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Stocks around the world fell in June as headline worries about the Greek debt crisis lead to some overall investor nervousness about possible ‘contagion effects’ from the potential default of over US$350 billion in debt. The S&P/TSX Composite Index fell over 3% in June as resource stocks lead the weakness in Canada while European stocks also entered ‘correction territory’ with the German index down another 4.1%. The bull market in Chinese stocks also hit a major road bump as the Shanghai Index fell by over 11% in June, more than 20% below the early June high, but still higher by over 26% in the first half of 2015. Utility and transport stocks continued to be the ‘weak sisters’ in the US stock market, with the Dow Jones Transport and Utilities indices down by 11.5% and 11.0%, respectively, so far in 2015. The resource sectors lead the downside in Canadian stocks as the Energy sector lost another 6.6% and the Basic Materials group slid 5.3% on weakness in base metals and gold stocks. Strong 2nd quarter bank earnings and positive results from the insurance stocks kept the losses in the heavyweight Financials sector to just 1.5%, while the ‘defensive’ Health Care, Telecom and Consumer Staples sectors all registered gains of under 1%.
Commodity prices were volatile but recovered slightly in June as the U.S. dollar pulled back from recent highs. The CRB Commodity Index jumped 1.8% in June on a 20% surge in corn prices and a 7% gain in natural gas. Base metal prices continued lower though on fears about slower growth in China. Aluminum, copper, nickel and zinc all had monthly losses in the 5% range. WTI oil prices also slipped back below US$60 on continued over-supply while gold prices continue to trade in a very tight range between US$1160-1200. Over in ‘bond land’, the FTSE Canadian Bond Index lost 0.56% in June as long-term bond yields followed global interest rates higher. U.S. 10-year yields rose from 2.12% to 2.34% while German 10-year yields jumped from 0.49% to 0.76%, after being as low as 0.18% only 3 months earlier. Investors are generally starting to see the likelihood that interest rates have seen their lows and that economic growth is improving.
Our investment strategy and outlook remain cautious. Central banks have ‘over-applied’ the medicine of zero/low interest rates with more success inflating the value of financial assets than stimulating global economic growth. Companies are eschewing real expansion in favour of stock buybacks and mergers, in many cases borrowing funds at low rates to do so. Average investors are being forced into riskier investments in order to receive a normal rate of return. Meanwhile the global economy is seeing few benefits from these low rates as consumers still paying down excessive debt loads instead of spending; US growth remains subdued compared to past recoveries due to the continued de-leveraging, the negative impact of stronger US dollar and low export growth. Europe is growing at only a 1.0-1.5% rate at best despite the Quantitative Easing, weak Euro and low oil prices. Chinese growth is deteriorating as it over-expanded capital spending after the 2008 financial crisis and now needs to push consumer spending as an offset. Despite weak growth, inflationary pressure could be starting to return due to rising wage growth and a lack of new spending which means that central banks are already ‘behind the curve’ and will need to raise rates. Earnings growth is slowing down as profit margins are already at all-time highs and revenue growth is coming down. Meanwhile, stock valuations are levels which were higher only during the ‘tech bubble.’ While low interest rates could keep stocks rising in the short-term, we see similar warning signs to what we saw in 1999 and 2007. Cash is not providing a strong return but it should prove to be a good source of capital preservation if other financial assets start to fall.
Corporate America has been on a spending spree since the financial crisis, paying ever-larger sums to shareholders via dividends and share repurchases. Cash returns to investors could hit $1 trillion this year, nearly equal to all of the operating earnings produced by S&P500 companies, according to Yardeni Research. While buybacks have the salutary effect of lifting earnings per share, and thus propelling stock prices, a growing chorus of critics has called the practice wasteful, if not a dangerous substitute for business investment. With interest rates approaching zero, returning excessive amounts of capital to investors—who will enjoy comparatively meager benefits from it in this environment—sends a discouraging message about a company’s ability to use its resources wisely and develop a coherent plan to create value over the long term. When companies borrow to fund buybacks, a trend encouraged by near-zero interest rates, the long-term ramifications could be even more painful. You’re basically robbing your future [through underinvestment], and you’re going to have a lower growth rate because of all this debt.
The chart below shows the quarterly amounts for dividends and stock buybacks in the U.S. over the last 10 years. Notice that these payouts peaked a few months before the market peak in early 2008 and have now moved back over those levels again in 4 of the past 5 quarters. Not only is this giving artificial support to stock prices, it diverts funds away from more productive uses for those same funds including adding capacity, expansion, increased employment or even just paying down debt or keeping extra liquidity available.
