Market Insights: Resource Equities Remain Undervalued

Macroeconomic and Market Developments:

• Stock markets in North America were lower this week. In Canada, the S&P/TSX Index declined 0.45%. The US fared much worse, the Dow Jones Industrial Average was down 3.45% and the S&P 500 Index dropped 1.91%.
• The Canadian dollar was much weaker this week, closing at 80.31 cents vs 82.24 cents last Friday, down 2.35%.
• Oil prices were quite volatile this week but ultimately ended higher, with US West Texas crude finishing at $71.59 vs $70.80 last week, and the Canadian WCS price at ~$58.10 vs ~$56.75 last week.
• Gold prices were hit hard this week, closing at ~$1,762 vs ~$1,877 last Friday.
• As a result of their standard quarterly review, S&P Dow Jones Indices will make the following changes to the S&P/TSX Composite Index prior to the opening of trading on Monday, June 21, 21: Additions: Capstone Mining (CS), Nuvei Corporation (NVEI), Stelco Holdings (STLC) and Trisura Group (TSU) and deletions: AcuityAds Holdings (AT) and Endeavour Mining (EDV).
• Vancouver based clothing company Aritzia has agreed to purchase athletic wear company Reigning Champ. The deal is based on purchasing 75% at a total enterprise value of approximately C$63M; the remaining 25% equity interest held by Reigning Champ's management shareholders will be converted into Aritzia shares in up to three instalments from 2024 to 2026.
• A key permit for the Enbridge (ENB) Line 3 oil pipeline was upheld by the Minnesota Court of Appeals, removing a potential delay for the controversial project. The pipeline will carry Canadian oil-sands crude from Alberta to Superior, Wisconsin.
• The big story in the markets this week was the US Federal Reserve meeting on Wednesday, in which they made no significant changes to monetary policy. However, the Fed took some big steps toward laying the groundwork for changes to policy it will make in the future. Their plan now shows seven of eighteen policymakers in favor of at least one 0.25% rate hike in 2022, up from only four in March. And for 2023, thirteen of eighteen think the Fed will raise interest rates vs only seven in March.
• The US economic data that was released this week included the Producer Price Index (PPI), a measure of inflation, which rose 0.8% in May, well above the consensus expected 0.5%. Producer prices are up 6.6% versus a year ago. Also, Retail Sales were released for May, posting a decline of 1.3% compared with the consensus estimates expecting a decline of 0.8%. Retail sales are up 28.1% versus a year ago. Sales excluding autos declined 0.7% in May vs expectations for a gain of 0.4%.
• In Canada, the Consumer Price Index (CPI) rose 3.6% year over year in May, a bit higher than 3.5% consensus and up from 3.4% in April. This was the largest yearly increase for the inflation measure since May 2011. Monthly CPI rose 0.5%, matching April's pace.

• Here is a link to a short video from Canaccord’s chief U.S. Strategist Tony Dwyer entitled Brief Economic and Market Update: DWYER VLOG

• For a deeper dive, the US investment company First Trust has put out a US COVID-19 Tracker. Click here: COVID TRACKER
• In addition, First Trust has created a COVID Recovery Tracker. Click here: RECOVERY TRACKER

Weekly Diversion:

Check out this absolutely amazing goal in the Euro 2020 Cup.

And from the Canada vs Haiti World Cup qualifying game, this absolutely terrible goal as well. Go Canada!

Charts of the Week:

Resource companies, among other inflationary assets, have had a nice run the last three quarters. In fact, the S&P/TSX Energy Index is up a pretty astounding 115% since just the end of October 2020. However, the latest Federal Reserve Meeting this week has apparently put a short-term halt to the rise of inflationary assets. The message that markets appear to be receiving from the announcement is that the Fed is becoming more hawkish after admitting inflation is higher than they expected. We find this a little confusing, considering for months now it seems the Fed were the only ones that actually believed their overly rosy inflation projections, while the market pushed that aside, not believing it, and buying assets that outperform in an inflationary environment. In other words, the Fed may have said they were surprised by higher-than-expected inflation, but the market should not have. Therefore, we view that while there may be a pause in the rise of inflationary assets for the time being, we still believe that inflation is not going away any time soon and should be above the Fed’s target for a while. Over the much longer-term, however, our view is that the current higher inflationary environment is more likely to be transitory than long-lasting. The question now is how long will ‘transitory’ be.

The big headline on Wednesday talked about two rate hikes being pushed from 2023 into 2020. And the market is taking this as hawkish? We are bit skeptical as this week’s downward price move in inflationary assets is just that, one week. We will see how the coming weeks play out, but this could just as likely be a pause/correction in the recent uptrend. The last time we checked it is only June 2021. So, they are only talking about potentially moving from an overnight rate of 0-0.25% to 0.50-0.75% over the next 18 months. We cannot really call that overly hawkish, but yes; perhaps a bit more hawkish than what markets thought they were going to say. We need to keep in mind that this overnight target rate was as high as 2.25-2.50% as recently as 2018, and it was 1.50-1.75% just prior to COVID. Only 15 months ago, the target rate was four rate hikes higher than what they are projected it to be by the end of 2023. We still view this as very accommodative to markets and risk assets in general.

According to a report from GMO, “with prices rising, one might expect to pay a premium for inflation protection, but resource equities provide protection at a steep discount while also providing impressive diversification, the ability to capitalize on an inefficient sector of the market, and exposure to an asset class that has outperformed over the long-term.”

Essentially what this is saying is that while we are seeing a short-term pullback right now, even after a 100%+ rise over the last many months, energy and metals companies are still significantly undervalued relative to the rest of the market. You can see on the chart below at the very end, the recent move higher in resource equities on a relative basis is only a small blip up from it lowest in history point last year.

Source: S&P, MSCI, Moody’s, GMO – Valuation metric is a combination of P/E (normalized historical earnings), Price to Book, Value, and Dividend Yield. As of March 31, 2021.

We will finish of this week’s comments by shedding light on a very rare occurrence that happened last week. It was just the 6th time in more than 7,800 trading days since 1990 where we saw the S&P 500 close at a 52-week high, the CBOE Volatility Index (VIX) close at a 52-week low, and the 10-year US Treasury yield close at three-month low. This is indeed very rare, and therefore its forward-looking predictive power is very low. Seeing the equity markets at a year-long high and the volatility index at a low is certainly common, but it is when combined with 10-year yields at a three-month low that makes it interesting and rare.

Here is a table that shows how markets performed over the following year on those five prior periods. Interestingly enough, the short-term numbers tended to skew towards the downside (as we are seeing this week as well). However, looking out further in the six to twelve-month range, returns were strong with an average (median) rise of 8.4% (8.3%) and 16.2% (12.1) which is well above all other periods for the S&P 500, and with no negative returns.

Source: Bespoke Investment Group

 

Sources: CNBC.com, Globe and Mail, Financial Post, BNN Bloomberg, Tony Dwyer, Canaccord Genuity, Bespoke Investment Group, GMO, S&P, MSCI, Moody’s