ECONOMIC & CAPITAL MARKETS COMMENTS- “Opportunity Awaits”
2015 by all measures was not a great year for investors in North America. The TSX Composite returned -8.3% (including dividends) and the S&P 500 returned 1.4% (with dividends). Bond investors did better as interest rates over the calendar year declined which increased the value of their bond holdings. The Government of Canada 10 year bond yield declined from 1.75% to 1.4% over the year. The US dollar played a significant role in the valuation of commodities. Below is a chart of the trade weighted value of the US dollar since 2011.
The value of the US dollar has been quite strong during this period, fueled in large part by the flight of capital out of troubled regions of the world. As Canadians well know, when the US dollar rises, the Canadian dollar declines. There is a similar relationship with commodity prices because they are priced in US dollars. Specifically, as the US dollar rises commodity prices decline.
While the rise in the US dollar played a major part in the decline of commodity prices, there has been a downward shift in the demand for metal and energy commodities due to slower global economic growth; particularly in China. Recently, China has been switching their economy’s direction from manufacturing and exports to domestic consumers and services. Reports to date have indicated that this process is proceeding well but major transitions such as this never go smoothly. GDP growth in China for 2015 is expected to be 6.5-7%. The growth rate is projected to decline to 6-6.5% in 2016.
Oil is a very important export for Canada. When oil was trading at $100 per barrel, it encouraged higher cost production such as fracking. At $35 per barrel, this high cost supply will eventually dry up and restore more balance in the marketplace. Another factor that supports a recovery in the oil price is the negative impact lower oil prices are having on Saudi Arabia’s budget. They require a price of $85 per barrel to pay for their public spending. At some point they will have to cut their production and allow the price of oil to increase. While it is impossible to call the bottom of any market, we feel at $35 per barrel, we are close to a bottom.
We will not be receiving the final tally on Canada’s GDP for another month. Canada will be lucky to have generated a 1% growth factor for 2015. The outlook for 2016 is not much better, 1-1.5%. Our Government has responded to this situation by reducing the Bank Rate 0.5% in 2015. In 2016, the new Liberal government has stated they will run a budget deficit to increase infrastructure spending to support the economy. We believe this is an appropriate strategy given our low national debt and historical low interest rates. With regards to further cuts to the Bank Rate, we feel this would be a poor strategic decision by the Bank of Canada. Given the high level of personal debt and the so called “housing bubble” in Vancouver and Toronto, a further reduction is counterproductive.
In the US, economic activity has been much better as their economy is moved by the consumer and not commodity exports. GDP growth in 2015 is expected to be 2.4% and 2.6% in 2016. The unemployment rate in November was 5%, consumer confidence is high and the housing market is on a solid footing. As a result, the Federal Reserve Board finally raised the Fed Funds Rate 0.25% in December. They feel that their economy no longer needs emergency low interest rates and believe “normalization” of monetary policy is an appropriate stance.
The question for investors is how high will the Fed Funds rate go and how long will it take? The best guess for how high is their long term policy target for inflation (2%). However, the Fed is on record that any further increases in the Fed Funds Rate will be “data dependent”. We expect them to move cautiously, making sure the higher lending costs are not impeding economic growth. A reasonable expectation at this point is the Fed Funds Rate to be 2% by Q2 2017.
In conclusion, we are expecting low Short Term interest rates and slightly higher Bond yields due to higher US bond yields in 2016. The oil price will hopefully stabilize and improve over the next 18 months as well as our dollar. The stock market in Canada has already discounted a lot of the negative impact of the lower commodity prices and slower earnings growth. Given the high dividend yield on quality stocks in Canada, long term investors just need to be patient. We believe the TSX Composite Index can achieve a 14,200 level over the next 12 months. That is a potential total return of 12% (with dividends).
