FIRST QUARTER 2016 RETROSPECTIVE AND PROSPECTIVE – Bull or Bear?  

Bull or Bear Voltaire

Bull or Bear “Uncertainty is an uncomfortable position. But certainty is an absurd one.”- Voltaire

Last quarter, we titled the Retrospective and Prospective “Foggy Weather”. While we would like to report that the fog has cleared, unfortunately that is not the case.

Global markets proved to be very volatile in the first quarter of 2016. In the first few days of the year, the sell-off was precipitous as investors’ concerns grew over the state of the global economy, particularly with respect to China as indications of lower levels of manufacturing were released. Trading in China halted as market circuit breakers were triggered. The sell-off persisted for the first half of January, corrected in the latter half, only to reverse trend again in the first half of February. Investors struggled with conflicting economic news relating to the deteriorating fundamentals in the energy and mining sectors, increasing corporate layoff announcements yet better employment statistics. From mid-February on through to the end of the quarter, the global markets were more sanguine focused primarily on improving conditions in the US.

The first quarter managed to record some positive results overall, despite severe declines in some sectors.

                     Canadian Dollar US Dollar
Q1 Q2 Q3 Q4 YTD Q1 Q2 Q3 Q4 YTD
Toronto Stock Exchange 4.5% 4.5%
S&P 500 -4.7% -4.7% 1.3% 1.3%
MSCI EAFE* -9.5% -9.5% -3.7% -3.7%
91 Day T-Bill 0.1% 0.1%
CUBI** 1.4% 1.4%
CDN/US dollar 6.7% 6.7%

* Europe, Asia and Far East Index

** Canadian Bond Universe Index

At year-end 2015, the Federal Reserve in the US postured a more aggressive stance going into 2016. Expectations were that there existed a strong possibility that interest rates would possibly be raised over four increments in the coming year as the US economy was getting stronger and employment was increasing. These facts appeared to be confirmed early in the quarter as estimates of 2015 GDP (Gross Domestic Product) came in ahead of expectations at 2.4% compared with 2014’s 2.1%. However, the quarter had not progressed very far when pronouncements from the Federal Reserve suggested a less aggressive stance and pundits began to forecast more gradual rate increases with possibly only two instances this year. This change in posture has caused some doubt about the strength of the US economy but this change is possibly more related to the state of the global economy and the continued strength of the US dollar.

In terms of geopolitical issues, the usual suspects continued to concern market participants. The issues dealing with the Ukraine and Russia, the South China Sea, conflicts in the Middle East (particularly Syria) and the massive refugee crisis in Europe were still very much in the news. Other unexpected issues occurred starting with a political fight between Saudi Arabia and Iran that temporarily impacted energy markets. North Korea claimed to have set off a hydrogen bomb although the rest of the world suspects it was really a less powerful atomic bomb. Terrorist attacks in Brussels generated concerns over the ability of authorities to coordinate efforts to protect the public. Surprisingly, the Brussels attack seemed not to have a major impact on markets suggesting that investors are becoming inured to these events.

The focus of investors was very much concentrated on the actions of the central banks this quarter. The ECB (European Central Bank) reduced the deposit rate to –0.4% from 0.3%, cut its interest rate from 0.05% to 0 and the lending rate reduced to 0.25% from 0.30%. Non-bank corporate debt was added to the ECB’s buying list and the Bank’s quantitative easing (QE) program was increased to 80 billion euros per month from 60 billion. The annual QE program of an estimated 1.74 trillion euros is now larger that the GDP’s of Italy and Spain. This action suggests conditions in Europe are not improving fast enough and that the problems with Greece, Portugal, Italy and Spain may re-emerge. Furthermore, these conditions bolster the side that wants Britain to leave the European Union; an event that would have many repercussions both domestically in Britain and globally. Norway reduced its interest rate to 0.5% from 0.75% sighting the possibility of negative rates while Hungary cut its overnight rate to –0.05% from 0.1%. One bright spot in Europe is the German economy that posted a year over year 2.3% increase in industrial production in February, the best in six years.

The Bank of Japan kept its overnight rate at –0.1% although the outlook for the economy was downgraded as exports fell 4% in February and imports fell 14.2%.

China reduced its reserve requirements for the fifth time in a year in order to increase liquidity. Exports in February were down 25.4% year over year while imports fell 13.8%. Concerns continue to grow with respect to the shadow banking system in China and the huge leverage in the economy.

It is in this light that the Federal Reserve has taken a more cautious stance as concerns grow about global growth and inflation. The US economy has thus far been resilient in the face of these global issues. Auto production is running at 17.5 million units a year, which is a record. Consumer credit continues to expand, albeit at lower rates than previously. Exports are beginning to feel the pinch of the high US dollar. Fourth Quarter GDP came in at 1.4%, better that the 1.0% expected. However, it is the state of the global economy that has alarmed the Federal Reserve.

In Canada we are fortunate to be situated so close to the United States. This is becoming more evident in the improving manufacturing sector; particularly auto parts; Canada’s largest export item.

Since the advance in the North American markets in mid-February, valuations in our view have become a little stretched as prices have risen faster than earnings, and, the quality of those earnings has deteriorated as more of the increases are stemming from cost cutting and share buybacks as opposed to revenue growth and investments in assets. Therefore, we advise a cautious approach at this juncture. This is becoming a stock pickers market where individual stock selection and valuation will be the critical ingredients to successfully navigate the volatile times ahead.

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