Tricia Leadbeater’s Market Updates
December 2015: What happened to the Santa Claus rally?
Some select forecasts for 2016
As 2015 is in its dying days, we tend to reflect on the year that is almost past and start considering what is in store for 2016. With respect to investing, I suggest that we look to the bond markets for some early indications on where to position portfolios, and sectors to avoid. It may be no surprise that it looks like the themes of 2015 will carry over into 2016.
As equity investors, bond market activity is often opaque to us – despite being multiples larger than the value of the equity markets. Bonds are traded over the counter and so don’t generally show up on retail investor news reports or the ticker tapes tracked on news media. But the bond markets are providing some great forecasting for us right now on where NOT to be. And, this note should also serve as a reminder that bond markets can be risky and entail loss, a misperception that many have about bonds, as they were predictable and reliable sources of return for most of the last three decades.
Many investors jumped into high yield bonds over the last several years, pushed into this risky territory out of the desire and need to achieve an attractive rate of return. As the low or zero-interest rate policy dragged into its seventh year, investment bankers and Exchange Traded Fund providers got busy creating vehicles to satiate that demand. This led in turn to funding projects, particularly in the mining and energy space, which were of higher cost and had even more marginal returns, as the demand for debt kept growing. Mutual funds were created too: US mutual fund ownership of corporate bonds hit 17% this year, up from 9% in 2008, as they also sought out ways to get acceptable returns for investors. Annual US corporate high-yield issuance never exceeded $147 billion until 2010, and has more than doubled that figure each of the past three years. (Wall Street Journal). The meteoric rise in US and Canadian oil and gas production was led by access to cheap capital (along with technological innovation), and 2016 will be the year we see banks and bondholders forced to face write-downs and defaults on many resource related investments. Canadian banks are included in this group of investors – the losses on oil and gas lending has been modest to date, but the rate of change of write-downs is increasing.
A snapshot of the bond market landscape is below, courtesy of the Wall Street Journal. A link to the article is here.
Junk markets have had a spectacularly bad year in 2015, as you can see by the price of one of the largest High Yield bond ETFs, HYG, the ishares High Yield Corporate bond fund, which is a good barometer of high yield activity. The price is down 11.25% year to date as of writing. If you bought HYG at the beginning of the year, with a 5.25% yield, you have not nearly been compensated for the loss in price:
High-yield, also called “junk” bonds, are trading back to where they were in 2009, many approaching a yield of 10%. Whenever you see a yield of 10%, this generally implies investors are worried about their return OF capital, so much that they need major compensation to take the risk of losing capital. Further, when bonds trade at a 10% spread over Treasury yields, the market thinks that issue is truly distressed. So, any bonds yielding 12% plus right now can be interpreted as in a danger zone. Right now, 20% of high yield bonds are trading in “distressed” territory. During the financial crisis, they fluctuated between 15% and 70% at one point (i.e. it is possible for things to get uglier). “Distressed” means investors are worried about the future, yet the bondholders are still getting paid. “Default” is when payments are missed. Defaults have been rising steadily from 1.4% in July 2014, to 2.8% on November 30. (S&P Capital IQ, wolfstreet.com). The majority in default are in the energy space.
When principal is lost, or investors feel they can’t easily sell an investment, then stress is placed on other areas of the market. Forced selling can occur should that investor need access to capital, which drives down asset prices in bonds and equities. We are seeing some of this volatility in the past week, as the fears about repayments in the high yield markets is spilling into equity markets. The spillover occurs because investors are increasingly risk averse now, and so are selling equities, especially in those same weak sectors as the bond markets. For the first time since the financial crisis, a bond fund, Third Avenue, closed itself to redemptions out of strains on liquidity – too many investors have been asking to get out at the same time. The fund is now going into forced liquidation, and it is uncertain what investors will get for their investment. This was not a large fund with assets of around $800MM, but it certainly added to insecurities over the last week.
High yield bonds have been much more volatile than the overall S&P 500, which tells me to expect the equity markets in the same stressed sectors to follow what is going on in the bond markets. This is because the level at where bonds are trading spells out that many companies in this sector are going to have serious cash crunches, requirements to raise equity through dilutive stock issuance, sell key assets, or go under.
Where the stresses are coming from are of particular interest for Canada, given the basis of our economy: Oil and Mining. The bond rating agency Fitch estimated in October that around 20 percent of the 1.4 trillion in junk bonds outstanding are issued by energy companies and another 5 per cent in metals and mining, certainly with the mid $30 handle on WTI oil that number is growing. With or without debt to service, very few oil companies are yielding positive returns at current prices. Some Canadian oil companies have an additional problem with servicing debt: the low Canadian dollar. Many turned to the much bigger US debt markets to raise capital in the last three years and now have much higher servicing costs in CAD terms, if they didn’t hedge out their currency exposure.
So, what are the bond markets telling us about where to make positive returns right now? US treasuries picked up a lot of investor flows over the last week, also giving support to the US dollar. The Fed will likely raise rates this week, and so investors are flocking to an investment that will likely be safe through the first interest rate raise and the current volatility. The market is telling us that US dollars are still a safe haven for investment. Companies that have real earnings growth are also being differentiated from those that have depended on access to large amounts of cheap capital to grow through acquisition, or to buy back shares. Real sales and earnings growth and low reliance on debt is what to look for in equities.
Early thoughts on where to focus investment dollars:
USD investments are still in demand, and likely will be for 2016 as the Fed raises interest rates and the US is probably the strongest developed economy. However, the 22% run the dollar has had since mid- 2015 may not be replicated next year. Still, as Canadian investors, the indicators point to maintaining a large position in USD investments compared to the home currency. (Our dollar is generally linked to the oil price.)
US based companies with international operations faced headwinds after repatriating foreign sales into US in 2015. This may continue for the first part of 2016, so the companies that have robust domestic tailwinds will continue to benefit while some of the multinationals lose out on overseas sales – think consumer discretionary, housing, travel and entertainment as some sectors that will benefit.
If cheap oil and a strong USD is here to stay for 2016, then certain exporters in Asia and Europe that sell to the US and benefit from cheaper energy inputs will benefit, for example, German and Japanese manufacturers.
Certain emerging markets are at a point of extreme fragility: think countries like Brazil, Venezuela and South Africa, where local currencies are stressed, there is a heavy reliance on commodity exports as a key driver of their economy, and inflation and corruption are adding to the stress.
In some respects, Canada is like an emerging market: we rely on commodity exports disproportionately to drive growth, and so expect Canada to be a low growth country generally, with growing risks in any industry connected to oil and gas and materials. Debt levels are high here, which will strain liquidity and put some into insolvency next year. Balance sheet flexibility will be critical next year; expect more dividend cuts and bankruptcies in the energy sector.
Expect Canada’s dollar to stay subdued along with interest rates. Interest rates are not likely to rise in 2016, and after a speech given by Poloz in mid-December, currency traders are now starting to modestly bet on another rate cut in mid-2016. It’s not impossible to imagine we may need to get used to a 70 cent dollar for the next while, although consensus forecasts still expect the Canadian dollar to trade around 74-75 cents to the USD (Bloomberg, GMP securities). But if oil stays in the $30 range, and our federal and provincial governments continue to increase deficit spending and borrowing, expect that consensus forecast to seem optimistic later next year.
With volatility expected to continue, hedge funds that actively short sell or pair trade should find lots of opportunity.
Big winds of change caused by technology.
Technology will continue to drive radical changes to all kinds of businesses. Very few sectors will remain static – witness the changes in energy, in the availability of low cost oil and gas owing to advances in technology. Capital budgets were generally cut by 25-40% in 2015, and early indications are that they will be cut again for 2016 spending by a further 25% – but oil and gas production levels in North America are still growing! The technology behind horizontal drilling and fracking changed everything.
The “sharing economy”: technology has allowed consumers to monetize their house (Airbnb); their car (Uber); or car share (Car2go); market their stuff (eBay, etc.). Technology has changed shopping altogether, whether you use Amazon or the Bay’s website – many people don’t need bricks and mortar stores for much of anything, unless you prefer that. You can even buy a car this way now (Tesla, which has lots of other disruptive technology too). You can even get outside the traditional banking system (Apple pay); watch your TV on demand, or produce your own shows (YouTube).
Certain services are not deflating in price despite these changes: airline travel and Disneyland seem to be immune; government services are going up, despite tax revenue declining at probably a greater rate in the future; Google and Facebook ads and “clicks”; certain health care services still are appreciating at a higher rate than inflation; as is corporate spending on internet security. In other words, we need to search out the technologies, services and business that are immune to these forces of deflation and have tailwinds for their business offering, who often are the disruptors and the enablers.
Please feel free to contact me with your comments.
Director, Wealth Management
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