Economic Update - Year End 2015

2015 was an interesting year from a variety of perspectives. Here is my understanding and interpretation of what happened in 2015 and then I'll wrap-up with expectations for 2016.

The big news items in 2015 were OIL, OIL, CHINA and of course OIL

Let's start with China.

  • For the past two or more decades China was the cheap place to manufacture almost everything.

  • There was huge migration of people from the country to the cities. (You may recall my article of a year or two ago where they were essentially building Million people cities at an inconceivable rate.)

  • This mass people transfer to fill manufacturing jobs not only created big factories but also the associated housing, roads and other infrastructure projects.

  • During this decades-long time span the demand for raw materials was extremely high.

  • Over time the Chinese economy was changing.

  • It started to concentrate on the development of a stronger middle class due to substantial wage growth.

  • China's economy began to focus on its own service sector which is now over 50% of its GDP to support a more concentrated population.

  • By comparison, the Service Sector in the US and Canada makes up about 70% of our GDP.

  • Now couple this shift in the Chinese economy with reduced demand for manufactured goods worldwide and we see lower demand for material commodities.

  • Lower demand for Commodities means lower prices for commodities.

  • Canada's economy is founded in large part on commodities and oil.

  • As a consequence this has had a significant negative impact on our mining and energy sectors, with resulting declines in share value and stock market decline.

  • The Shanghai Stock Exchange has been on a rollercoaster ride this year.

  • 2015 started at a level of about 3,300 in January, peaked in June at almost 5,200 and then fell to 3,500 by year end.

  • By June the Market had grown 57% YTD and this was on top of the 2014 growth of 49%.

  • From December 2013 to the first 6 months of 2015 there was a 135% increase in 18 months.

  • There were a number of reasons for this but if this alone doesn't speak to overvaluation then nothing does.

  • If you compare the two year growth from January 2014 to December 2015 this stock market still grew by 45%.

  • All of this was happening when Manufacturing was slowing and international demand was declining.

  • In response to this, the Chinese Government had been doing a number of things including devaluing the Yuan by about 5% to try and ignite manufacturing. It's interesting to reflect on the fact they had increased the value of the Yuan not that long ago. This was in some respect due to foreign pressure that the Yuan was to low.

The conclusion I reach is China continues to evolve and is beginning to realize the impact and influence it has worldwide now that it is the 2nd largest GDP country in the world. The overriding concern is they go about directly impacting the market when they feel intervention is warranted.

Oil.

  • The impact of the drop in oil prices has been huge on the Canadian Market. This sector represents about 25% of the TSX.

  • About two years ago the price per barrel of oil was about $110. Today it is in the low $30s or a 70% drop.

What explains this drop?

There are a variety of factors: 1) Reduced Demand, 2) Supply Glut, 3) Saudi Arabia's strategy to maintain Market Share, 4) new or alternate sources of energy, just to name a few.

  • REDUCED DEMAND: This was brought about by lower worldwide demand for 'stuff'. Brought on initially by 2008 but compounded by ongoing events worldwide.

  • SUPPLY GLUT: With firms trying to maintain former production levels or trying to squeeze out the high cost producers we have seen the supply of oil and gas increase or oil being stored in anticipation of increasing demand.

  • Saudi Arabia, OPEC and others: Saudi Arabia's cost of producing oil is among the lowest in the world. Drill a hole, in sand, and up pops oil. Contrast that with the Canadian Oil Sands: drill a hole through Rock and sand, force hot steam into a second drill hole to break apart the oil from the sand, then suck up 'dirty' oil requiring more distilling. OR take Oil Sands on the surface and steam clean it.

  • Canadian Oil must be discounted in price to make it MARKET comparable to West Texas Crude. Currently this is about $13 a barrel. So the world prices oil at $33 per barrel and we price it at $20. Canada's oil issue is how to balance lower Canadian prices & higher production costs. The current Canadian response has been to reduce production and lay off workers. Alberta's employment has dropped by over 66,000 workers in 2015 alone. Plus there are ripple effects on other Canadian suppliers to those oil companies.

  • Saudi Arabia has embarked on a Maintain Market share strategy. They will pump as much oil as is necessary to ensure they are in command as much as possible.

  • This low price strategy has strained relations with other OPEC countries.

  • SILVER LINING or NOT:

  • Most OIL Exporting countries: Saudi Arabia, Iraq, Russia, Nigeria and Venezuela (to name few) have a need for higher oil prices because the internal Taxes they raise is necessary to balance their National Budgets. They cannot survive in the long term with low Oil Prices.

  • The question here is: How long will they sustain low prices before their economy folds? This is the big question.

  • ALTERNATE SOURCES of Power:

  • The US in particular has gotten into gas and oil fracking in a very big way.This has increased their homegrown energy production to be one of the top world producers. It feeds more of their domestic need and means less energy is required from foreign suppliers.

  • OIL CONCLUSION: We probably have one or two years or more of low oil prices before seeing any upward trend. It will only be then when we see Canadian Oil and stock prices increase. In the meantime we will see more infighting among Oil Producing countries. AND don't forget Iran is coming back with their oil where they have been excluded for the past 5-10 years due to economic sanctions.

Banks.

You have seen bank stocks decline as a ripple effect of lower oil prices, higher unemployment and lower future Profit prospects. The dividends they pay are still great but stock appreciation will be strained over the next couple of years.

INTEREST RATES:

These will remain low until the economy picks up, again it will be a while yet. There will be no push by the Bank of Canada to increase rates with the economy getting by. You can be assured the governments don't want to see higher rates as that will create greater deficits. Expect GIC rates to remain low. Current 5 year rates are at best just over 2%.

MARKET RETURNS in 2015:

Canada's Stock Market return was negative for 2015 at -11%. This is consistent with my previous E-Newsletter comments stating markets go negative roughly every 4 years.

In the last three years we have seen growth of 4% (2012), 9.6% (2013) and 7.4% (2014).

The real secret to overall performance was diversification in the funds in your line-up.

  • Balanced funds have a buffering effect because some portion of the fund is in Bonds. These bond holdings would normally be in the range of 30% to 50%.

  • Those with Dividend funds would have seen the drop in Stock prices being partially offset by ongoing Dividend payments that are reinvested in the fund.

  • The more money you had in foreign funds the better you should have done. Not only were most of these investable markets positive but they contributed positively when converted back to Canadian dollars.

  • Currency exchange has been a major factor in maintaining overall fund values.

  • Although you are negatively impacted when you travel, having foreign investments in your portfolio with a declining Canadian dollar can have significant benefits to your financial health. This is what we have found with the majority of our clients.

Looking Forward to 2016.

The prospects for 2016 are not exactly glistening.

  • We can expect interest rates to remain low.

  • I would project a Bank of Canada reduction in rates in the next quarter or two by one quarter of one percent.

  • There is a need to spark exports from our manufacturing sector and lower rates will assist in that.

  • A lower Canadian dollar will make our products more competitive.

  • The oil sector will remain at the same level and possibly lower as oil prices remain low.

  • Commodities will remain under pressure as we wait for world demand to rise.

  • China will continue to waffle so my projection is for more of the same fluctuations we've seen as of late. These are more internally China focused but with rippling effects globally.

  • The bigger unknowns are more geopolitical. What will happen in the middle east between Saudi Arabia and Iran? What will happen to Oil prices as countries struggle with balancing their budgets? What economic fallout will occur in the refugee migration to Europe? Will North Korea ever grow up as country? All of these have been unsettling and play on the minds of all investors.

REMEMBER:

  • The vast majority of investors are not high risk.

  • Most investors have a diversified investment strategy including Balanced, Dividend and US/International/Global Funds.

  • Most investors are in it for the long run so minor fluctuations in any one year do not detract from their long term goals.

  • Most investors have the correct asset mix matching their investor profile which help them feel more comfortable as markets vary.

If you would like to meet or simply discuss your Portfolio just let us know.

Please share this e-mail with others who could also benefit from this information.

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