This past summer has taken investors on a roller coaster of a ride with capital markets rising and falling so much, it’s no wonder investors are feeling queasy. Mixed economic data may be stoking fears of a “double dip” recession, but one North American strategist says that while there will be an extended period of moderate economic growth, the chances are slim we’ll see another actual recession hit.
He reasons that China’s recent credit tightening doesn’t immediately imply doom. He believes that China is withdrawing some stimulus in order to avoid a property bubble, but points to money supply still growing in that country at a robust rate of 18%.
However, this mystery strategist does present the following cautionary notes:
- While the ultimate path of equity markets will be upwards, the frequency and amplitude of market gyrations is likely to remain unsettling until fears of the double dip recession wane and investors embrace long-dated assets;
- While the European banks passed their stress test, many banks still need to rebuild their capital bases and refinance sizeable maturing debts over the next three years;
- A low interest rate, moderate growth environment should benefit the shares of quality businesses that pay dividends;
- The risk of future inflation due to excessive monetary stimulus keeps real returns bonds appealing.
Now that we’ve peaked your interest, let's reveal the person behind these insights: Norman Raschkowan is Chief North American Strategist at Mackenzie Investments.
Biography: Norman joined Mackenzie Investments in 2007 as Executive Vice President and Chief Investment Officer after having spent 27 years at Standard Life Investments Inc. He exchanged his CIO role for the role of North American Strategist and head of the Maxxum team in July of 2010.
Norman began his career in 1980 as a Fixed Income Research Analyst and became a bond fund manager in 1981. He became an equity fund manager in 1984 and was promoted to Senior Vice President, Head of Canadian and US Equities in 1990. In 2006, Norman was appointed Chief Investment Officer at Standard Life. During that time, Norman demonstrated a track record in long-term investment performance results in both the fixed income and equity areas as well as demonstrated leadership in people management, team building and institutional client servicing.
Norman graduated in 1980 from McGill University with a degree in Finance and a gold medal in Economics. He also earned his MBA in International Business and Real Estate from McGill in 1985, and is a member of the CFA Institute.
Q: The most recent new home sales drop to 3.83 million units undercut the depression low of January 2009 by 15% and evidence from the Richmond Fed index, which sagged five points to 11 in August, indicates that net exports look to be no better than exerting a neutral effect. In terms of economic data in the United States, Mr. Raschkowan, while corporations are sitting on record amounts of cash and demonstrating strong profits, one could argue that the bulk of those profits are from overseas, namely the emerging markets. Also a number of retailers have mentioned growing inventories and price cuts to encourage sales. Even John Chambers of Cisco (CSCO) appears to be wary of the uncertain future and Cisco is a technology company, a sector many market participants are/were drawn to recently. My question would be, what happens if those companies that have record amounts of cash (despite low prevailing interest rates) decide not to deploy their cash back into economy due to the uncertainty (expiring tax cuts, health-care and financial reform, elections etc.) going forward, what happens then?
A: I think that it is very unlikely that companies will keep these record cash balances on their books, given the low yield at which they can invest it in the marketplace. I agree that companies may choose not to invest in capital projects (although the government is trying to encourage this through the rumored tax incentives), but other options exist that will benefit shareholders, including:
- Increasing dividends
- Share repurchases – this is another way of returning cash to shareholders and boosting earnings (buying back shares with a p/e ratio of 15x = an effective after-tax yield on the cash of 6.67%).
- M&A activity: this can also be a more profitable use of cash than just investing in t-bills. As above, buying a company at a p/e of 15x = an after-tax yield on the cash of 6.67% (provided that the earnings are sustained).
Thus, even while a company may want to retain the flexibility / security afforded by having cash balances, management has a number of value-enhancing options for deploying excess cash reserves.
Q: As a follow-up, what do you make of the recent plunge in US bond yields? Also, what do you think is needed to quell the outflow of funds from equity mutual funds into fixed income and when do you think that will happen?
A: I think that the recent plunge in US bond yields reflects two factors: the substantial monetary stimulus provided by the Federal Reserve that has driven short term yields down, and steepened the yield curve. As investors have perceived that this low rate policy is likely to persist for a longer period, they have sought incremental yields by extending term, pulling down longer term rates. This force has been augmented by the heavy fund flows into Bond mutual funds, and by the persistence of low inflation and sluggish growth. The 2.7% yield offered by 10 year US Treasury bonds would be consistent with a consensus view of future real economic growth of about 1.5% and future inflation of 1.2%.
It may not take much to halt and reverse the flow of money into bond funds – at present yield levels, a relatively modest rate up-tick of about 40bp would be sufficient to cause bond fund returns to turn negative on a 12 month basis. Some of these bond fund withdrawals would invariably go to equities. However, I think that we will need to see greater optimism about future economic growth, and a period of less volatile equity markets, in order to rebuild investor confidence and get sustained fund flows back into equities. Of course, a period of rising inflation would also drive funds away from bonds and towards commodity-related shares and hard assets.
Q: In terms of Canadian economic data, Mr. Raschkowan, the retail sales price deflator declined 0.8% in June on top of a 0.7% falloff in May and now down in five of the past six months. Furthermore, if we were to strip out the effects of the HST, consumer prices fell 0.1% in July. Not only that, but the CPI excluding indirect taxes has been flat or down now for six months in a row, during which it has deflated at a 1.2% annual rate. It I could extrapolate the significance of these numbers, it would appear that deflation is what we are currently facing in Canada. Given this backdrop, what are your thoughts on the Bank of Canada’s options going forward with regards to raising interest rates? What are your own thoughts on the direction of interest rates in Canada going forward?
A: The weakness in the CPI data (x-taxes) can be attributed to softer energy prices, earlier weakness in food prices, and the benefits of the strong Canadian dollar. The Canadian dollar’s strength over the past year has helped to temper price increases on imported goods, and this generally has a material impact on food and clothing retailers. The core inflation rate has remained stable between 1.5% – 2.0% over the past 18 months, so I do not think that the Bank of Canada will be focused on deflation risk. That said, the muted growth environment that we are presently in would suggest that the BoC will not be raising rates aggressively – the recent softening of the housing market gives them greater latitude to simply “stay the course”.
Q: Mr. Raschkowan, you appear to be fairly positive of China, citing that the money supply is still growing in that country at a robust rate of 18%. Does this predispose you to be positive on commodity producers in Canada, namely companies that supply iron ore, potash, nickel etc? What are your thoughts on the commodity producers going forward? Are there any commodities that you prefer over others?
A: There are certain commodities (copper, coal, iron ore, potash) that we like at present. However, the moderate pace of global growth will support commodity prices over the next 18 months, but will not necessarily drive them higher. I am more bullish about commodity prices looking out 3 years, when the cumulative impact of continued global growth and below average investment in new supply, will I believe push prices higher.
Q: In terms of asset allocation/ and or investment strategy, what are you recommending to clients at this time?
A: Of course, each individual’s circumstances, investment objectives and risk tolerances differ, so I prefer to place this in the context of a strategic range. A good rule that many financial advisors employ is that the allocation to equities should equal 100 minus the client’s age because the younger you are, the more time you have to recapture any ground lost due to short term market declines. Thus, for someone who is 50 years of age, a “target” equity weight might be 50%, and they might employ a strategic range of 40% – 60%.
We believe that equity allocations should be at the higher-end of an investor’s strategic range. We generally favour quality businesses that have strong balance sheets and that we believe can grow earnings by taking market share from weaker competitors, or because they have pricing power. Companies that pay dividends should also be favoured in this slow growth environment. Multinationals offer low risk access to the faster growth markets of Asia, Africa and Latin America.
Q: How do you suggest client/investors mitigate risks against a double dip or significant equity market decline?
A: The investor’s time horizon is a key consideration in determining their strategic asset mix range, and thus asset mix is the most effective way of managing exposure to a “double dip” or market decline. If the time horizon is very short (ie. < 1 year), then they should not put their capital at risk. If the time horizon is 3 years or greater, then some exposure to equities is appropriate – an investor who is very concerned about an equity market decline would then keep their equity exposure at the low end of their strategic range.
Q: What is your highest conviction investment idea right now? Can you please elaborate in detail on the valuation metrics, the calibre and performance of management and the relative position/standing of this investment idea with regards to its peers?
A: Our highest conviction idea right now is Rogers Communications (RCI), but we like the cable/telecom sector in general because the companies have a reliable earnings stream, pricing power, strong balance sheets and dividends that are likely to be increased. Rogers presently trades at only 12.2x consensus 2011 earnings, has projected earnings growth of 7.6% for 2011, and offers a 3.4% dividend yield.
Q: Mr. Raschkowan, in terms of exogenous shocks or black swans, what worries you most about the current global economic/investing environment?
A: My greatest concern is that investors are fearful of deflation, and are not paying sufficient attention to the risk that inflation might rise sharply in the future due to all the monetary stimulus that has been poured into the financial system. There are few tools available to investors to protect them should inflation arise, real return bonds and commodities (including gold) are two that come to mind.