Oil Patch

World markets currently less desirable than developed markets, where some of the best opportunities lie in the oil patch..

March was a volatile month for the markets, with worries over global stocks in emerging markets, most notably China and Ukraine, driving the upheaval.

But despite the uncertainty, investors took the market’s dips in stride, often stepping back in a few days later with buy orders.

In fact, over the past year there have been five periods during which the S&P 500 has declined by between three per cent and six per cent.

Each time, the market has promptly climbed back up. But will it get back on its feet after this latest crisis of confidence? In a word, yes.

In March, Janet Yellen held her first press conference as the newly-minted Chairwoman of the Federal Reserve. As expected, she announced a further $10 billion reduction in the Fed’s monthly asset purchases.

But what caught the market by surprise was the 25 basis-point increase in the official median forecast for the Fed funds rate by the end of 2015.

In response to a question relating to how long the Fed might wait before halting its asset purchases and raising interest rates, Yellen let a very specific “six months” slip out from her otherwise scripted remarks.

This was sooner than the market expected and, in a matter of seconds, the S&P 500 shed one per cent and yields on Treasury securities soared.

Investors globally seem to view the Fed with reverence, believing that the direction of Fed policy is all that matters for investment success.

For the last ten or fifteen years, lower rates have trumped fundamentals in driving returns. This viewpoint has translated into a positive (but complacent) stance amongst investors toward U.S. stocks and equities.

This view has only been exacerbated by the strong returns of the S&P 500 over the past few years. For many investors, the U.S. is the place to park your investments; for growth, they look to the emerging world markets. And the current volatility has left many global stock investors in a giddy mood, as they look for any sign that unbridled growth is returning to the emerging world markets.

Not So Solid

I couldn’t disagree more with these sentiments. Emerging world market growth is unlikely to repeat the heady growth rates of the early 2000s. That’s because China, the world’s number two economy, is clearly slowing.

More reports and evidence keeps piling up, virtually every day, that China is no longer pursuing growth at any costs. In 2007, China’s gross domestic product expanded by 14 per cent. Last year, it was 7.7 per cent – and Goldman Sachs recently lowered its 2014 China GDP forecast to 7.3 per cent from 7.6 per cent.

Compounding the growth story in China is a credit bubble that has sent China’s public and private debt soaring.

In 2007, overall Chinese debt was about 150 per cent of GDP; today it’s about 220 per cent. And to bring down borrowing before it becomes unstable, Chinese regulators will have to clamp down on the vast shadow banking system (i.e., leasing companies, insurance firms, trust companies etc.) that has kept the economy booming by pumping vast quantities of money into the system.

And China’s growth matters a lot to emerging world markets. In 2012, China’s expanding economy accounted for 60 per cent of global market growth. As growth in China comes down, the global economy will need to find a new driver, probably a futile process.

Slowing Chinese growth translates into falling inflation rates, and already the European Central Bank (ECB) is pushing the panic button over falling inflation.

With inflation well below the banks’ two per cent target for the euro zone, many are predicting that Fed-style quantitative easing is coming to Europe.

Where to Invest?

Developed world markets are displaying superior momentum compared to emerging economies. In my view, this can best be explained by the pro-growth measures that have been adopted in the West.

In Japan, America and the United Kingdom, central banks have embarked on quantitative easing (QE) stimulus programs; in the euro zone, rate cuts have stimulated the economy.

By contrast, policies in Brazil, China and other emerging economies have been geared towards containing inflation pressures at the expense of growth.

Many investors have viewed the strong markets in the United States with suspicion, fearing that the gains of years past have made the market too expensive. But simple comparisons of market multiples to long-term averages ignores the important role of inflation in asset prices.

My research has shown that periods of under three per cent core inflation have had an average market multiple of near 19 times. This suggests that considerable upside in the market is still to come.

The biggest correlation between stock performance and the broader global market economy is the direction of earnings, which remains positive.

The overall direction of earnings is driven by economic activity, which is clearly expanding (aided by Fed policy). This has kept credit flowing to the economy, and is likely to continue remaining accommodative until late 2015 and beyond.

Meanwhile, the European Central Bank (ECB) looks poised to spur growth. The ECB has been concerned about persistent low inflation, with the March 0.5 per cent year-over-year print setting off alarm bells along with a euro that has strengthened of late.

There is a strong likelihood of the ECB initiating a quantitative easing program of its own, to combat deflation and to lower the euro.

With central banks in developed markets priming the pump, it makes sense to hitch your wagon toward countries and regions that are actively embracing pro-growth policies as opposed to those regions that are trying to constrain economic activity.

What I Recommend

With economic activity strong (and likely to get stronger) in the developed world, I am looking to bolster my energy holdings. Oil prices have remained persistently solid for many months now, and natural gas prices have shown a healthy rebound from previous years.

Canadian Natural Resources (TSX-CNQ) is one of our benchmark energy producers that will continue to benefit from the closing of the light/heavy oil differential.

The company has a strong and diverse portfolio of development projects with the potential to create significant long-term value for shareholders.

In the near term, I believe that share price performance will be positively impacted by the improving outlook for western Canadian crude oil and the potential IPO of a dividend-paying royalty company.

I have a buy recommendation on the stock and a 12-month price target of $48.00 per share.

Whitecap Resources Inc. (TSX-WCP) is a name that I prefer. Whitecap is a light oil levered name that should provide steady five per cent to seven per cent per-share production growth, primarily from low-risk drilling in the Cardium and Viking light oil plays.

The company has a sustainable dividend and has sufficient financial flexibility to grow through acquisitions or through dividend growth.

I have a buy recommendation on the stock and a 12-month price target of $16.00 per share.

TORC Oil & Gas Ltd. (TSX-TOG) is another oil & gas name that is really coming into its own.

TORC is a junior oil producer focused on development of its Cardium light oil acreage, as well as early-stage delineation of its Monarch light oil resource play in southern Alberta. Management has a top-tier track record over the past decade, during which it has grown and monetized three corporate entities.

The company’s shares are attractively valued given the management team’s track record, low debt levels and the potential associated with the company’s emerging Monarch asset.

I have a buy recommendation on the stock and a 12-month price target of $15.00 per share.

The Bottom Line

For my money, the best opportunities are in North America, particularly in the Financial, Energy and Technology sectors. Financials, especially the big money-center banks, are unloved by investors, who see them as slow growth and fraught with regulatory risk. Investors have dismissed out of hand the dividend and consistent growth of large-cap technology companies, driving valuations down to ridiculous levels. They have focused their attention instead on small-cap social media companies.

North American companies are sitting on vast stockpiles of cash that will ultimately be spent on acquisitions and capital expenditures.

But this is a slower-moving train than those of previous cycles, where infusions of liquidity by the Fed set markets soaring.

A peaceful resolution to the crisis in Crimea is in everyone’s interest, but I for one will be avoiding emerging market stocks that are too closely linked to growth in China. Instead, I will be focusing on the secular bull market in North America.

– John Stephenson, CFA


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

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