Mackenzie All Cap Value Team
Underlying economic growth in North America remains tepid but has continued along a positive trajectory. Jobless rates in both Canada and the United States were lower to end the second quarter than they were to end the first. Elevated growth expectations following the US election have been tempered in recent months as delayed action on healthcare and tax reform has put into question whether any meaningful, pro-economic growth policies will be passed in the near term.
Economic indicators in North America were mixed with Canada showing momentum while numbers in the US softened. Despite these indicators, Canadian equities, as measured by the S&P/TSX Composite Index, were dragged lower by falling oil prices, returning -1.6% while U.S. equities, as measured by the S&P 500 Index (USD), rose 3.1%, a signal that market optimism is still alive and well south of the border.
In June, the US Federal Reserve raised its benchmark target interest rate by 25 bps, the second such increase so far this year. It went further, providing additional details on how it would unwind its $4.5 trillion USD balance sheet, the result of its expansive quantitative easing program post financial crisis. The speed at which it will be able to unwind its bond portfolio, which equates to additional monetary tightening above and beyond an increase in its target rate, is up for debate as the US inflation rate is hovering below 2% and has not yet shown signs of running away.
Bank of Canada governor Stephen Poloz sent a strong signal in May that a rate hike could be on the horizon and subsequently raised the key rate in July, the first increase since 2010. Although the Canadian economy is not yet running at full capacity, and the May inflation rate was a modest 1.3%, Poloz saw enough momentum building and felt it necessary to tap the brakes.
SNC-Lavalin Group Inc., an engineering and construction business, contributed positively to Fund performance during the quarter. The company has a strong management team that is undertaking a growth strategy with the goal of making SNC a more diversified professional services and project management company. Part of the implementation of this strategy was the recent acquisition of WS Atkins PLC, a large UK based design, engineering and project management firm. SNC was trading at an attractive valuation relative to its peers due to its narrower focus on engineering and construction and the project risk that come with this type of business. As a result of the acquisition, SNC has broadened their service offering and eliminated part of this valuation gap. We continue to hold SNC in the portfolio and believe it still offers upside at an attractive valuation.
Large grocery retailer, The Kroger Co., detracted from performance during the quarter as the acquisition of Whole Foods by retail behemoth Amazon cast a cloud over its future competitors, including Kroger. Contributing to the share price pressure over the quarter, Kroger’s earnings came in below market expectation. Although pricing inflation made its way into food, helping lift the grocer’s quarterly revenues, Kroger took the additional revenues and discounted pricing on several food lines to increase its competitiveness and take market share. The company has consistently delivered strong free cash flows and despite some shorter term challenges, we believe it still offers good value.
As valuations have risen across the board, investors, challenged to find attractive valuations, have focused their attention on growth-oriented stocks, helping growth to outperform value in recent quarters. We remain in a relatively defensive mindset and have taken steps to reduce portfolio risk by moving the average market cap weighting higher, reducing smaller cap names where appropriate. We have no real concerns over inflation or interest rate increases and do not expect a pronounced impact on the portfolio from potential future rate increases in Canada.
Demand for crude oil continues to trend higher though supply, especially in the US, is currently growing at a faster pace. We believe global demand will continue to grow at over 1 million barrels per day and the supply-demand balance should firm up prices back above $50. We believe valuations in the sector are inexpensive, with some stocks trading below levels seen at the depths of the credit crisis. Importantly, this is based on a mid-50 dollar price of oil versus $65-$70 at that point in time. In the long run, fossil fuels will face challenges from advances in technology and green energy, including the adoption of electric vehicles and increased use of solar power. We believe there are some attractive valuations in the energy sector that could provide strong investment opportunities as valuations normalize in a cyclical recovery.