Fund Manager
Frank Mersch
Over the past couple of months we have outlined some of the negative forces faced by Canadian equities, including 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 this past month 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. We would note that 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).
Amongst the chaos in the financial system, fundamental economic and corporate news items received little attention. Nonetheless, the economic picture in much of the Western world is still deteriorating, particularly in the U.S., but also in Europe and Japan. The Case-Shiller Home Price Index has declined 19.5% from its peak in July 2006 and although the pace of the decline in prices has slowed in recent months, we have not yet hit a clear bottom and inventory remains near all-time highs. On a related note, consumer spending appears to be contracting in the third quarter as the tax rebate-fuelled growth from earlier in the year fades and the unemployment rate climbs higher. The fall in auto sales to 1993 levels exemplifies both the decline in discretionary spending and the tightening of consumer credit.
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%. Expectations, and some evidence of declining demand growth in China for industrial metals, have pushed metals prices lower; metals stocks are sharply lower and now sit at price-to-cash flow levels not seen for several quarters. 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 20.3% on the month, despite modest declines in oil and natural gas. The volatility in commodities hit new highs during the month 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 month the fund was down 17.3%, compared to a 14.7% decline in the TSX, and 9.1% decline in the S&P 500. Comparable to last month, the fund experienced greater-than-market declines due largely to its significant agriculture holdings. Some of the most liquid, most profitable, best positioned companies experienced share declines of greater than 25% during September 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.
Front Street Canadian Hedge Monthly Commentary
Date Published
Related Fund(s)
Fund Manager
Over the past couple of months we have outlined some of the negative forces faced by Canadian equities, including 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 this past month 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. We would note that 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).
Amongst the chaos in the financial system, fundamental economic and corporate news items received little attention. Nonetheless, the economic picture in much of the Western world is still deteriorating, particularly in the U.S., but also in Europe and Japan. The Case-Shiller Home Price Index has declined 19.5% from its peak in July 2006 and although the pace of the decline in prices has slowed in recent months, we have not yet hit a clear bottom and inventory remains near all-time highs. On a related note, consumer spending appears to be contracting in the third quarter as the tax rebate-fuelled growth from earlier in the year fades and the unemployment rate climbs higher. The fall in auto sales to 1993 levels exemplifies both the decline in discretionary spending and the tightening of consumer credit.
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%. Expectations, and some evidence of declining demand growth in China for industrial metals, have pushed metals prices lower; metals stocks are sharply lower and now sit at price-to-cash flow levels not seen for several quarters. 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 20.3% on the month, despite modest declines in oil and natural gas. The volatility in commodities hit new highs during the month 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 month the fund was down 17.3%, compared to a 14.7% decline in the TSX, and 9.1% decline in the S&P 500. Comparable to last month, the fund experienced greater-than-market declines due largely to its significant agriculture holdings. Some of the most liquid, most profitable, best positioned companies experienced share declines of greater than 25% during September 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.