One sector of the stock market that has been a relative underperformer over the past two years has been Energy, which has been a particular problem for the Canadian market where this sector represents almost 20% of the TSX Composite Index. But energy stocks are now as cheap as they have ever been in the last five years in comparison to the underlying price of commodities. While there may be limitations to further upside potential in the commodity, valuations in the energy sector have not reflected this latest rally. The oil surplus that started the downfall in late 2014 took eighteen months to reach its peak. With the cutbacks in both OPEC and non-OPEC production last year as well as continued growth in global demand for oil, it will have taken only nine months to bring that total surplus back down to the five-year average. The oil market should be in complete balance by spring 2018. The most important thing for Canadian investors to look at is the product mix of the energy companies they invest in. Natural gas prices continue to suffer from chronic over-supply and pipeline restrictions, so the companies that have a higher oil weight are preferred. But Canadian crude oil also tends to be a ‘heavier’ oil than in the U.S. and is therefore more expensive to refine and gets a discount to lighter oil. The Western Canadian Select price, which measure the difference between those grades of crude oil, has been getting an even wider discount over the past year due to pipeline restrictions which leave excess supplies unable to get to market. The widening in this spread to almost $30 per barrel basically offsets the gains in light oil (WTI) crude seen over the past few months. We are therefore more focused on Canadian companies that sell light oil into the U.S. market and have access to transportation. Encana and Crescent Point are two Canadian energy companies that are showing growth, have a proportionately higher weigh in oil versus gas and also produce lighter grades of oil.

The other part of the energy sector we like is the energy services group. With oil prices moving in the US$60-68 range so far this year, the producer group will have more cash flow available to them than they had budgeted for. For the more indebted companies, some of this windfall will be used to reduce debt. But for many of the more conservatively managed oil majors, these funds should find their way into larger exploration and development plays. We were on the quarterly conference calls with both Halliburton (HAL) and Schlumberger (SLB), the two largest oil service companies in the U.S, and both were extremely positive on the drilling outlook for the balance of this year. With the stocks still trading near cycle lows and valuations not reflecting any potential growth, we feel that the upside for this group is significant. Trinidad Drilling stands out in Canada as it moves its rigs into the highly productive Permian Basin in Texas. In the U.S. market, our best idea is the Vaneck Vectors Oil Service ETF (OIH), which is a portfolio of drilling and service stocks with Halliburton and Schlumberger being the two largest holding, making up over 36% of the ETF value. The risk with energy stocks and all other commodity stocks is the potential for a short-term increase in the value of the U.S. dollar based on a more ‘hawkish’ outlook on interest rates from new U.S. Fed Chairman Jerome Powell.

Canadian bank earnings also hit the tape in late February. The major banks all beat expectations, but this should not come as a surprise to anyone though since capital markets were extremely strong in the recent quarter (ending Jan 31st) and the economy was basically ‘booming’ here and in the US for most of last year. Better capital markets are always good for bank earnings as it bolsters their trading as well as wealth management businesses. But stronger economic growth also allowed banks to take down their loan provisions and that contributed to much of the ‘beat’ versus expectations. In some cases, we’ve even seen some loan losses reversed and booked into earnings. That’s an interesting way to generate profits! The bigger test for bank earnings will once again come when capital market gets tougher and/or economic growth slows down. The “rising tide lifts all ships” but when the ‘tide goes out’ we’re wondering where the earnings ‘beats’ will come from. With Canadian consumer debt at record levels, there is clearly downside risk from any deterioration in economic conditions. Within the group, we like CIBC here as it got an added shot in the arm in the quarter as its strategy to push back into the U.S. banking market through its US$5-billion purchase of Chicago-based PrivateBancorp Inc. began to pay off. It also trades at a significant discount to the rest of the group despite stronger earnings growth in the past few quarters.

Our overall strategy in the market remains cautious and has gotten even more defensive following the volatility last month. The stock market action of the past few months has the clear appearance of a ‘buying frenzy’ followed by a rounding top. We may bounce off those early February lows, but we just don’t see this as another ‘buy the dip’ opportunity. While the sharp downturn allowed us to add to some key growth positions at very depressed prices, we found ourselves selling many of those same positions (particularly in the financial and technology sectors) as the same stocks recovered to inflated values again much too quickly. Commodity stocks continued to be a disappointment as the stocks did not move higher when the underlying commodities increased in December/January, but they did fall in February as those same commodities gave back some of those gains. While they remain at historically low valuations, they do face some short-term headwinds as the U.S. dollar recovers from its most recent swoon. However, we still see the U.S. dollar heading into a longer-term downtrend due to its massive budget deficits and growing debts and the need to borrow internationally. It would not surprise us to see a downgrade of U.S. debt by the rating agencies if these deficits persist, which would further increase the cost of borrowing in the U.S. However, politics might get in the way of that. We would not expect to see Donald Trump take a debt downgrade quietly!

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