A “year of the commodities”

Quarterly Letter

As in 2004, this year has again been labelled a “year of the commodities” but with a lot more strength in stock prices, reflecting the massive price rise of oil, natural gas and other energy related resources.

The following table summarizes the price performance of the main indices for the 4th quarter and the year of 2005.

  4th Quarter Year 2005
  in local currency in Cdn dollars in local currency in Cdn dollars
S&P/TSX (Cdn) +2.36% +2.36% +21.91% +21.91%
S&P 500 (U.S.) +1.59% +1.50% +3.00% -0.42%
Nasdaq (U.S.) +2.49% +2.40% +1.37% -1.99%
Europe (Euro) +3.52% +1.91% +20.95% +2.23%
Nikkei (Japan) +18.69% +14.32% +40.24% +18.17%

Overall, the economic activity has been firm or improving in most parts of the world and inflation has been subdued.

After a long decline from 2002 to 2004, the US Dollar has strengthened in 2005 compared to most major currencies except the Canadian Loonie.

Gold has been the surprise in terms of performance. This phenomenon is unusual given that inflation is so low and the US Dollar was stronger than expected. The sharp run up in gold prices seems to be driven more by excessive liquidity and speculation than by fears of inflation.

The Canadian Dollar has been a pillar of strength thanks to our structural advantage, i.e. we are resource rich. This is likely to continue for the foreseeable future. Canada’s economy is growing at full capacity and job creation is strong. It also benefits from the twin fiscal and trade surpluses. Although we still see parity versus the US Dollar in the coming years, we do not believe it can be achieved over the short term. Its strength has already undermined the competitiveness of the Canadian manufacturing sector and the economy could turn for the worse if the exchange rate were to rise much further.


As investors, most of you might have read during the last month of 2005 numerous forecasts and comments by economists, analysts and/or investment strategists regarding the outlook of 2006. We would like to shed some light on several topics that have been mentioned as major concerns for the economy and the financial markets.

Inflation

Many investors wonder, with the rise in oil prices and other commodities, why inflation has been so tame.

Firstly, if we exclude food and energy prices from the inflation rate, a term known as core inflation, it continues to be low almost everywhere, including China. The key reason of this phenomenon is what economists call a supply-side shift in production of goods. In other words, as more and more of the worlds population (China, India, other Asian countries and some Eastern European countries) joins the work force and produces more goods and services, they boost economic activity while keeping prices down due to globalization.

Secondly, most manufacturing and production activities always move from high cost regions to low cost ones, again due to globalization. China seems to be the target for protectionism by most developed countries by being the manufacturer of the world but there is also a shift from Western Europe to Eastern Europe. The resulting effect is twofold: lower production costs and higher efficiencies.

Lastly, increased competition has forced companies to respond with sweeping measures to stay alive, let alone thrive, even in Japan and Europe. Layoffs and outsourcings might have undermined employment growth in those high cost regions but this is part of the creative destruction that is ultimately very positive for global economies. Meanwhile, with all the public outcry about layoffs and outsourcings, the unemployment rate is historically low and national income has risen in the US. It reminds us of the basic human behaviour that is so well exploited by politicians: if someone loses his job and two other people find one each, the economy has moved forward. But don’t ask the first one how he feels about losing his job.

Budget deficit, trade deficit in the US

Massive government spending and trade imbalances have created the biggest twin deficits in the history of the US that are financed by foreigners buying US Treasuries. What if the Chinese and Japanese decide to sell their US Dollars reserves? The Dollar would plunge, interest rates would skyrocket and the US economy would enter a deep recession … so goes the rhetoric of the doomsayers.

This is of course is a major concern. The key is to know if and when it might occur. While these deficits cannot persist forever, they can be sustained for long periods of time.

It is in nobody’s interest to trigger a US recession, especially Asia, and this is why that regions’ central banks are quite prepared to be US Dollar buyers of last resort. However, that does not prevent the US currency from losing value, not unlike the period of 2002-2004. Going forward, as long as interest rates stay stable, their impact on financial markets will be limited.

How does this all play out over the long haul? Theoretically, it will all come to an end when it is no longer in the economic and/or political interests of Asian governments to continue to accept US Dollars in exchange for their goods. For now, it is not an issue since Asia, with its growing work force, needs to keep expanding to keep its population employed. Rising protectionism in the US could also be a catalyst for a crisis. Hence, the US unemployment rate is one indicator to watch closely. If the US starts losing more jobs than it creates, protectionism will come to the forefront of politicians’ agenda and this could become problematic to maintain the status quo with Asian countries. However, a slow and steady upward revaluation of the RMB (Chinese currency) versus the US Dollar, should correct the situation.

Consumers’ debt, negative savings rate

The financial position of the US consumer has been the cause of concern for many years now. Yet, it has been an investor’s nightmare to bet against them. In reality, consumers are in much better shape than everyone seems to think.

It is only fair to look at both sides of the US consumers’ balance sheet in order to determine their financial health. The facts are as follows: despite an extremely high ratio of household debt as a % of income (121%), homeowners’ equity in real estate as a % of income is also at a historical high (120%). Moreover, net worth as a % of income is at 550%, surpassed only by the high tech bubble years (in 2000, it was over 600%). This is not to say that some consumers are not facing problems. It merely says that as a sector, consumers are not on the edge of a financial precipice unless the value of their main asset drops. (See “Housing Bubbles” below).

Concerning the negative savings rate, there is no doubt that it has fallen sharply in recent years to historical lows. However, it is also true that consumers have saved less of their income because they have seen their wealth increase in value over the last 25 years (with short periods of negative adjustments). If their value of assets stagnates, they will probably retrench and their savings rate will rise back to more normal levels. As long as real income keeps rising and employment keeps growing (which is the case now), there should not be a spending collapse, as some analysts have been predicting.

Housing bubbles …

History shows that in the US, national house prices have never suffered a year-onyear decline in NOMINAL TERMS since the Great Depression. Specific regions have experienced sharp declines at one time or another but national house prices in aggregate have never fallen since. However, a different outcome could arise if mortgage rates did spike up sharply. It is difficult for us to envision this scenario in the coming year since inflation remains subdued.


As for the stock market, let us reiterate that we do not believe anyone can forecast consistently and reliably. That of course does not prevent some brave people from trying, including us, in our spare time of course, knowing full well that it is an exercise in futility.

That being said, let us share with you some popular indicators frequently mentioned in the financial industry, so as to try to glimpse into the future.

  • We are in the 2nd year of a 4-year presidential cycle. Statistics show that the average annual return is 3.3% since 1888. The highest return was 45%, under president Eisenhower and the lowest was –29.7%, under President Nixon.

  • The annual return of the S&P 500 in 2004 was 9%.

    The annual return of the S&P 500 in 2005 was 3%.

    Based on the first statistic above, we should have another year of single-digit gains. However, 3 consecutive years of single-digit gains have never happened!

  • Mid-term years tend to be fairly neutral. However, they also tend to have weak first halves, culminating with a low in October and a strong year-end rally.

  • With the Federal Reserve raising short-term rates over the last year, one statistic we observe shows that after the last rate hike, markets tend to stay weak for the following 10 months on average.

  • As the Federal Reserve tightens, i.e. raises interest rates, it is important to watch the difference between short-term and long-term interest rates. Markets tend to turn sour if short-term rates are higher than long-term rates, creating what economists call an inverted yield curve.

As you read through the above section, let us remind you that THERE ARE LIES, DAMN LIES AND STATISTICS.

Claret Asset Management Corp.