Tetrem comment Q3 2010 2
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Third Quarter 2010 Review The Canadian equity market surged 10.3% during the quarter ended September 30, setting new highs for 2010. The increase was broad-based, with nine of ten sectors rising. The materials sector led the advance, thanks to prospects for mergers and acquisitions and strong performance from base metals and gold producers. Investor interest in yield-generating investments pushed bond yields to multi-decade lows (See Chart 1) and helped generate outperformance among the traditionally defensive dividend-paying sectors, such as telecommunications, utilities, and consumer staples. Financials underperformed, primarily due to continued weakness among the life insurance companies. The only sector to fall in value, information technology, was driven lower by continued weakness in Research In Motion’s shares – which we continued to avoid. BHP Billiton’s unsolicited bid for Potash Corporation of Saskatchewan is a major development. We hold a substantial position in Potash Corp., which we began building during the market lows of 2009 at approximately $85. We are in the early stages of a global agricultural cycle that is expected to support multi-decade demand growth for fertilizers. Aside from population growth, developing economies face the challenges of shrinking arable land as cities and industries expand, and a rapidly growing middle class whose diet is changing in ways that require higher-intensity farming. Potash (the commodity) is ...
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Third Quarter 2010 Review
The Canadian equity market surged 10.3% during the quarter ended September 30, setting new highs for 2010. The increase was broadbased, with nine of ten sectors rising. The materials sector led the advance, thanks to prospects for mergers and acquisitions and strong performance from base metals and gold producers. Investor interest in yieldgenerating investments pushed bond yields to multidecade lows (See Chart 1) and helped generate outperformance among the traditionally defensive dividendpaying sectors, such as telecommunications, utilities, and consumer staples. Financials underperformed, primarily due to continued weakness among the life insurance companies. The only sector to fall in value, information technology, was driven lower by continued weakness in Research In Motion’s shares – which we continued to avoid. BHP Billiton’s unsolicited bid for Potash Corporation of Saskatchewan is a major development. We hold a substantial position in Potash Corp., which we began building during the market lows of 2009 at approximately $85. We are in the early stages of a global agricultural cycle that is expected to support multidecade demand growth for fertilizers. Aside from population growth, developing economies face the challenges of shrinking arable land as cities and industries expand, and a rapidly growing middle class whose diet is changing in ways that require higherintensity farming. Potash (the commodity) is required to meet these challenges, and Potash Corp.’s assets are world class and strategic in nature. We therefore believe that potential acquirers won’t let this rare opportunity pass them by – in other words, we expect a transaction to occur at a higher price than BPH’s US$130 a share offer, although it is possible that no deal closes if BHP stands firm. In the latter scenario, we would not be disappointed as we (and the market) believe the company is worth substantially more, and we didn’t buy the shares to flip them for a small shortterm profit. We think the bid for Potash Corp. presages further M&A activity in the politically safe, resourcerich Canadian market, which should act as a catalyst for higher equity valuation. Assuming Potash Corp is taken out, approximately 3% of the money invested in the TSX will need to find a new home. We believe investors will seek other resource companies with longlife assets, such as those tied to the oilsands. Our portfolio has significant exposure to such highquality companies, and we added to existing holdings such as uranium producer Cameco Corp. during the quarter. Our view is that commodity prices, though volatile in the short term, will be underpinned by global economic growth that requires increasing amounts of energy and materials. From a defensive perspective, these assets provide protection from inflation, which we believe will return during our investment horizon. The energy sector lagged the TSX during the quarter and we believe it is due to catch up. A big part of the problem has been low natural gas prices, which have traded under US$4 per million cubic feet (mmcf). This is below the commodity’s marginal cost of production, and also falls far below its normal relationship to crude oil. Crude now trades at approximately US$82 a barrel, or a 20:1 ratio to natural gas. On a “heat rate” basis, this ratio should be 6:1, which implies a price of $13 for natural gas, all else being 2 Queen Street East, Twentieth Floor, Toronto, Ontario M5C 3G7Iwww.ci.comHead Office / TorontoCalgary MontrealVancouver ClientServices 4163641145 40320543965148750090 6046813346English: 18005635181 18002689374 1800776902718002681602 18006656994French: 18006683528
Third Quarter 2010 Review
equal (which, admittedly, is rarely the case). We don’t see the ratio reverting to 6:1 any time soon, but even a partial return to a more normal relationship would send natural gas to much higher levels and lead to strong outperformance of companies levered to the commodity.There are several possible catalysts for natural gas to rise: continued economic growth accompanied by rising industrial production, continued switching away from coal and oil, or an unexpectedly cold winter. The timing is uncertain, but we view this outcome as highly probable and our portfolio is positioned for it, with exposure not only to producers such as EnCana and Talisman, but also to service companies such as Precision Drilling and Mullen Transportation. Corporations have cut costs and are holding on to their cash. Dividend yields are now at historically attractive levels relative to bond yields, and we are seeing companies start to raise their dividend payments – the Canadian banks are likely to be next. It is noteworthy that the market rose strongly in the third quarter while retail investors, in the aggregate, have been redeeming equities in favour of fixed income investments. Investor psychology follows a cycle, and when sentiment improves for equities, positive inflows will be a further catalyst for valuations to expand. On the flip side, we are concerned that the bond market could be in a bubble, and that investors are in for a rude shock if yields back up to more normal levels. In the heady bull market of the late 1990s, having a balanced portfolio implied adding bonds to an equitydominated portfolio; now it should mean that investors continue to hold equities, which are cheaper than bonds and provide a hedge against rising inflation and rising bond yields. As shown in Chart 2, the U.S. has a significant portion of its burgeoning debt to refinance in the next three years. Continued deficits mean that there will be incremental borrowing prospectively. The U.S. is taking a page from the Bear Sterns and Lehman Brothers book of balance sheet management, using short term debt to finance longterm liabilities. This works as long as you have willing lenders, but is a risky strategy as the debt burden grows. We are seeing lenders, such as China, show an inclination to diversify their reserves into other currencies and hard assets such as gold, which raises the possibility of them selling U.S. bonds or withholding purchases of more U.S. debt. It is not unreasonable to hypothesize that lenders will require a higher rate of interest in order to compensate for the risks of the government’s deteriorating balance sheet. The result would be rising yields and capital losses for bonds. Our message: now is not the time to dump equities in favour of bonds. On the contrary, investors who want to be ahead of the curve should give serious consideration to increasing their equity exposure. There has been a lot of talk about the possibility of the U.S. and Canadian economies experiencing a “doubledip” recession, with bears pointing to signs of slowing growth. Developed economies – particularly the U.S. – face some serious structural issues, such as ongoing deleveraging, that will act as headwinds to robust economic growth. We acknowledge there are risks, but we view continued expansion as the more likely scenario. A slowdown in the economy’s growth rate, as some of the recent data have shown, is a normal part of any recovery, and investors should not expect otherwise. However, we believe that positive corporate fundamentals, consisting of strong balance sheets, positive operating leverage and continued earnings gains, will lead to an improving trend in equity prices – but it will continue to be bumpy.
Third Quarter 2010 Review
20
16
12
8
4
Canada 10 + Year Yield
2.7 %
0 J ul56J ul62J ul68J ul74J ul8 0J ul8 6J ul92J ul98J ul0 4J ul10
Sour ce: RBC DominionSecur it ies Inc. A s ofSept ember 30 , 2 0 10 1 Chart1:Governmentbondyieldshavefallentotheirlowestlevelsinover50years,addingtotheappealofequities,especiallydividend‐payingequities.
Third Quarter 2010 Review
35% 30% 25% 20% 15% 10% 5% 0%
30.2%
012 M
Sour ce: St r at egas Resear ch Par t ner s A s ofOct ober 1, 2 0 10
U.S. Out st andi ng Sover ei gn Debt(by Mat uri t yTi mel i ne)
31.0%
13 YR
21.1%
47 YR
7.8%
810 YR
9.9%
10+ YR
2 Chart 2: A significant portion of U.S. government is being financed at shortterm maturities, despite the government’s massive longterm liabilities. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. This commentary is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities.
