The Quarterly:

April 2016

“The intelligent investor is a realist who sells to optimists and buys from pessimists.” – Benjamin Graham


The purpose of this quarterly commentary is to communicate with you about our thoughts on the markets, provide some snap-shots of market metrics, and provide an overview of topical issues; however, it will also be married with some aspects of our recently initiated monthly commentary, in order to provide you with a succinct update of our views on the market, without the need for two separate communications.  We hope you enjoy this information, and that it allows you to better understand what we see going on in the market place.






Market Commentary: From Grexit to Brexit

As the axiom goes: “History does not repeat itself, but it does rhyme”. The statement is often attributed to canonical literary author Mark Twain, however, research suggests its first recorded utterance to have been within Canadian poet Joseph Anthony Wittreich’s Feminist Milton. Regardless of attribution, the words could not be more literally or figuratively true at the present time. Throughout 2015, market headlines were ablaze with discussion of a potential “Grexit” or the possibility of Greece leaving the Eurozone. Fast-forward one year, and it is the “Brexit” that is dominating headlines; same concept, different country – there is popular concern and debate over whether the United Kingdom of Britain and Northern Ireland will leave the Eurozone. The notion has been put to a referendum, and will be decided upon by the British people on June 23rd of this year. As the fifth largest country in the world by GDP, any drastic change to its status quo has definitive implications on the global economy; as such, we have decided to discuss the situation in this month’s commentary.


For context, it helps to provide an overview of recent history, and discuss the reasons why Greece considered leaving the Eurozone, as well as the reasons it ultimately decided not to. The genesis of the “Grexit” stems from the creation of the European Union itself, as well as its inherent construction. The European Union (EU) was created in 1993, and has been labelled an equal parts political and economic experiment. Politically, the EU was a powerful statement of cooperation, tracing its roots to the post-World War era and seeking to align the interests and affluence of the continent. Economically, the goal was to allow less-fortunate member states access to cheaper financing by borrowing debt denominated in a currency backed by much stronger economies. This was hoped to spur economic growth.


Both of these listed items are noble pursuits and at first, it worked tremendously for weaker economies such as Greece, who were able to borrow cheap debt to catalyze economic growth. However, most of the inherent issues of the structure lie within the monetary implications of many countries using the same currency, and these structural faults would manifest in the post-financial crisis world of 2009.

In the wake of an election which yielded a new government in Greece, it was revealed that their pursuit of debt financing after joining the EU had been much larger in magnitude than had previously been disclosed. In conjunction, the country’s GDP was in the throes of recession – as was much of the rest of the world – due to the Financial Crisis, and it was likely that the country would default on their debt. In order to justify a bailout for the country, the EU central bodies imposed harsh austerity measures, which crippled the Greek citizens and economy in favour of fiscal surpluses to repay debt. Turmoil resulted, and the notion of defaulting on the debt and leaving the EU gained significant momentum.


Aside from over-borrowing on the part of the Greek government, the primary structural issue impacting the situation was the inability of the Greeks to initiate any targeted monetary policy, due to their shared currency. Normally, a typical course of action is to depreciate a nation’s currency in order to benefit exports and tourism, which in turn is hoped to eventually lift the country from recession; however, without explicit control of the Euro, and with the other member states in various economic states, Greece was unable to do so.


Greece eventually opted to stay within the EU – at least for now – having negotiated slightly relaxed austerity measures in order to unlock bailout funds from central EU bodies. The main deterrent to splitting from the EU was the short-term pain necessary to establish themselves after leaving. The Greek Drachma would need to be re-introduced, the country would have to print massive amounts of money in order to finance debts, which would cause massive inflation, and the country would likely enter depression before being able to meaningfully reap the rewards of the increased allure of their exports and tourism industry. The country continues to deal with this ongoing ordeal, and has now had the added complication of the refugee crisis.

The “Brexit” situation, however, is quite different. The UK is not in trouble economically, and doesn’t even use the Euro as a currency. Despite the absence of turmoil, the vote scheduled for June 23rd is forecasted to be extremely tight, with a slight lean towards remaining as an EU member state. Bloomberg is currently forecasting a 24% chance that the UK leaves.

The driving force for the “Brexit” is quite ‘Trump-ian” in its essence, with the main issues revolving around immigration, trade deals, regulatory burdens, and the ability to self-govern.

In terms of immigration, the right wing anti-EU crowd – known as the ‘Euroskeptics’ – are increasingly concerned with the level of immigration entering the UK, which serves to increase the population by 500 citizens every day, mostly from Eastern European countries.  Chart 1, from Bloomberg, shows the ramp up of UK immigration over time.

Chart 1:


Euroskeptics argue that this high level of unbridled immigration is facilitated by EU membership, and that it is placing undue strain on the fiscal situation of the country. Although relatively few Syrian refugees have landed in the UK, the crisis, in conjunction with recent terrorist attacks, has heightened the concern on immigration.

Another primary issue revolves around trade, which is vitally important to both the UK and the EU as a whole. Euroskeptics argue that the UK is getting the short end of the stick when it comes to trade deals, and are not benefitting as much as they could as an independent entity. As an island, the issue of trade is necessarily important, and Chart 2 from the Economist displays this importance.


Chart 2:


The chart shows that 51.4% of total British exports are sent to EU member states, and 6.6% of total exports from the EU go to the UK; it’s clear that this is a necessary relationship, and that if the skeptics believe they are receiving unfair deals, how impactful this could be on the economy.


Lastly, there is concern over UK sovereignty or ability to self-govern, as current rules state that laws made by EU Parliament supersede those of the individual members. Skeptics believe that they should have greater control over the rules that govern their country.


Prime Minister David Cameron has publically supported remaining within the EU, citing the benefits of free EU trade as well as the mobility provided to UK citizens. The Confederation of British Industry estimates that EU membership provides a net benefit of 4-5% of the country’s total GDP, or $1500 USD per citizen. They also estimate that the total explicit costs of being an EU member state amount to only 0.4% of total GDP. In tandem, Prime Minister Cameron has also recently negotiated a new deal with the EU which reaffirms their ability to remain using the Pound Sterling, allows new rights to control immigration, and limits the benefits required by the government to be provided to non-UK citizens working in the country. Cameron argues that this deal directly addresses many of the skeptics’ main points, however, many remain resolute in their belief that leaving the EU is the best option. Some within the Prime Minister’s own party disagree as well as most notably, the Mayor of London Boris Johnson. As such, despite Cameron’s arguments to remain within the EU, as the polls indicate, there are still many who disagree.


The most logical question thereafter would be: what happens if the UK does exit the EU? In the midst of the “Grexit” debate, a Societe Generale Analyst predicted that a disorderly exit of Greece could cause European stocks to drop as much as 50%, with a corresponding spike to European bond yields. It is important to note, however, that the key differential between these situations is the circumstances. The “Grexit” was predicated on a debt crisis, and had the potential to result in massive losses experienced by various European banks, as well as an ensuing Greek recession. The “Brexit” has arisen from far less dire circumstances, and revolves around much more social issues. The UK is also using its own currency, so it would not suffer the initial consequences involved with switching from using the Euro. That being said, the situation would not be without consequence.

One would be needed to renegotiate almost all trade deals between the UK and EU member states, individually. This could take some time and cause some inherent friction in the meantime, leading to trade disruption. As the Eurozone accounts for ~25% of total international trade, the implications of trade disruption are clear.


Additionally, and perhaps most importantly, would be the setting of a precedent for a member state to leave the EU. Currently, there is no mechanism or precedent in place to follow for a member that wishes to leave the union, and, if successful, the “Brexit” could provide a clear path. Greece remains in precarious circumstances and the Czech Republic have already stated the possibility of a “Czexit” if the UK were to exit. The ensuing situation would result in turmoil and unrest in the region. The dissolution of the EU would most definitely emerge as a possibility, and capital flight from Euro-denominated areas would be likely. With such a backdrop, it is assumed that EU officials will do whatever it takes on their end to keep the UK in the union.


The most notable implication on the home front for UK citizens would be the impact on the Pound, which has already fallen off significantly in anticipation of the referendum. Any citizens which hold property or employment within other EU countries would also be subject to increased complications, costs or taxes, resulting from the fall out.


We do not believe that the “Brexit” carries the same concern as the “Grexit” due to the absence of the global financial contagion narrative. However, it is a major geo-political event which we intend to monitor continuously. As we have noted in the past, we believe that holding Precious Metals in all portfolios is a proficient hedge against such scenarios, as tumultuous environments promote demand for ‘safe haven’ assets.


The Trudeau Show

It has been some time since we have touched on the Canadian economy, and there have been some interesting developments as of late.


You may not have noticed, but our economy is performing surprisingly well so far in 2016. January GDP growth was up 0.6% in month-over-month terms, which was double the estimated figure. 41,000 jobs were added in March, and the unemployment rate fell from 7.3% to 7.1% while holding the participation rate steady. Currently, Canada is on track to exhibit 3% year-over-year GDP growth in the first quarter, which would make us the fastest growing G7 economy in the world over that time period.  The Bank of Canada increased their growth forecast for 2016 to 1.7%, up from 1.4%, and the OECD said that they see ‘signs of stabilization’ in the Canadian economy. All of this data is encouraging in the short term, but, due to our continued bearish view on oil, we are not completely convinced that we are out of the woods.


Other experts seem to agree with us in this regard, as Bank economist Diana Petramala stated fear to Bloomberg TV that she thinks the Q1 pop could be temporary in nature. Reporters at the Globe and Mail and the Chief Economist of Desjardins echoed this sentiment as well.


A large reason for the uptick in growth, in our opinion, has been the rebound experienced by the Canadian dollar and oil prices. The strengthening CAD has allowed Canadians to regain lost purchasing power, while rallying oil prices has allowed for confidence in the belief that we may have seen the bottom in oil. Charts 3 and 4 below display how the CAD and oil have rallied approximately 15% and 35%, respectively, off of their lows.

Chart 3:


Chart 4:


The particular aspect of these charts to note is how both the CAD and the price of oil rose in lock-step; this illustrates what we have discussed in the past in terms of the high level of correlation between our currency and oil prices. The CAD has also benefitted from a weaker-than-expected interest raising schedule from the US.


Our lack of exuberance over the recent jump in Canadian economic activity, as mentioned previously, stems from our inability to believe that oil prices will continue their recent strength. Simply put, the market remains over-supplied, and the United States is a major culprit. The US continues to pump 9 million barrels a day, which is only 300,000 below their all-time peak, which is partially out of necessity due to the amount of leverage exhibited by the fracking companies. These companies need to pay their debts, and will maintain or increase their supply in order to do so. In addition, Iran continues to ramp up their production, and has indicated several times their lack of interest in curbing production. Chart 5 below indicates how the global oil equilibrium remains ~2 million barrels per day over-supplied, and how global oil inventories remain at record highs.


Chart 5:

Renowned market analyst Gary Shilling references these statistics, stating that the oil market is over-extended and likely to re-test lows. Even with sideways movements to supply, oil inventories will eventually need to be liquidated and pushed into the market, and once they do, this could be the catalyst for the next leg down in the market. Additionally, the Canadian Association of Petroleum Producers noted that they expect 2015 – 2016 capital expenditure in the oil and gas sector to drop by as much as 62%; this will undoubtedly provide further downwards pressure on the industry and our economy. As we’ve seen in the past, any meaningful move downwards in the oil sector would have meaningful impacts on the Canadian economy. Along with avoiding oil stocks, we also believe the near-term strength of the CAD to be a great opportunity to reaffirm USD and US market exposure.


Another consequential occurrence recently was the release of Prime Minister Trudeau’s first Federal Budget. The budget and its outlined mandates will have meaningful impacts on all Canadians and as such we think it is important to outline the most important aspects of it. The list below is non-exclusive, but includes the major points which we believe to be most important and consequential.


  • The forecasted deficit for 2016 – 2017 is $27B, which is almost triple the amount predicted by the Liberals while running their campaign. The difference is said to be attributable to vastly lower oil prices than those which were included in the initial budget.
  • $60 billion in infrastructure has been earmarked for infrastructure projects over the next 10 years, split between public transit, green infrastructure, and social infrastructure. $3.4 billion has specifically been allocated to public transit projects, with $1.5 billion headed to Ontario, and $923 million for Quebec.
  • No immediate changes have been made to the capital gains tax, as some investors had feared. Small business taxes were frozen, reverting a promise by the Harper government to decrease taxes on the first $500K of revenues from 11% to 9%.
  • The middle income tax bracket of $45,000 to $90,000 has been lowered from 22% to 20.5%, and a new tax bracket for income over $200,000 has been added, at a rate of 33%.
  • In an effort to ease the effect of the oil crash on Alberta, Employment Insurance stipulations have been changed, lessening the amount of time it takes to receive benefits, and extending the amount of time eligible by 5 weeks.
  • The Canadian Child Benefit has been introduced, replacing similar past benefits, which seeks to aid lower-to-middle income families, with an average rebate of $2,300 per family
  • First Nations communities have been allocated $8.4 billion over 5 years, Veterans have received specific funding, and the CBC has had its budget increased by $675 million over 5 years.
  • Income splitting for families has been removed, which lasted only one year under the Harper government and allowed an individual to transfer up to $50,000 of income to the lower-earning spouse, for a maximum benefit of $2,000 a year. It was stated that this was only benefitting 15% of all Canadians.
  • The retirement age was held at 65, and some tax breaks for child fitness and textbooks were removed.


As a summary, the Globe and Mail put together Chart 6 which summarizes the revenues and expenses inherent in the budget forecast.


Chart 6:

We remain cautious in regard to the current state and valuation of the market, and seek to protect client’s wealth through utilization of non-correlated assets and safe haven assets such as precious metals. We believe that upside still exists in this market, but that it will require individual stock picking to capitalize on.



MacNicol & Associates Asset Management Inc.

April 2016