We have had another amazing year in the market, not all good and not all bad but overall pretty wild! With everything that happened in 2015 it's funny to sit back and watch, with two hours to go before the final closing bell of the year, the S&P is sitting at 2055.65, almost exactly the level it opened the year – of course the TSX didn't do so well, down 10% in local currency. Before discussing our approach to 2016, I wanted to discuss a few of the big drivers in 2015:
1. Energy prices sink again:
Q3/Q4 of 2014 was pretty horrible for the energy markets and expectations into 2015 were for a rebound.And while oil did rally back to $60 (-45% from the top) through June, USD strength and supply outstripping demand led to a second significant leg down, close to $34/bbl (another 45% down!) But, while the oil price collapse grabbed the headlines, the natural gas market in North America had its own collapse on the back of one of the warmest winters on record. By the end of the year, oil and natural gas fell 30% and 35% respectively. With well timed hedges behind them, a lot of precarious business models will have to be restructured or liquidated in 2016 without an oil price rebound.
2. High-yield (HY) bonds act like garbage:
After years of rates falling and spreads contracting, risk was again priced into the fixed-income market with high-yield bonds feeling the biggest impact: with nearly 20% of the index exposed to commodities, the collapse in prices hit the HY index hard. Into the beginning of 2015 there was not a lot of risk priced into this risky asset class, but with defaults starting to show up investors started liquidating holdings and we saw the asset class quickly re-priced. By the end of the year, the HY bond index had given up nearly 100% of all the returns it generated since the end of 2012. Clearly, the return junk bonds offered didn’t justify the risk you had to take on.
3. USD strength/CAD collapse:
After peaking well above par ($1.06) in 2011, the Canadian dollar had depreciated by nearly 20% through the end of 2014 leaving it at $0.86 CAD/USD. However, in 2015 the CAD fell another 16% leaving it very close to $0.70 CAD/USD, a level not seen in over a decade! USD exposure has been a great driver of performance over the last four and a half years, contributing nearly 9%/yr to the performance of USD assets. For those who had taken a USD position four years ago, this has been a great way to retain the value of your wealth while the CAD has declined, but from where we are today we don't believe the trend will continue to a great degree. Through 2015 we have increased our USD hedge and we will continue to do so for further strength.
4. Digital economy inflection point:
A lot has been written about the FANG’s (Facebook, Amazon, Netflix and Google) performance in 2015, with the four companies adding more than $400B to their combined market cap over the year and contributing the majority of the return for the S&P500. While this performance is shocking, it looks like we have fundamentally hit an inflection point for the digital economy, in many regards. Take the consumer discretionary sector, while it was the best performer in the U.S. stock market, performance was concentrated on a few winners, including AMZN, NLFX and SBUX (which introduced a new app that boosted sales). In fact, while the overall sector performance was positive for the year, the median stock return was -20%. The media space also saw an inflection, with online video consumption continuing its strong growth, causing weakness in TV and motion pictures (many films struggled at the box office). Video games is another area that has seen an inflection in digital monetization, driving increased profits for the publishers and difficulty for the retailers. Catching these inflection points can be very profitable for investors, both owning the winners and avoiding the losers. Focusing on the key drivers for businesses can help up figure out who the clear winners are and what exactly is priced in for the companies.
As you will note, the first three above are correlated – they really start with the USD strength. As we have discussed, strong USD tightens credit conditions in developing countries as access to cheap global credit disappears while having to rely on much higher domestic rates to fund their growth. Brazil is probably the best example we see of this today*. After a 25% rally in the DXY (trade weighted dollar) from early 2014 into 2015 global growth really slowed, lead by emerging markets, which drove commodities down and, in turn, industrial demand. This caught up with the bond market in the U.S. because of the high exposure to commodity companies – especially oil, gas and coal.
What will 2016 bring?
That is the $64,000 question. The pain inflicted in the HY market may just be starting with significant retail ownership now realizing that owning bonds doesn’t mean you won’t lose money. Over the last few months we have seen the HY market move from “sell what you want” to “sell what you can” with more indiscriminate pricing of securities. Today nearly 20% of the HY market trades below 80% of par vs. only 10% in early November. We continue to hold significant cash in our asset allocation and income fund’s bond allocation and we think continued patience will continue to pay off.
On the equity side, areas where we find the most opportunity today are related to the areas of the most pressure from the last 18 months: commodities, industrials and EM equities. Once again, patience is required with significant downside risk if credit markets, and inturn economic growth, doesn’t improve in developing countries (keep an eye on the DXY). There is also risk of a significant devaluation of the RMB, as we have been discussing for the last few years. Beyond these areas of the market where expectations are very low, we are finding companies with company specific drivers, be them inflection points as discussed above, or self help including M+A synergies. Our cash positions continue to be high and we are very diligent as to what price we are willing to pay for our businesses today, but just because the market overall is expensive doesn't mean there are opportunities for hard working stock pickers. As the saying goes, there is always a bull market somewhere!
To that point, we are fortunate that our process and philosophy has been reinforced over the last year and our team of investment professionals continue to work hard uncovering new potential investment opportunities. Our job for the year ahead will be to focus on the best opportunities, making sure we understand the risks involved and only buying when we are getting paid to take on the risk. Once again, patience is required with fundamentals still murky and valuations only fair overall.
Finally, I would like to say thank you to all our supporters for continuing to entrust us with your clients’ savings this year. This job is a privilege, one we don’t take lightly, and every day we are trying to improve so we can continue to deliver the results our clients deserve.
Thank you and happy holidays,
*Petrobras raised $10B in USD debt from 2011-mid 2015 at coupons of 5.5-7%, but with the collapse in energy and the Brazilian real the global market is closed to them. Overnight rates are 16% in Brazil with a spread required on top, so without significant government support they would see their cost of financing go up more than 300%.