To date this year, equity market performance in North America has been decidedly lackluster. During the first half of 2011, the TSX in Canada was essentially flat, while the S&P 500, in Canadian dollar terms, was up a modest 2.5%.
To paraphrase Yogi Berra, it’s déjà vu all over again, with the past two months being a replay of May and June, 2010. Negative sentiment in global equity markets has been fuelled by concerns of slower growth in China, financial contagion in the Euro zone, and the sustainability of the U.S. economic recovery. Given this rather familiar backdrop, it is instructive to recall that the second half of last year was characterized by strong stock market performance.
We do not believe there is cause for concern. Let’s address the negative sentiments first.
It appears that economic growth in China is slowing. This is not unwelcome. The moderation of growth helps control the pace of inflation and curbs the escalating price of resources, such as copper, coal and oil. Controlled and sustainable growth in China is preferable to the creation and subsequent destruction of a bubble scenario. With the interconnectivity of modern times, an economic meltdown in China would have negative consequences globally. Hence, the slowing of economic growth is, in our view, positive.
The European Union is a mess. The financial difficulties in countries such as Greece, Ireland and Portugal all point to a fundamental flaw in the Euro. While a common currency and economic union fosters trade through the removal of trade barriers and currency exchange, it does not provide the “escape valve” of currency devaluation for countries that cannot keep their financial houses in order. The long term success of the European Union is dependent on their ability to bring financial discipline to their weaker members. The will to accomplish this is evident amongst both the stronger and weaker countries in the union. While it will be messy, we believe that Europe is heading in the right direction.
There are renewed concerns about the sustainability of economic growth in the United States, and the possibility of heading towards a “double dip”. The Chairman of the U.S. Federal Reserve, Mr. Ben Bernanke, recently announced the central bank’s belief that U.S. growth was slowing, but also predicted that it was not expected to slip back into recession. There are several indications that the U.S. economy is continuing to struggle. Stubbornly high unemployment, coupled with record levels of government debt, continue to plague the economic environment. However, there are several positive indications, as well. For the first time in decades, consumer debt is falling. Individuals have backed away from the brink, and are beginning to pay down credit card and mortgage debt. Second, the United States continues to lead the world in innovation, and to export that innovation successfully around the world. This is particularly the case for technology. Third, a relatively low U.S. dollar is benefitting that country’s traditional export industries. While economic challenges remain for the U.S., we do believe that it will be a steady, if slow, recovery.
In our portfolios, we continue to emphasize the following themes: We believe that a historically strong Canadian dollar provides us with opportunities to buy into terrific companies both in the U.S. and abroad. As such, we have been building up our U.S. dollar denominated equities over the past year, rewarding our investors during the first half of 2011. Further, we believe an ongoing global economic expansion will continue to benefit resource commodities. We are thus emphasizing energy and base metal producers. Finally, we believe that technological innovation is the key to real value creation. Innovation can come in many guises. For example, it can help a company like Canadian National Railway run an ever more efficient operation, aid the energy industry to unlock previously unattainable reserves in tight rock reservoirs, or assist in the development of both the old world’s and the new world’s infrastructure. As always, we continue to favour investing in companies that generate strong and growing cash flows, and follow a disciplined approach to managing their free cash flows.