Tricia Leadbeater’s Market Updates

Q1 2016 Review: What just happened?

If you were a fairly casual observer of markets, and only looked at stock market index levels at the beginning and end of this quarter, it would look like a fairly benign start to 2016. However, for those who were watching on a daily basis, the markets went through a few rounds of shocking volatility that in some minds brought back echoes of the financial crisis. Market participants went decisively “risk off” in January, rapidly pulling capital out of equity and junk bond funds. Within three weeks from January 1st, the Canadian and U.S. markets were down over 10%, the Canadian dollar dropped another 5% to bottom at 68.5 cents to the USD (its lowest point since 2002); and the price of oil dropped another 27% from its already depressed levels, to US$27 WTI on January 20th, from US$37 on January 1.

One year TSX: -9.6%


News media began giving air time to pundits who were positing that the markets felt similar to 2008 just before they plunged; there were concerns on whether the U.S. was actually in recession versus moderate growth; and concerns over growth rates in China and emerging markets also weighed in. From mid-January to mid-February markets rallied, only to drop back to near January lows, further frustrating those trying to stay the course in their equity allocations.

Spring came in with a roar in March as a very powerful rally took hold across the spectrum of asset classes. Equity indexes and commodity prices recovered the losses of the past winter to end in the green. Many blue chips, like the Canadian banks, or U.S. names like Johnson and Johnson, and AT&T, even cyclicals like GE and CN Rail ended the quarter on new annual highs. The best performers in the quarter, after being the worst for the last two years, included gold, base metal miners, and oil and gas. Note that the commodity sector remains well below peaks hit in 2011 even with that rally. The biotechs, pharmaceuticals and some of the tech sector were mostly shut out of the end of quarter rally, but are now participating as April has started with investors strongly embracing “risk on.”

What caused all this volatility?

Several culprits came together at the same time to press down on markets, and many of them remain unresolved factors that are likely to cause more noise through the rest of 2016. Ultimately, all of these are interconnected:

The Fed and the course of interest rates

  • The first interest rate hike in the U.S. happened mid-December, with indications the Fed would raise four times more in 2016. Markets were digesting what higher borrowing rates for consumers and businesses would mean, after a decade of enjoying ultra and artificially low rates. Rates were also expected to rise for sovereign and corporate borrowers outside the U.S., as their cost of borrowing is based on a spread off the US.

  • Monetary policy is diverging globally. While the U.S. is trying to raise rates, Europe, Japan, Canada, Australia are still easing. Many countries in Europe and Japan now offer negative interest rates for depositors and debt holders also referred to as “NIRP”, Negative Interest Rate Policy. Negative interest rates work like a commission for the service of holding cash at a bank, a twist of the normal relationship. This amounts to an effective tax on savings. The notion is that by disincentivizing savers, spending and capital investment will ensue. In fact the opposite is occurring: banks are holding on to their cash and companies are borrowing to buy back stock instead of investing in plant and equipment.

  • Central banks hope that low or negative interest rates will encourage businesses and consumers to invest. A dangerous outcome of persistent and unnaturally low rate is that that capital can be misallocated relative to risk in order to chase desired rates of return. Second, the unintended outcome of minimal rates of return on cash is that the velocity of money has dropped to historical lows. This is the exact opposite of the hoped for outcome of easy monetary policy. Consumers and businesses are not spending or investing enough. In fact savers (in the U.S., not Canada) are spending cautiously ever since the financial crisis, perhaps because they realize that low expected returns on investments means a lower standard of living offered by retirement funds over time. Money needs to be spent more prudently in this scenario.

  • The two charts below show the increase in the supply of money in the U.S. and the velocity of money in the U.S. We can see that while more and more money was printed the movement of money through the economy continued to slow down. Money is not being turned through the economy and stimulating growth, but is sitting dormant on the balance sheets of banks and consumers:

The supply of money

The speed that a dollar moves through the economy

USD strength

  • The strong U.S. dollar continues to hurt U.S. based exporters, and the companies that operate internationally. Companies earn relatively less for sales abroad when they convert back to USDs.

  • Many emerging market sovereigns borrow in USD, and a strong USD to the local currency makes it harder to bear the cost of servicing debt. This is causing extreme pain in some regions. There is as much dollar value outstanding in stressed and distressed emerging market debts as there was at the peak of the financial crisis (over $300 billion).

  • The chart below graphs the 5 year move in the USD against its major trading currencies. The U.S. moved up by 25% in less than a year, and remained strong through 2015.

  • Note commodities are priced in USD, so when the USD moves up, the price of globally traded commodities tends to move down in tandem in USD pricing, all else being equal. Oil fell from US$105 in July 2014 to US$45 by March of 2015, tracking the direction the USD. This holds the same for other major commodities, like gold, copper, nickel, coal, etc. As the USD has weakened in the start of 2016, many commodities have moved up in USD prices.



Earnings growth rates are slowing for U.S. corporations

  • Investors have been looking to U.S. markets as a key investment opportunity for attractive dividends, and a domestic economy that has real growth.

  • Employment numbers continue to strengthen in the U.S., which is good for workers, but profit margins have likely peaked in the U.S. as wages begin to rise after staying stagnant since the financial crisis.

  • Outside of the Energy sector, multinational companies are especially showing weaker margins. Companies like Johnson and Johnson and McDonald’s that translate over 50% of their sales from weaker non-U.S. currencies have felt the biggest impact. Domestic manufacturers that export are also struggling to show profit growth with the strong USD.

  • We have had three consecutive quarters of slowing rates of earnings growth in the U.S., and a 3.6% drop in four quarter earnings compared to last year weighed on markets as the data started to roll in in January.

Emerging Markets Growth rates, especially China

  • China is a major contributor to global GDP, and a slowdown in China could mean a continued drop in demand for commodities unless other emerging markets pick up some of the slack from China. India is a possible candidate to pick up some commodity demand slack.

  • China is a heavily indebted nation, with extremely volatile stock markets over the last year, which has also caused anxiety in global markets.

  • Worries around defaults in EM among the countries that borrow in USD and whose economies are founded on commodity exports.

The high yield bond markets and the oil price

  • As mentioned, investors have been chasing higher and higher risk investments in order to beat the returns now offered by corporate and sovereign investment grade bonds, which generally offer 0.25%-2% expected returns for up to 5 year maturities.

  • High yield bond markets offered comparatively interesting yields, and investors flocked to them, financing many resource development projects that now look uneconomic, especially in the oil and gas sector, and particularly in Canada. About 20% of outstanding high yield debt in the U.S. market is exposed to oil and gas exploration. Fifty north American oil and gas companies declared bankruptcy last year, owing more than $17 billion, and more are expected in 2016 (Bloomberg). Energy debt is trading at yields back to peak financial crisis levels.

  • As junk debt issuers continue to have solvency issues, investors pulled out of that risk sector and back into safe havens. JNK, the large ETF that tracks the high-yield bond market, was down 12.3% last year.

What caused the rally?

  • With all these factors at the forefront of investor’s minds, what caused the turnaround in the markets?

  • The Fed signaled they are not going to raise rates as fast as they previously indicated.

  • The U.S. dollar has weakened, helpful for emerging markets and U.S. multinational companies.

  • Enough data has come in to assuage investors that the U.S. remains in moderate growth versus recession (for now).

  • U.S. dividend paying stocks still offer very strong balance sheets for investors and much more attractive dividend yields than high grade corporate bonds in a world of negative interest rates.

  • In Canada, first quarter GDP grew, commodity prices were moving up along with the CAD, and the Federal government commitment to deficit spending and supporting the economy means that the Bank of Canada is unlikely to lower rates again, for now. Our heavily shorted markets rallied strongly to become one of the best performing developed markets in the first quarter.

  • The oil price bounced meaningfully: production has started to modestly decline in the U.S. (however storage remains at all-time highs); and OPEC has indicated they may keep production levels flat to January levels instead of continuing to increase supply. The oil sector was so heavily shorted that the turn-around in sentiment was enough to trigger a powerful short-covering rally as speculators scrambled to buy and cover off their short positions, and investors started to take risk again by investing in the sector. Investors feel the worst is behind them in terms of oil prices. Oil and gas producers and pipeline companies took advantage of stock market strength and renewed investor appetite to raise equity. In Canada, over $8 billion was raised in new equity issues, dominated by TransCanada and Enbridge. However, even at $40 oil, it is uncertain whether many Canadian companies can operate profitably. Canada suffers from a lack of pipeline capacity to global markets, higher taxation on energy, and a very uncertain regulatory environment. In the U.S., it has been reported that breakeven costs have been driven down to $30/boe on the best plays.

How to position portfolios for the rest of 2016:

  • Dividend paying stocks will continue to have investor support in a low interest rate world

  • Keep oil and gas positions modest as the sector struggles for profitability

  • High yield bonds offer opportunity: in moderation, caution around oil and gas

  • Modest positions in gold as a hedge

  • Investment grade corporate bonds: portfolio stability

  • Alternative strategies that can take advantage of increasing volatility in markets

  • Canada has had a good rally but returns could be modest from here given the outlook for economic growth

  • Hold U.S. dollars to hedge against continued downside risks to the Canadian dollar


Please feel free to contact me with your comments.


Tricia Leadbeater
Director, Wealth Management


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