It seemed all might be lost. Around 1 p.m. on Aug. 16, all the worries weighing on markets coalesced into a moment of unadulterated panic. “It was scary,” says Peter Hodson, fund manager with Sprott Asset Management Inc., in Toronto. “Market psychology shifted, and the focus on fundamentals gave way to something else.” Everything was getting dumped. “When you get a fear-induced sell-off and forced redemptions, fundamentals don’t matter,” says Hodson. “People do the stupidest things.”
Mass freak-outs are rare in capital markets. But something somewhere had to give. The U.S. sub-prime mortgage sector had been melting down for a year, and the defaults had finally filtered up to the institutions. Prevailing sentiment (hey, no risk!) in Canada and the States was destined to burn off. “Unfortunately, I’ve been around so long I’ve become blasé,” says Veronika Hirsch, chief investment officer with Toronto-based BluMont Capital Corp. “But it’s not fun whenever you’re at an inflection point.”
The upside? The meltdown cleared the way for equilibrium to emerge. “There is going to be volatility as the market figures out whether there is going to be a recession,” she says. “I think we should know by November.” This is good for investors. There is time yet to orient portfolios to new conditions. Will there be a blip in prices, then more gains? Or are we facing a recession? And what about that distant but plausible scenario, the meltdown?
To get a grip on where we’re headed, we asked the professionals whether we should expect a fast recovery, a moderate slowdown or total economic meltdown, and then asked them to provide picks based on those Green Light, Amber Light and Red Light scenarios. Here’s what they said.
Scenario One
GREEN LIGHT
“Empirically, we see little sign this is slowing anything globally,” says Scott Baker, the founder and president of Toronto-based S. D. Baker & Associates Inc. His take is a popular one. Many believe the current crisis is a mid-cycle correction, on the way to new gains in stock markets. Hodson thinks markets could pop in the months ahead. He spent “a lot of money” on Aug. 16 buying panic-cheapened stocks, and he’ll be watching earnings closely to see if that was a wise move. “The market is starting to assume the worst,” he says. “If Q3 earnings are better than expected, that could paint a good picture. Anything other than doomsday is going to be good.”
Beata Caranci, director of economic forecasting at TD Economics, thinks North American stock markets could stabilize in the fall, and that the United States should avoid a recession for the next couple of years. Key to her outlook are expected rate cuts from the U.S. Federal Reserve, which should ease concerns about liquidity. And the financial markets just aren’t showing the telltale signs of an upcoming American recession. “We saw the original pullbacks in stocks, but haven’t seen cascading markets by any means,” she says. “The yield curve on U.S. Treasury bonds was inverted for quite a while, but when all of this turmoil happened, it actually self-corrected.” (An inverted yield curve often precedes a recession.)
Still, she would like to see the spread narrow between asset-backed commercial paper and U.S. government bonds, and between BBB-rated U.S. corporate bonds and Treasuries. “That would be an indication there’s not only more liquidity in the market,” she says, “but also greater market confidence in those instruments.” Caranci does believe the U.S. economy will feel the effects of its housing and credit-crunch problems, and expects GDP growth to slow to an annualized 2% in the back half of 2007. Because of pent-up consumer demand, wage growth and historically low unemployment, that will rise to 2.4% next year. All in all, Caranci puts the odds of a U.S. recession at one in four.
At RBC Financial Group, assistant chief economist Paul Ferley takes a similar view. “Our base-case scenario is a 50-basis-point cut by the Fed near term,” he says. “We see the credit crunch easing through ’07. But in 2008 the Fed will refocus once again on inflation. That will see rates rise again by 50 basis points and then hike another 25 basis points by the middle of next year.”
That the Fed will do what it takes to keep the economy running is a solid assumption, says Baker. “Whenever you get something like this, the big fear is this debt super-cycle comes to an end,” he says. Some $5 trillion in U.S. currency is held outside the country, and Fed chairman Ben Bernanke, of course, is aware of the risks — he is motivated to avoid a major slowdown of the U.S. economy. “Who wants to be the guy who ushers in the Day of Reckoning on the U.S. dollar?” asks Baker.
Bob Gorman, chief portfolio strategist at TD Waterhouse, also has a relatively upbeat outlook. He believes Canadian equities will return high single digits this year, and U.S. ones will do equally well — if not better. But over the next few years, Gorman believes, certain sectors will outperform others. In Canada, he expects non-cyclical companies will shine more than cyclicals, which have enjoyed a long run. That’s one reason he likes Shoppers Drug Mart Corp. (TSX: SC). Gorman says the Toronto-based retailer, which boasts more than 1,000 stores across the country has shown a knack for growing sales and earnings. What’s more, its stock price barely budged during the recent volatility. “The stock never looks cheap on a P/E multiple basis, but people will pay for consistent sales and earnings growth,” he says. Gorman likes Tim Hortons (TSX: THI) for similar reasons. South of the border, he says, “big caps are the place to be.” As the U.S. economy slows, earnings growth will be harder to achieve, and investors will favour companies that deliver consistent results. Gorman particularly likes Microsoft (Nasdaq: MSFT) and Cisco (Nasdaq: CSCO), two big tech companies that look reasonably priced.
Hodson likes tech, too: “The corporate spending cycle is different than the consumer spending cycle. Seven years after Y2K, everyone needs to replace their technology. It’s time to upgrade.” He also thinks resource stocks — cyclical though they are — might be a good place to be. Forced selling has left deals on the table in the commodity and resource sectors. Quadra Mining Ltd. (TSX: QUA) is one stock he thinks will do well. “They’ve got cash on the balance sheet and that’s good,” Hodson says. “If you’re a mining company and you haven’t raised the $500 million you need to build a mine, it’s going to be harder to do that now. I’ve always liked companies that don’t need money.” Baker mentions Skye Resources Inc. (TSX: SKR). “We think ultimately it will be bought out,” he says. “It’s a world-class nickel mine.”
Scenario Two
AMBER LIGHT
If there is a consensus among managers, it’s this: The mortgage debacle in the States has to affect consumer spending. If U.S. home prices dip, the average American is going to feel poorer. “As mortgages default, consumers could get hurt,” says Hirsch. “If that spills into the retail markets, it could hurt industry. The consumer will slow down.” She isn’t predicting a meltdown, just a significant slowdown in U.S. economic activity, which suggests investors will want to be cautious.
William MacLachlan, chairman of Calgary-based Mawer Investment Management Ltd., says he’ll be watching for signs of a slowdown in U.S. consumer spending and a sharp increase in house foreclosures, especially at the end of this year and the beginning of ’08, as a tremendous number of mortgages are going to reset. U.S. employment data and retail sales data will help identify the onset of a recession; pending home sales and consumer confidence figures could also be a good gauge of the likelihood of a slowdown. (Caranci also likes the Fed’s “Beige Book,” which shows anecdotal evidence of how consumers and businesses are faring, as a helpful gauge of the future strength of the economy.)
If MacLachlan sees a recession on the horizon, he’ll avoid Canadian or U.S. companies in the basic materials and energy sectors, since a contraction in the U.S. economy would hurt commodity prices. He’d also steer clear of such pricey stocks as Research In Motion (TSX: RIM) and Google (Nasdaq: GOOG). Businesses struggle to meet growth expectations in a difficult economic environment and investors reprice risk, he explains, and since these two tech darlings have “fat valuations,” MacLachlan says, they have plenty of room to fall.
So where would MacLachlan park his money? Unloved companies with low P/Es that compete in businesses less sensitive to the U.S. economy, such as grocer Loblaw Cos. Ltd. (TSX: L), data provider Thomson Corp. (TSX: TOC) and Richelieu Hardware Ltd. (TSX: RCH). And there’s always the Big Five banks — which have had a good run but also have a solid history of uninterrupted and increasing dividends. After the tax credit, a 4% yield on a financial institution stock such as Bank of Montreal (TSX: BMO) is equal to a bond that yields 6%.
Thomas Caldwell, chairman and founder of Caldwell Financial Ltd., likes the banks, too. “For me, it’s about going back to basics,” he says. “When I don’t know what to do, I go back to dividend yield.” The Big Five trade at P/Es below the market, yet boast returns on equity generally in the mid-teens. MacLachlan says the banks have written off some of their exposure to sub-prime mortgages, and he doesn’t expect their holdings in asset-backed securities will cause their stock prices to tumble. Both UBS and RBC have released reports suggesting Canadian financials are a safe place to be.
As for Hirsch, she’ll be watching what happens in China. America has long been the world’s economic engine; where it goes, so does the world. But Hirsch suggests that historical pattern may not apply: “America has been the world’s economic engine for so long, but the growth we’ve seen in Asia, South America and Russia sees those countries poised to act. It could be different this time around. This might be the first time in history that we have a U.S. slowdown but a booming China, Europe and the rest of the world.”
If China slows, Hirsch recommends getting defensive with health and consumer staple stocks. Like Gorman, she thinks Shoppers is a solid Canadian defensive equity. If China does not slow, Hirsch suggests sticking with resource plays. “There will be a big difference in how you build your portfolio, depending on how the world economy goes,” she says.
Another fund manager keeping a close eye on the global story is David Burrows, the president of Barometer Capital Management Inc. (formerly Rockwater). Burrows looks to credit markets for validation of his calls. Much has been made of the spread between inter-bank interest rates and the Fed funds rate — which are normally strongly correlated but have been diverging. “The banks don’t trust each other right now,” says Burrows. “But spreads between corporate bonds and U.S. government bonds have narrowed.” What does that say? There is less concern than you might think about corporate credit quality. “The market is saying this [crisis] is contained to financials and consumers in the U.S., but that the global market is okay,” Burrows explains.
Many large-cap U.S. companies derive a much larger share of earnings from outside the States than they have before. “They keep hitting new highs,” says Burrrows. “Cisco and IBM are up. The market is saying, Play the globe — not the U.S.” He worries that Canadians’ love of domestic financial services firms will leave them badly positioned to take advantage. “What we’re seeing is different than anything we’ve seen over the last 20 years,” he says.
By contrast, Burrows’s firm has been buying very large-cap global growth stocks in agriculture, telecom, global tech, energy and infrastructure. In the ag sector, he likes Monsanto (NYSE: MON), Bunge (NYSE: BG), Deere & Co. (NYSE: DE), the Mosaic Co. (NYSE: MOS), and the Saskatchewan Wheat Pool (TSX: SWP), which has just become Viterra because of a merger. In infrastructure, Barometer has been buying General Electric (NYSE: GE), Foster Wheeler (NYSE: FWLT) and SNC-Lavalin (TSX: SNC). In telecom: Telefonica (NYSE: TEF), France Telecom (NYSE: FTE), Vodafone Group (NYSE: VOD) and Vimpel Communications (NYSE: VIP), a US$27-billion company that has more than 50% of the telecom business in eastern Europe. “There is little exposure to the purely domestic U.S. economy here,” says Burrows. “These are huge global giants that service the world and would benefit from a lower U.S. dollar.”
Many expected the price of oil to sell off on fears of a U.S. recession, but that hasn’t happened. Fears about supply have trumped fears of a recession, and money managers are taking advantage of that by flocking to oil. “The demand out of Asia continues to grow, and there are no new big fields being found,” says Baker. So “EnCana (TSX: ECA) is probably a decent investment.” He also likes Petrobank Energy and Resources (TSX: PBG). The company’s much-discussed new technology — toe-to-heel air injection — promises to control the high costs of oilsands mining. Baker also mentions Schlumberger Ltd. (NYSE: SLB), an oil services company. The fact that oil and gas assets are increasingly locked up by big nationalized oil companies, such as Venezuela’s PDVSA, Saudi Aramco and the National Iranian Oil Co., spells trouble for the big guys like Exxon and BP, but for oil service companies it’s business as usual. “Because they don’t own assets,the oil service companies are not threatening to governments, and that can get them into these places,” says Baker.
Scenario Three
RED LIGHT
We might actually be on track for a severe downturn. Sure, the chances look slim, but many have been intrigued by what American economist Martin Feldstein had to say at the annual Federal Reserve–sponsored conference in Jackson Hole, Wyo. He said he was concerned that an expected sharp decline in house prices could lead to a wide recession. Historically, major falls in home building are usually followed by recessions. “Since housing wealth is now about $21 trillion, even a 20% nominal decline would cut wealth by some $4 trillion and might cut consumer spending by $200 billion, or about 1.5% of GDP,” said Feldstein. “The multiplier consequences of this could easily push the economy into recession.” Is this already happening? U.S. retail sales were up by a weak 0.3% in August. Excluding the 2.8% increase in motor vehicle sales in August, retail sales actually fell 0.4% that month.
So what to do if a slowdown in the United States becomes a full-blown recession that goes global? Gold has always represented basic, fungible value in times of stress, and is now retesting highs it hit a year ago after a 12-year swoon. “These are signs new legs are breaking out in that market,” Burrows says.
If U.S. housing prices, consumer demand and confidence continue to trend lower, watch for markets to get extremely defensive. “[You would] start to see a lot of risk aversion by investors and flights to quality, meaning movements toward bonds, money markets and cash,” says Caranci. Ironically, that reaction might cause the greenback to appreciate, since some will flock to the perceived safety of U.S. Treasury bonds, she adds.
Then again, the Fed would likely cut rates to pull the United States out of a recession, and that could cause the greenback to depreciate against the loonie. MacLachlan would choose Canadian or euro-denominated government bonds as safe havens, if faced with an impending global slowdown. He’ll also watch spreads between corporate and government bonds, which widen during recession. He would switch to corporates from government bonds to improve returns, when the spread warranted the risk.
Fleeing to Canadian or euro bonds carries risk, too. “There really is no asset class that competes with stocks on a long-term basis,” says David Rea, chairman of Davis-Rea Ltd. Investment Counsel. If you leave equities and a slowdown is short, he says, you could miss the next bull run — and get hurt by capital gains taxes and transaction costs. “For a well-diversified portfolio that has quality stocks and bonds,” Rea insists, “you stay with it.”
