian banking sector will likely continue to attract significant flows from yield-related
investors looking for companies that can generate earnings growth in a more cyclically led market. Life
insurance stocks as well as banks can also benefit from increasing interest rates so investors should
continue to bid up their valuation relative to other low-growth, high-yield sectors. Within the banking
sector, we continue to favour quality domestic franchises with growth drivers outside of Canada with
Toronto-Dominion Bank and Royal Bank of Canada being our top positions in the sector.
Fourth Quarter 2013
Market Commentary
Healthcare
The end of the debt ceiling debate put the final nail in the Obamacare debate, setting the stage for better
visibility for U.S. hospitals and health maintenance organizations. At the same time, Big Pharma has
weathered the patent cliff better than expected through new growth initiatives, and high growth biotech
companies have become market darlings. Gilead Sciences Inc. remains a core holding in our funds. We
anticipate approval of its new Hepatitis C drug Sofosbuvir followed by positive phase III data of the drug
in an all oral regimens in the first quarter of 2014. Greater than expected drug pricing and/or patient
numbers would provide even further upside to the stock. We are neutral on the sector in Canada with our
largest position being Valeant Pharmaceuticals International Inc. Valeant has successfully executed an
accretive acquisition growth strategy and has recently articulated its longer term goal of becoming a top
five global pharmaceuticals company over the next three to five years.
Consumer Staples
We remain bearish on consumer staples in light of ongoing headwinds across the space. Lower end
consumers continue to feel budget pressures and changes to the U.S. food stamp program certainly will
not help. We expect these issues to weigh on food and household product volumes. A low volume, low
inflation environment is typically negative for retailers as well that can end up in a vicious cycle of
competitive promotional activity. Emerging market growth continues to be subdued compared to earlier
heady projections. In Canada, staples underperformed dramatically as fundamentals deteriorated. In
addition to a weak consumer environment, incremental square footage from Walmart and Target has hit
critical mass. Increased competition has resulted in less rational behaviour in the zero sum game of food
retailing. Against this back-drop, Loblaw Cos. Ltd. remains a core holding given its operational
momentum, more attractive fundamentals at recently acquired Shoppers Drug Mart and the substantial
synergy potential from the aforementioned acquisition.
Utilities
We are increasingly cautious on global utilities. Our previous bearishness stemmed from the sector’s lack
of earnings growth, high valuation and tendency to underperform in a rising interest rate environment.
However, our newest concern is that increasing penetration of renewable energy sources could threaten
the traditional structure of utility markets. Policy support for renewable energy technologies has wiped
billions off the market capitalization of utilities in Europe. Competitive renewable energy businesses have
hit the profits of German generators and we believe that there could be similar impacts in North America
over time. In order to hit regulatory targets in the U.S., renewable capacity could double in the next seven
years. At the same time, the cost of renewable power has become increasingly affordable at the retail
level. For example, a citizen in the South Western U.S. can install a solar power system and consume
energy at a lower cost than buying from traditional suppliers on the grid. With rates providing a cyclical
headwind and renewables providing a structural business challenge, we could be seeing a new regime
develop where traditional utilities lose their “low risk” reputation.
Fourth Quarter 2013
Market Commentary
Telecommunications
We are underweight the global telecommunications sector. The U.S. market appears to be getting
increasingly competitive, Canada has regulatory overhang as the government tries to devise ways to
reduce costs for consumers, and Europe has seen earnings multiples expand without signs of earnings
growth following. In the United States, T-Mobile USA launched a financed hand-set offering that allowed
them to take significant market from incumbents and from Sprint. AT&T and Verizon have responded by
reducing prices on their lower-end plans. While there remains some scope for special situations to deliver
good results for shareholders, we believe that telecommunications, in general, will have a difficult time
exceeding expectations in the medium term.
First published January 2014
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