Fixed Income and Equity Quarterly Commentary

Transcription

1 The Johnson, Johnston and Macrae King St. E. Kingston, ON K7K 6Y3 Moe Johnson First Vice-President Portfolio Manager Fixed Income and Equity Quarterly Commentary September 2015 Chris Macrae Vice-President Investment Advisor Ryan Johnston Associate Investment Advisor Glen Johnson Associate Investment Advisor Linda Wilson Client Associate Michelle Flegal Client Associate Connect with: China and Interest Rates. Fixed Reset Preferreds. Volkswagen, Volatility and Value Gov t of Canada Rates Jun 30/15 Sept 30/15 Change 5-Year 0.88 % 0.79 % (0.09) 10-Year 1.77 % 1.43 % (0.34) 30-Year 2.39 % 2.19 % (0.20) Indices % Change S&P/TSX 14,553 13,307 (8.56) % S&P500 2,077 1,920 (7.56) % DJIA 17,758 16,285 (8.29) % Source: Thomson Reuters

2 China and Interest Rates. The Connection. interest rates [will] remain lower for longer. the Chinese are exporting deflation to the rest of the world Interest rates are positively correlated to the expected inflation rate The August 11 th devaluation of the Chinese renminbi added weight to our long-held thesis that interest rates would remain lower for longer. In short, the Chinese are exporting deflation to the rest of the world by cheapening their currency and effectively lowering the price of products shipped worldwide. Forces conspired this year against the Chinese currency, as capital outflows reached about $500 billion. Sending money out of the country comes with permission only, but illegal transfers do occur and have contributed to a weaker currency. The authorities responded by spending foreign reserves to help prop up the currency, but in so doing drained credit and liquidity from the system. They finally reacted with a devaluation so that now the renminbi stands about 2.4% lower than the US dollar. Based on China s weaker than expected economy, by some accounts growing by only about 2% versus the targeted 7%, this could just be the start of further currency adjustments. China is the biggest exporter in the world. A weaker currency in China translates into lower prices for consumers worldwide, and a lower overall inflation rate. Buyers in the US are particularly benefiting and it shows up in the most recent core inflation figures of 1.2%, far off the Federal Reserve s (the US central bank) target of 2.00%. Interest rates are positively correlated to the expected inflation rate, so it is that we find that ten-year US treasury bond (one proxy for the general level of interest rates) trading at an uninspiring level of 2.05% after hitting just over 2.50% in June. Underwhelming worldwide economic growth, along with low domestic inflation, were factors in chair Janet Yellen s September 17 th decision to hold off on increasing interest rates. We continue to look for a range of 2.25% and 2.50% on the tenyear US treasury before substantially extending term (the maturity dates) on clients bond holdings. Fixed Reset Preferred Shares. A Poor Performing Asset Class, and The Silver Lining. The prices of many fixed reset preferred shares have fallen dramatically of late. The culprit has been the decline in bond yields and more specifically the five-year Government of Canada bond. The dividends on these issues are reset every 5 years based on a reset rate, expressed as a percentage, plus the five-

3 pricing of this class of preferred shares has also suffered. And someday, interest rates will move higher. we think this [preferred share] market is underpriced. year bond rate. For example, the Brookfield Asset Management preferred, priced at $19.60, currently yields 5.74%, pays a dividend of $1.125 and will be reset on September 30, 2019 to a rate of 2.86% (the reset rate) plus the five-year Canada bond rate prevailing at that time. Right now, that five-year rate stands at 0.81%. Yields have moved lower on these issues consistent with the move down in interest rates, meaning that pricing of this class of preferred shares has also suffered. We conducted a study showing the yields of various fixed reset preferreds under the scenario of a 0% five-year rate, 0.50%, 0.75% (not far off the current reality), and 1.00%. One conclusion is that most of the fixed reset preferreds we follow currently provide a very attractive yield relative to bonds and GICs under each of those scenarios. Secondly, although we clearly expect interest rates to remain low for some time, this investment asset class represents an important hedge against higher interest rates the higher rates move, the more dividends our clients will receive, with the added benefit that pricing on the preferreds should improve. And someday, interest rates will move higher. In the meantime, a new form of fixed reset has recently emerged. Canadian Utilities and Brookfield Asset Management issued shares with an important difference a minimum guaranteed dividend of 4.50% and 5.00%, respectively. Pricing in the fixed reset market has been hurt not only by lower interest rates, but also by a notoriously thin market. Either way, the new version or the old, we think this market is underpriced. Magna s profits will be negatively affected by the fallout to the tune of $0.12 per share, or about 2%. Of Volkswagen, Volatility and Value Magna International (MG S&P/TSX $61.70) is a large producer of auto parts with sales of $42 billion. The stock has fallen from a high of $74.50, some of that drop attributed to the well-publicized problems at Volkswagen. One anlayst expects that Magna s profits will be negatively affected by the fallout to the tune of $0.12 per share, or about 2%. In the words of a Barron s article September 28 th on the subject, Volkswagen s sales volumes will probably decline, but not implode. The article cited Ford Motor s rollover-related recall in 2000, Toyota Motor s sticky gas peddle in 2010, and General Motors faulty ignition switches as being responsible for a subsequent 15% drop in market share in the following year. All three companies went on to recover. Magna trades at 10.1 times 2015 earnings and yields a 1.8% dividend.

4 this market is beginning to offer more value than we have seen in some time. We believe this market, against the backdrop of anemic growth prospects in the Chinese economy, low inflation and a very volatile trading pattern of late, is beginning to offer more value than we have seen in some time. The S&P 500 closed at a level of 1,884 on September 30, 11.5% off its high of 2,128 reached on July 20. Investors are all too familiar with stock market volatility, the oftused term of defining the market s violent gyrations both up and down. We have never believed that volatility defines risk, as popular business media would have us think, rather risk can be more accurately described in terms of a client s potential loss of purchasing power if rates of return do not keep up with inflation, or financial risk, as when a bond credit fails in the marketplace. volatility can be seen to represent an opportunity to exploit the irrational behaviour of investors the seeds of this volatility were sown years ago with the growth of ETFs The company currently holds cash of $35 billion Given that our clients are long-term investors, volatility can be seen to represent an opportunity to exploit the irrational behaviour of investors in the short-term, and benefit from the increased distortions brought on by Exchange Traded Funds (ETFs). This is not to downplay the recent market declines from their 2015 highs. More than ever, we can expect to see repeated sessions of rapid sell-offs to occur in the stock market. Following the huge August 24 th 588 point loss on the Dow Jones Industrial Index, Danesh Robinton of Cambridge Global Asset Management suggested the seeds of this volatility were sown years ago with the growth of ETFs in the market and the risks they pose to investors. He cites intraday losses on some popular ETFs of between 25% and 40% as evidence of an illiquidity problem in the group. With an estimated 30% of all trading activity attributed to ETFs on that day, the sale of these issues in turn forced the sponsors to liquidate component stocks. As an example, Pepsi, GE and Visa all dropped 15% intraday before recovering. Johnson & Johnson (JNJ NYSE $93.04), the huge New Jersey based supplier of pharmaceuticals and medical devices, has a market capitalization of $257 billion. To illustrate the effects of volatility, the stock on Monday August 24 th traded as low as $81.79 before recovering to close at $92.82, compared with its closing price of $95.56 on Friday, August 21. The company currently holds cash of $35 billion and with a rocksolid balance sheet, J&J can afford to embark on some large scale acquisitions in a sector that has seen a widespread sell-off, in part due to Hillary Clinton s threats to hold in check what she sees as excessive drug pricing. As a large exporter, the

5 the company s earnings have been negatively affected by a higher US dollar company s earnings have been negatively affected by a higher US dollar, but we think that concern is largely priced into the stock. Down from a recent high of $109.49, the stock now trades at $93.04 and represents a good value at 15 times 2015 earnings, at the low end of its average price earnings multiple over the last twenty years, and yields a dividend of 3.3%. Other examples abound. Low price entry points for many high quality stocks will allow the long-term, value oriented investor to take meaningful positions. CIBC Wood Gundy September 2015 Connect with:

6 Please click the applicable link(s) below to view important disclosures that relate to this and the investment recommendations and/or products mentioned in it. Ryan Johnston is an Associate Investment Advisor working with Moe Johnson, Investment Advisor. Glen Johnson is an Associate Investment Advisor working with Moe Johnson, Investment Advisor. Yields/rates are as of September 30, 2015 and are subject to availability and change without notification. Minimum investment amounts may apply.