Quarterly Comment

Market Commentary – Q2
Picton Mahoney Asset Management
Second quarter 2011
Stock markets have rallied significantly since last summer – but the bears fought back in the second quarter and landed some
stinging blows. Economic indicators weakened significantly in the developed world, while inflationary pressures continued to
grow in many emerging markets. European sovereign debt issues again reared their ugly head. Protests and armed conflicts
continued in troubled Middle Eastern and North African (MENA) countries, keeping a firm bid in oil prices. Following a good
start to the quarter, stock markets corrected significantly, but most major stock market indexes ended the quarter near breakeven levels. The MSCI World Index was up 0. 1% in Canadian dollar terms, while the S&P 500 Index finished up 0.1% in the
quarter. The S&P/TSX Composite was down 5.1% driven by weakness in technology, energy and materials.
The global economy and financial markets are at a critical juncture. On one path, the world economy lurches back into
recession with governments and central bankers having few options to arrest the slide. Equity markets fall and sovereign debt
concerns start to grow in developed countries with massive budget deficits. On the other path, the world economy experiences
a typical mid-cycle slowdown, which stabilizes and begins showing signs of modest re-acceleration. In this case, equities return
to rally mode and sovereign debt concerns are pushed into the future. Each of these scenarios has some probability of occurring
and the probabilities will increase or decrease as time wears on. Our belief is that we are on the path of a typical mid-cycle
slowdown and that improving economic data will help fuel market gains over the next six to 12 months.
We acknowledge that the fundamentals behind the current economic recovery, especially in developed countries, are weaker
than in past cycles. In developed countries, previous excesses have led to a situation where pent-up demand is weak and
massive de-leveraging is constraining a pick-up in consumption. Central banks have resorted to unproven methods such as
quantitative easing to try and inject more life into the economy and stem deflationary pressures. To make matters worse, the
global economy was finally beginning to pick up when it was hit by various shocks earlier this year, including the Japanese
earthquake and nuclear meltdown, rising tensions in many MENA countries, and renewed sovereign debt concerns in Europe.
These unanticipated headwinds should turn into tailwinds in the second half of this year, helping pull the global economy out
of its current soft patch. Following the earthquake, Japanese industrial production went into freefall, but roared back in April
and May. Restarting Japanese plants should begin to filter into global industrial production as many supply chains begin
restocking depleted inventory.
As the end of the second round of U.S. quantitative easing (QE2) approaches it is important to note that, economic conditions
are much stronger today than they were when the program began last summer. The typical conditions for a recession are not in
place as monetary policy still remains very accommodative, real short-term rates are negative and the U.S. yield curve is very
steep. Gasoline prices are falling, which is a welcome stimulus. Corporate balance sheets are strong and free cash flow as a
percentage of GDP is at a record high. CEO business confidence remains high. Corporations are one of the major sources of
pent up demand that exists, because they have under-spent on plant, equipment and hiring. We believe that all that is required
to get corporations to increase their cap-ex spending are signs of economic stability.
If economic conditions stabilize and improve, the stock market should enjoy a significant rally. Sentiment indicators suggest
that stock market participants are bearish, which has historically been a positive contrary indicator for share prices. Cash seems
to be building on the sidelines. Conservative positioning within equity portfolios seems a strong likelihood, given that more
defensive sectors have outperformed cyclical groups by 630 basis points from the market’s peak. Stock prices have recovered
considerably from of 2008, but valuations aren’t overly stretched and are still attractive relative to other asset classes. The chart
below, from Empirical Research Partners, compares the free cash flow yields of stocks to corporate bond yields in the U.S. and
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Market Commentary – Q2
shows how attractively valued equities are compared to the alternatives. It is likely that improving economic data will be the
key catalyst to driving markets higher. However, if the U.S. government allows a repatriation of foreign cash holdings, this
could also be a key stimulus for the stock market. According to JP Morgan, U.S. companies currently have US$1.4 trillion in
undistributed foreign earnings and it is possible that US$500 billion to US$1 trillion of these earnings could be repatriated if
the legislation were passed. This could serve to boost assets because companies would directly manage this cash and a
significant use of proceeds would likely be increased share buybacks or dividends.
Equity Free Cash Flow Yields Compared to Baa Corporate Bond Yields
1953 Through Early-July 2011
%
1
4
0
(4)
Average
(8)
(12)
(16)
53
56
59
62
65
68
71
74
77
80
83
86
89
92
95
98
01
04
07
10
Recessions
Source: Federal Reserve Board, Corporate Reports, Empirical Research Partners Analysis.
Large-capitalization stocks excluding financials and utilities; capitalization-weighted data.
1
There are a number of forces that could derail our near-term bullish outlook. One only has to turn to the bond market’s pricing
of Greek debt to realize that Greece is insolvent and will likely default at some point. For now it appears that Greece has passed
a large enough austerity package to gain the country access to more loans and the ability to refinance upcoming maturities.
However, we believe this whole process has been focused on ‘kicking the can down the road’ so that holders of troubled
sovereign debt can gain time to better prepare for an eventual default.
Other short-term risks include the elevated inflation levels and ongoing tightening cycles occurring in emerging markets.
Output gaps in emerging markets have closed, leading to the onset of inflationary pressures. Central banks have been
tightening policy to try and stem these pressures. China is being followed most closely and some solace can be taken from the
fact that Chinese money supply growth rates have returned back down to historical averages after spiking in response to the
global recession.
Market Commentary – Q2
We think economic conditions will start to improve in the near-term which will provide the catalyst for a solid rally in share
prices. However, we view this rally as more cyclical as opposed to the start of a new secular bull market. We do not believe
that the conditions for a secular bull market exist at this point. After all, there has been only limited progress made in dealing
with the financial imbalances that precipitated the economic crisis. It will take years to work through the ill effects of the deleveraging process, public sector debt (especially in developed countries) and unbalanced global trade flows. Either
governments will change policy voluntarily, or markets will force them to change. We would prefer the former (at an
appropriate pace) since it would be much less disruptive than the latter. For now, the costs of funding massive deficits are
reasonably low, but the trajectory of their debt growth is unsustainable. We believe that the medicine required will likely mean
a period of below-trend economic growth, earnings growth and wealth accumulation. Our expectations of a continued rally for
the equity market remain in the context of a longer term range-bound market for equities.
We believe that the oversold cyclical groups will likely have the biggest initial bounce as economic indicators stabilize and the
market rallies. Following this bounce, the market is likely to gravitate to companies that can generate reasonable and consistent
earnings growth in an environment where the economy grinds its way higher without providing significant tailwinds. While we
have boosted positions in materials and energy, our portfolios continue to remain overweight industrials, consumer
discretionary and technology. Many stocks within these groups have the potential to generate positive change and earnings
growth without requiring a powerful economic tailwind.
We continue to believe that technology has strong, secular growth characteristics. Despite of the recent soft patch, enterprise
spending intentions have not wavered.
Free cash flow yields are high across U. S. companies, balance sheets remain pristine and 35% of large cap non-financial
companies are currently spending below their depreciation rate. Enterprise spending is on the uptrend with lots of room to
grow. Our largest technology positions in Canada include CGI Group and Opentext, which have generated strong earnings so
far.
Our biggest Canadian positions in industrials and consumer discretionary are companies that have specific growth drivers in
addition to cyclical upside. For instance, Canadian National Railway and Canadian Pacific Railway continue with steady
volume gains, but also enjoy the ability to increase pricing. Bombardier is benefitting from a surge in aerospace spending and a
pick-up in demand for business jets. Auto parts companies like Magna should benefit from some short-term pent up demand
following a temporary drop in automotive supply due to the Japanese earthquake. Canadian Tire has been a significant position
in our portfolio for some time. Its recent acquisition of Forzani Group has improved the earnings potential of the company.
Traditionally oil stocks have been well correlated to oil prices, but over the last quarter, this correlation has broken down. Oil
stocks failed to respond as oil prices climbed above US$100 and came under pressure as the market began anticipating slowing
economic growth. We believe oil stocks are discounting US$70 to US$85 long-term pricing, with some names trading at or
below their net asset value. We expect outperformance in well run oil companies that generate production and free cash-flow
growth. As a result, our top holdings continue to include Suncor and Canadian Natural Resources. The services sector
continues to run near full capacity and our favourites remain Trican Well Services and Precision Drilling.
Many other commodity markets endured significant weakness in the second quarter but seem poised for a rebound. The recent
collapse in Chinese copper inventories and a 50% increase in LME cancelled warrants in late June improved the near-term
copper outlook significantly. Iron ore should benefit from the surprisingly robust steel production figures coming out of China,
as well as new highs in steel industry utilization rates in the U.S. We believe stocks levered to copper – steel inputs and coals –
have the best tailwinds. As always, we hold positions with a production or reserve growth profile in order to lessen their
dependence on the economic cycle. For instance, one of our favourite long-standing positions has been the Labrador Iron Ore.
We recently added Quadra FNX Mining given our belief that operating challenges at existing Quadra operations are now
largely behind the company.
Market Commentary – Q2
Gold prices increased 5% in the quarter. Large marginal producers continued to disappoint and South African companies now
require gold prices of US$1300 an ounce – which likely presents a floor price – just to break even. Goldcorp is one of our large
positions due to the company’s success ramping up Penasquito. We have added New Gold to our portfolios.
We continue to hold Agrium Inc. and Potash Corp. Agrium’s retail division is also likely to benefit from pent up demand from
its farmer customer base, while Potash Corp. should return to a premium valuation as a holder of the world’s highest quality
long-life potash resources.
We see pockets of momentum within Canadian financials and believe that stock selection will play a greater role in the future.
Canadian banks, as a whole, have benefitted from strong economic growth over the past decade, but slower loan growth will
make it crucial to evaluate differences in each bank’s individual platforms to determine the relative winners going forward.
Toronto-Dominion Bank remains our top pick because of its strong domestic business, coupled with being well positioned U.S.
We have boosted positions in the Bank of Montreal given its upside earnings potential from integrating its Marshall & Ilsley
acquisition. We added Manulife Financial to portfolios this past quarter. The company still has significant sensitivities to
equity market and interest rate changes which may prove beneficial in the short run. Intact Financial, which is also a significant
holding, should benefit from its acquisition of the Canadian holdings of AXA Group as well as from positive underlying
fundamentals in the Ontario auto market.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments.
Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past
performance may not be repeated. This commentary is provided as a general source of information and should not be
considered personal investment advice or an offer or solicitation to buy or sell securities.