Harbour Monthly. The Harbour Group of RBC Dominion Securities. All For One: You. RBC Dominion Securities Inc.

Transcription

1 RBC Dominion Securities Inc. The Harbour Group of RBC Dominion Securities Harbour Monthly All For One: You An Exclusive Newsletter for Our Clients DECEMBER 2014 Main Reception: Toll-free: RBC Dominion Securities Brookfield Place Bay-Wellington Tower 181 Bay Street, Suite 1520 Toronto, Ontario M5J 2T3 Peter Coward, hba Vice President & Director, Investment Advisor Graeme MacGregor, fcsi, cim Vice President & Director Portfolio Manager & Wealth Advisor Christopher Newall, fcsi, cim Vice President & Director, Portfolio Manager John Grant, cfa, mba, msc Associate Portfolio Manager & Wealth Advisor Robin Gullason, cfa Vice President, Lead Strategist Putting you first, every time, to help you navigate the complexities of managing your wealth. All of our team members, all of our resources, all of our collective insight: ALL FOR ONE: YOU. TSX Slips on an Oil Slick The volatility in the energy space has been a trying experience for Canadian investors given the outsized index weight. An oversupply condition and a shift in strategy from OPEC to defend market share over price has turned a correction in oil prices into an allout rout. We are now at a point where having any energy exposure has become uncomfortable but we do not think it is wise to abandon the sector. Maintaining a diversified portfolio has stood the test of time. The arrival of tax-loss selling season has exacerbated market volatility as investors lock in losses and portfolio managers purge losers from their funds. Lost in the market melee is the fact that lower oil prices are positive for almost every other part of the global economy and amount to a significant real-time tax cut for consumers! Falling oil prices are particularly positive for the U.S. economy, and when the U.S. economy is strong, Canada typically benefits, especially now that the currency has depreciated. Due to the unbalanced nature of the TSX we continue to advocate for continued investment in U.S. dollar equities to add both diversification and the hedging properties of the U.S. dollar. Markets are behaving irrationally, with multi-billion dollar companies valuations changing 10%+ from one day to the next, and we think cooler heads will prevail once the calendar turns. Continued on page 2 THE HARBOUR GROUP OF RBC DOMINION SECURITIES

2 continued from page 1 The Energy Sector Has Been a Blessing and a Curse for Canadian Investors This Year The price of commodities such as crude oil and natural gas have always had an outsized effect on the TSX, which over the years has been both a blessing and a curse has seen extremes in both directions as detailed in Exhibit 1 below. After years of lackluster performance despite oil averaging $95 over the past three years, it seemed as if Canadian energy stocks were finally getting their due in The sector rallied 20% while the price of crude drifted higher over the first half of the year only to see the sector correct as oil softened in the fall. Exhibit 1 TSX Energy Sector Year to Date Performance flows and sentiment at the moment. Longer term, however, we have to consider the following: 1. Much of the recent crude oil supply is of the high cost variety, and lower prices should dim the supply outlook. 2. Many U.S. shale gas drillers have used a heavy amount of high-yield debt to fund their operations, a market that is now essentially closed to them. With cash flow declining rapidly and debt likely unavailable, drilling should slow down. 3. Shale oil wells have very high decline rates, and a high amount of drilling is required to keep production flat. 4. Many OPEC nations require oil in excess of $80 per barrel to balance their budgets, and some need more than $100. Heavyweights such as Saudi Arabia have the financial wherewithal to tough it out for a while, but even they will feel the pinch eventually. We think the chart below courtesy of The Economist provides the best overview of various national breakeven prices. Note this was produced in October we have indicated current (December 10) Brent crude oil pricing on the chart. Exhibit 2 Breakeven Prices OPEC Turned an Oil Price Correction Into a Rout While a correction in a hot sector was not unusual, the response from the OPEC (Organization of the Petroleum Exporting Countries) oil cartel was. After years of valuing price over market share, OPEC (led by Saudi Arabia) decided to hold production steady at its November meeting, shocking the energy sector the world over. There are many theories as to OPEC s motives, but for now, they seem willing lean on high-cost producers to see if they will cut production to balance a market that is deemed to be oversupplied at the moment. The lack of any nearterm supply relief led West Texas Intermediate oil prices to quickly drop from $73 to $60 in under two weeks and leading energy shares sharply lower. Making a near-term prediction on oil prices is challenging given the volatility and cross currents at play in the short term we are in an environment where anything can happen as the crude oil futures market seems to be driven by fund Brent Currently at $64 Source: Deutsche Bank; Thomson Reuters Longer term, we would expect oil prices to drift higher as OPEC would likely be forced to cut production if prices fall much further and high-cost extraction would slow down, but putting a timeline on that outcome is difficult. The consensus of the economics community seems to be that prices should rebound in the second half of 2015 but in the meantime we are running with the assumption that current prices prevail for a while. 2 RBC DOMINION SECURITIES INC.

3 continued from page 2 We Still Advocate Holding a Diversified Portfolio The move in energy stocks has undoubtedly been painful, even in the context of a diversified portfolio. For a long time having a structural underweight position in energy was adequate to balance risk and reward in portfolios. While we still feel that is the case, some investors may be tempted to think why bother holding any energy at all? While that is a tempting thought at a time like this, we go back to portfolio management basics allocating capital is a study in probabilities, and going to zero weight in energy is making an all-out bet that oil prices are destined to stay low, and companies will not be able to innovate their way to profits. In any given year, sector performance varies widely as seen below (Exhibit 3), and often times the worst performing sector bounces back strongly the next year. Considering this sell-off in energy is coinciding with tax-loss selling season, we think there is a reasonable probability that energy outperforms early in the New Year, particularly if oil prices stabilize at a time when tax-loss selling pressure abates. Exhibit 3 TSX Sector Ranked by Annual Price Return Last 10 Years TSX Sector Ranked by Annual Price Return Last 10 Years TECH: 67% NRG: 29% NRG: 61% MAT: 38% TECH: 48% STP: -8% TECH: 44% HC: 50% HC: 50% HC: 24% HC: 72% MAT: 26% FIN: 17% UTE: 33% TECH: 27% MAT: 29% UTE: -24% FIN: 38% MAT: 36% TEL: 19% STP: 20% DSC: 40% FIN: 24% TECH: 12% FIN: 21% TEL: 16% TEL: 16% IND: -27% NRG: 35% DSC: 22% STP: 5% DSC: 19% TECH: 36% NRG: 24% STP: 9% IND: 17% FIN: 16% IND: 9% MAT: -27% MAT: 33% TEL: 16% IND: 2% FIN: 13% IND: 35% IND: 21% DSC: 8% MAT: 14% DSC: 13% UTE: 7% TEL: -27% HC: 29% IND: 14% UTE: 2% IND: 13% STP: 21% UTE: 20% TEL: 8% TEL: 10% IND: 13% NRG: 5% HC: -34% IND: 24% UTE: 13% FIN: -7% TEL: 6% FIN: 19% DSC: 20% MAT: 6% DSC: 9% STP: 4% DSC: 2% NRG: -36% UTE: 13% NRG: 10% NRG: -12% UTE: -1% NRG: 10% STP: 19% UTE: 5% STP: -2% NRG: 3% FIN: -5% DSC: -38% DSC: 11% STP: 8% DSC:-18% TECH:-3% TEL: 8% TEL: 13% IND: 0% HC: -3% UTE: 2% STP: -7% FIN: -39% STP: 6% FIN: 6% MAT: -22% NRG: -4% UTE: -9% HC: 1% HC: -17% TECH: -16% HC: -1% HC: -27% TECH: -54% TEL: 1% TECH: -12% TECH: -53% MAT: -7% MAT: -31% TECH= Technology; MAT = Materials; FIN = Financials; NRG = Energy; IND = Industrials; UTE = Utilities; DSC = Consumer Discretionary STP = Consumer Staples; TEL = Telecom; HC = Health Care Source: The Harbour Group; Bloomberg There are Many Positive Offsets to Lower Oil Prices While energy is a large sector in Canada, it is but one of ten, and we think it is important to focus on the many positives that come from lower oil prices. First and foremost, the move lower in oil is effectively a gigantic global tax cut for consumers of oil. Yardeni Research estimates the value of a 40% plunge in oil is worth US$ 1.5 trillion globally at an annual rate, so while this obviously is negative for energy producers, it creates a number of winners among energy users: U.S. equities in general are a winner in a low oil price scenario, as it is the world s largest consumer and lower gas bills are supportive of growth. Consumer sectors in particular should benefit as money saved on lower gas prices flows into spending for lower income households. In Canada, a weaker Canadian dollar will benefit exporters and companies that have significant U.S. operations that will have income translated back into Canadian dollars. Lower headline inflation driven by weak energy prices could push out the first Federal Reserve rate hike and keep bond yields in general pinned to low levels. A continued low rate environment bodes well for income oriented sectors such as REITs, Telecom and Utilities. A combination of low interest rates and low gasoline prices bode well for U.S. real estate activity, which would benefit U.S. growth, the auto sector and Canadian sectors such as forestry. 3 RBC DOMINION SECURITIES INC.

4 continued from page 3 Canada Does Well When the U.S. Does Well It is also important to remember that regardless of the volatility in commodities, the performance of the U.S. economy is the number one determinant of Canadian economic growth, as seen in Exhibit 4. As indicated above, the drop in oil is unabashedly bullish for the U.S. economy as a whole. Combined with a weaker Canadian dollar, the non-energy portion of the Canadian economy is poised to increase its share of the pie. Despite the volatility in commodities, we still do not see a U.S. recession on the horizon it is important to remember that recessions are usually preceded by high oil prices, not low ones. Exhibit 5 Canadian Dollar and Manufacturing Jobs Exhibit 4 Canada and U.S. GDP Bottom Line This sort of extreme volatility in one large Canadian sector demonstrates two things: 1. The TSX is not an effective benchmark for conservative investors, as the energy and materials weightings are beyond what we deem to be prudent (please see our May 2012 Market Note). This explains our persistent underweight in these sectors for managed accounts. As seen in Exhibit 5, manufacturing employment (a proxy for manufacturing activity) tends to follow the Canadian dollar with an approximately three-year lag, so we should start to see the positive effects of the weaker Canadian dollar in the central Canadian economy soon. We are already starting to see the performance of exporters starting to pick up relative to the TSX, a trend that should continue as long as the currency is weak. 2. It also illustrates the value of having an allocation to U.S. securities, both in terms of diversification benefit (we don t have anything like CVS, Procter and Gamble, Visa, etc. in Canada) and the performance uplift from the currency in times of stress. 4 RBC DOMINION SECURITIES INC.

5 continued from page 4 It is tempting for investors to try to catch the bottom during volatile times like this and there is no doubt some bargains are emerging in the energy space. Our base case view is that we are currently in the eye of the storm and making major sector allocation decisions in the context of a sell off can lead to rash decision making. Our focus going into year-end is to optimize opportunities to match gains and losses, as there are ample opportunities in energy to take a loss but Exhibit 6 maintain exposure in a similar security. We expect cooler heads will prevail as the calendar turns and tax loss selling season is behind us, at which point all involved will be able to take a more sober assessment of the investment landscape. For those of you that have made it to the back of this research report a tongue-in-cheek view of behavioural finance: Real Investor Psychology Source: Streettalklive.com This commentary is based on information that is believed to be accurate at the time of writing, and is subject to change. All opinions and estimates contained in this report constitute RBC Dominion Securities Inc. s judgment as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. Interest rates, market conditions and other investment factors are subject to change. Past performance may not be repeated. The information provided is intended only to illustrate certain historical returns and is not intended to reflect future values or returns. This information is not investment advice and should be used only in conjunction with a discussion with your RBC Dominion Securities Inc. Investment Advisor. This will ensure that your own circumstances have been considered properly and that action is taken on the latest available information. The information contained herein has been obtained from sources believed to be reliable at the time obtained but neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers can guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell or the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers is to be under any responsibility or liability whatsoever in respect thereof. The inventories of RBC Dominion Securities Inc. may from time to time include securities mentioned herein. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities which are affiliated. *Member-Canadian Investor Protection Fund. RBC Dominion Securities Inc. is a member company of RBC Wealth Management, a business segment of Royal Bank of Canada. Registered trademarks of Royal Bank of Canada. Used under licence RBC Dominion Securities Inc. All rights reserved.