The following was excerpted from Third Eye Capital
Management Inc.'s Q2 2014 Investor Letter.
Canadian equities were stand-outs among
developed stock markets in the second quarter with the S&P/TSX
Composite Index gaining 6.4% in total returns (and 12.9% for the
first half of the year). Earnings among Canadian publicly-listed
companies have shown strong momentum this year, with growth up 14%
over 2013 after relatively flat performance since 2012. A key
driver has been the stronger U.S. economy and improved business
confidence, factors we predicted would lead to higher Canadian
corporate profits. Exports to the U.S. are up 11% year-over-year,
reflecting mainly higher energy prices. As logistical constraints
that have impeded the flow of Canadian oil to the U.S. get
alleviated (in part due to leading companies like Banister
Pipelines, which we have financed in the past),we expect Canadian
energy exports to continue to grow. A further tailwind supporting
Canada's overall pace of export growth is the weaker Canadian
dollar, which most economists expect to fall further for the
remainder of the year. Canadian GDP is now on track to rise 2.5%
this year given firmer U.S. demand.
In the United States, real GDP rebounded in the
second quarter after contracting at the start of the year due to
severe winter weather. The 4% annualized pace of expansion in the
U.S. economy was broadly supported by business spending, exports,
and employment. The U.S. economy created 816,000 jobs in the second
quarter, the strongest quarter for job creation since the low point
of the recession. The Institute for Supply Management (ISM)
Purchasing Managers Index (PMI) combines five manufacturing
indicators (new orders, production, employment, deliveries, and
inventories) to create a composite of U.S. manufacturing activity.
The ISM PMI Index posted a 55.3 reading for June 2014 (a PMI
reading above 50 generally indicates manufacturing expansion), with
all categories rising. The most recent U.S. Industrial Production
Index also gained 4.3% over the prior year, and the
non-manufacturing PMI jumped to 58.7 in July 2014, the highest
reading since December 2005. Expectations for a rise in U.S. GDP
for the balance of the year seem well supported by the data, and
this is good news for Canadian businesses.
The Bank of Canada's Summer 2014 Business
Outlook Survey shows that Canadian firms are now more confident
about the positive direction of the economy and plan to increase
investment in machinery and equipment over the next 12 months, with
a focus on efficiency gains from upgrades. The accommodative
interest rate environment and generally favorable borrowing terms,
are also making investment decisions easier to make. Companies are
likely to invest in order to alleviate capacity constraints since
Canada's industrial capacity rate reached 82.5% in the first
quarter, just 2% below its prerecession peak in 2005. Companies do
not make capital expenditures for its own sake - it is only when
they see rising demand for their goods and services that they
undertake new investment spending. We believe the pent-up demand
for machinery and equipment is high and that this will underpin the
cyclical recovery in commercial credit.
Strong economic fundamentals, low rates, and
easy money will continue to provoke demand for risk assets.
Although rockets in Gaza, US airstrikes in Iraq, crisis in Ukraine,
Ebola in West Africa, and stagnating European growth have returned
volatility to markets in recent weeks, the corrections in stock and
corporate bond markets have been neither severe nor broad-based.
The bounce in second quarter U.S. GDP has reignited expectations
for rising interest rates, which should keep investors attracted to
yield paying asset classes such as dividend stocks and corporate
credit. Investors need to be careful about compounding their equity
exposure since certain types of corporate credit, such as
high-yield bonds, have a high correlation to stocks and will reduce
any diversification benefits if unexpected shocks cause a broader
market correction. As our clients know, we believe investors should
adopt a more guarded posture toward traded corporate credit, where
leverage levels and covenant-lite structures are on the rise while
coupons and downside protections are on the decline. Investors need
to select their exposures to credit in terms of valuation and risk,
focusing on investments that preserve capital and generate returns
through consistent execution rather than taking on higher risk.
With weaker borrowers accessing credit markets, and more loan
proceeds applied to unproductive uses (such as share buybacks and
dividend payments), investors must put manager selection ahead of
asset class exposure.
Third Eye Capital Management Inc.