Plan for a long recovery: BMO Harris

While the worst of the downturn may be over, investors should bear in mind that recent gains in the market are fragile and remain under threat of the negative economic data, according to the two chief investment strategists at BMO Harris.

The bounce back in the equity markets has undermined the “this time it’s different” argument. There is a strong case to be made that the recovery process will be much longer and [more] painful than previous downturns, says Jack Ablin, the chief investment officer (CIO) at with Chicago-based Harris Private Bank.

“It’s going to be slow going. I think we will see some cyclical progress, but from a secular outlook, I think you’re looking at a W-shaped recovery or a shallow U-shaped recovery. Our unemployment rate in the United States could get to 11%,” Ablin told those listening in to a conference call yesterday.

“What I’ve noticed is that every time we have a recovery, the lag-time between the recovery and the subsequent gain in jobs is extended. In fact, if you recall, the 1990s was viewed as a jobless recovery. We could see a peak in unemployment, followed by really stubborn lacklustre growth. Jobs just aren’t going to pick up the pace, and that will keep us treading water for a while.”

It’s been a great run-up in stock prices; the S&P 500 posted its best quarterly performance in more than 15 years. For Ablin, much of the run-up in equity prices has been the result of investment sentiment turning from panicky to skeptical. In other words, there is a consensus that the worst is over — but by no means does that mean things are going to be great.

Ablin infers that the patience of investors could be wearing thin, particularly if the next round of earnings reports don’t offer much in the way of growth.

“Seventy percent of the companies in the S&P 500 beat their earnings numbers. The bad news is that earnings are expected to still be down 34% year over year. It was a very low bar to jump over,” Ablin says. “I do think manager outlook has been pretty sanguine; that’s really where most of the optimism is being generated. As management looks out a couple of quarters, they starts to see light out there and that boosts some of their its confidence nowadays.”

Ablin’s Canadian colleague, Paul Taylor, CIO of Toronto-based BMO Harris Private Banking, noted that the margins on earnings can only be obtained through cost cost-cutting. At a point, investor confidence could be shaken, creating the risk of some pullback in equity prices.

“The big risk with this market is a W-shaped recovery, [which could happen] if we get an outcome that doesn’t prove to be sustainable. This will be an issue of confidence at the consumer level, at the corporate level and at the institutional investor level. Right now, we have the consumer in the better mood,” he says. “There is a big risk at the corporate level — you can’t manage revenues in a downturn; you can manage expenses. That’s the biggest risk that confidence erodes as [earnings margins stagnate].”

Canada well positioned

Taylor believes the Canadian equities market is in a great position to benefit from a recovery, given its strong weighting to resources and materials, which will see demand increase as economic production gets back to normalized levels.

Taylor used the example of a company like FNX, a base metals producer, where profit margins can be grown at certain commodity price levels. Commodity prices dropped to the point where it wasn’t profitable for resource producers to extract from the ground.

“Nickel goes from $4.50 to $21 a pound, with the cost of production to bring ore from the ground to the surface at $6.00 a pound. The price they receive on world markets going from $4.50 to — there are huge cash flows and huge earnings. When the commodity does a round trip as it did and goes back down to $5.00 a pound, they are net negative on the cost of bringing a pound of ore to the surface,” he says. “With the price of the commodity hovering around $6.50 or $7.00, you’re at a point now where companies like FNX are starting to produce positive cash flows and good earnings. The potential margin expansion if we do get an economic recovery is huge and a company like FNX, which a few years ago earned in the neighbourhood of 50¢ to 75¢ a share, if it sees those earnings again, it will trade well through where it is now, which is the $6.00 to $7.00 level. This was a stock that did trade, at one point in time, at $37.”

Again, the difficulty for investors is determining where the ceiling is on stocks. There’s little evidence to suggest that a recovery will quickly take stock prices back to their 2007 or early 2008 levels.

“If you look at the total debt in the U.S. that is a combination of private debt, corporate debt and government debt, if you look at that relative to GDP, there is no doubt where we are. At some point, it will take time to unwind this to return to more normalized levels,” he says. “There is no doubt that this will continue to be a headwind beyond the next couple of quarters, and will be a factor that plays out in 2010, 2011 and 2012. That doesn’t mean we can’t have positive economic growth. It won’t be as strong as if this was (what I refer to as) a normal cyclical bounce back that tends to occur after a very sharp downturn.”

Taylor said his team has been adding to Canadian equity holdings across many sectors over the past six months, at prices that were attractive. In light of the rally, those discounts are not as deep, but he believes they are still trading at attractive valuations. Taylor says he’s going to be a patient investor going forward, using equity markets setbacks to add to holdings.

He says investors have to remain aware of the sensitivities of the Canadian market to the U.S. and emerging economics.

“Canada came into this downturn with a much firmer footing. However, we are very much dependent on the health of the U.S. economy and commodity demand from Asia. We’ve seen a massive implosion in commodity prices. I just referenced how dire the situation is for many of our commodity players — the base metal players are a prime example of that,” he says. “I think it would be naive for us to believe the issues that we’re facing are not very significant. I believe we will have an economic recovery — we’re positioning our portfolios for that. Will we get growth of the 2.5% or 3.5%, the post-World War II averages? Our sense is we’ll get to that, but only as we get through the heart of 2010 and turn the corner in 2011.”

(07/30/09)