Fund Manager
Frank Mersch
The month of July was poor for the overall TSX Index, which was down 6.04%, but it was a nasty month for the materials and energy sub-indices, which were down 12.18% and 13.00% respectively. To put this performance into perspective, it has been close to three years since energy stocks have had such a weak month and it has been six years since materials have recorded such a decline. The dynamic at play here, as we have discussed in previous months (and on a weekly basis in our blog Viewpoint), concerns the apparent short-term peak in commodity prices due to the expectation of a slowdown in global growth (particularly in China) and the resurgence of the US Dollar. Adding further fuel to the fire in commodity selling is the newfound perception that the recent high rate of inflation (4.2% in the EU and 5.0% in the US) is a transitory phenomenon and will drift lower over the course of the next several months, and as such, interest rates do not necessarily need to go higher. In a slower growth, lower interest rate environment, other sectors and asset classes become relatively more attractive and commodities (and commodity stocks) are sold off accordingly. Making matters worse for equity investing in the past few months is the near doubling in volatility of the stock market, making already volatile sectors such as energy and materials all the more so.
The fundamental economic backdrop in the US remains stable although far from robust. The much-watched employment picture continues to surprise modestly to the upside, as the month of July saw a loss of ‘only’ 51,000 jobs, matching June’s number, coming in ahead of economist expectations. Likewise, Q2 GDP growth was 1.9%, which despite being slightly worse than expected still signals that the economy is in slow-growth mode and has not yet hit recession. Offsetting these positives is the real estate market, where home prices are now declining at close to 16% nationally, and the financial services sector, which continues to see massive asset writedowns related to mortgage-backed securities. Even the very solvency of mortgage giants Fannie Mae and Freddie Mac, which own or guarantee close to half of the $12 Trillion mortgage market, now appears to be in question and it seems likely that they will require massive capital injections from the Federal Government.
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 otherwise high level of inflation. While domestic demand is quite healthy, with retail sales growth running at 23%, the export picture has dimmed somewhat with export growth slowing materially to 17.6%. 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.
For the month the fund was down 10.96% versus the above-mentioned decline of 6.04% on the TSX, and a 0.99% pullback in the S&P 500. Despite holding close to 30% of the portfolio in cash, the fund experienced greater-than-market declines due to its significant agriculture holdings and to a lesser extent its exposure to base metals and energy. Although we have pared our energy holdings in recent weeks in anticipation of a commodity pullback, clearly we have been impacted by the sharp drop in energy stocks, particularly for the small-cap stocks with which we primarily invest. We expect that the pullback in the commodity complex will continue in the short-term and are positioning the portfolio as defensively as possible.
Front Street Canadian Hedge - Monthly Commentary
Date Published
Related Fund(s)
Fund Manager
The month of July was poor for the overall TSX Index, which was down 6.04%, but it was a nasty month for the materials and energy sub-indices, which were down 12.18% and 13.00% respectively. To put this performance into perspective, it has been close to three years since energy stocks have had such a weak month and it has been six years since materials have recorded such a decline. The dynamic at play here, as we have discussed in previous months (and on a weekly basis in our blog Viewpoint), concerns the apparent short-term peak in commodity prices due to the expectation of a slowdown in global growth (particularly in China) and the resurgence of the US Dollar. Adding further fuel to the fire in commodity selling is the newfound perception that the recent high rate of inflation (4.2% in the EU and 5.0% in the US) is a transitory phenomenon and will drift lower over the course of the next several months, and as such, interest rates do not necessarily need to go higher. In a slower growth, lower interest rate environment, other sectors and asset classes become relatively more attractive and commodities (and commodity stocks) are sold off accordingly. Making matters worse for equity investing in the past few months is the near doubling in volatility of the stock market, making already volatile sectors such as energy and materials all the more so.
The fundamental economic backdrop in the US remains stable although far from robust. The much-watched employment picture continues to surprise modestly to the upside, as the month of July saw a loss of ‘only’ 51,000 jobs, matching June’s number, coming in ahead of economist expectations. Likewise, Q2 GDP growth was 1.9%, which despite being slightly worse than expected still signals that the economy is in slow-growth mode and has not yet hit recession. Offsetting these positives is the real estate market, where home prices are now declining at close to 16% nationally, and the financial services sector, which continues to see massive asset writedowns related to mortgage-backed securities. Even the very solvency of mortgage giants Fannie Mae and Freddie Mac, which own or guarantee close to half of the $12 Trillion mortgage market, now appears to be in question and it seems likely that they will require massive capital injections from the Federal Government.
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 otherwise high level of inflation. While domestic demand is quite healthy, with retail sales growth running at 23%, the export picture has dimmed somewhat with export growth slowing materially to 17.6%. 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.
For the month the fund was down 10.96% versus the above-mentioned decline of 6.04% on the TSX, and a 0.99% pullback in the S&P 500. Despite holding close to 30% of the portfolio in cash, the fund experienced greater-than-market declines due to its significant agriculture holdings and to a lesser extent its exposure to base metals and energy. Although we have pared our energy holdings in recent weeks in anticipation of a commodity pullback, clearly we have been impacted by the sharp drop in energy stocks, particularly for the small-cap stocks with which we primarily invest. We expect that the pullback in the commodity complex will continue in the short-term and are positioning the portfolio as defensively as possible.