Commodity Boom and Bust, Global Credit Problems and Chinese Slow Down

How has your portfolio performed and what lies ahead ?

Equities returns versus a well balanced portfolio

Investment returns in equities have become more difficult to achieve over the past few years and well balanced portfolios have outperformed pure equity portfolios. Equity returns on the S&P 500 index have returned 1.0% over the past 5 years including dividends up to April 30, 2012. Without dividend the S&P 500 would have lost 1% over the same time period. Canada’s TSX has underperformed the S&P 500 by more than 5% during that time period. The TSX lost 8.4% during that time period not including dividends. Including dividends the TSX has still lost more than 5%. Equity returns both in Canada and the US have underperformed bonds and preferred shares and experienced extreme volatility as investors fled to safer investments. As investors have bid up prices on bonds and preferred shares, yields on 10 year bonds have fallen from 4.5% at the beginning of May 2007 to 2.1% at the end of April of this year and preferred shares yields have fallen by at least 1% during the same time period. Bond yields decline as prices appreciate. If an investor held a 10 year bond in 2007 until now it would now be a 5 year bond and the yield at 1.7%would even be lower than on a 10 year bond. An investor investing in a 10 year bond 5 years ago had a capital appreciation of at least 20% since then. The total return on the his or her 10 year bond over the past 5 years was 6.8% compounded. Long-term or perpetual preferred shares fared even better. Many perpetual preferred shares yielded more than 6.0% in 2007 and now have declined by 1% or more. This has offered investors at least a 20% capital appreciation on the preferred shares plus a 6% coupon over the same time period. The overall rate of return on quality perpetual preferred shares was 10% per year or more, significantly better than equity returns. A well balanced portfolio yielded between 5% and 10% per year from 2007 to 2012, however many portfolios yielded less because they were either heavily weighted towards equities or did not hold longer term fixed income assets.

European economic and debt crisis, Chinese slowdown and end of commodity super boom

Increased government debt burden, corporate and real estate mismanagement and changing economic dynamics in the US and Europe have added uncertainty and volatility in equity markets in the US and overseas over the past 5 years. While Canada has not been isolated from the equity volatility during that time period, Canada’s fundamentals were significantly stronger. Canada benefited from rising oil and other resource prices. Canada has also benefited from a more conservative banking environment. In spite of all these positives in Canada, the TSX has not performed better than its US counterparts over the past 5 years. Canada’s resource economy has turned negative in the last 1 to 2 quarters and much of the benefits have been lost since. Canada’s commodity boom has come to an end with both oil prices and other resources including gold weakening. In the past year alone oil prices have declined from as high as $108 last year to below $90 last week and gold prices have declined from over $1,900 to the mid $1,500’s this past week. Most analysts value oil companies at the moment with $70 ?oil?. The current valuation is between 15% and 20% less than last years high and the oil price assumption in analysts’ valuation would be 35% below last year’s high. In our opinion this is only the beginning of the end of the commodity super cycle. Part of the decline is that the Chinese economy has ground to a snail’s pace compared to the Chinese economic growth over the past decade. In our opinion the slowdown in the Far East points to even further weakness in the commodity and resource super boom that started more than a decade ago. The decline in commodity prices caused the TSX to underperform US markets over the past 6 months. While the US economy is the strongest economy in the developed world with a GDP growth rate of 2.2%, Canada’s GDP growth has slowed to a mere 0.4% compared to the last year growth rate of 2.2%. Canada’s resource sector has taken a hit from a slowdown of Chinese economic growth that came in at 1.8% annualized rate in the last quarter from a constant 8% to 10% per year growth rate over the past decade.
Fig 1.1

Country GDP 2011 Debt / GDP GDP growth GDP growth Unemployment
(U$   millions) % QoQ –Q4 Q1 YoY %
% %
US 14,582 103 2.2 2.1 8.1
Canada 1,574 85 0.4 2.2 7.3
China 5,879 25.8 1.8 8.1 4.1
Euro Area 12,456 87.2 0 0 10.9
Germany 3,310 81.2 0.5 1.7 7.4
France 2,560 85.8 0 0.3 9.8
UK 2,246 85.7 -0.3 0 8.2
Spain 1,407 68.5 -0.3 -0.4 24.4
Ireland 204 108.2 -0.2 0.7 14.3
Portugal 229 107.8 -0.1 2.2 14.9
Italy 2,051 120.1 -0.8 -1.3 9.8
Greece 305 165.3 0.2 -6.2 21.7
Switzerland 524 55 0.1 1.3 3.1

With Europe in an economic crisis, China in a significant slowdown and Canada slowing because of an ending commodity boom that was driven by growth in China and India, the US is shining as the fastest growing economy in the developed world. The only countries with a measureable economy in the world that have outperformed the US economy are either resource rich countries or developing countries.
Europe’s challenges and China’s slowdown overshadowed equity markets over the past year. I have mentioned several factors in this newsletter that outline why certain factors should or should not be of concern. Europe’s economic crisis is definitely real and of concern. The impact to the various countries however is very different. The main reason of the crisis in Portugal, Italy, Ireland, Greece and Spain (the PIIGS) is that Europe has a split economic union. The Euro, by its nature, consists of a common monetary policy where interest rate movements are determined by a single financial entity, namely the European Central Bank; however Europe does not have a common fiscal policy or simply put, a common taxation and government spending policy. This has resulted in severe divergences in budget surpluses and deficits among the members of the Euro zone, hence the economic crises among several members of the currency union. The biggest winners of course of the Euro zone were, and probably still are, Germany and France, each benefitting from increased exports that they have enjoyed because the individual currencies of the importing countries did not depreciate against Germany’s and France’s currency. This allowed many of the counterparty countries to import goods and borrow disproportionate sums of money from Germany and France. The same countries now appear to be falling off a cliff, both economically and politically. Greece has an unemployment rate of almost 22% of the total work force and over 50% of people under 25 are unemployed. While the overall unemployment is a devastating number, the significance is the group under 25, which is over 50% unemployed. This is even more frightful when considering that this is the group that should be the productive workforce in the next generation. If 50% of an entire generation is unemployed for an extended period of time, the entire social makeup of the country is at significant risk to disintegrate, both economically and politically. While the economic loss of Greece to the Euro zone would not be significant, the loss of the confidence in the financial and banking system would most likely be devastating. The entire loss of the Greek economy to Europe would be less than half of the 5% US contraction in 2009, which was the worst contraction since 1950. Both Italy and Spain, much larger economies, also face significant economic challenges however are in a much better position than Greece. Spain’s debt to GDP ratio at 68.5% is much lower than Greece’s 165% and Italy’s 120% and Italy’s unemployment is much lower at only 9.8% versus Greece’s 21.8% and Spain’s 24.4%. Each of these countries are in much better positions because they have additional taxing capabilities or much less debt.

While both Europe and the slowdown of China will put a damper on equity markets and cause global growth to slow, the impact will be more significant in Canada than in the US. Canada has over the past 10 years become a predominantly resource based economy again where it was in the 1970’s and part of the 1980’s. The setback in demand of resources in China will have a more pronounced impact on Canada as a major exporter of commodities than it will on the US. The US will actually benefit as a net importer of commodities. The US economy will also prosper more as it is predominantly supported by its own consumers who have now recovered to a large extend from the credit crisis.

We feel that equity markets will do well this year in the US. In the US, 75% of the companies of the S&P 500 and 93% of companies of the Dow Jones either met or exceeded their earnings targets, whereas in Canada only 51% of the companies met or exceeded their earnings targets. We believe this is a good indicator what can be expected of the directions and magnitude of US and Canadian Equity returns over the foreseeable future.

Albrecht Weller, CFA
President
Schwaben Capital Group Limited
with contributions from Oliver Weiss