Fund Manager
Frank Mersch
During the third quarter of 2008, the Canadian equity market slid into bear-market territory, declining 18.76%, while the S&P 500 fell 8.88%. Over the first half of the quarter, some of the negative forces faced by Canadian equities included weaker commodity prices, a stronger U.S. Dollar, slowing global growth (particularly in China), and a collapse in inflation expectations. These forces had sent the TSX index lower, but they paled in comparison to the havoc unleashed in September as the financial system itself came under severe strain, resulting in the demise/forced sale of Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, AIG, Washington Mutual and Wachovia. Investors lost confidence in the assets of these financial institutions and their stock prices collapsed as a result. Capital in the debt markets became extremely difficult to come by as yield spreads surged and interbank lending effectively ground to a halt. Against this distressed setting, the U.S. Treasury was compelled to institute a Resolution Trust-like entity to create a market for the complex mortgage-backed securities held by the nation’s financial institutions. The expectation is that such an entity would enable price discovery and halt the vicious cycle, whereby assets are written down, credit is constrained and expensive capital infusions are required. Stability in the financial sector, through a combination of asset price discovery, liquid corporate debt markets and accounting changes, would be a significant short-term positive for the equity markets, although it will likely be several quarters before actual earnings growth returns to the sector (see our weekly blog Viewpoint for more details).
Although U.S. economic activity does not appear to be particularly robust, it has exhibited strength relative to the world’s other major economies and the pressure on the U.S. Dollar has subsided accordingly. Specifically, in the second quarter, the Eurozone economy contracted 0.2%, while the Japanese economy shrunk 0.6%. Over the same period, the U.S. economy expanded by 3.3% on an annualized basis (roughly 0.8% on a quarterly basis), driven almost entirely by growth in net exports. Behind this strong overall number, the pressure on the U.S. consumer continues to mount and its likely that consumer spending contracted in the third quarter as the tax rebate-fuelled growth from earlier in the year faded and the unemployment rate climbed higher. The most telling statistics this past quarter came in the form of the 16-year low in auto sales, the surge in existing housing inventories to 11.2 months of supply and the Federal Reserve’s quarterly Senior Loan Officer Survey that suggested the majority of banks will continue to tighten their lending requirements over the next twelve months.
The new investor sentiment is that inflation has peaked. And, thanks to declining economic activity and energy prices, inflation will moderate over the course of the year, and central bankers will not need to raise interest rates any further. Moreover, having lagged the U.S. in terms of economic stimulus over the past year, the European and Asian Central Banks have shifted into rate cutting mode, undermining their currencies. As a result, the U.S. Dollar has now rallied in five of the past six months, gaining 5.7% in August alone (the largest monthly move in 16 years), and now sits at a 12-month high. We expect this U.S. Dollar strength will continue to play out over the rest of 2008 and will temper enthusiasm for future commodity rallies.
At the other end of the spectrum, the Chinese economic picture has clearly shifted towards an expectation of slower growth, with the rhetoric from government officials now squarely focused on the need to keep the economy growing at a robust rate, with less emphasis on the level of inflation. While domestic demand is quite healthy, with retail sales growth running at 21.9%, the industrial production picture has dimmed somewhat, with growth slowing materially to 12.8%. Beyond these two key sectors, there is a growing expectation of a pullback in the east coast real estate markets, which could act as a significant drag on economic growth.
On the resource front, we have seen an acceleration of the downturn in the price of commodities as the CRB Index declined close to 12% in September, bringing the quarterly decline to 25%. While we would expect a cooling in Chinese demand over the next few quarters, it strikes us as unlikely that base metal prices will be declining as much as is implied in the equity prices, given the ever-rising marginal costs, sluggishness in new supply and increasingly tight credit conditions. On the energy side, the TSX energy sub-index dropped a whopping 27.6% on the quarter as oil declined $39 and natural gas dropped 44%, to $7.44. The volatility in the commodities hit new highs during the quarter and it was clear that institutions were liquidating positions in expectation of lower prices in the medium term. While U.S. oil demand has declined by close to 5% compared to last year, and now sits at levels not seen since 2003, the U.S. represents less than a quarter of global demand and non-U.S. demand remains solid. Similar to the base-metal picture, we are near the marginal cost of oil (the cost of producing a barrel in the oil sands is estimated to be between $70 and $100) and a strained credit market may limit some of the planned capital expenditures on new energy projects.
For the quarter, the Fund was down 28.17%, compared to the aforementioned 18.76% decline in the TSX, and 8.88% decline in the S&P 500. The Fund experienced greater-than-market declines due largely to its significant agriculture holdings. Some of the most liquid, profitable and best positioned companies experienced share declines of greater than 40% during the past few months, as institutional investors rotated out of the sector. For the time being, capital flows and government bailouts trump fundamentals and while the fund has suffered in the short-term, we feel that the long-term opportunities are intact. As in recent months, we expect that the pullback in the commodity complex will continue and are positioning the portfolio as defensively as possible. This includes holding close to 30% of the portfolio in cash.
Frank Mersch
Portfolio Manager
Front Street Capital
FRANK MERSCH - Q3 2008 COMMENTARY
Date Published
Fund Manager
During the third quarter of 2008, the Canadian equity market slid into bear-market territory, declining 18.76%, while the S&P 500 fell 8.88%. Over the first half of the quarter, some of the negative forces faced by Canadian equities included weaker commodity prices, a stronger U.S. Dollar, slowing global growth (particularly in China), and a collapse in inflation expectations. These forces had sent the TSX index lower, but they paled in comparison to the havoc unleashed in September as the financial system itself came under severe strain, resulting in the demise/forced sale of Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, AIG, Washington Mutual and Wachovia. Investors lost confidence in the assets of these financial institutions and their stock prices collapsed as a result. Capital in the debt markets became extremely difficult to come by as yield spreads surged and interbank lending effectively ground to a halt. Against this distressed setting, the U.S. Treasury was compelled to institute a Resolution Trust-like entity to create a market for the complex mortgage-backed securities held by the nation’s financial institutions. The expectation is that such an entity would enable price discovery and halt the vicious cycle, whereby assets are written down, credit is constrained and expensive capital infusions are required. Stability in the financial sector, through a combination of asset price discovery, liquid corporate debt markets and accounting changes, would be a significant short-term positive for the equity markets, although it will likely be several quarters before actual earnings growth returns to the sector (see our weekly blog Viewpoint for more details).
Although U.S. economic activity does not appear to be particularly robust, it has exhibited strength relative to the world’s other major economies and the pressure on the U.S. Dollar has subsided accordingly. Specifically, in the second quarter, the Eurozone economy contracted 0.2%, while the Japanese economy shrunk 0.6%. Over the same period, the U.S. economy expanded by 3.3% on an annualized basis (roughly 0.8% on a quarterly basis), driven almost entirely by growth in net exports. Behind this strong overall number, the pressure on the U.S. consumer continues to mount and its likely that consumer spending contracted in the third quarter as the tax rebate-fuelled growth from earlier in the year faded and the unemployment rate climbed higher. The most telling statistics this past quarter came in the form of the 16-year low in auto sales, the surge in existing housing inventories to 11.2 months of supply and the Federal Reserve’s quarterly Senior Loan Officer Survey that suggested the majority of banks will continue to tighten their lending requirements over the next twelve months.
The new investor sentiment is that inflation has peaked. And, thanks to declining economic activity and energy prices, inflation will moderate over the course of the year, and central bankers will not need to raise interest rates any further. Moreover, having lagged the U.S. in terms of economic stimulus over the past year, the European and Asian Central Banks have shifted into rate cutting mode, undermining their currencies. As a result, the U.S. Dollar has now rallied in five of the past six months, gaining 5.7% in August alone (the largest monthly move in 16 years), and now sits at a 12-month high. We expect this U.S. Dollar strength will continue to play out over the rest of 2008 and will temper enthusiasm for future commodity rallies.
At the other end of the spectrum, the Chinese economic picture has clearly shifted towards an expectation of slower growth, with the rhetoric from government officials now squarely focused on the need to keep the economy growing at a robust rate, with less emphasis on the level of inflation. While domestic demand is quite healthy, with retail sales growth running at 21.9%, the industrial production picture has dimmed somewhat, with growth slowing materially to 12.8%. Beyond these two key sectors, there is a growing expectation of a pullback in the east coast real estate markets, which could act as a significant drag on economic growth.
On the resource front, we have seen an acceleration of the downturn in the price of commodities as the CRB Index declined close to 12% in September, bringing the quarterly decline to 25%. While we would expect a cooling in Chinese demand over the next few quarters, it strikes us as unlikely that base metal prices will be declining as much as is implied in the equity prices, given the ever-rising marginal costs, sluggishness in new supply and increasingly tight credit conditions. On the energy side, the TSX energy sub-index dropped a whopping 27.6% on the quarter as oil declined $39 and natural gas dropped 44%, to $7.44. The volatility in the commodities hit new highs during the quarter and it was clear that institutions were liquidating positions in expectation of lower prices in the medium term. While U.S. oil demand has declined by close to 5% compared to last year, and now sits at levels not seen since 2003, the U.S. represents less than a quarter of global demand and non-U.S. demand remains solid. Similar to the base-metal picture, we are near the marginal cost of oil (the cost of producing a barrel in the oil sands is estimated to be between $70 and $100) and a strained credit market may limit some of the planned capital expenditures on new energy projects.
For the quarter, the Fund was down 28.17%, compared to the aforementioned 18.76% decline in the TSX, and 8.88% decline in the S&P 500. The Fund experienced greater-than-market declines due largely to its significant agriculture holdings. Some of the most liquid, profitable and best positioned companies experienced share declines of greater than 40% during the past few months, as institutional investors rotated out of the sector. For the time being, capital flows and government bailouts trump fundamentals and while the fund has suffered in the short-term, we feel that the long-term opportunities are intact. As in recent months, we expect that the pullback in the commodity complex will continue and are positioning the portfolio as defensively as possible. This includes holding close to 30% of the portfolio in cash.
Frank Mersch
Portfolio Manager
Front Street Capital