Risk Provacateur (Q2-14)
Jun 30th, 2014
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.