Maple Leaf Memo
The world economy is treading a narrow path between recession and inflation, but investors seem to be getting increasingly relaxed. Stock market prices rose around the world in August, and measures of risk aversion and volatility have declined.
This may be a perfectly rational response to the prospect of a nice, gentle mid-cycle slowdown. But history suggests there may be at least one more ordeal to overcome before the world economy and financial markets arrive at the bullish promised land of a “Goldilocks economy”: growth that’s just right, neither too weak nor too strong.
It’s pretty clear now that the world economy is entering a period of slowing growth; what’s unclear is whether inflation has been brought under control.
But stock market investors around the world seem a lot more confident than they were two months ago. Have the fears of recession and inflation that dogged financial markets in the early summer simply disappeared?
The US economy could come in for a soft landing after its housing boom. But it’s a huge economy and may not enjoy a boost from global growth other countries enjoyed when their respective housing booms slowed. And US inflation is still running a little hotter than is comfortable for most observers. As a result, the Federal Reserve may be unable to support the economy with monetary easing. If it does, inflation could accelerate even further, undermining the credibility of the Fed and the dollar and threatening the combination of stagnation and inflation last experienced in the late 1970s.
Nearly all the greatest financial accidents–the Wall Street crashes of 1929 and 1987, President Richard Nixon’s closure of the Bretton Woods gold window in 1971, the Asian currency crisis of 1997, the Mexican and Russian defaults, the attack on the French franc in 1993, the sterling devaluations of 1949, 1976 and 1992–have occurred between late August and October. If there’s going to be a financial accident of some kind on the way to the Goldilocks expansion, experience suggests it’s most likely to happen in the next two months.
But are there rational grounds to worry that the markets may now be entering the period of greatest risk? What forces might explain the seasonality of financial crises?
One possible explanation of late summer/early fall market weakness–supported by studies of monthly stock market returns–is that equity selling is partly a passive phenomenon because portfolios have to be liquidated when their owners die or retirement checks cashed or insurance claims made.
These liquidations happen steadily through the year, regardless of seasons. Buying, on the other hand, requires conscious decisions, and investors are less likely to make these when they and their brokers are vacationing. For institutional investors, low liquidity in the summer also deters big buying decisions.
Selling is often driven by stops or margin calls and can actually be accelerated by thin markets. And investors who feel worried during the summer but aren’t forced to close their positions often delay their selling decisions until liquidity returns in September.
As a result, stock markets in September and October can sometimes be dominated by a backlog of stale bulls trying to get out as liquidity improves–and becoming increasingly desperate if the improvement in liquidity is accompanied by a further fall in prices instead of the hoped-for bounce.
Most people naturally prefer to spend the summer thinking about their holidays rather than their portfolios. When the markets get back into full swing in the early fall, the backlog of delayed sell decisions creates huge pent-up pressure on any asset whose fundamentals have deteriorated during the summer.
Market seasonality doesn’t prove that a financial crisis will definitely hit this fall. It does suggest that the period of maximum risk for investors may not yet be behind us.
A Maturing Sector
Canadian income and royalty trusts haven’t hit a wall after a spectacular rise from obscurity that began early this decade. But they have lost the fizz that made them so popular with investors and the investment industry. Think of the income trust market of mid-2006 as a cool, calm and collected version of its former manic self.
The cumulative five-year gain for the S&P/TSX Capped Income Trust Index is 82 percent, while the S&P/TSX Composite Index gained 60 percent. In 2006, though, trusts are up almost 6 percent, well behind the 7.5 percent posted by the composite index.
After a strong rally through summer 2005, the market lost about CD23 billion in value as investors worried about the Canadian federal government’s review of the trust sector. Trusts later regained all the lost ground in a quick advance.
Since then, trusts have meandered without a storyline. They may well be boring, but that’s what happens when you grow up and take your place in society; in the investing world, that means joining a major stock index. A few months ago, the global stock-index minders at Morgan Stanley Capital International decided that trusts should be included in the MSCI Canada Index. That followed a decision last year by Standard & Poor’s to include trusts in the S&P/TSX index.
Trusts now account for a tenth of the value of the S&P/TSX index, a larger weighting than sectors like health care and information technology.
Another sign of the maturation of the trust market is that it’s a gross generalization to talk about trusts as a group. Energy trusts depend almost entirely on the outlook for oil prices, while business trusts are tied to the economy and pipeline and utility trusts to interest rates. Real estate investment trusts (REITs) are influenced a bit by rates and also by the economy.
It happens that all these influences are supportive for trusts when you look ahead. Interest rate increases in Canada and the US are on hold, and rates could head lower in the next 12 months if economic growth weakens. Oil prices have eased in recent days, but it’s hard to see a major decline unless slowing economies undermine demand.
Selling OffEnergy prices have continued to slide lower this week–oil to the USD65 per barrel range and natural gas to the USD5.50 per million British thermal units (MMBtu). And with flash points like Iran and hurricane season at least temporarily fading from view, they could well go lower in the coming days, as investors’ focus turns to the potential for a 2007 recession.
As I’ve said, major bull markets in commodities are typically riddled with severe downturns, before the upward momentum resumes. And with no real pause in the energy bull market for several years, we’ve arguably been long overdue for one.
With little or no conservation, limited switching to non-fossil fuel energy alternatives, no real “North Sea” discoveries of conventional oil and gas reserves and no severe recession on the horizon, nothing has changed in the long-term bullish picture for energy. And as long as that’s the case, selloffs will be short term in nature and always resolved on the upside.
That doesn’t mean, however, that we can’t see some quite vicious corrections that could shake a lot of people out of this market. And that’s a real possibility during the next few weeks and possibly months.
As I wrote in the September issue of Canadian Edge, we’re already seeing some heavy damage inflicted on individual Canadian royalty and income trusts. Worst hit have been smaller oil and gas producers and energy service trusts. But the pain is spreading to the stronger trusts, which are as yet well insulated from what’s going on now in the energy market.
The bad news is that things will very likely get worse before they get better. For one thing–as the September Dividend Watch List makes clear (see current issue)–I don’t believe we’ve seen all the dividend cuts we’re going to see in the natural gas-focused trusts. And if oil prices should break down to the USD50-a-barrel range, we’ll see the same at the smaller heretofore spared oil-reliant trusts. Dividend cuts always mean lower share prices, and the steeper the reduction, the greater the pain.
The good news: Trusts’ prices across the board have retreated to levels not seen in several months. In fact, high-quality trusts are almost universally pricing in far worse news than we’ve already seen. It may be a while before they return to the upside. But at least future downside should be limited. That appears to be especially true with the oil service trusts, which are being battered on the fear that Canada’s energy patch is about to go into full reverse despite continuing evidence of the precise opposite.
Best of all, trusts that have been trading well above reasonable prices are starting to come back into play. For example, Canadian Oil Sands Trust (COS.UN, COSWF) has now come nearly a third off its highs, while Enerplus (ERF.UN, NYSE: ERF) is off 20 percent. Both are still a bit too top heavy, but it won’t take too many more down days to make both very strong buys again for long-term investors.
Given the likelihood of more downside in the near term–i.e., still lower prices–I’m not going to get aggressive on oil and gas producer trusts at this time. A day of real opportunity to add to the Portfolios may be on the horizon, including for the high-quality trusts that have been out of reach for so long like Enerplus, Canadian Oil Sands and even Vermillion Energy (VET.UN, VETMF).
For now, however, the best idea is to stay conservative. That means holding onto trusts of the quality of ARC Energy (AET.UN, AETUF), for example, while limiting positions in the more-leveraged plays and keeping a strong base of trusts that have little or nothing to do with energy prices. Electric power and pipeline trusts and REITs are all holding their own, even as oil and gas producer trusts slide. So are a number of business trusts I continue to recommend.
For more on individual recommendations, see the How They Rate Table (www.canadianedge.com). The best buys in the September issue are still ARC Energy and RioCan REIT (REI.UN, RIOCF).