In the Turning Lane

The MoneyLetter, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846

Industrials offer great leverage to an improving economy and will outperform in the months ahead

The market was recently jolted out of its slumber by the Federal Reserve.

At its September meeting, the Fed ignored market expectations by deciding not to begin scaling back its bond-buying stimulus.
While policy makers acknowledged that the U.S. economy was getting steadily stronger, they expressed concern that the rise in market interest rates – which spiked over the spring and summer in anticipation that the Fed was poised to change course – had risen too high, too fast.

The decision to refrain from reducing the $85 billion pace of monthly bond buying was based (in part) on weak conditions in the job market, and on concern that the rapid tightening of financial conditions in recent months would have the undesirable effect of slowing growth.

Treasury yields have jumped since May, when Federal Reserve chairman Ben Bernanke first outlined a possible timetable for a reduction in the asset purchases that have swelled the Fed’s balance sheet to $3.66 trillion.

After the announcement, U.S. stocks rallied, sending the S&P 500 to a record close. Gold prices spiked, and Treasuries rose sharply. The surprise move by the Fed could cause interest rates to reverse course – and potentially weaken the dollar – as the prospect of higher interest rates increases the demand for the currency.

Despite the recent rise in interest rates, inflation expectations have actually been falling, resulting in higher real interest rates.

While that may be concerning for some, our research has shown that both stock market and economic performance is relatively strong during periods of rising interest rates, particularly when starting from extremely low levels (as is currently the case). And research has shown that over the past 40 years, rising real interest rates have benefitted cyclical areas of the market while defensive areas underperformed.

Game Changer

For months, Ben Bernanke had been hinting that the program – known as quantitative easing, or QE – could be curbed later in 2013 if the U.S. recovery continued at a reasonable pace. (In addition, bond yields had risen sharply since May and June when Mr. Bernanke first started musing about gently putting the brakes on economic stimulus.) But that didn’t happen.

Hiring continued at only a modest pace and factory production and exports stumbled. The disappointing indicators forced the Fed to cut its economic outlook for American growth, from a potential 2013 maximum economic output of 2.6 per cent down to 2.3 per cent, while postponing the onset of tapering.

Ben Bernanke had warned investors that if financial markets continued to take interest rates higher in the anticipation of action by the Federal Reserve, the Fed would have to “push back” against any such increases. And so it has.

Although there were some warnings signs, the recent Fed announcement still managed to take the Street by surprise. In fact, it really is a game changer for stocks, heralding in a new era of momentum-driven investing.

One of the reasons cited by Ben Bernanke for the reprieve was that President Barack Obama and the Republican-led House of Representatives are hurtling toward another potentially destabilizing fiscal showdown.

Just the other week, Republican leaders said their co-operation on a budget for the fiscal year (which begins next month) and for raising the country’s debt ceiling is contingent on defunding Obamacare, the President’s signature domestic achievement. President Obama rejected this outright.

Helping to propel stocks further will be the lackluster bond market performance

In his comments, Ben Bernanke said that “a government shutdown, and perhaps even more so, failure to raise the debt limit, could have very serious consequences for financial markets and for the economy.”

What was made abundantly clear by the Fed was that the extraordinary levels of stimulus would remain in place until the data shows incontrovertible evidence that the economy has reached escape velocity, Congress passes a budget, and interest rates back down from their lofty perch.

The likelihood of these three scenarios aligning by the end of this year is close to zero. This suggests that tapering is off the table until 2014.
And with the policy accommodation likely to remain in place for the foreseeable future, stocks are poised to continue their rally in the months ahead.

The sugar rush from the Fed’s non-taper announcement will likely propel the S&P 500 through 1,800 by year end, and possibly through 1,900 in mid-2014. Both the S&P 500 and the TSX are up five per cent or more from early May, when yields troughed.

Will stocks soar?

With tapering postponed for the time being and the Fed to remain accommodative, the news is overwhelmingly positive for stocks.

Since 1971, there have been four prior periods when the Fed has remained accommodative after lowering the Fed funds rate. In all prior cases, stocks soared. Therefore, the longer the Fed refrains from tapering, the better the stock market will perform.

Helping to propel stocks further will be the lackluster bond market performance. This will likely help spur renewed fund flows into equities, especially when the calendar flips over to 2014.

While a rise in interest rates is not yet a certainty, clearly those days are not too far away.

It’s important to note that, over the past four decades, rising real rates have benefitted cyclical areas of the market while more defensive areas have underperformed.

Outperforming sectors

Based on our analysis, three sectors have outperformed during prior periods of rising interest rates – financials, industrials and technology.
Industrials remain a sector to overweight within your investment portfolio. In particular, the automotive sector looks appealing as U.S. car volumes have soared from eight million units five years ago to more than 16 million units today.

Financials has been re-rated in the aftermath of the 2008/2009 financial crisis; a steepening yield curve has historically enhanced the earnings power of most financial firms.

Technology, meanwhile, should benefit from a recovery in capital expenditures by corporate America as companies start to replace aging hardware and software with the latest offerings.

What to buy

General Motors (NYSE-GM, $36.92) is one of our favorite auto names. The company is levered to the continued cyclical recovery in North America. Europe (i.e., GM’s Opel division) remains a headwind for the company, but data out of Europe suggest that significant improvements are close at hand.

GM is planning a record number of new product launches in North America, including the all-important next-generation, full-size track platform (K2XX).  The company is also able to leverage its increasing percentage of global platforms. The corporate culture, too, has been realigned with a greater focus on efficiency.

Another reason that GM looks attractive: the potential for the company to initiate a dividend or further share repurchases. Cash flow is strong, unit sales in North America have more than doubled in the last five years, and Europe has turned the corner.

* Our advice is a buy  rating on the company’s stock and a 12-month price target of $47.00 per share.

Magna International Inc. (TSX-MG, $85.64) is a global auto parts company that has been on a tear for a while now. The global auto industry is projected to grow at three per cent a year through 2017, a rate that Magna should be able to easily surpass. As well, improvement in Europe is expected to move the company’s margins from 1.3 per cent currently to 4.0-4.5 per cent by 2016.

Emerging markets, historically an area of the world in which Magna has under-invested, is now being heavily invested in (through both organic growth and target acquisitions) to build its international footprint.

The company trades at a discount to its auto parts peers, despite a very strong balance sheet, a global footprint and solid earnings momentum.

* Our advice is a buy recommendation on the stock and a 12-month price target of $95.00 per share.

Westjet Airlines Ltd. (TSX-WJA, $24.48) is another company that we really like. The company boasts a solid balance sheet and a management team that is among the best operators in the airline industry.

Westjet is set to deliver profitable growth in the coming years through new routes and other growth; the firm is already starting to experience both unit profitability improvement and margin expansion.

* Our advice is a buy rating on the stock and a 12-month price target of $30.00 per share.

The Bottom Line

The recent Fed decision not to curb the stimulus measures has put a renewed focus on stocks and on the U.S. market in particular.
Despite the strong momentum of late, the market is not overvalued on a historic basis and is poised to head much higher in the months ahead.

The industrial names offer great leverage to an improving economy and should be one of the best performing sectors in the months ahead.
The strong, thirty-year (or more) run for bonds is over, and continued anemic returns from fixed income should provide for meaningful funds to flow into stocks and continue to extend the gains for longer.



The MoneyLetter, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846

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