Picton Mahoney Asset Management Synergy Funds Investors emotions remain fickle. In late April, the market seemed convinced that the global economy would be on a high-growth recovery. By the end of June, the mood had changed and uncertainty seemed to prevail. It was only five or six quarters ago that global governments and central banks were throwing everything but the kitchen sink at their economies to break the spiral of falling asset prices and imploding economic activity that characterized the great recession. Given the damage, re-building confidence and re-establishing a strong foundation for the economy was bound to take time. Inevitably, there were going to be set-backs along the way and this happened in the second quarter. The MSCI World Index fell 9.6%, while the S&P500 Index was down 11.4%. The S&P/TSX Composite Index fell 5.5%, driven by the weak performance in technology, financial and industrial sectors. This volatile market behavior is to be expected in the new era of debt de-leveraging, falling asset prices and unprecedented policy stimulus. It will take years to work through the ill effects of large fiscal imbalances, growing public sector debt and continued private sector de-leveraging. Over the past decade, central bankers have solved financial crises by injecting enough stimuli into the system to persuade the private sector to spend. But as financial institutions hoard capital and consumers continue to rebuild their savings, it is unlikely that a typical re-leveraging binge will occur. The medicine required to change our debt driven recovery will likely mean a period of below-trend wealth accumulation, economic and earnings growth. We believe that the negative drag on capital markets from global indebtedness will be influenced by what stage of recovery the economy is in. When the economic cycle is bottoming and/or accelerating, markets should be able to rally. But, when the economy is growing and growth is tepid, cyclical forces and secular issues battle for attention with investors leading to volatile equity trading. We believe that we entered this phase this past quarter. We believe the sustainability of economic growth will now become the key focus for investors in the near term. This may explain the recent interest in leading indicator data. Chart 1 shows that according to ECRI Leading Indicators, the economy has transitioned and is now decelerating, but growth is still positive. Historical analysis has shown that the best equity returns are often found when leading indexes are accelerating, especially off a trough. Once they peak, average annual returns are typically in the single digits. If leading indicators turn negative, we believe that a defensive positioning would be warranted, especially given sovereign debt concerns. 2 Queen Street East, Twentieth Floor, Toronto, Ontario M5C 3G7 I www.ci.com Head Office / Toronto 416-364-1145 1-800-268-9374 Calgary 403-205-4396 1-800-776-9027 Montreal 514-875-0090 1-800-268-1602 Vancouver 604-681-3346 1-800-665-6994 Client Services English: 1-800-563-5181 French: 1-800-668-3528
Chart 1: Many leading indicators, including this one from Economic Cycle Research Institute in New York, show that the economy is still growing, but that it s starting to decelerate. This is not a good sign for equity markets, since historical analysis indicates that the best equity returns occur when leading indicators are accelerating. While sovereign debt issues in Greece and other European countries were contributors to the recent turbulence, the performance of the U.S. and Chinese economies will be critical drivers of market performance for the balance of this year. The U.S. appears to have hit a soft patch recently. These types of growth scares have occurred in past recoveries, but the fear of a double dip recession has increased as the stimulus package comes to a close and bank lending remains stagnant. China has been aggressive in tightening policy to rein in inflation and dampen a possible real estate bubble. We believe that growth will slow and a recession will be averted. The U.S. Federal Reserve has made it clear that its zero interest rate policy will last longer in order to sustain economic growth. We are hopeful that there is enough momentum in the economy to allow it to transition from being stimulus driven to becoming more self-sustaining. A real key to this transition will be whether corporations have enough confidence to boost capital spending and start hiring. There is pent-up demand, since corporate investment has lagged for a number of years, while free cash flow has jumped significantly. Chart 2 shows that the ratio of corporate cash flow to non-residential fixed investment is at the highest levels since the late 1940 s.
Chart 2: This chart shows that the ratio of corporate cash flow to non-residential fixed investment is at its highest level since the late 1940 s. U.S. companies have the capacity to invest and hire, but the recent turmoil could depress business and consumer confidence at a critical stage in the return to economic growth. Currently, we expect softness and volatility in equity prices until the fall. From there we are hopeful of a rally that takes prices back to their highs from earlier this year. Stability in U.S. and Chinese economic trends should reinforce the idea that the economy is becoming more self-sustaining and this will boost the prospects for a re-acceleration in economic growth. We don t expect a market collapse, since sentiment has deteriorated considerably and a wall of worry is beginning to be priced into markets. Valuations are quite reasonable and very attractive, relative to bond and cash yields. Chart 3 shows that free cash flow yields of the largest 1,500 U.S. stocks relative to corporate bond yields are approaching 50-year highs. Chart 3: Free cash flow yields of the largest 1,500 U.S. stocks relative to corporate bond yields are approaching 50-year highs. Even if the total return prospects from stocks are modest, it won t take much to beat the returns on low-risk assets, such as bonds. This should provide some support for the markets.
Our equity portfolios are positioned for a deceleration in economic growth, but with the expectation of upside potential in equities over the next year. We are underweight most cyclicals, materials and energy. The soft patch in developed economies and the Chinese slowdown took their toll on commodity pricing and metal stocks during the quarter. We continue to own Labrador Iron Ore Income Fund, as well as Teck Resources Ltd. We believe that long-term supply constraints in copper will propel the metal to higher levels, but have reduced our positions. We continue to favour Equinox Minerals Ltd. which has achieved full production in recent months and we are modestly constructive on fertilizers because inventories are low and the eventual restocking could lead to a dramatic boost in demand. Agrium remains our preferred holding, because of its diversified portfolio. While we have reduced exposure to industrial metals, we have increased our exposure to gold stocks. It seems likely that global central banks will remain in easing mode for much longer than originally thought. Loose monetary policy has generally been supportive for gold prices. Our large-cap gold exposures include Barrick Gold Corp., Red Back Mining Inc. and recent addition Yamana Gold Inc. Among the exploration and development companies we prefer Premier Gold Mines Ltd., as well as Osisko Mining Corp. Within energy, we continue to believe that crude oil will be range bound throughout 2010. Preliminary figures indicate OECD stocks at 61 days are approaching the same levels as in the spring 2009 during the height of the global recession. Top holdings include Canadian Natural Resources, Suncor Energy Inc. and Baytex Energy Trust Units. We believe that the fundamentals of the natural gas market remain troubled in the short-term due to the emergence of low-cost plays and the frenzy of drilling being done to grow production. Delphi Energy Corp. and Trilogy Energy Corp. have exceeded expectations. We still want cyclical exposure to economic growth, but with a focus on companies that can grow earnings without needing a strong an economic tailwind. Sectors that we are most overweight are technology, consumer discretionary and industrials. Many stocks within these groups provided good relative earnings in the tougher economic environment that existed, yet still delivered cyclical leverage to the economic recovery of the past year. Technology sector has benefitted from the recent recovery in consumer spending and remains poised to take advantage of a potential refresh cycle in the next few years. In Canada, we believe that Celestica Inc. and CGI Group Inc. will continue to build on the strong results they have generated over the past year. Although Research In Motion has delivered solid results, its share performance has been a disappointment. We have reduced our holdings, but expect RIM to benefit from a boost in spending, as well as the release of its new product line-up later this year. Within the industrial and consumer sectors, we remain focused on companies that have delivered solid results and can continue to grow in a less buoyant environment. Canadian National Railway Co. remains a top pick, as well as Magna International Inc.
We continue to underweight financials. A cyclical improvement in loan loss provisions is occurring and U.S. operations of some banks offer continued cyclical recovery prospects. We were pleased with the recent earnings results of Toronto-Dominion Bank and Bank of Montreal, which are our largest financial positions. We own Sun Life Financial Inc. and Industrial Alliance Insurance, which have shown strong execution in a turbulent life insurance environment. 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.