Caution advised for 2008
Ricky Wong, KRTA FINITE GAME: How long can China's labour and productivity offset input costs?
The Canadian equity market has had a roller coaster ride this year, although some stocks have done extremely well. What is the outlook for 2008? Will the credit crunch continue to dampen stock market performance? How will the proposed regulatory changes to the energy sector and Canadian telecom sector affect the stocks? Will there be any place to hide if this turns out to be a bear market? Buy and Sell columnist Sonita Horvitch posed these and other key questions to a stellar panel of three growth managers and three value managers in a four-instalment series.
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Q Ian, what is your take on the Canadian equity market?
Hardacre It is important to emphasize that a good percentage of the return of the S&P/TSX composite index year to early December, 2007, came from three companies --Research In Motion Ltd. (RIM/TSX), Potash Corp. of Saskatchewan Inc. (POT/TSX) and Alcan Inc. (AL/TSX). I do not think that anyone of us predicted this at last year's December roundtable. It is tough to predict. I do not forecast markets, but the fact that everyone, including the media, is so negative potentially means that 2008 could be a good year for the Canadian equity market. But it will be volatile, and this creates opportunities.
Morphet We are not seeing value yet in the Canadian equity market, even though the market has come off. We would look for the equity market to become more discriminating between higher quality stocks and more speculative ones and stocks that typically hold up in rough times should start to do so. A lot of consumer stocks, for example, are being negatively impacted by a variety of factors and this is being reflected in these stocks.
Howson Last year at this time, I was reasonably optimistic. Like most value managers, we do not try and forecast the equity market, but I think this is a time to be a little more cautious. It looks as if corporate earnings are slowing and that is going to restrain rising stock prices. We are starting to see more value than in the past. In the new highs and lows list for stocks, there are more stocks making new lows. Ian is correct, there are really only three stocks have been driving the Canadian stock market up this year. I do not think that there is all that much pessimism about stocks. There is pessimism about developments in the credit market and concerns about what might happen to the U.S. economy. We are finding value not so much in the individual sectors that have done significantly poorer than some others, but rather it is company specific.
Q It is time for the growth managers around the table to provide their assessment.
Pynn There are questions as to whether the United States will slip into a recession. I do not do a lot of forecasting, but I do see a lot of headwinds both in the United States and Canada. There is an economic slowdown occurring, which translates into lower profit growth. We are already seeing that. In the last five years, Canadian corporate profits, using the S&P/TSX composite index, as a proxy, were up 26% compound per annum, off the low in 2002. The current earnings estimates for 2007 and 2008, are calling for an increase of 10% to 11% in each year. So, the numbers are coming down quite sharply. Even if there is not an economic recession in the United States, there is still a good chance that earnings numbers turn negative at some point in 2008. That might be enough to have people talking bearishly about individual securities. The strong Canadian dollar and the credit crisis are creating headwinds. It is going to be a stock pickers' stock market. You have to be more selective.
Q Fred, You consider that there could be negative EPS growth in Canada in 2008?
Pynn In Canada, some 75% of the composite is in three sectors - financial services, energy and materials. All it is going to take is a few more difficulties in the heavily weighted financial services sector. For example, if the banks have to take further write downs, this could cause it. Or in the energy sector, gas prices are not strong and if the oil price cracks, then you have weakness in another 25%-30% of the Canadian equity market. If this happens, you are going to see pretty big energy companies reporting year on year earnings declines. The bloom is already off the rose in materials stocks, the other big sector of the composite. Metal prices have all come off their highs in U.S. dollars and then there is the impact of the strong Canadian dollar on top of it. This could certainly impact profit growth.
Q Ted, you have been defensive for some time.
Macklin Being a growth-at-a-reasonable-price manager, I would share some of the comments of the value managers round the table. The valuations are attractive, but they are a function of the earnings and the earnings growth is slowing down. We have had a credit problem. It has spread well beyond the U.S. borders. We do not know the economic impact of this. There are problems as a result of the U.S. housing market and these will continue. This has been a large reason for our caution at Guardian. It will take a number of years for the U.S. housing problem to unwind. The question is how policymakers manage this? What I do see are risks to the economy and therefore risks to the stock market.
This will be an interesting market. There is a big unknown out there and that is the credit market, particularly the credit derivative side of the market, which has been untested, as yet. If there is a problem on the derivative side, then there could be severe problems. If there is not, then we could probably skate through. I expect the Fed and central banks around the world to keep injecting liquidity into the market place and to keep cutting rates. While there is a slowdown, providing there is no further deterioration in the credit situation, the equity market will eventually climb a wall of worry. From a GARP or growth at a reasonable price manager's perspective, the Canadian equity market does not look expensive, but it is not exceedingly cheap either. You are certainly paying for earnings growth. What is interesting about this stock market is that there are usually some sectors that are cheap relative to others, but valuations currently appear to be fairly even across the board. The exception is the paper and forest products industry and here you could argue that there is reason for it to be cheap. You have utilities trading at 18 or 19 times forward earnings. Shoppers Drug Mart Corp. (SC/TSX) trading at 22 or 23 times. This is well deserved, Shoppers is a great company, so the multiples are fairly even across the board.
I think there will an economic slowdown in the early part of 2008 and a recovery in the back half, assuming that the credit derivative market does not come apart.
Howson We have all been reasonably cautious about the outlook for the economy, with our focus on the troubled U.S. housing market. This should be balanced by what is going on in the rest of the world. In 2008, the GDP of the developing countries will represent 50% of the world's GDP. The developing countries are growing much more quickly than the developed world.
Macklin That goes beyond China.
Hardacre That is a good point. If the United States really struggles, can the rest of the world grow at the same pace? I am not a believer that it can. Expectations are so high for China and India and other emerging economies.
Morphet I agree with Ian. I think that global equity markets are synchronized. You cannot escape a U.S. equity market decline.
Howson I would suggest that in 2008, the developing world will be less dependent than it was in 2007, and that in 2009, it will be even less dependent than it was in 2008. The developing world will become increasingly more self-sustaining.
Macklin What has us all cautious is that transition period.
Howson Then there is the potential negative impact of problems in the credit market. We have not had this experience before, not to this extent.
Q How does this credit crunch differ from previous problems in the financial markets, particularly credit problems at the banks?
Hardacre I think this one is more opaque than the other ones.
Pynn We have not had a situation like this in the U.S. housing market since the 1930s. Even with the Fed easing, who is going to buy the unsold housing inventory? There is no pent up demand. We have not seen this before with respect to the credit crunch and the troubled U.S. housing market.
Macklin Will the central banks be able to unwind the excesses from these credit problems without fueling inflation? The developing economies are likely to continue to adopt a tight monetary policy, but other global central banks are showing signs of flexibility. It all depends how this is managed. It is a pivotal point. Global growth is there, but the credit market risk is there as well.
Hubbes I agree. I think that inflation will be an issue in the coming years. The most painless way for someone to get out of a debt problem is to inflate and I suspect that that is the course of action that the United States is going to take. The challenge to the emerging world will be to keep down the rate of inflation. You can already see China's input costs going up. The only offset has been labour and productivity. That is a finite game. At some point, that game ends and China will face pressures on profit margins. It will be interesting to see how China manages that. It already has a stock market bubble. It should deflate that without any consequences to the rest of the world, because it inflated it without global consequences. But, given how tied together the world is, that is another issue out there.
shorvitch@nationalpost.com
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Tomorrow: Strategies and emphasis.
