Can the summer rally continue?

Earlier this week, stock markets around the world put the finishing touches on what has been a sizzling month of performance in July. Even Canada’s resource-heavy TSX index rose 3% on rising energy and gold prices in July.

This week, a dovish FOMC meeting and the fact that Chinese manufacturing for July came in above the threshold that separates expansion from contraction, helped push U.S. stock indices once again to new all-time highs. But has the stock market run too far?

Read: Markets calmed as Fed stands pat on stimulus

The bulls would suggest any bad news out there on Fed tapering, China and the Eurozone have already been factored into stock prices since these issues have been around for a while and are no longer ‘news’ to investors. In addition, although second quarter U.S. GDP was not spectacular, it beat expectations, which shows the increasing resilience of an improving economy. This week revealed that manufacturing and auto sales were ahead of expectations. As well, just as the Fed contemplates an end to QE, the overall monetary policy stance across all the major economies—including the U.S.—remains favorable and supportive of the stock market.

However, the stock market is now pricing in a pretty optimistic outcome. The U.S. economy is doing better relative to the rest of the world, but that’s a ‘best house in a bad neighborhood’ analogy. Housing and employment may be improving, but July’s payroll data was well below expectations of 200,000 new jobs (162,000 reported in July and June revised lower), which shows very little momentum in hiring. As a result, GDP growth is unlikely to materially improve any time soon.

Read: U.S. unemployment falls to 7.4%

On the earnings front, recent results have only been so-so, and don’t be fooled by the rosy consensus estimates for the second half of the year. Estimates have started coming down already and will likely fall further. With the Fed communicating an end to QE in the not-too-distant future, investors will need to pay close attention to both the corporate and economic fundamentals.

In summary, we do believe the current secular rally in stocks likely has further to go, but we should brace ourselves for a bumpier ride in the months ahead. The incredible momentum we’ve recently seen in the market is most likely unsustainable for the second half of 2013.

QUESTION OF THE WEEK

We witnessed a big shake up in the global fertilizer business this week. What are the short- and medium-term implications for Canadian fertilizer stocks?

For many years, the global potash market was effectively a duopoly (Canpotex and Belarus Potash Company) where potash volumes were controlled in an effort to support the price of the fertilizer commodity. When Russian potash producer Uralkali announced it had decided to abandon its current potash marketing partnership (some would say cartel) it clearly caught the markets off guard.

This week, we learned that Uralkali has decided to ramp up its own production as it attempts to capture market share at the expense of lower prices. As the lowest cost potash producer, Uralkali’s decision puts pressure on all producers, but especially the higher cost producers. Potash pricing is likely to further deteriorate this year due to Uralkali’s new volume over price mandate. Potash suppliers will have little choice but to accept lower future prices, which effectively ends the supply-disciplined industry and ushers in the beginning of a new era.

Uralkali’s move was likely triggered by frustration over its marketing partner’s (Belaruskali) decision to sell potash outside of the quotas of the partnership. The quota cheating was likely many years in the making and therefore it may take some time to heal the feelings of mistrust. There are also some Russian politics at play between Uralkali (Russia) and Belaruskali (Belarus), so how quickly or on what terms they patch up the relationship is anyone’s guess. It’s unlikely there will be a reversion back to the old discipline on volumes, so it is also unlikely Canpotex (the Canadian producers) will take a “wait and see” approach with Chinese and Indian buyers looking to lock in contracts. The question is, at what price?

Read: How to play resource scarcity

Despite near- and intermediate-term headwinds, the potash supply overhang worries may be overdone, with stocks falling 15-30% initially. If potash prices fall as we anticipate, the economics of new production projects will erode, resulting in several project cancellations. Additionally, higher operating volumes and lower prices could serve to boost global demand, particularly in emerging markets such as India.

Keep in mind though that this incremental increase in demand is not likely sufficient to sustain the valuation premiums of key Canadian potash producers. Canadian potash producers are likely range bound stocks for a while but dividends appear safe given the high cash flow generated, even at significantly lower potash prices.

David Andrews is the Director, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends. @David_RGMP