Fourth Quarter 2016 – Quarterly Commentary

2016 – The year of Oil…and Politics

  

As 2016 comes to a close and we reflect back on all that occurred, it’s nice to know that, for the most part, we made it intact given all that this tumultuous year begat.

Although it seems like a distant memory now, the year started off with an oil price crash (to a low of $27 US/bbl) which initially took the equity markets with it. In round numbers, both New York and Toronto were off nearly 12% by the third week of January. Bond rates trended lower on the ongoing dis-inflation/deflation outlook with, at one point, a quarter of all bonds issued in the world, trading at negative yields. It was a cautionary start to the year to put it mildly.

4QTR YCHARTS S&P 500 TSX 60 OIL

Then, on a dime, paralleling the oil market, the equity markets turned and headed north – significantly, such that by the end of February, all the losses had been pared back. By March, equity markets were posting a small gain for the quarter. It seemed unreal but it turned out to be just a sharp “dip” after which the markets picked themselves up, brushed themselves off and drove on.

And on they drove…straight into Brexit, the second shock of the year and in the second quarter of the year! It wasn’t supposed to be this way. The pollsters got it wrong across the board. When the vote from Sunderland began rolling in, it became evident that many more than had been thought were opposed to Britain remaining in the European Union let alone forming an ever-closer political union to back up the currency union from which Britain was already an outsider. One could literally hear the brakes being slammed on “globalization” with a distinct screeching sound. Still, the markets after an initial sell-off, sorted themselves out and drove on and drove higher.

And on November the 8th they drove straight into shock number three, the American electionand Donald Trump. Once again, things weren’t supposed to be this way. The pollsters got it wrong, across the board. (Well, to be absolutely fair, the L.A Times called it right – alone amongst some 15 pollsters of record). “The Donald”, a focus of much media derision, and outright condemnation, had essentially blown away not one party but two parties for, while he carried the Republican banner, it could be argued that he was running on his own ticket. Initially, on the actual evening of the election as the results poured in, the markets swooned but, by morning (around the time of Hillary Clinton’s concession speech) were already back in the black. And they didn’t look back from there! On they rallied to new all-time highs in New York. Toronto was somewhat less exuberant but, also rallied to within hailing distance of its all-time high.

4QTR 16 YCHARTS SPX

By now, it was crystal clear that globalization had its costs and its detractors, especially those who perceived themselves as being at the losing end of it. To coin a phrase from the 1976 film “Network”; they were mad as hell and they weren’t going to take this any more! That film, took three academy awards for acting (Best Actor, Best Actress and Best Supporting actress) and is one of only two films to do so in Oscar history. One wonders if we shall need to nominate Boris Johnson, Donald Trump, Theresa May and/or, Hillary Clinton for such roles on the world stage.

There was, however, one “casualty” in market terms which is worth drawing our readers’ attention to: the bond market. In the forth quarter of the year, while the equity markets soared, the bond market – especially after Trump’s victory, went into a tailspin. Why matters. The rise in interest rates and the commensurate decline in the price of bonds, signalled that the end of the long spell of declining and rock-bottom low interest rates may have come to an end. This would be because of the stated President-Elect’s pronouncements to rev-up infrastructure spending as well as defence spending. Clearly, if this comes to pass, it will have a pronounced, and negative, effect on the US deficit particularly when combined with proposed tax cuts if and when enacted. The bond market senses the additional borrowing (to come) as well as the Federal Reserve Board’s being willing to accommodate higher rates. Rates up, bond prices down. A higher cost of borrowing could equate to the need for more borrowing. More spending could equate to higher inflation all with the same outcome, more downward pressure on bond prices.

4QTR 16 YCHARTS 30 YEAR MTGE

There’s an old saying which tells of the key differences between “Bondies” and “Stock Jocks” in the business. It goes: “Equity managers drive Mercedes and own golden retrievers while bond managers drive Volvos and own cats”.    Well maybe, but it does help to explain why the bond market might begin to slide when things are looking rosy for the equity crowd. The equity crowd loves the possibility of more (and faster) growth while the Bond crowd worries, “somebody’s got to finance all this new spending.”

 

2017 – “It ain’t ova ‘til it’s ova”

With due respect to Yogi Berra (fabled coach of the New York Yankees) what started in 2016 may well only be the precursor to what’s to come in 2017. In other words, it may once again be all about oil…and politics.

Let’s start with the knowledge that the recounts in those four crucial states (Pennsylvania, Ohio, Michigan and Wisconsin) found Trump the winner, putting the 2016 election results to bed once and for all. What’s entirely conceivable as we head forward, is the potential for three elections in Europe to drive a stake into the heart of the European Union which would make Brexit look like a Sunday picnic. In this order, the Dutch (March), the French (April – May) and Germans (not later than October), will each be going to the polls.

In Holland, if the Dutch elect, Geert Wilders, of the Party for Freedom in March, the French elect Marine LePen of the “far right” National Front in May, and the Germans oust Angela Merkel, in favour of a combination of parties which might only form a government incorporating the Left Party, the Pirate Party and the Alternative for Germany Party in October, the entire EU project could be thrown into question. While we cannot conclude (in advance) that this might take the equity markets down, it surely would prove destabilizing. And conversely push the bond market up.

On the oil front, it appears that OPEC and several non-OPEC members, notably Russia, have come to some accommodation to trim output and support prices in the vicinity of where they presently are – somewhere in the $45.00 – 55.00 US range for the time being at least. If this holds and it is a big IF, this will perhaps put some form of “floor” under the Canadian dollar. One of the key factors which will impact the swings in oil prices in 2017 is US shale oil production. With the rally in crude oil prices, US shale production increased almost 200,000 barrels/day in November alone. Is it possible, that the US is becoming the “swing” producer that Saudi Arabia used to be, increasing production as prices rise (thus creating a ceiling) and reducing production as prices decline (thus creating a floor)? If, for whatever reasons, pricing doesn’t hold and oil prices slide back below $40/bbl US, the Loonie will most likely wilt into the lower 70 cent US range. As can be seen from the following charts, the ties between crude oil prices and the Canadian dollar are striking.

4QTR YCHARTS C$ TO U$ AND OIL

Stock market valuations are a function of corporate earnings (magnitude and direction) and multiples of those earnings which equates to the price of company shares. The good news here is that notwithstanding the rally in equity prices of late, the outlook for the “Price-Earnings Multiple” is still not in nose-bleed territory. Certain ‘assumptions’ have to be made to accept this outlook we grant. American corporations need to continue to re-purchase their shares with some of those earnings. They must also repatriate some of the significant cash pile (estimated at $3 trillion plus) they hold outside the US again, to invest in new plant and equipment as well as innovation, research, share buy-backs and dividend increases. The US economy must continue to grow at least its current rate of 3 percent or, more (which it did in the third quarter of ’16). Interest rates may rise gradually (normal in an economy with accelerating growth) which is reflective of the strength of that growth but, not so rapidly as to snuff out the growth. By-the-way, if any of this is starting to sound “Goldilocks” like to you, you will have read our previous Quarterly Report from September of this year.

One of the conundrums with the ongoing strength of the US dollar is the drag effect it will have on the translated (back into USD) foreign earnings of big US multinationals. It is believed that in aggregate, approximately half of those earnings accrue from outside the US so, this is material. Conversely, the strength of the US dollar has a deleterious impact on Emerging Market corporations (in particular) because A) much of their import costs are priced in US dollars and B) an increasing amount of the debt on their balance sheets is also denominated in US dollars making it more expensive for them to finance that debt from local currency sales and earnings.

Here at home, if the oil price holds up, Alberta will begin to recover and central Canada might export more. Our growth numbers will not match those in the US but they look to be better than those in 2016. We remain vulnerable to any sign of a housing collapse – especially in Ontario. Further, one thing that will constrain Canadian growth will be the (very) high levels of household debt.

4QTR 16 NATIONAL POST HOUSEHOLD DEBT

In all, there are grounds for optimism heading into 2017 to be sure. However, as always this is tempered with an awareness of the risks – especially for Europe. That said, the biggest single risk would have to be the outbreak of a trade war. Here, the good news is that the new US President owns properties all over the world and will not likely make a conscious decision to reduce his own net worth by triggering the kinds of events that brought on the Great Depression of the 1930s. At least, we hope not.