Economy points to late cyclicals

By Mark Noble | December 1, 2009 | Last updated on December 1, 2009
5 min read

Economic performance may outpace market returns in the coming months, according to a 2010 forecast by Scotiabank. Like many other forecasters, Scotiabank is predicting a return to muted but stable returns for Canadian investors, with the prospect of rising inflation towards the end of next year.

Scotiabank chief economist Warren Jestin says the world is already undergoing an uneven recovery, with emerging market economies like China, already back to pre-recessionary levels. This has led to an increase in commodity demand, which in turn has fueled a run-up in commodity prices.

The developed economies of Europe and the U.S. are still stumbling, while Canada is somewhere in between, stunted by the slow U.S. recovery, but a strong source of hard commodities for the developing world’s rapid industrialization.

“Our banking system is widely regarded as the strongest in the world. Our labour market has shown greater resilience, with job losses running about half the rate of decline evident south of the border. Household and corporate sector balance sheets also are in relatively better shape,” Jestin says. “These factors have supported a rebound in consumer spending and the revival of Canada’s housing market, where buyers are taking advantage of historically low interest rates at a time when U.S. residential activity remains deeply mired in recession.

“At the same time, Canadian exporters continue to face heavy headwinds, with sales volumes during the summer down roughly 20% from the previous year. Add in steep price declines, and overall receipts have fallen nearly 30%,” he adds. “Commodity producers are beginning to benefit from a rebound in global markets, but with three quarters of external sales going to the U.S., the pace of recovery will be subdued.”

All of these factors, lead Jestin to conclude that Canada is on pace for a slow grind upward next year. The continued rise of the loonie will remain an albatross around the neck of exporters, and dampen domestic growth. Meanwhile the weaker U.S. dollar will provide much needed support to American exporters.

“In Canada and the U.S., for example, growth in 2010 will probably be around 3%, doing little more than backfilling the hole created by the steep decline in activity over the past year,” Jestin says. “Even this modest performance will compare favourably with trends in Europe and Japan, where economic retrenchment has been much deeper and the timetable for regaining lost GDP stretches well beyond 2010.”

In the same outlook report, Scotia’s director of portfolio strategy, Vincent Delisle, says the modest economic growth may still outpace that of the equity markets over the early months of the year, as the market has largely priced in a recovery. Upside earnings surprises will likely be necessary to boost stocks further.

“Robust earnings growth [between 25% to 30%] and positive funds flows could lift equity indices another 10%. The equity risk-reward outlook is not as compelling as it was at the start of 2009, however, and investors should expect more modest equity gains now that the normalization phase is in the latter stages,” Delisle says. “Rising interest rates should represent one of the main challenges next year as Central Banks likely implement their ‘exit strategies’ in the second half of 2010. Bond returns are expected to range between 0% on government bonds to low single digits on corporate bonds next year versus low double digit gains for equities.”

Given this view, Scotia is taking a an equity overweight stance in its portfolio for the coming year. Delisle expects cyclical sectors of the economy to dominate equity performance in the coming year.

“We are the stage of cycle where equities outperform high yield bonds,” Delisle says. “Cyclical sectors have been leading the charge since the spring rebound started in March and 2009 sector performance has provided a text-book illustration of late-stage recession leadership. We expect this cyclical domination to continue in 2010, albeit at a lesser margin.

He adds, “mid-to-late cycle areas such as technology, industrials, energy, and materials should outperform the ‘early cyclical’ financials and discretionary [consumer] when the tightening cycle begins in the latter half of 2010. We are reducing our financials weighting to market weight and raising our recommendation in telecom as we believe the sector will perform better in 2010.”

Deslisle warns that investors may be in a long trek back to their performance experienced in 2007, when the market cycle peak.

“Equity markets have turned in a stellar performance in 2009, but it will likely take years before indices revisit their 2007/2008 peak levels. Our objective in 2010 will be to adapt our asset mix stance when the risk-reward outlook no longer dictates an aggressive cyclical bias. By the end of 2010, portfolios should not look as cyclical as they do now.”

Sprott warns on banks

If you take Canada as whole, the market outlook appears okay. But a recent a commentary by Eric Sprott, the CEO of Sprott Inc., issues a dire warning on the risk of investing in Canadian banks.

Sprott argues that the banks have done little to deleverage their balance sheets, despite industry-wide claims to the contrary. By comparing the banks’ total common equity to their actual tangible assets, Sprott says the “Big Five” are on average leveraged more than 30:1.

“We remove intangibles, such as goodwill, from this calculation because they have no real value. You cannot buy goodwill and then sell it at a profit — and under a bank bankruptcy scenario, which we have seen so often over the past year, goodwill is worth nothing. What we are interested in calculating, therefore, is how many tangible assets are supported by one dollar of tangible common equity. This number gives us an indication of how levered a common equity investor in a bank stock is to changes in asset prices,” Sprott writes. “Applying our definition of leverage to the current system reveals the inherent weaknesses that still exist within it, and confirms why we question the value in bank stocks.”

Sprott admits the Canadian banks have had a healthier leverage ratio than their U.S. counterparts over a three year period, but he estimates that a mere 3% decline in the value of assets would wipe out all of the tangible value of their common equity. He postulates that the banks have survived due to careful and robust assistance from various funding mechanisms of the Canadian government.

“First, they received $65 billion in liquidity injections from the Insured Mortgage Purchase Program, whereby Canada Mortgage and Housing purchased insured mortgages from Canadian banks to provide additional liquidity on the asset side of their balance sheets,” Sprott says. “Next, the Bank of Canada provided them with an additional $45 billion in temporary liquidity facilities. Finally, a Canadian bank (that shall remain nameless) also received assistance from the Canada Pension Plan (CPP) through the purchase of $4 billion in mortgages prior to the IMPP program, for a total government expenditure of $114 billion.”

Sprott says this number exceeds the total tangible common equity of the Canadian banks, which he pegs at $68 billion.

“Can you put two and two together? The Canadian government injected a sum through mortgage purchases worth more than the entire tangible common equity of the Canadian banking system,” he says.


Mark Noble