2014 Kicked Off With Too Few Bears

Navigating a Sea of Opportunity

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2013, the
financial markets began to put the fears rooted in the Financial Crisis
behind them as investors began to sense that there was light at the end
of the tunnel. Optimism seemed to replace fear and investors began a
flight out of the safety of bonds and into equities. As last year drew
to a close, eyes and ears began to focus on what 2014 would bring for
the markets. Without question, the biggest topic of debate is about the
direction of interest rates this year and their impact on the financial
markets. From our perspective, the interest rate debate can be broken
down to a ‘’glass half full or half empty’’ argument. The optimistic
perspective is rooted in the belief that interest rates are only
returning to a more normal level due to the fact that the global
economy is getting stronger. The gloomy argument is that the economic
recovery is not strong enough to withstand higher interest rates and it
could be cut short just as things were getting back to normal.

Rates: A new normal?

Investment GuidanceConventional
wisdom coming out of the financial crisis was that the dominance of the
US economy would gradually wane as the US was akin to a wounded giant
with far too many problems.  In addition, it was thought that
super charged economic growth rates of China, India and Brazil would
shift the fulcrum of the global economic balance away from the US. Over
5 years later, it would be safe to say that the decline in US economic
relevance was greatly exaggerated. The US economy is showing the
strongest growth rate amongst the G7 group of countries and as the
largest economy in the world, the US is a key part of reigniting global
economic growth.


economic conditions have stabilized, the US Federal Reserve has begun
to take the first tentative steps towards normalizing US interest rates
by decreasing its monthly bond purchases from $85 billion to $65
billion.  Since these bond purchases (known as quantitative
easing) were aimed at keeping interest rates low, the markets have
interpreted this as the first step towards a tightening of monetary
policy. The bond market has wasted little time in pushing interest
rates upwards. In fact, between May and December of last year, interest
rates rose at the fastest pace in nearly 50 years. This has many
observers wondering if the three decade trend of falling interest rates
has come to an end and whether there will be a long term trend shift
towards rising interest rates.

Markets Fall

Historically, the emerging markets have felt firsthand the effect of a
backup in US bond yields. It used to be said that whenever the US bond
market sneezes, the emerging markets get the flu. Amazingly, despite
the enormous wealth created in those nations over the last decade, it
seems that they are still at the mercy of the US bond market and
interest rates. We are amazed because no matter how much things change,
they still remain the same for the emerging markets.

interest rates in the US have risen, the weakness of emerging markets
nations has been exposed. Chief amongst them is the fact that they have
been borrowing and spending more than they ought to have while their
imports have been rising too quickly. The imports are being fuelled by
easy money policies that are aimed at continuing the economic recovery.
As the US makes a switch towards a slightly less accommodative monetary
policy and its interest rates rise, international capital flows have
been coming to the US – leaving the US dollar stronger and the
currencies of the emerging markets nations weaker (see chart below).

Global Currencies vs US Greenback

Click here to view a larger
version of this chart.

These nations cannot afford a weaker currency because it tends to fuel
inflation in their economies by making their imports stronger. The only
cure for inflation and the discouraging of the capital exodus is to
raise interest rates. But here is where it gets challenging for them:
if they raise interest rates, their economic growth rates will weaken
and capital outflows will only increase once again. So begins a vicious
circle as selling begets more selling. Some emerging markets countries
have tried to shock their currencies higher by raising interest rates
by 3-5% in one fell swoop. So far, markets have calmed down but the
consensus is that this is not enough as investors believe that
ultimately these countries will have to walk away from higher interest
rate policies. They believe that they will buckle under the pressure of
trying to maintain economic growth rather than price or currency

A textbook illustration of this scenario is playing out in India. A
falling currency and rising inflation have left India’s central bank
between a rock and a hard place as it must choose between stopping
inflation with even more vigor (raising interest rates again) and
holding economic growth back still more. India’s central bank has gone
so far as to call for central bank decision making to be more
coordinated globally. While this is easier said than done and perhaps
not even feasible given that the economic constraints of nations vary
so widely, it is a recognition that the US footprint is cast far and
wide and ultimately the decisions of the US central bank have
implications for the international community. The Fed has been
unusually blunt in responding to critics who blame US monetary
tightening for the problems of the emerging economies. Jeffrey Lacker,
a Federal Reserve governor was recently quoted as saying that its
policies are conducted strictly towards its mandate of “price stability
and maximum employment here in the United States.”

China is also suffering from the after effects of its ultra-easy
monetary policies that was implemented to combat the effects of the
financial crisis in 2008. China’s monetary stimulus far exceeded the
one undertaken by the US even though its economy was less than half the
size of the US economy. Chinese policy makers have come to grips with
the fact that they have lost control of their economic levers and have
begun to crack down with vigor on lending activity within the Chinese
economy. Several times in the last three months, Chinese banks have
found a severe lack of liquidity and overnight interest rates ended up
spiking to nearly 9 percent as the Chinese central bank sought to send
a message to the banking industry that it was serious in its attempts
to cool lending activity.

One of the great debates in the financial markets is whether or not
China will suffer a hard landing or a gentle slowdown. As we have
highlighted in past commentaries, China’s problems are rooted in too
much lending that is fueling an excess in the construction of housing
and factory capacity. According to data from the International Monetary
Fund, China is only using about 60% of its industrial capacity even
though the economy is growing at over 7 percent annually according to
the latest government data. The challenge of Chinese policy makers is
to ensure that they are able to engineer a slowdown that does not turn
into something more severe.

America: Getting Squeezed

no country has suffered as great a decline in investor enthusiasm as
Brazil. It has gone from a nation that was able to borrow money at
interest rates lower than the US in 2007 to one that has now raised
rates to 10% in order to contain inflation (which is approaching 6.3%)
and support its currency which is down nearly 20% since May of last
year (coinciding with the first rumblings from the Fed that tapering
would begin).

North America:
Recovery in Place

North America seems to be an island of relative tranquility. US
economic growth has begun to show some stickiness as the construction
industry has continued to flex its recently thawed out muscles and car
sales continue to be strong. Of these two important pillars of the US
economy, car sales are worth watching at this point with a small level
of caution. Unsold car inventories sit at about $100 billion currently
and that amounts to about three to four months of demand – whereas 60
days of sales in inventory is considered healthy. Going forward, it
should be a buyer’s market for cars. Real estate continues to show a
healthy decline in inventory and this should fuel future demand as the
US housing stock is rebuilt.

US housing is especially important for Canada as its lumber industry
has begun to benefit from the impact of the rebound in home
construction. Lumber prices are strong and the Canadian dollar has
declined – making Canadian exports cheaper. This is sorely needed for
the Canadian economy as manufacturing in Canada has been very slow to
recover since the last recession. Throw in a moderation of commodity
prices and a reduced US appetite for oil and gas from Canada and we can
see why Canada’s economy needs a little help.

help has come in the form of a lower dollar but more is needed.
Canadian consumers have moderated the rate of increase in their debt
levels and are heeding the warnings from the Bank of Canada and the
Canadian government that leverage needs to be reduced. A great deal of
the debt predicament has to do with Canadian mortgage debt. Canada has
received not so favorable comments from international bodies such as
the IMF and OECD about the overvaluation of Canadian real estate. So
far, those comments have had little impact. Part of this is due to the
fact that interest rates continue to remain low and we have recently
seen additional declines in mortgage rates this year.

The weak Canadian economy has left the Bank of Canada with no choice
but to become a little more vocal in its stance that interest rates in
Canada could remain lower for longer. This policy change and a weak
commodity backdrop has pressured the Canadian dollar lower. From its
highs of Q3 2011, the Canadian dollar is down almost 16%.


markets have now declined to valuation levels that have made them cheap
relative to most developed markets. From these levels, emerging markets
have historically gone on to outperform the developed
markets.  While we are attuned to the valuations in this part
of the world, we continue to weigh the potential of further declines
and have highlighted our stance in our most recent Strategy Notes
publication. (Please contact us for a copy of this

MSCI Emerging Markets Index vs S&P 500

Click here
to view a larger
version of this chart.

Once again, we find ourselves looking at equity markets as being at
best fairly valued as a whole but continue to find good companies
trading at cheap valuations from a bottom up, standalone basis. We
believe that at this point, investors should remain selective towards
opportunities in the equity markets. As our title to this newsletter
suggests, investors had likely become too enamored with equities and
were beginning to throw money at the equity markets for fear of being
left behind.  

Interest rate anxiety is the best way to describe the behavior of the
capital markets thus far in 2014. History shows there is always an
adjustment period as interest rates begin to normalize and this time is
no different. But capital markets tend to have a resilience and a
capacity to look through the fog and chart a course that is often
questioned through the lens of fear induced volatility.


Management Inc.

Navigating a Sea of Opportunity

report is for information purposes only and is neither a solicitation
for the purchase of securities nor an offer of securities. The
information contained in this report has been compiled from sources we
believe to be reliable, however, we make no guarantee, representation
or warranty, expressed or implied, as to such information’s accuracy or
completeness. All opinions and estimates contained in this report,
whether or not our own, are based on assumptions we believe to be
reasonable as of the date of the report and are subject to change
without notice. Past performance is not indicative of future
performance. Please note that, as at the date of this report, our firm
may hold positions in some of the companies mentioned. 

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