Fund Manager
Frank Mersch
Global equity markets ended 2007 on a note of cautious optimism, with the expectation/hope that a slowing US economy would be offset by Federal Reserve interest rate cuts and robust non-US growth, particularly from emerging market nations. Hopefulness gave way to near-panic however as weak economic data, massive asset write-downs at financial institutions and a general fear of a ‘credit crunch’ took centre stage. US economic data over the first few weeks of the year stoked investor fears about US recession, as manufacturing, consumer confidence, housing and retail sales data each came in beneath expectations. The flashpoint however was the much weaker-than-expected employment data that was released the first Friday of the year. Economic optimists had held out the robust nature of the employment market as evidence that the economy was in no particular trouble and was simply working it’s way through a ‘soft patch’. Making matters worse, name brand banks across the globe began taking multi-billion dollar write-downs against their assets in an effort to purge their books of complex (and hard to value) derivatives impacted by the housing market slowdown.
In the ensuing weeks equity markets swooned, volatility measures spiked back to multi-year highs, and investor confidence virtually evaporated. The Federal Reserve reacted to these ominous conditions by slashing interest rates, first with a 0.75% inter-meeting cut followed up with another 0.50% only days later. The reaction in the debt markets has been mixed: the short end of the curve has rallied ever-further suggesting that additional cuts are expected in the coming months; the spread between LIBOR and the fed funds rate has shrunk noticeably signifying that banks are once again willing to lend to each other; mortgage rates and investment grade corporate debt spreads remain elevated. In essence the Fed has managed to sharply reduce the benchmark upon which loans are priced, but its efforts to restore confidence to debt markets and stimulate the ‘willingness to lend’ have been less successful.
Against this challenging investment backdrop industries tied to discretionary consumer spending, housing and loan origination have been virtually left for dead, while those with above-average earnings growth expectations, such as technology, have been knocked down as investors reduce their risk tolerance. Despite the global economic worries commodities have fared well with certain base metals and energy only exhibiting modest pullbacks before returning to former highs, while the price of gold now sits comfortably above $900. Over the past few weeks we have taken the opportunity to add exposure to energy, particularly natural gas, while also accumulating positions in some of the depressed metals stocks. As has been the case over the last several months, we continue to overweight agricultural industries in the portfolio as our expectations for prolonged food inflation have not diminished. For the month, the fund was off 8.4% versus declines of 4.9% on the TSX and 6.1% on the S&P 500. This underperformance is largely attributable to being underweight the financial sector which rallied 8.5% in the two weeks following the emergency fed rate cut. Despite this short-covering rally we still believe that financials will be under pressure until the significant uncertainty that hangs over the sector begins to dissipate.
Frank Mersch
Portfolio Manager
Front Street Capital
Front Street Canadian Hedge
Date Published
Fund Manager
Global equity markets ended 2007 on a note of cautious optimism, with the expectation/hope that a slowing US economy would be offset by Federal Reserve interest rate cuts and robust non-US growth, particularly from emerging market nations. Hopefulness gave way to near-panic however as weak economic data, massive asset write-downs at financial institutions and a general fear of a ‘credit crunch’ took centre stage. US economic data over the first few weeks of the year stoked investor fears about US recession, as manufacturing, consumer confidence, housing and retail sales data each came in beneath expectations. The flashpoint however was the much weaker-than-expected employment data that was released the first Friday of the year. Economic optimists had held out the robust nature of the employment market as evidence that the economy was in no particular trouble and was simply working it’s way through a ‘soft patch’. Making matters worse, name brand banks across the globe began taking multi-billion dollar write-downs against their assets in an effort to purge their books of complex (and hard to value) derivatives impacted by the housing market slowdown.
In the ensuing weeks equity markets swooned, volatility measures spiked back to multi-year highs, and investor confidence virtually evaporated. The Federal Reserve reacted to these ominous conditions by slashing interest rates, first with a 0.75% inter-meeting cut followed up with another 0.50% only days later. The reaction in the debt markets has been mixed: the short end of the curve has rallied ever-further suggesting that additional cuts are expected in the coming months; the spread between LIBOR and the fed funds rate has shrunk noticeably signifying that banks are once again willing to lend to each other; mortgage rates and investment grade corporate debt spreads remain elevated. In essence the Fed has managed to sharply reduce the benchmark upon which loans are priced, but its efforts to restore confidence to debt markets and stimulate the ‘willingness to lend’ have been less successful.
Against this challenging investment backdrop industries tied to discretionary consumer spending, housing and loan origination have been virtually left for dead, while those with above-average earnings growth expectations, such as technology, have been knocked down as investors reduce their risk tolerance. Despite the global economic worries commodities have fared well with certain base metals and energy only exhibiting modest pullbacks before returning to former highs, while the price of gold now sits comfortably above $900. Over the past few weeks we have taken the opportunity to add exposure to energy, particularly natural gas, while also accumulating positions in some of the depressed metals stocks. As has been the case over the last several months, we continue to overweight agricultural industries in the portfolio as our expectations for prolonged food inflation have not diminished. For the month, the fund was off 8.4% versus declines of 4.9% on the TSX and 6.1% on the S&P 500. This underperformance is largely attributable to being underweight the financial sector which rallied 8.5% in the two weeks following the emergency fed rate cut. Despite this short-covering rally we still believe that financials will be under pressure until the significant uncertainty that hangs over the sector begins to dissipate.
Frank Mersch
Portfolio Manager
Front Street Capital