This is what the reforms are all about.  The ‘much-hyped’ increase in the reserve lending rate last month was designed to stop the ‘shadow-banking’ system from expanding.  The ‘shadow banking’ includes most of the non-traditional lenders who have been providing financing for some of the less financially stable projects, which need to be dialed back a bit.  Increasing the lending rates to that group was essentially the government’s way of slowing down the growth of those loans, much like the U.S. government should have controlled the excessive lending practices that lead to the housing collapse in the U.S.  The real policy target here is risk control.  It simply doesn’t want to see a full-fledged credit bubble due to rapid credit expansion.  This has negatively impacted growth in the short-term but will also make it more sustainable in the longer term.  China’s authorities, mindful of the risk of a sharp economic slowdown that could derail their reform efforts, sent their clearest signal yet that they will safeguard growth and tweak policy when necessary. The message from a meeting of China’s top decision-making body, the Politburo, sought to dispel market concerns about China’s near-term economic outlook by stressing stability of growth. The main economic planning agency followed with assurances that this year’s growth goal was safe and that the authorities would supply markets with relatively ample funding.” Reuters

If you buy the idea that China is indeed not heading into a serious growth slowdown, the overall picture for the global economy and the stock market is quite robust, particularly with the better data seen recently from Europe and Japan as well as the continued expansion in the U.S.  As mentioned earlier, the stock market seems to be sensing this turn in the global economy as the ‘cyclical’ stock groups have started to generate better performance over the past few months, with even the Canadian stock market started to act a bit better this month.  More importantly for the recovery story though, is the fact that the resource group has been one of the leaders in July, helped in large part by a ‘seasonal recovery’ in the gold sector, but also by strength in the energy stocks.  The chart below shows how the performance of ‘cyclical’ stock groups, such as resources, tends to mirror the moves in the global economic indicators.  Those stock groups had lagged the overall stock market over the past two years as slower growth in Europe and China kept down the global growth numbers despite the recovery in the U.S.  But after interest rates started to rise in mid-May and the defensive stocks started to falter, the cyclical stocks have taken over the stock market leadership.  While resource stocks have not exactly been ‘on fire’, the industrials, technology and energy sectors have shown the largest gains, suggesting that stock market investors are starting to ‘buy in’ on the global recovery story.

Cyclical and Resource Stocks set to Climb Higher

Canada has been one worst performing global markets, next to China and Brazil, over the past two years as resource-related markets have lagged.  The recent trend in leadership, if it holds, should favour Canada as well as the emerging markets.  Canada has also been held back by the relative under-performance of our banking sector, as many foreign investors believed that our housing market was on the verge of collapse and would hurt banks here much like they did the U.S. banks during the financial crisis.  We don’t expect any such outcome and believe that the analysis fails to take account of the difference in Canadian lending practices, the capital strength due to the concentration of our banking sector and the continued influx of foreign funds into our housing market.  PIMCO, the world’s largest bond fund, is also casting doubts on what investors have come to call the “Great White Short”.  It’s been a popular theme this year to bash Canadian assets.  “Based on our observations, bearish trades on Canada, commonly referred to as the ‘great white shorts,’ are gaining popularity among hedge funds and other investors as the U.S. economy picks up steam while Canada’s economy lags,” says PIMCO. ”Many investors are buying Canadian federal government bonds, shorting Canadian bank stocks and selling Canadian dollars in anticipation of a prolonged downturn.”  But PIMCO thinks the bearishness has gone too far and they don’t see deleveraging leading to any sort of recession in Canada, and certainly not a housing crash.  They make an interesting point that some of the homebuilding going on right now is compensating for underinvestment in housing seen in the 1990s and 2000s (when Canada’ population was growing just as quickly, but the economy was more stagnant, which resulted in fewer homes being built).

We had been adding to the bank stocks in June and continue to hold those positions.  We also had a position in the Canadian life insurance companies (specifically Manulife and SunLife Financial) but sold both recently as they reached our annual price targets.  Investors have become more enamoured with the lifecos as they benefit from stronger stock markets as well as rising interest rates.  But the lifecos did reduce their leverage to these variables over the past few years and their core businesses are not growing any more quickly than they were before.  Given that the lifecos have had a huge run-up in 2013 (we sold Manulife after a 34% gain so far this year), we believe that it is time to take profits and shift some of those funds into the bank stocks, particularly CIBC and ScotiaBank.

1 2 3