Knowledge Centre Archive
First Quarter 2012 Market Update
Since the beginning of the year, equity markets around the world have rallied strongly at the expense of the overvalued bond market. Two factors seem to have driven this improvement in risk appetite. First, the European Central Bank (ECB) opened up the policy toolkit when it introduced the Long-Term Refinancing Operation (LTRO), injecting monetary stimulus and liquidity into European banks. This ultimately tamed yields on troubled sovereign debt. Second, U.S. macroeconomic data improved, convincing investors that the U.S. may be able to lead a global recovery.
The rally in risk assets, combined with the liquidity support provided to the market by central banks, has acted to depress volatility. Investors have been appeased so far in 2012 as central banks in the U.S., Europe and Asia stepped in to increase the speed of the recovery by providing cheap money. The U.S. Federal Reserve (Fed) has pledged to keep its interest rate target near zero through at least late 2014, while the ECB has lent banks more than $1 trillion of three-year loans through the LTRO. The Bank of Japan unexpectedly added 10 trillion yen ($120 billion) to an asset-purchase program in February as well.
The Canadian equity market continued its recovery from the October lows of last year by contributing 4.4% during the first quarter. While most markets outside of Canada rallied more aggressively on the backs of positive results for bank stress tests and a rediscovery of dividend payers and share buybacks, the strongest results were contained within the Financial, Consumer Discretionary and Information Technology (IT) sectors. In Canada, both Consumer and IT have narrow constituencies; thus, participation in this theme was limited.
Statistics Canada reported that Canada’s gross domestic product (GDP) came in at a modest 0.1% in January, after rising to 0.5% in December. This figure was in line with economists’ expectations, as earlier data showed manufacturing shipments and exports had been faltering. Manufacturing and Utilities performed strongly in an otherwise weak Canadian economy. The Manufacturing sector rose 0.7%, its fifth straight advance, while the Utilities sector rose 1.1% as the colder January increased demand for electricity.
Mergers and acquisitions were buoyant during the quarter. Of the deals announced, some of the more noteworthy included Glencore International, the largest publicly traded commodity supplier, agreeing to buy Viterra for C$6.1 billion. Glencore agreed to the deal in partnership with Agrium and Richardson International, which will buy the majority of Viterra’s Canadian and other assets for about C$2.6 billion. The bid was a 48% premium to Viterra’s closing price of C$10.98 in early March. On the small-cap side, semiconductor producer Gennum agreed to the offer forwarded by Semtech Corporation, and Pan American Silver Corp acquired Minefinders Corporation for C$1.5 billion.
Banks have substantially outperformed the broader market year to date, although they have lagged the higher-beta U.S. bank stocks. Banking earnings in the first quarter were better than expected, increasing 2% year over year. Earnings growth was led by National Bank, TD, BMO and BNS at 8%, 7%, 7% and 4%, respectively. Despite another challenging quarter for the banks, their profitability levels remain extremely strong, with a return on equity of 18.8%. Strong profitability was reaffirmed this quarter by TD, Royal Bank and BNS increasing their dividends by 6%.
Eight of the ten sectors contributed positive performance during the quarter; the Utilities and Energy sectors lost 0.9% and 0.5%, respectively. The strongest sector performers included Health Care (+15.7%), Consumer Discretionary (+14.0%), Financials (+11.0%) and IT (+7.8%). The two most volatile sectors in Canada, Energy and Materials, both lagged the recovery this year as investors remain concerned about growth in China and its potential impact on global commodity prices.
Canadian Fixed Income
The current year began with a lingering hangover from 2011, in which non-domestic events continued to dominate the direction and performance of Canadian bond markets. Domestic market volatility remained driven largely by persistent concerns over the European sovereign debt crisis and the viability of a proposed restructuring plan for Greek debt. By the end of the first quarter, The DEX Universe Index (the Index) slid into modestly negative territory, generating a loss of 0.2%.
Throughout the quarter, politicians and authorities feverishly pushed for a successful restructuring of Greek debt. During these negotiations, however, several credit rating agencies further downgraded the credit quality of Greek debt toward the lower rankings within junk status. By late February, a deal was struck to convert €206 billion of bonds held by the private sector to new bonds with a face amount equal to 31.5% of their original face amount. This allowed the European Union, ECB and International Monetary Fund to approve a second financial lifeline worth €130 billion. Within days, record numbers of borrowers flocked to the ECB, which made loans worth nearly €530 billion to over 800 European financial institutions to replenish bank capital reserves and maintain systemic stability. By the end of the quarter, however, Greece became the first eurozone member to officially be rated in default, just 13 years after the adoption of the common currency. Standard & Poor's cut Greece's long-term credit rating to selective default from double-C, supporting a decision by the International Swap Dealers Association to recognize the bond writedowns as a trigger event for payments under credit default swap agreements. By early March, holders of credit protection received payments totaling $2.5 billion, or approximately 78.5 cents on the dollar, given that the total notional amount of outstanding credit default swaps was $3.2 billion.
With the European sovereign debt situation resolved for the time being, investors’ interest in riskier assets was rekindled. This not only led to higher equity prices in general, but helped to lower risk premiums for corporate debt. In Canada, the average investment-grade corporate bond spread subsided from 172 basis points at the beginning of the year to 143 basis points by quarter end. This boosted returns from Canadian corporate bonds, which outpaced the Index by an average of 1.6% for the quarter.
In the U.S., the Russell 1000 Index increased by 12.9% in local currency during the quarter, while the smaller cap Russell 2000 Index increased by 12.4%. During the period, the U.S. dollar (USD) depreciated versus the Canadian dollar (CAD), losing 1.8%. Hence gains in USD terms were offset by translation losses. As a result, in Canadian dollar terms, both the Russell 1000 Index and the Russell 2000 Index gained 10.9% and 10.5%, respectively.
U.S. GDP was confirmed at 3% quarter over quarter in the fourth quarter, in line with expectations. Details signaled an upward revision in durable goods consumption versus a more modest pace in growth for services. The economy continued to expand at a moderate pace in the first quarter, and economists expect full-year GDP at 2%.
The U.S. Conference Board's Leading Economic Index (LEI) rose 0.7% in February, up for the fifth straight month and by the most in nearly a year. Economists expected a slightly smaller advance of 0.6%. Eight of the 10 LEI components made positive contributions to the Index, led by weekly jobless claims, the interest rate spread and stock prices. Initial unemployment insurance claims fell 5,000 to 348,000 towards the end of the quarter, its lowest level since March 2008.
U.S. equity markets have been re-rated, with a price-to-earnings multiple expanding from 11.7x at the start of 2012 to approximately 13.2x. Economic developments supporting a higher multiple included a series of positive macroeconomic data releases, most notably in the area of job creation. Payroll growth has averaged nearly 250,000 per month since December, the unemployment rate has declined to 8.3% and the four-week moving average of the initial unemployment claims data series has returned to its pre-crisis average.
U.S. financial stocks contributed strongly during the period, as investors embraced the release of bank stress test results. The Fed approved the capital plans of most banks in terms of proposed dividend hikes and share repurchases. Financials returned 19.9% for the quarter.
The MSCI EAFE Index (net of withholding taxes) increased by 8.9% in CAD during the quarter. Regionally, Western Europe increased by 8.7%, reflecting a modest improvement in the risk profile for European equities, while the Pacific Rim gained 9.3%.
Governments across Europe are planning deep spending cuts to reduce debt. The concern is that lower spending will slow down an economic recovery in Europe, which in turn could put a drag on other regions. On March 30, the new centre-right Spanish government unveiled its 2012 budget, which aimed to reduce the deficit to 5.3% of GDP after a large overshoot in the previous year’s deficit. The required spending cuts in 2012 compared with 2011 amount to a staggering €34 billion.
Across the wider eurozone region, the flash estimate of the March Purchasing Managers’ Index (PMI) survey came in notably lower than expected, with the composite output index falling for the second successive month from 49.3 to 48.7. The first quarter average stands at 49.2 after 50.2 in the fourth quarter, and suggests that eurozone economic activity continues to contract. However, the big picture still suggests that Germany is avoiding contraction, while French activity is flat.
The eurozone crisis has been in retreat since the introduction of the ECB’s LTRO in late December 2011. The LTRO has been used by European banks to top up higher-yielding sovereign debt. In the short term, this has reduced borrowing costs for the Italian and Spanish governments. But the LTROs have not magically reversed the fundamentals. Both countries will record appalling GDP figures over the next 12 months as the short-term effects of austerity measures and structural reforms take effect.
Emerging Markets Equities
The MSCI Emerging Markets Index increased 12.1% in CAD during the period. The best performing region was the Middle East (38.1%), followed by Eastern Europe (17.2%), Central Asia (17.8%) and South America (12.4%).
China's manufacturing activity rose to the highest level in the last twelve months following the Chinese New Year. The official PMI rose to 53.1 from 51 in February, due mostly to new orders. In China, there exists a seasonality whereby PMI tends to accelerate in March. However, economists widely expect the world's second largest economy to slow this year as export markets such as Europe and the United States suffer from falling demand. Last month, the government reduced its growth forecast to a target of 7.5%. China's economy grew 9.2% last year and 10.4% in 2010.
Investors believe that the Chinese government will still need to loosen credit this year to offset the economic slowdown. In February, the Chinese central bank cut the amount of cash banks must hold in reserve for the second time in three months. Policymakers are trying to increase lending and boost domestic consumption by focusing on growth, as inflation has come down significantly in China.
Equity markets have rallied in anticipation of stronger global demand and an end to the euro crisis. But the latest indicators for global industrial activity suggest that global demand remains subdued. Economic data has failed to keep pace with the improvement in market sentiment. Global trade and industrial production data have been decidedly weak. The most encouraging development for investors has been that the European economy seems to have stabilized following an extremely volatile year.
While the investment climate has improved, and stock valuations have increased from below fair value to a more normal valuation appropriate for the interest rate climate, it is important to remain cognizant of the investment risks investors have been exposed to over the last year. The return to global growth, while still underway, will be fraught with moments of uncertainty and perhaps high volatility. It is abundantly clear that investors need to embrace diversification and risk management. Analysts have cut 2012 revenue and earnings-per-share estimates across nearly all sectors during the past three months, and higher crude oil prices may start to pressure corporate profitability while income growth remains weak.
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