A Frosty Start To 2008
No sooner had 2008 begun before investors hit the sell button, and hit they did, and they hit it repeatedly throughout the month. As poor U.S. economic data continued to trickle out confirming that the world’s largest economy was slowing.
In Canada, the S&P/TSX Composite which has risen for the last five years quickly erased all of 2007’s gains and delved into 2006’s returns, including a stomach-churning loss of 605 points on Monday, January 21st as equity markets worldwide sold off. Fortunately the U.S. markets were closed for a holiday that day, and the U.S. Federal Reserve (Fed) declared an intra-meeting Fed Funds interest rate cut of 75 basis points the next day. It was the first time the Federal Reserve had made an intra-meeting cut since September 2001.
The Fed cited the weakening economic outlook and increasing downside risks to growth. By month end the Fed had doled out another 50 basis point cut at its regularly scheduled meeting to leave the Fed Funds rates standing at 3.00%, down from the 5.25% level seen before its first cut in September, 2007.
The main catalyst for the slowing American economy has been the weak housing market and to put it into perspective, U.S. Federal Reserve Chairman Ben Bernanke noted that “about 21% of subprime adjustable rate mortgages are ninety days or more delinquent, and foreclosure rates are rising sharply.” The housing market has put continued focus on the ratings of so-called “monoline” insurers, which have provided insurance to numerous financial institutions on their Collateralized Debt Obligations (CDOs) and Residential Mortgage Backed Securities (RMBS).
By month end, bourses around the world had firmed up off their lows as bargain hunters combed through the market and the U.S. interest rate cuts gave some reassurance to investors. Nonetheless many world indices still posted double-digit percentage declines for January.
Fallout from credit markets will continue into the second quarter of 2008 and possibly the second half of the year, restraining financial performance and possibly the TSX Index.
The second half of 2007 became synonymous not only for equity price declines but also for words and phrases such as sub-prime, the consumer, asset backed commercial paper, and mortgage backed securities.
In hindsight, we can conclude that the market was caught off guard by the severity of what has been labelled as the “credit crunch.” We do not believe the market was surprised by the decline in the U.S. housing market, as this trend has been in place since 2006. We do however believe the surprise and resulting selling action was a result of the depth and magnitude of financial engineering which has resulted in investors and financial institutions sitting on credit related products which to this day are difficult to explain and value.
A lack of clarity leads to nervousness and nervousness leads to selling, which we saw not only in July and August but also in November and December as the extent of the credit crunch became more apparent. We could write volumes on the credit fallout but will summarize by saying that a lack of clarity amongst financial companies led to a broad market sell off and raised a number of questions about the direction of the U.S. economy. We do not believe investors will rush to put capital back into Financials until the full impact of the credit crunch becomes clear. The problem is, the fallout from the credit market continues to evolve and, there is no return to normalcy expected in the near future. Many U.S. and global banks took substantial write-downs in the fourth quarter of 2007. However, most investors expect more write-downs are forthcoming as credit markets have deteriorated further, leading us to conclude that Financial stocks will continue to come under pressure during the first quarter of 2008 and almost certainly beyond.
Canadian banks have shown that their exposure to riskier assets is not as severe as what has been revealed at U.S. and global financial institutions. However, the financial industry is a global industry, so investors tend to stay away from the sector as a whole regardless of geography.
Therefore, whether justified or not, Canadian bank stocks will likely be restrained by the credit markets until confidence is restored. Since Financials tend to make up a large percentage of many indices including the TSX, it is possible that some major exchanges worldwide will see little upward momentum in the first half of 2008
The TSX Index should move higher in 2008 with single digit returns, however, this does not mean that an overwhelming majority of stocks will finish the year in positive territory.
Even after the declines of the banks, Financials, Energy and Materials continue to comprise close to three quarters of the TSX Index.
If you want to know where the index is going this year, then you really only need to focus on these three sectors. Banks may underperform in the first half of the year but could see some momentum in the second half of 2008. The belief is that gold and fertilizers may offset any potential weakness amongst base metals thus supporting materials that suggest that Canadian energy stocks should be able to post positive returns in a high oil price environment.
You’ll also note that our enthusiasm for positive returns is somewhat restrained due to current credit markets and the related effects that may emerge worldwide.
We believe there is a good chance for the TSX to post a positive simple return in 2008, but that return will likely not reach double-digits.
We would also caution investors that market capitalization indices such as the TSX can be misleading due to the weighting of individual stocks within that index. A recent example shows that even though the TSX posted a simple price return of 7.16% in 2007, 155 stocks within the index declined whereas only 146 advanced and 2 were unchanged. In other words, the TSX only advanced because most of the higher weighted stocks appreciated while more of the lower weighted stocks declined. Our expectation for single digit returns again this year opens the possibility that we could see a repeat of what happened in 2007. In Canada, we believe there are a few focus themes that should emerge during the first half of 2008 if not the entire year:
- Defense may be the best offense
- Portfolios should continue to hold gold
- Canadian banks look attractive, but may outperform in the second half of the year following first half under-performance
- Base metals may lose some shine, but the Materials sector will likely move higher
- The days of sky rocketing energy equity prices are long over, but the sector still offers value
- Opportunities still exist amongst select telecommunications and technology stocks