Commentaries
December 2011
Some thoughts about 2012
1. Can the current imbalance in the growth rates between industrialized and emerging economies continue? What are the implications for financial markets in the medium and long term?
This imbalance, or difference in the rate of growth, is to be expected given the different stages the two groups are at in their long term economic cycle. Of course, companies that do business in countries with high growth rates should be more attractive from a stock market standpoint. However, these companies do not have to be located in the emerging countries. They can be located in more advanced but slower growth economies where their stocks trade on established exchanges. As examples, one can think of American companies with the majority of their growth occurring in Asia or Latin America, or of Canadian companies in the Base Materials sector whose output prices are strongly influenced by the growth of developing countries.
2. What might be the expected return from the Canadian equity market (S&P/TSX Composite Index) in 2012? What about the performance of the American market (S&P 500 Index)?
We are optimistic about the outlook for financial markets in 2012 and 2013. Barely three years ago, in 2008, we witnessed the second worst market decline in history and just last summer we experienced another significant pullback. The latter was again caused by excessive debt and is an echo of the previous one in 2008, but this time, it was related to sovereign governments rather than the household or real estate sectors.
We continue to believe that equity markets can generate annual long term returns of 8% or more. Given the declines of 2008 and 2011, and our belief that advanced economies are near their cycle lows, our expectations for the next two years are higher than average, in the range of 15% per annum. We also think the American market should do better than the Canadian market, which is usually the case early in the economic cycle, after a recession.
3. What are the most attractive sectors of the North American equity markets?
It is still too soon for aggressive bets on banks or insurance companies given the current economic slowdown; the financial sector should thus be underweighted.
We are assuming that the locomotive that will pull the global economy from its torpor will be the American consumer. We therefore find several stocks in the Consumer Discretionary sector from the United States interesting. The same is true for the Industrial sector which will benefit from the current gradual expansion of the American economy and, in the case of many companies, will also profit from the rapid growth of emerging markets. One can also overweight a sector such as Health Care which does not have a homogeneous make-up and where one can always find stocks operating in well-defined growth areas, whatever the economic environment.
In Canada, we believe we should continue to underweight the Materials sector as weak global growth depresses commodity prices, while any re-acceleration of growth will be gradual.
Securities with high dividend yields should continue to be highly rated as investors seek current income that fixed income investments no longer offer. Thus, at the moment, we still favor Telecommunications stocks and the Pipeline subsector, which is part of the Energy sector, as well as Utilities and Real Estate Trusts.
4. In your opinion, can the price of gold continue to rise?
Over the near term, gold is attractive to investors as a safe haven since the common perception is that the current environment is much more uncertain than usual. However, we hasten to add that we do not share this perception. There is always uncertainty in the financial markets or at the macro-economic level but investors tend to quickly forget and look at the past through rose-colored glasses. Nonetheless, gold is indeed attractive since the opportunity cost of holding gold, an investment that does not pay interest or a dividend, is low at the moment since the cost of capital (i.e. interest rates) is also low.
For the same reason, the value of the American dollar, the preeminent safe haven, should continue to be firm.
5. For some time now the Canadian dollar has been at or close to parity with the American dollar. What will its trend be over the medium term?
We do not expect a clear trend over the medium (2-3 year) term.
The American dollar should benefit from its value as a safe haven and the gradual economic expansion currently in place in the United States. However, its strength will be handicapped by large government deficits as well as current account and trade deficits.
In Canada, the federal government debt and the national accounts situation is better which should support the Canadian dollar. On the negative side of the ledger for Canada, a weak global economic growth will weaken the price of oil as well as other commodities exported by Canada, ending the status of petrodollar that it had acquired to some extent.
6. What is the greatest risk to investors in 2012 and what investment strategies would you recommend in order to minimize their consequences?
We believe that the greatest danger is opportunity risk: remaining too prudent or defensive and miss the next move up in the equity market.
The second largest risk, which could derail our scenario of low growth and of a rebound in the equity market over the next two years, is a new global recession caused by current deflationary forces. These forces do exist at this time as a result of debt reduction efforts by governments and consumers, of austerity measures currently being instituted and of excess labor capacity following the 2008-2009 global recession. With regards to this second largest risk, which is Triasima’s alternative scenario, the bond market is not very encouraging as long term rates imply a long period of low inflation lies ahead, which could possibly veer into deflation.
7. Will high yield, low volatility stocks outperform bonds?
Undoubtedly, provided one considers a time horizon of two or three years. For this, or longer periods, we presume that equity markets will have experienced a period of strength at some point and that interest rates will not have declined further from their current levels. Of course, it is possible that outperformance of high yielding stocks could occur sooner, in the next year for example.
If equity markets remain moribund for another couple of years, it will likely be the result of a still weak and uncertain global economy. In this case, the deflation scenario is back on the table and long term interest rates could fall further. Under this scenario, growth stocks would suffer and those with high dividends would outperform the general stock market, as they did in 2011. These stocks should remain attractive compared to bonds even in an economic context that does not favor equities as a whole.
It should be noted that bond issues offer little attraction given their low yield to maturity; while high dividend stocks often have a current yield higher than the bond market. If an investor can tolerate short term market volatility, a portfolio of high quality stocks with high dividend coverage is more attractive than a diversified bond portfolio.
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