Portfolio Strategy Equity Strategy: Not Strong, the Force Is, with Manufacturing and Commodities Stéphane Rochon, CFA, Equity Strategist
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January 2016 Portfolio Strategy Equity Strategy: Not Strong, The Force Is, With Manufacturing and Commodities Stéphane Rochon, CFA, Equity Strategist 2016 is off to a rocky start and, in a continuation of 2015 trends, oil prices continue to fall with obvious negative implications for the Canadian market and Loonie. Our technical analyst Russ Visch believes we could see more weakness for stocks in the short term but, importantly, also remains bullish longer term as he believes this is a cyclical pullback in the context of a secular (i.e. multiyear) bull market. Fundamentally, we agree with this view and believe that the massive monetary stimulus that has been injected into the system will positively impact the real global economy in 2016. While recent Chinese and U.S. manufacturing data (Purchasing Managers’ Index (PMI) –known as ISM in the U.S.-, which is one of the best economic cycle indicators and correlates strongly with stock returns) has been relatively soft, we think we could see a positive inflection point in the next few quarters. This is an important reason why we believe further weakness will be yet another buying opportunity, as it has been over the last four years. Once again, we strongly advocate a disciplined and diversified portfolio approach which will allow investors to ride out any further market weakness with less damage. While we became “less negative” on Canada and the energy sector late last year, we continue to advocate being underweight the Great White North and oil stocks from a broad asset allocation perspective. The S&P 500 Index (the S&P) is not immune to the current downdraft in risky assets but it is the most defensive stock market given the strength of American corporations (e.g. Google (now Alphabet), Pfizer, Pepsi etc., all of which are members of our Guided Portfolios), which tend to have very strong balance sheets and far better dividend growth prospects than commodity centric markets such as Brazil, Australia and Canada. The issue for oil is that the market remains badly oversupplied and while we could see some improvement in the next year as oil prices curb production increases, we think this will be a drawn out affair. As our BMO Capital Markets analysts note: “We estimate that the global oil market is oversupplied by roughly one million bpd. Balancing the global oil market requires that that surplus be eliminated. The only reliable mechanism to accomplish this is the oil price. Our base case is that crude oil prices remain low enough long enough to convince U.S. producers to cut the rig count by a further 25-30%. This price level should also be low enough to shut-in some uneconomic production such as conventional heavy oil and mature offshore platforms. We believe that this could be enough to balance the oil market by the end of 2016 and move it into a supply deficit in 2017. This could result in a trading range for Brent crude oil of US$35-55 a barrel in 2016 and US$50-60 a barrel in 2017.” Figure 1: BMO Nesbitt Burns Investment Strategy Committee’s Recommended Asset Allocation (%) Income Balanced Growth Aggressive Growth Recommended Benchmark Recommended Benchmark Recommended Benchmark Recommended Benchmark Asset Mix Weights Asset Mix Weights Asset Mix Weights Asset Mix Weights Cash 5 5 5 5 5 5 0 5 Fixed Income 65 70 35 45 15 25 0 0 Equity 30 25 60 50 80 70 100 95 Canadian Equity 15 15 20 25 25 35 25 40 U.S. Equity 10 5 30 15 35 20 45 30 EAFE Equity 5* 5 5* 5 10* 10 15* 15 Emerging Equity 0 0 5 5 10 5 15 10 * Within EAFE, we specifically recommend Continental European equity. Source: BMO Nesbitt Burns Private Client Strategy Committee BMO Nesbitt Burns Inc. is a Member-Canadian Investor Protection Fund. Member of the Investment Industry Regulatory Organization of Canada. All figures in C$ unless otherwise noted Portfolio Strategy | January 2016 Error! Reference source not found. | Error! Reference source not found. Since a picture is worth a thousand words, we thought we would update charts we have published several times already which show just how much oil price trajectory matters for our market and currency. Figure 2: Canadian Dollar vs Oil 1.10 $160 1.05 $140 1.00 $120 0.95 $100 0.90 0.85 $80 0.80 $60 0.75 $40 0.70 $20 0.65 0.60 $0 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 CAD/USD WTI Oil Source: Bloomberg Figure 3: TSX Composite Index vs West Texas Intermediate Oil 18000 $160 16000 $140 14000 $120 12000 $100 10000 $80 8000 $60 6000 $40 4000 2000 $20 0 $0 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 TSX WTI Oil Source: Bloomberg Portfolio Strategy | January 2016 2 We hasten to add that lower oil prices are actually a net positive for most of the globe (the U.S. and Europe in particular) as lower gasoline prices are akin to a tax cut, which boosts consumer confidence and spending. The chart below illustrates this and shows gasoline prices on the left axis vs. consumer confidence (inverted) on the right axis. Figure 4: Gas Price vs Consumer Confidence $4.50 50 60 $4.00 70 $3.50 80 $3.00 90 $2.50 100 $2.00 110 Jun-10 Oct-10 Feb-11 Jun-11 Oct-11 Feb-12 Jun-12 Oct-12 Feb-13 Jun-13 Oct-13 Feb-14 Jun-14 Oct-14 AAA Avg. U.S. Unleaded Gas Prices Consumer Confid. (Univ. of Mich.) Source: Bloomberg Markets do not go down in a vacuum of course. Aside from scimitar rattling in the Middle East, a large part of the recent market weakness has been due to weak(ish) ISM/PMI data from China and the U.S. Specifically, the ISM Manufacturing Index unexpectedly fell slightly to a 6�-year low of 48.2 in December, below most European measures. This extends the woes in a sector that accounts for about one-tenth of economic activity. While manufacturing is not contracting, it has yet to turn up which has equities and other risky assets on the defensive. The silver lining is that equity markets seem to have fully priced in the manufacturing slowdown to date (based on historical relationships) but we will need to carefully monitor these trends and be particularly vigilant should there be further deterioration in the data. Portfolio Strategy | January 2016 3 Figure 5: Caixin PMI vs MSCI Emerging Markets Year over Year 20% 54 15% 53 10% 52 5% 51 0% 50 -5% 49 -10% 48 -15% 47 -20% 46 -25% 45 -30% 44 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 MSCI Year-over-year Caixin PMI (right axis) Source: Bloomberg Figure 6: S&P 500 Index Monthly Returns vs ISM Services New Orders Index Source: Bloomberg Portfolio Strategy | January 2016 4 The Importance of Risk Management in a Shaky Market Environment As we wrote last year, few pundits and investors predicted the speed and magnitude of the oil price decline in 2015 and the associated downdraft in the Canadian dollar. Last August, the U.S. market experienced its first 10%+ correction since 2011. It had been a very long time without a major pullback by historical standards and the economic turbulence in China provided a clear catalyst for this selloff. But even in the relatively quiet stock market environment of the last five years, we have still seen a number of 5%+ pullbacks, as shown in the chart below. The bottom line is that stocks do not go up in a straight line and there is a lot of truth to the old adage that stocks normally “grind up” but sometimes “gap down”. Figure 7: Market Corrections – 5% or More 2500 2000 1500 Market Corrections (Peak to Trough)5 5% Corrections or More: 1000 Aug-11: -17% (32 days) Nov-11: -5% (12 days) Jun-12: -3% (25 days) Nov-12: -5% (8 days) 500 Feb-14: -5% (11 days) Oct-14: -7% (20 days) Aug-15: -6% (25+ days) 0 Jan-11 Sep-11 May-12 Jan-13 Sep-13 May-14 Jan-15 Sep-15 S&P 500 Index Source: Bloomberg Remaining focused on long-term goals—through a diversified portfolio across asset classes and geographies—and the market’s ability to recover over the long-run is the best course of action. Effective diversification helps control the volatility of portfolios when certain assets move up as others are going down. For example, typically, bonds tend to do well when the stock market sells off, which decreases the ups and downs which can lead to overly emotional reactions on the part of investors. Investors must have a plan which includes an understanding of objectives and the risks we face in attaining them. This starts with understanding our longer term income needs (to maintain a certain lifestyle) and then building sufficient assets to achieve these aims. It is very important to build a “safety cushion” which will allow us to handle longevity and health and long term care risks (which are impossible to predict ahead of time). We believe that above all else, investors should focus on adjusting the level of risk in their portfolios, and this requires decisive selling and buying when warranted (for example, selling a stock, even at a loss, when the risk / reward proposition becomes unfavorable).