Market Overview
Global economic weakness and deflationary forces were still at work in the first quarter of 2016. Volatility and uncertainty remained stubborn themes, with markets reacting to major central bank decisions and potential oil supply resolutions.
Global oil prices remained weak throughout the quarter, but rebounded from their lows. Oversupply continued to hamper price recovery, with the International Energy Agency (IEA) estimating that worldwide supply rose by 2.4% in 2015. OPEC showed no sign of cutting production by any meaningful amount, while the lifting of sanctions on Iran allows an additional supply to re-enter the market. Meanwhile, reports surfaced of strain within a number of oil-producing countries, including Russia, Venezuela and the Middle East.
The Canadian economy soldiered on, however, expanding 1.5% year over year in January with a surge of investor enthusiasm in defiance of more than a year of low oil prices and shrinking business investment. The 2016 Federal Budget was announced at the end of March, with the Liberal government expecting its two-phase infrastructure spending program to boost Canada’s GDP by 0.2% this year and 0.4% in 2017.
The theme of central bank intervention continued this quarter as a number of them implemented incrementally looser monetary policies which, in some cases, led to negative interest rates. Japan and Europe were among the most aggressive, expanding their quantitative easing programs and implementing even further negative deposit rates this quarter than they did last year. These actions followed persistently low inflation numbers and anemic growth, which continue to signal that the effectiveness of monetary policy may be nearing its end in some of these markets.
In China there remains overcapacity in a number of industries. While some economic releases at the end of the quarter were modestly positive, overall, the information we are getting out of the country is suggestive of difficult economic conditions. Many investors seem to concur that China’s near-term economic prospects look unwelcoming. Capital outflows have continued. During the quarter, China’s FX reserves fell, and ended the quarter at around $3.3 trillion, a significant decline from the $4 trillion of a year ago. According to Bloomberg News, Chinese companies have also canceled more than double the amount of bond offerings in March versus a year earlier--62 Chinese firms postponed or scrapped 44.8 billion ($7 billion) of planned notes last month.
In Europe, Italy reached an agreement with the European Commission on a rescue deal that will help domestic banks offload €200B of bad debt. These negotiations were small but important steps in helping to clean up some of Europe’s banks, many of which fall into what some are calling “zombie” banks–those that are insolvent but continue to operate through government support.
BREXIT grabbed headlines as the debate over whether Britain should leave the European Union gained traction as we move closer to the June 26th 2016 referendum. Support for BREXIT has climbed over the quarter, with roughly half the population supporting an exit according to recent polls. But at the time of this writing, telephone surveys indicated the “remain” side is leading. Many say it’s still too close to call. We expect volatility to remain elevated in relation to the referendum.
In the U.S., the Federal Reserve began to signal that it might take longer than previously anticipated to raise interest rates to more normalized levels. This shifting stance appears to be a result of unfavourable market conditions, weaker than expected overseas growth and an uncertain inflation outlook. The Fed highlighted that a strong US dollar was one of many reasons the U.S. may not have experienced as high inflation figures as would otherwise be anticipated.
Overall, this past quarter saw low inflation in the developed world, escalating private sector debt in emerging markets and weak business investment all around.
How did we do?
(All performance is expressed in Canadian dollars and net of fees.)
Where 2015 closed with broad strength in international equities, weakness in energy, and a continued decline in the Canadian Dollar, the first quarter of 2016 was a bit of a mirror image. Worries over slowing global growth, geopolitical events and a bounce in oil prices added up to challenging conditions. The Canadian Dollar figured prominently again but reversed from a tailwind (i.e., the CAD depreciated against major currencies) to a near-term headwind against most major currencies, particularly against the U.S. Dollar – rising over 12% from the January 20th bottom of 69 cents per USD.
Despite the challenging conditions, Mawer’s funds performed well with eight out of ten beating their respective benchmark returns. The Mawer Balanced Fund fell by a marginal 0.9% this quarter, better than the 1.2% decline of its benchmark. Canadian equities and bonds were positive contributors to performance with bonds contributing most and helping to mitigate stock volatility. Non-Canadian equity funds (save the Mawer Global Small Cap Fund) posted positive returns in local currency terms but none were able to offset the full force of the relatively quick advance of the Canadian Dollar. Broad benchmark outperformance was driven primarily by stock selection and ensuring diversity across currencies within portfolios.
This is most evident in the Mawer Global Balanced fund, which posted a 2.5% decline against a benchmark decline of 4.1%.
Chart A - Q1 2016 Fund Performance relative to Index (C$)
The Mawer International Equity Fund dropped by 3.4%, beating the 9.7% decline of the MSCI EAFE Index (net) benchmark. Stock selection was the primary factor leading to relative outperformance. Meda AB, a Swedish pharmaceuticals company that received a takeover offer from Mylan (MYL, Financial) rose 36.6% to lead performance contribution. Next highest contribution came from Markit Ltd. which rose 9.1% after an agreed merger with IHS Inc. (IHS, Financial), a financial data services competitor.
The Mawer U.S. Equity Fund dropped 4.2% compared to a drop of 5.6% in the S&P 500 Index. The top contributor to quarterly performance was World Fuel Services, an aviation, marine and transportation fuel services company, up 17.8%. Next highest performance contribution came from consumer household goods producer Whirlpool, up 15%.
The Mawer Global Equity Fund dropped 4.6% in the first quarter, beating the benchmark MSCI World Index (net) which dropped 7.2%. Stock selection was the primary driver of relative outperformance, led by the performance of the Fund’s holdings in Financials. Markit Ltd. (see International Equity Fund above) was the top contributor to performance while U.S. communications company Verizon Communications Inc. was next in line, rising 18.5% in U.S. dollar terms and 10.3% in Canadian dollars.
The Mawer Global Small Cap Fund fell 6.3% in the quarter, better than the 6.9% retreat of the Russell Global Small Cap Index. Small cap stocks felt more of the pain of the quarter’s volatility due to investor preference for the liquidity and perceived safety of larger cap stocks. With cash to deploy in times of volatility, the Mawer Global Small Cap Fund is positioned to take advantage when we see attractive opportunities. The primary source of outperformance for the Fund was its relative underweight to the poorest performing sector, Healthcare, which was down 17.4% in the quarter versus a high single digit gain for the Fund’s holdings. Top performance contributors during the quarter were Canadian alternative mortgage lender Home Capital Group Inc. (TSX:HGC, Financial) (up 31.2%) and Swedish medical equipment company AddLife (spinoff from AddTech) executing a strategic growth transaction that provided 146% return to AddLife shares.
The Mawer Canadian Equity Fund (Trades, Portfolio) posted a strong 3.8% return for the quarter but was behind the S&P/TSX Composite Index return of 4.5%. The relative underperformance can be attributed to overall stock selection, combined with an underweight position in the commodity sectors (Energy and Materials) as investors drove those sectors higher on a rebound in gold prices and anticipation of an oil price recovery. This was partially offset by the Fund’s 0% exposure to Healthcare, the benchmark’s poorest performing sector which was dragged down by Valeant (VRX, Financial). Top performance contributions came from global cheese & dairy company Saputo (TSX:SAP, Financial), up 26.2% and Bank of Nova Scotia, up 13.4%.
The Mawer New Canada Fund (Trades, Portfolio) posted positive performance of 2.0% but was behind the 7.7% return of the BMO Small Cap Index. The index moved higher during the quarter on strength from a number of highly leveraged commodity related companies, which are not part of our portfolio. This is better exemplified by the strength seen in the Materials sector (a sector where we are underweight) which was up over 22% on strength from a number of small-cap Gold and Precious Metals stocks (stocks we do not own). Top performance in the quarter came from the strong recovery in Home Capital Group shares (+31.2%) and strong performance from bus manufacturer New Flyer Industries (TSX:NFI, Financial), up 18.6%.
The Mawer Canadian Bond Fund rose 1.5%, exceeding the 1.4% gain of the FTSE TMX Canada Universe Bond Index. A focus on high-quality corporate issues and patience in seeing some opportunistic trading results were reasons for outperformance. Bond performance offset the mostly negative returns from equities in many balanced portfolios – this positive effect of diversification is a key example of why we believe it is important to hold bonds in balanced portfolios. Top performance came mainly from Government of Canada bonds given investor appetite for safety and the inaugural Liberal government budget.
Looking Ahead
Despite ongoing central bank interventions, the global economy may remain in a slow growth environment for some time to come. The main possible exception could be the U.S., where there appears to be a better balance of economic growth, inflationary conditions and rate normalization.
The overarching rationale for the loose monetary policy that we see across a number of advanced economies is to stimulate growth and achieve target levels of inflation. By driving down interest rates, central banks are hoping to encourage consumers and businesses to borrow and spend more. In simple terms, cheap credit = more investment = more jobs = more growth = inflation at targeted levels. Central bankers are pulling on the credit lever in the economy.
The problem is that for the most part we aren’t seeing the desired outcomes. Economic growth is not accelerating, credit expansion is limited to central bank balance sheets, and inflation is sporadic at best. The outcome we can point to with some conviction is that the prices of financial assets have soared.
Just how full or expensive equity valuations may be depends on how long interest rates remain at these low levels. If we sound like a broken record here, it’s because the needle on the global economy has been stuck in the same groove for some time now. As interest rates have fallen, asset prices have gone higher. Without incremental growth, we receive a decreasing margin of safety and tend to be cautious about valuations. Disinflationary forces and the actions of central banks continue to imply that this scenario could linger on longer than previously anticipated.
While low interest rates may be the only tenable policy option for Japan and Europe right now, the logic of applying additional stimulus seems questionable. When a person gets into a bad car accident, it is reasonable for the doctor to put the patient on morphine to get them through the most painful moments of healing. But after the initial healing has occurred, injecting further morphine is not going to help in the recovery process–furthermore, it risks turning the patient into an addict. Quantitative easing, negative interest rates…these experiments have a low probability of driving desired outcomes if the credit lever in these economies is already pulled to the limit.
In our view, loose monetary policy increases the probability of capital misallocation. The longer it goes on, the more likely investors and companies are to misallocate capital. We see signs of this happening in the current environment: companies appear willing to pay more for acquisition targets, many companies are increasing their total leverage, and investors seem willing to accept poorer credit standards on corporate bonds (i.e., covenants are getting weaker).
Maybe central bankers have it right and growth and inflation do return. Or maybe, these policies amount simply to “pushing on a string” and end up only supporting asset prices. Either way, we believe portfolios need to be positioned to put the odds of success in our clients’ favour regardless of the outcome of these unknowns. So until the broken record skips forward we’ll keep in harmony with the tune we know best by maintaining our strategy of building diversified portfolios that will be resilient regardless of where the needle bounces.
