The key to weathering market uncertaintly: Look through the noise

 

The end of the June resulted in turbulent securities markets as Brexit made its way to centre stage.  The dire warning was there: if the UK voted to leave the EU, it would spark a major financial crisis, perhaps even as serious as occurred in 2008. The unthinkable event occurred, yet this dire prediction thankfully was way off the mark.

Notwithstanding the wildly exaggerated news stories, very little actually happened. In the two days following the vote, $3 trillion was wiped off the value of stocks around the world – the biggest two-day dollar loss in history. Significant, however nowhere near the largest percentage drop.

Most stock markets have recovered. To the end of July, the S&P/TSX Index was up 3.2 percent since June 23, the day before the results of the vote were known. The S&P500 Index was up 2.9 percent. The UK market was up 6.1 percent. Surprising! Not so good news on the European continent. Germany was up a mere 0.5 percent and France minus 0.6 percent. In Europe the currency fell modestly, equities much more. In Britain it is the currency that is feeling the pressure, stocks less so.

The Kingwest Portfolios have participated along with the market improvement. Since June 30th, the Canadian Portfolio is up over 4 percent and the US Portfolio is up over 5 percent.

The first reaction was that markets have functioned without disruption. That is good. There are three longer term consequences of the referendum:

          1. The exchange value of the Pound and the Euro is likely to be lower versus the US dollar

          2. Interest rates around the world are likely to be lower for longer.

          3. Economic uncertainty.

The Sterling has depreciated sharply – down 12 percent to around $1.31; the Euro is down about 3 percent to $1.11. Mario Draghi, the head of the European Central Bank, said even before the vote, that he would like to see the Euro below $1.10.

The important point to us in North America is that our dollar has not changed very much if you compare it to the countries where we trade the most (the Canadian Dollar has remained in a tight range with the US Dollar in this period). The Trade Weighted US Dollar Index has risen 1.4 percent. Not such a big deal! Were the exchange rate to rise a lot more it could cause the Federal Reserve Board (Fed) to keep interest rates on hold for a longer time, but at least for now the affect of the exchange rate adjustments is negligible in North America.

The impact of the lower currency in the UK will make their exports much more attractive but it will raise the price of imported goods to consumers and might even push inflation up. This might offset some other weakness expected as a result of the vote.

Things in North America are improving.

Interest rates are likely to be lower for longer. It seems the Federal Reserve will not increase interest rates in September, but do not rule out an increase in December. If the economy gets worse in Europe and everything else looks bad, then an increase would be unlikely. Otherwise the Fed will look at domestic concerns, in particular the employment situation. Employment improvement has been strong throughout the recovery.

For over a year, the Fed has said that it would raise rates when unemployment dropped to 4.9 percent. Unemployment has hovered around 4.9 percent for all of this year, and it was 4.9 percent in June.

Janet Yellen, the Federal Reserve Board chairperson, said her overall assessment of the labour market is quite positive and wage growth may “finally be picking up”. In July, average hourly wages rose eight cents an hour to $25.69; average weekly wages climbed to $886.31, a post-recession high. Core inflation is running at over 2 percent currently.

Wage growth has been solid since 2012

Year-over-year change in weekly and hourly wages, three-month moving average 

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Source: US Bureau of Labour Statistics

If the trend in wage growth persists, it is quite probable that rates will rise in December. It would be unlikely to happen before then because the Fed has historically not interfered in the US election.

While markets abhor uncertainty, those uncertainties are now known and everything will remain the same until an agreement is finalized. Businesses need to keep investing for the long term. Consumers need to keep spending within their means. The UK remains a member of the EU and companies continue to benefit from being able to trade within the free market. Workers and consumers continue to be afforded the same protections as before the vote. The most important thing now is to look through the noise.

What does all this mean to our Portfolio?

In 2015, our Canadian Equity Portfolio outperformed the market by about 9 percent because we did not own any gold companies or extractive mining companies. These companies staged a big rebound this year (up 50 percent as a group) and we have given back one-half of that outperformance. In the short term this is not good but we still think supply of those commodities has risen a lot and demand is sluggish. China, which has accounted for most of the marginal demand, continues to weaken and economic growth in Britain and Europe has not improved, particularly for large investment projects. So the outlook for these basic commodity prices is not improving, and while we bought a little of these companies at cheaper prices earlier in the year, we still are of the opinion that this is not the place to be yet.

We have a heavy weight in financial companies. Lower rates for longer is not good for most of them. But we expect that interest rates will go up late in 2016 or early 2017, a setback of a few months but not really that serious. These companies offer superb value and have been made very strong because of the regulations put in place post 2008. But the market is overlooking that because it will take higher interest rates to push profits even higher.

Finally, we have quite a bit of cash. We have slowly started to invest it and will deploy more as opportunities present themselves. For the moment, we think it is prudent to let the dust settle.

Company Profile: Citigroup Inc.

This year’s round of stress tests for the big US banks was less stressful than the last. All of the important 30 banks that took the test were deemed to have what it takes to survive the bleakest of scenarios. Many were given permission to boost returns to shareholders as a result.

One example is Citigroup, one of our investments. The company was allowed to pay out over $16 billion to shareholders and tripled their dividend, a very strong vote of confidence in the strength of the bank by its very conservative regulator.

We are confident that we will do well with this investment. Citi dramatically transformed in the past few years. New management with a conservative bias has focused on profitability; they have exited many underperforming businesses and have reinvested the capital in high return businesses that are being retained. The stock is trading at two-thirds of tangible book value – implying that the bank will earn very low capital returns. Even their regulator has recognized the inherent safety in Citi’s business today. A bank with the characteristics of Citi should trade at a premium to book value. Therefore within two years there is a high probability that Citi will trade at $72; 67 percent higher than the current price.

We have a number of other companies in the portfolio with characteristics like Citi and therefore we are very positive about the outlook over the next couple of years.

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