Fund Manager
Frank Mersch
With the bottom of the credit crisis panic in mid-March (the Bear Sterns rescue being the symbolic low-point), the second quarter of the year saw global capital markets return to operating in a fashion that we consider to be ‘nearly normal’. While the economic and corporate news remains mixed, markets are functional, assets are being revalued and, if necessary, disposed of (albeit typically at sharp discounts), and investor psychology has steadily improved. Nonetheless, after putting in two solid months of gains in April and May, global equity markets came apart in June, as crude oil and a host of other commodities surged to new highs while financial institutions were once again under attack. The S&P 500 had its worst month since September 2002, declining 8.60%, while the NASDAQ fell an even greater 9.10%. The resource-insulated TSX managed to lose only 1.68% on the month, with double-digit gains in gold and fertilizer stocks offsetting sharp losses in virtually all other sectors.
In recent months the Federal Reserve has made the choice to stimulate economic growth at the expense of containing inflation. We suspect that this situation is nearing a turning point, and that interest rates and the U.S. Dollar have likely seen their lows for the medium term. The opposite could be said of the European Central Bank, which is likely at the start of an interest rate reduction cycle, undermining the Euro and adding to the positive U.S. Dollar sentiment. As a corollary, we would expect commodity prices to become less of a “Dollar story” and make a modest retreat from their recent lofty highs. Both the ECB and the U.S. Federal Reserve need to find a way to manage inflation expectations down while at the same time keeping monetary policy relatively loose in order to cushion their respective fragile economies. Unfortunately for the central banks, food and energy inflation are two of the most visible components of overall inflation and, given their current high levels, they are serving to anchor inflation expectations even higher than would otherwise be warranted. In the medium term we expect consumer spending to be depressed in the U.S. and Europe, and for global economic growth to be impacted accordingly. Ultimately we expect that it will take a marked decline in energy and food prices, either via increased supply or reduced demand, to engineer an environment of robust growth.
As we have written previously, our belief is that fundamentals justify the recent high prices in oil, although the current ‘oil mania’ in the press has likely pushed crude to levels that are not sustainable in the short term. Our preference in the energy sector has been for natural gas producers, namely those with large, predictable, ‘resource-plays’ located in royalty-friendly British Columbia. In the month of June, oil and natural gas rallied 9.9% and 14.1% respectively, while the energy sub-index only managed a gain of 1.65%. This suggests to us that investors have become uncomfortable with the potential impact of high commodity prices on the overall economy, and that even energy stocks will have a difficult time benefitting in this environment (for more on these topics see our weekly blog Viewpoint).
Within the portfolio we remain particularly positive on the global agriculture picture as the supply-chain price inputs (energy, fertilizer, labor, machinery, etc.) remain elevated in the face of rising demand from the new middle class in developing markets. Decades of government mis-management and trade-distorting subsidies in the world’s major economies have resulted in a global agriculture industry that is simply unable to respond quickly to these changes in consumption. From our perspective, the investment emphasis should be on areas such as crop yield improvements, seed technologies and equipment providers, while industries such as food processors, retailers and restaurants should be avoided as their cost structures continue to rise.
As we have observed in recent months, positive returns are being found in an increasingly slim number of market sectors. Over the past few weeks, even energy stocks appear to have lost their upward momentum as investors appear to be discounting lower commodity prices in the near-future. While we have reduced our energy exposure over the last few weeks, it still plays a central role in the portfolio, as do agricultural stocks and select base metals. Lastly, we would expect the setting for financials to continue to deteriorate (and have been shorting banks accordingly), and continue to hold cash levels far above historical norms. For the quarter, Front Street Canadian Hedge was up 18.19%, owing to the sector overweights/underweights described above versus a rise of 8.37% on the TSX, a gain of 0.61% on the NASDAQ and a decline of 3.23% on the S&P 500.
Frank Mersch
Portfolio Manager
Front Street Capital
FRANK MERSCH - Q2 2008 COMMENTARY
Date Published
Related Fund(s)
Fund Manager
With the bottom of the credit crisis panic in mid-March (the Bear Sterns rescue being the symbolic low-point), the second quarter of the year saw global capital markets return to operating in a fashion that we consider to be ‘nearly normal’. While the economic and corporate news remains mixed, markets are functional, assets are being revalued and, if necessary, disposed of (albeit typically at sharp discounts), and investor psychology has steadily improved. Nonetheless, after putting in two solid months of gains in April and May, global equity markets came apart in June, as crude oil and a host of other commodities surged to new highs while financial institutions were once again under attack. The S&P 500 had its worst month since September 2002, declining 8.60%, while the NASDAQ fell an even greater 9.10%. The resource-insulated TSX managed to lose only 1.68% on the month, with double-digit gains in gold and fertilizer stocks offsetting sharp losses in virtually all other sectors.
In recent months the Federal Reserve has made the choice to stimulate economic growth at the expense of containing inflation. We suspect that this situation is nearing a turning point, and that interest rates and the U.S. Dollar have likely seen their lows for the medium term. The opposite could be said of the European Central Bank, which is likely at the start of an interest rate reduction cycle, undermining the Euro and adding to the positive U.S. Dollar sentiment. As a corollary, we would expect commodity prices to become less of a “Dollar story” and make a modest retreat from their recent lofty highs. Both the ECB and the U.S. Federal Reserve need to find a way to manage inflation expectations down while at the same time keeping monetary policy relatively loose in order to cushion their respective fragile economies. Unfortunately for the central banks, food and energy inflation are two of the most visible components of overall inflation and, given their current high levels, they are serving to anchor inflation expectations even higher than would otherwise be warranted. In the medium term we expect consumer spending to be depressed in the U.S. and Europe, and for global economic growth to be impacted accordingly. Ultimately we expect that it will take a marked decline in energy and food prices, either via increased supply or reduced demand, to engineer an environment of robust growth.
As we have written previously, our belief is that fundamentals justify the recent high prices in oil, although the current ‘oil mania’ in the press has likely pushed crude to levels that are not sustainable in the short term. Our preference in the energy sector has been for natural gas producers, namely those with large, predictable, ‘resource-plays’ located in royalty-friendly British Columbia. In the month of June, oil and natural gas rallied 9.9% and 14.1% respectively, while the energy sub-index only managed a gain of 1.65%. This suggests to us that investors have become uncomfortable with the potential impact of high commodity prices on the overall economy, and that even energy stocks will have a difficult time benefitting in this environment (for more on these topics see our weekly blog Viewpoint).
Within the portfolio we remain particularly positive on the global agriculture picture as the supply-chain price inputs (energy, fertilizer, labor, machinery, etc.) remain elevated in the face of rising demand from the new middle class in developing markets. Decades of government mis-management and trade-distorting subsidies in the world’s major economies have resulted in a global agriculture industry that is simply unable to respond quickly to these changes in consumption. From our perspective, the investment emphasis should be on areas such as crop yield improvements, seed technologies and equipment providers, while industries such as food processors, retailers and restaurants should be avoided as their cost structures continue to rise.
As we have observed in recent months, positive returns are being found in an increasingly slim number of market sectors. Over the past few weeks, even energy stocks appear to have lost their upward momentum as investors appear to be discounting lower commodity prices in the near-future. While we have reduced our energy exposure over the last few weeks, it still plays a central role in the portfolio, as do agricultural stocks and select base metals. Lastly, we would expect the setting for financials to continue to deteriorate (and have been shorting banks accordingly), and continue to hold cash levels far above historical norms. For the quarter, Front Street Canadian Hedge was up 18.19%, owing to the sector overweights/underweights described above versus a rise of 8.37% on the TSX, a gain of 0.61% on the NASDAQ and a decline of 3.23% on the S&P 500.
Frank Mersch
Portfolio Manager
Front Street Capital