First Quarter 2016 – Quarterly Commentary

A long way to travel to wind up where we started Or, The 90-day bungee jump!

Investors left 2015 behind without great regret as it had been, at best, a so-so year. Perhaps we hoped it would prove to be the “pause that refreshes” and 2016 – a US presidential election year – would herald the return of the equity bull market dating from 2012.

Surely, the oil price crash had now run its course and the Federal Reserve (FED) was making noises (they call them “minutes” of their meetings) that the economy was strong enough to withstand more interest rate increases in 2016. Sure, global growth – ex the US – was tepid but, China would be sure to come to the rescue and global demand would pick up. Commodities outside of oil would also begin to turn the corner and technology would again begin to lead the way forward after the drubbing (as measured by the NASDAQ Composite Index) received in the latter half of the year.

Well, that was the theory of it anyway.

Literally, from the opening bell on January 4th, the equity markets plummeted. Ditto on the opening bell on Tuesday, January 5th and so on until at the end of the first week alone, we had the worst opening week on Wall Street for half a century! Like ice melting on a hot day, optimism began to give way to fear and then by the end of the first six weeks of the new year, near panic. Now, we had the worst opening six weeks on the equity markets since the 1930s! The Dow Jones Industrial Average (DJIA) had already dropped 11% in just six weeks and that was only from its opening on January 4th. From its all-time high of 18,351 points less than nine months prior, it had declined by some 3000 points or 16%. The price of oil had crashed through $40/barrel, then through $30/barrel and was now sitting at a paltry $26/barrel. All petro-currencies including the Canadian dollar were also plummeting with the hapless Loonie falling through the 70 cent US mark, five cents below its bottom in 2008. The benchmark Canadian stock index (S&P/TSX) was back to the 12,000 level, a level it had stood at some 15 years before in 2001. Natural gas prices were plumbing depths not seen for decades with copper, nickel and other industrial commodities were also deep in the doldrums. Nothing was working.

1 dow

Source: S&P Dow Jones Indices LLC

2 s&p

Source: S&P Dow Jones Indices LLP

Time to call for the cavalry!

And, like a ‘western’ movie of yore, the cavalry seemed to come to the rescue. The FED changed its tune on possible interest rate increases and the markets smelled a more conciliatory (for which read loose) monetary policy. Plus, the dramatic sell-off had created some opportunities. The markets suddenly turned on a dime and commenced as breathtaking a rally as they had a decline a scant six weeks prior. By the end of the quarter, the DJIA had recovered the entirety of the losses of the first six weeks and was showing a gain of 2.5%! For fans of roller-coaster rides, it was thrilling. For investors with weak stomachs, it was nauseating. But it did, as it were, have a “happy” ending. That said, a quarter, even a dramatic one like this one, does not a year make. The question remains: Where from here?

And up through the ground came a bubblin’ crude…black gold, Texas tea…. It’s all about oil.

The outlook for corporate profits remains muted and while that is the long-term determinant of equity market levels, for the moment at least, it has become all about oil and the direction of the price of oil.  What really ‘rang the bell’ in the middle of the first quarter was the change in the direction of the price of oil. Here, it is important to note that it seemed not to be the absolute level of the price of oil that mattered so much as the change in direction of the price. West Texas Intermediate (WTI) the North American benchmark for crude oil pricing, bounced off what has thus far anyway, proven to be a “floor” of $26.00/barrel.

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Source: NYMEX

Let us step back for a moment and look at a little history of oil prices since the first embargo of 1973. The chart below presents the “big picture” of major moves both up and down over the last thirty years.

4 west tex 2

Source: NYMEX

It is quite evident that the price of this key commodity has swung wildly for various political and economic reasons over the last three decades. The last red bar (down to the right hand side of the chart) shows that the latest collapse in the price, while dramatic, is not out-of-line with previous price meltdowns. The question now is: where might it stabilize and if it stabilizes, will the equity markets stabilize with it??? The slightest news or, even rumours, will have the oil price gyrate by up to six percent in a trading day, with the equity markets usually in tow. The truth is that an inch ahead is darkness and as investment managers, all we can do is to make selected investments based on knowns and our best analysis of the outlook not for tomorrow or, the day after tomorrow, but for the next three-to-five years.

On this basis, although we think the oil price could well re-test its recent lows, we don’t think that the world will suddenly cease using it altogether in the foreseeable future. Yes, the Saudi’s are looking to make a political point and can keep their foot on the proverbial production accelerator for a good while yet. However, we are of the view that oil will find a “trading range” somewhere between $25.00 and (say) $45.00/barrel barring some significant shock or, interruption to supply allowing things to settle down. If indeed the worst of the oil price crash is behind us, we must now look to delineate between the winners and the losers in this new world. We are positioning our portfolios to take advantage of this. Longer term, a rally is possible back to prices that, while not expected to get back from whence they fell, could rebound to the $60 – 70/barrel zone. The immediate challenge is that equity prices and those of oil stocks in particular, have rebounded as if oil were already back at $100/barrel! We expect the waters to remain choppy for a while yet.

Whence the battered Loonie?

As previously noted, there is clearly a strong correlation between “petrocurrencies” such as the Canadian dollar and the price of oil. As the chart below evidences, in the case of the Loonie, this correlation is very strong indeed. Thus, as the price of oil crashed the Loonie went with it. As an aside, this created one of the “bright” notes for Canadian investors in 2015 and the first six weeks of 2016 as the value of non-Canadian assets rallied strongly. However, when the price of oil reversed course in mid-February, the Loonie also reversed course rallying from 68 cents US to over 76 cents. While this “rally” may seem muted, we would make two observations: in fact, it amounts to a gain of 11% for the currency and, not dissimilar to the equity market’s quarter, a complete ‘round trip’ for the Loonie thus far in 2016. Secondly, of late, the C$ has begun to outperform the oil (far right-hand side of chart below) and this is, in part, due to weakness in the US dollar itself. Nonetheless, it seems fair to conclude that “So goes oil, so goes the Canadian dollar”. Once again, it’s “all about oil” these days.

5 oil vs cdn                                                                                                                                                              Source: NYMEX