Maple Leaf Memo
In recent weeks, we’ve discussed the looming economic slowdown, the recent slide in energy and the implications for Canadian oil and gas royalty trusts.
There are many factors at work here. For example, the unwinding of speculative positions has driven the per-barrel price of oil to around USD60 from a high near USD78. In response to the slide, OPEC hinted at its most recent meeting that it would consider production cuts; member nations Venezuela and Nigeria–acting apart from OPEC–already trimmed output.
Short-term shocks can impact oil to the up- or the downside, as you’ve no doubt experienced in recent months. However, if you get caught up in the major financial media’s frenzied story-chasing, it’s possible to miss the bigger picture: The era of cheap energy is over.
The foundation of the long-term energy bull argument is Asia. We’ve turned to our comrade Yiannis Mostrous, editor of The Silk Road Investor for some context. Yiannis, along with our comrades Elliott Gue and Ivan Martchev, is the co-author of The Silk Road to Riches: How You Can Profit by Investing in Asia’s Newfound Prosperity, a detailed look at what’s emerging as the engine of global economic growth for the 21st century.
Recession Fears
By Yiannis G. Mostrous
The prevailing view is that the US economy is slowing–taking its cue from the housing sector–and that the probability of a 2007 recession has risen significantly. Some say the likelihood is up to 40 percent.
My view is a little more sanguine, although signs of slackening growth are clearly visible. The case for a recession is based on the fact that the yield curve remains inverted–admittedly an alarming development–but other economic indicators show nothing more than a slowdown. Hence, nothing more than some strategic hedging to offset potential disappointments is required right now. I’ll have more on that below.
For investors who have a large part of their portfolio in Asian equities, the issue is how much a US slowdown will affect the Asian economies. It all depends on the magnitude of the weakness–i.e., whether it’s a slowdown or a recession.
If the US falls into a recession next year (while this isn’t my forecast, it’s a strong possibility), economies around the world will be negatively affected. The dominant view among knowledgeable observers is that Asia will suffer the most.
But it won’t hurt as much as is commonly believed. I offer no vote of confidence–yet–to those who state that Asian economies have decoupled from the US. But Asian nations are better prepared than ever before to deal successfully with a US economic slowdown.
The US is gradually becoming less important to Asia’s well-being. Total Asia-ex China exports (including indirect exports to the US through China) have decreased from a high of 26 percent of total exports to a low of 18 percent currently, the same as the European Union (EU).
It’s well-known that consumption represents 71 percent of US GDP. Of that, 22 percent represents expenditures in goods (ex cars, food and energy) where Asia’s exposure is greatest. Keep in mind that American businesses account for 75 percent of US tech spending, where the majority of Asian exports are concentrated. If capital spending doesn’t collapse, Asia will do just fine. And the US’ share of global imports has also steadily declined to 17 percent from a high of 21 percent in 2001.
If the US housing slowdown brings with it a total collapse of the US economy and a deep recession, all bets are off, no matter where you’ve invested (expect maybe gold bullion). But, I reiterate: This isn’t the base-case scenario I envisage.
What about China? Most observers–and I agree with this part of the thesis–expect its economy to slow. But they lose me when they argue that China’s slowdown will be severe enough to damage long-term growth prospects, and that, coupled with a crippling US recession, it will devastate the global economy.
My view is that China will weather the storm, proving more resilient than those observers anticipate. One of the main reasons is that it has policy flexibility–currency reserves, surpluses, renminbi appreciation, etc. For the month of August, China’s trade surplus reached a record of USD18.8 billion. Given how the rest of the year has gone, the surplus could surpass USD150 billion by the end of 2006. And China’s foreign exchange reserves should surpass the USD1 trillion mark by the end of the year.
Most of China’s exports to the US are to the lower end of the market and should therefore hold up better and maintain momentum, as they did in Japan during the prolonged recession in that country.
As the US and the global economy slow, China will follow. There are already signs of it happening: Industrial output slowed down during the summer months and should continue to do so. This doesn’t mean economic activity in China will collapse, but the market will feel the change.
Chinese leaders will eventually have to pass measures intended to boost domestic demand, which will lead to a stronger yuan and lower surpluses. Until then, China will have to find ways to absorb investment growth that will often be directed to ill-advised projects.
This is why US-China cooperation remains at the center of the global economy–a mutual understanding will solve each other’s and the world’s problems.
The US will play a vital role in this transition because the two countries have reached such a level of economic integration that cooperation is the only viable alternative. As US Treasury Secretary Henry Paulson recently said, “The relationship between the US and China is the most important bilateral economic relationship in the world today.”
And as I noted [September 20]:
China has demonstrated that it won’t respond to outright pressure, something Paulson well knows; he’s been doing business with the Chinese for a long time. He’s currently visiting China again, and I expect an understanding to be reached during his time there. China’s leadership (especially its central bank officials) knows what needs to be done, but it also knows it needs more time than the G-7 would allow.
It looks as though the US administration now understands what’s at stake and has brought in people who can deliver. The US-China Strategic Economic Dialogue, the creation of which was announced during Paulson’s recent visit to China, is a step in the right direction. According to the official press release, the Dialogue “…will be the first of its kind and will occur at the highest official level, with Paulson and Wu (Chinese Executive Vice Premier) at the helm.” (Visit the US Treasury Dept for more.)
Given China’s importance to the world economy, don’t underestimate the efforts by Secretary Paulson and President Bush to work with China as a strategic partner rather than an adversary. And although short-term domestic political tricks (prevalent now, given the upcoming elections) create some disturbing noise, serious, long-term investors will understand it for what it is: just noise. The US and China will be the dominant players in the foreseeable future; the sooner you realize the implications of this world order, the sooner you can make the appropriate investment decisions.
Turning to the markets, plummeting oil and commodities caught a lot of people off guard. Speculators have had very large positions in natural gas and crude based on their assessments of certain meteorological phenomena.
We all know how that’s worked out. I’ve written on commodities many times, most recently early this summer. As I noted then:
Commodities remain the biggest question mark in the markets, as their parabolic ascent has created an unsustainable trade that should correct more. If it doesn’t, the final correction will be extremely brutal, affecting not only the current market cycle, but also potentially destroying the new commodities bull market that started in 2001 and should otherwise last beyond 2010.
There’s no doubt the correction has started. From a long-term perspective, the hope is that the correction will be orderly.
I see the current correction primarily as an unwinding of speculative positions and secondarily as an issue of weaker anticipated growth. My assessment would certainly change if facts prove me wrong, but for now, don’t abandon structural bullishness on oil. Lower per barrel prices are in fact positive for Asia as the region is overall an oil importer.
Market participants are more bearish now than circumstances warrant; all the economic indicators I follow indicate a slowdown, but nothing more than that, and market indicators continue to point upward. I therefore reiterate the view I expressed in August that the global markets could run higher as we approach the end of the year.
Round-UpReal Estate Trusts Retirement REIT (TSX: RRR.UN, OTC: RRR.GF) announced that PR Capital Corp, a new company controlled by Paul Reichmann, former partner in Retirement REIT, will bid to purchase the real estate investment trust (REIT) at CD8.60 per unit. The PR Capital bid provides about a 10 percent premium over current asset values and depends on assistance from the REIT to enable it to pursue a due diligence process. PR Capital now holds 13.1 million units of the REIT, or 14.1 percent, and will send a letter to the board about its plans. PR Capital’s bid for Retirement REIT puts added pressure on the special committee of the REIT’s board, which for months has appeared bogged down in a strategic review.
The move also could be designed to force the hand of other possible bidders who are waiting in the wings. The offer establishes a floor for Retirement REIT units, which had taken a hit, falling dramatically from a high of CD10.19 in February after several bidders left the table, including its industry rival Chartwell Seniors Housing. The deal could carry a price tag approaching CD1 billion once the REIT’s CD350 million in convertible debentures is added in with the price of the stock PR Capital doesn’t already own. Continue to hold Retirement REIT.
Top 10 Portfolio holding Summit REIT (TSX: SMU.UN, OTC: SEIFF) and ING Real Estate Canada Trust have now mailed friendly takeover bid documents to shareholders. Investors have until 11:59 pm Vancouver, British Columbia, time on Oct. 11, 2006, to respond–either to approve or disapprove the bid.
The official offer from ING is to pay Summit holders CD30 per share (USD26.63) in cash. The light industrial properties real estate investment trust (REIT) will then become a wholly owned subsidiary of ING Real Estate Canada Trust.
As I pointed out in the September issue of Canadian Edge, I have mixed feelings about the offer. On the one hand, it values Summit at a substantial premium to its pre-deal price, which itself had risen sharply during the past couple years. And a bird in the hand is more often than not worth several in the bush when it comes to investing.
On the other hand, Summit has definitely been a star in the Canadian REIT sector. During the past few years, it’s transitioned to the country’s fastest-growing markets, particularly Alberta. It’s dramatically cut debt and unloaded less-attractive properties. It’s now the premier light industrial property play in Canada.
During the next several years, an independent Summit would be worth far more than CD30. However, given that the bid is friendly, I see little or no chance it will be rejected, particularly by larger owners who are no doubt looking to lock in a big profit in a year that’s been somewhat rocky, particularly for oil and gas producer trusts.
As pointed out in the September issue, I had intended to advise holding onto Summit shares through the buyout and collecting the cash. My reasoning was the all-cash nature of the deal eliminated market risk, and there was a slight chance the price could be sweetened further.
There’s still no market risk for hanging on. But the odds of getting a better deal now are nil. More important, there may be complications getting the cash due for US investors who hold on until the deal is done.
Some, for example, could wind up getting withheld 15 percent, just as is the case with a regular dividend. That happened to some investors with the Avenir (AVF.UN, AVNDF) split. There was absolutely no justification for it, and most have recouped, but only with a lot of hassle.
At this point, Summit trades exactly 15 cents Canadian (13 cents US) below its takeover value of CD30 a share in cash. That’s what you’ll sacrifice by selling your shares now. But you’ll save yourself the worry of possible erroneous withholding. Note that the US dollar takeover value of the deal is about USD26.70 at the current exchange rate, again within a whisker of the current price.
In short, there’s very little reason to hang onto Summit shares now and some good ones to sell and move on. My one cautionary note is how to proceed with the sale itself.
It’s possible that a flood of market sell orders from US investors could drive the shares down momentarily. Those most exposed will be investors who put in market sell orders after the close, as that will afford market makers the ability to take the price down at the open.
Should that happen, it’s critical to remember that the price will bounce back very quickly because Summit has a CD30-per-share cash value guaranteed in the buyout. That’s why I strongly advise everyone selling to put in a limit order. Don’t part with your shares for less than USD26.60. If you do, you’re getting ripped off.
New Issues/Conversions
Brookfield SoundVest Commodity Services Fund, an actively managed portfolio consisting primarily of equity securities of companies that provide services and infrastructure to the resource and commodity sectors, will debut October 9. The closed-end trust may also invest a portion of its assets in equity securities of resource and commodity producers.
Canadian Wireless Trust, a closed-end trust mutual fund to be managed by Scotia Capital Management, will debut October 17. The fund will initially be weighted to the Canadian telecommunications companies that are expected to benefit most from growth in wireless telecommunications–BCE, Rogers Communications and Telus Corp. The fund will make quarterly distributions.
Extendicare, a nursing home and care provider with 439 nursing and assisted-living facilities in North America and the United Kingdom, will hold a shareholders meeting on October 16 to vote on a resolution approving the previously announced spinoff of Assisted Living Concepts to Extendicare’s shareholders and the conversion of Extendicare’s remaining business into a Canadian REIT. If all approvals are met, the reorganization is expected to be completed on or about November 1.
Standard Broadcasting Corp, a Toronto-based radio giant, is nearing a decision on whether to revive its mothballed initial public offering (IPO) after ruling out the outright sale that some analysts expected. The Slaight family, which owns and runs the business, plans to make a decision in the next few days about whether to remain private or go ahead with an IPO that would bring cash in return for at least part of the family’s stake, said a source with knowledge of the family’s deliberations.
Standard Broadcasting received regulatory approval September 29 for a corporate reorganization that would allow the company’s network of 51 radio stations to be spun out into an income trust. Investment bankers who follow the media business said that the market’s appetite for a radio income trust is better than it was in June, when Standard shelved its IPO plans, citing “market conditions.”
Since then, radio operators have reported healthy revenue gains. According to Canadian Broadcasting Sales, which tracks the sector, industry sales rose 6.3 percent in the last year and 19 percent in the most recent quarter. Shares of rival radio station owners have also climbed, with Corus Entertainment gaining 18 percent since the Standard Broadcasting IPO was pulled and Astral Media gaining almost 9 percent.
Another catalyst was the sale of radio and television broadcaster CHUM to Bell Globemedia for a 50 percent premium to its market price. Montreal-based Astral Media, which owns 29 radio stations, may already be lining up to buy Standard Broadcasting after it goes public. Astral, which is sitting on a cash hoard, was outbid earlier this year in the auction for CHUM. Astral will have to pay a higher price after the IPO, but Standard Broadcasting boasts the best margins in the Canadian radio business.