(0413)(0413)The United States: Poised for Further Outperformanceforward PERSPECTIVESBruce Cooper, CFAVice-Chair, Equities, TD Asset ManagementCo-Chair, Wealth Asset Allocation CommitteeKen Miner, CFAVice-Chair, Fixed Income, TD Asset ManagementCo-Chair, Wealth Asset Allocation CommitteeApril 2013 – Volume IX
2(0413)(0413)We believe that the United States offers strong investment prospects, and despite the recent robust performanceof American equity markets, we retain our overweight stance and positive bias for U.S. equities. It’s true that thecountry is facing sizable structural issues, particularly the size of its federal budget deficit. However, regardless of theshadows cast by these issues, U.S. equity markets have performed well over the past several years. We believe theyare poised to rise even further and to continue outperforming Canadian equity markets. In this issue, we discuss twofactors that have the potential to significantly impact both economic growth and equity markets — housing and theenergy renaissance. Both of these areas are on the cusp of spurring real growth in the U.S., and we are optimisticthat as this happens, corporations and financial markets will benefit, fuelling even stronger returns for investors.We believe that Canadian advisors and clients who have built a home country bias into their portfolios may wantto take a fresh look at the role that U.S. equities can play in helping them achieve their financial goals.*Ironically, the great recession and its aftermath havehelped U.S. corporations become healthier. Followingthe financial crisis, corporations had to be disciplinedto survive and implemented rigorous cost-cuttingmeasures. Meanwhile, the government’s response tothe financial crisis and ensuing recession was to lowerinterest rates and print money in order to stimulategrowth. These actions led to historically low interestrates, which allowed companies to refinance debtat attractive rates. In addition, many investors foundthat the low-rate environment meant their fixedincome investments were no longer able to sufficientlyaddress their needs, so they began to explore alternatives, leading to increased interest in stocks. Dividend-payingstocks became particularly popular, as the dividends can serve as an added source of income and the potentialfor capital growth affords investors a measure of protection against inflation. Indeed, renewed investor interestin stocks has sent U.S. indexes upward — during the first quarter of 2013, most flirted with all-time highs,and some surpassed them.Some investors worry that this stock market success means it’s too late for them, that most of the upside has alreadybeen realized. We do not believe that is the case. We believe that many U.S. equities are still solid investments.We are particularly optimistic about the prospects for companies that have a history of growing their dividends.Dividend growth is important not only because it helps support share price, but also because an increasing dividendgives investors a better chance of keeping pace with rising inflation, as the rising income allows them to maintaintheir purchasing power.An important question arises from this: Will U.S. companies be able to grow their dividends from here?We believe they will. Dividend payout ratios are at a historically low level, and we expect that continuedeconomic recovery will drive earnings and cash flows higher. This economic recovery will be boosted in largepart by two key tailwinds — housing and energy.*Readers can also refer to forwardPerspectives Volume VII, in which we discuss the reasons for Canada’s impressive outperformance over the decade from 2002-2012 and the reasons why we believethat outperformance is unlikely to be duplicated going forward.The United States: Poised for Further OutperformanceTD Asset Management (TDAM) is committedto providing thought leadership on key issuesimpacting markets or the investment climatein general. At a time when information isplentiful but wisdom is harder to discern,forwardPerspectives, the thought leadershipseries from the co-chairs of The TD WealthAsset Allocation Committee, offers insightsinto market risks and opportunities.
3(0413)(0413)A Resurgence in the Housing SectorRecently there has been a lot of attention paid to the burgeoning recovery in the housing sector, and with goodreason. Just as the collapsing housing sector helped to bring the U.S. economy down, so too will a rebuilt housingsector help to support sustainable economic recovery. Improvement in housing impacts the economy in severaldifferent ways, including: underpinning consumer confidence, which encourages spending; strengthening bothlender and household balance sheets; and, critically, providing jobs. These economic tailwinds all contribute to animproved outlook for the profitability of U.S. companies, which in turn supports the equity market.Signs that the sector is staging a comeback have been emerging for a while. For example, for each of the past20 months, year-over-year existing home sales have increased, and year-over-year prices have increased for eachof the past 12 months.1Perhaps more importantly, new housing has also been improving. In 2012, residentialconstruction added 0.3% to GDP growth, a welcome change from six straight years of negative contribution,and the trend appears to be continuing in 2013. February 2013 housing starts were running at an annualized paceof 917,000 and new construction permits were issued at an annualized rate of 946,000, close to a 5-year high.2Although levels are greatly improved, they are still significantly below their long-term averages, indicating thatthere is potential for continued increases.New construction is critical to the economic recovery because it means jobs. It is simple really; the more housesbeing built, the more workers required to do the building. We anticipate that, starting in the second half of 2013and continuing through 2014, new home construction will provide a major tailwind to employment. In additionto the construction jobs created, we anticipate that there will also be some spillover benefit to ancillary industries.Figure 1: U.S. Construction Employment (National)As at March 31, 2013. Data for February and March, 2013 is provided on a preliminary basis.Source: Bureau of Labor Statistics and TDAM.1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 20125,0006,0007,0008,000AllEmployees,Thousands
4(0413)(0413)Canadian Conundrum: Inflated Housing ActivityWhile not of the magnitude of the U.S. housing bubble (due in part to stricter lending rules in Canada),Canadian housing has still experienced substantial growth, and real estate prices have increased significantlyover the past decade. In economic terms, the simplest way to illustrate the contribution of housing to growthis to look at the ratio of residential investment to GDP (see chart below).Note that in the U.S. this contribution is near a 30-year low. Given the current dynamics described above,we believe this is poised to improve. In contrast, the situation in Canada is very different, with residential investmentnear a 30-year high. We are not sounding the alarm bells and suggesting there is going to be a large correctionin Canadian housing. However, it seems that while housing will likely be supportive of growth in the U.S., it maywell be a headwind for growth in Canada. This changing dynamic may be crucial for the relative performanceof Canadian versus U.S. bank stocks. Canadian banks have prospered over the past 10 years while U.S. bankswere hit hard by the collapse of the U.S. housing bubble. Recovery in the U.S. is likely to be particularly importantto this key sector of the equity market.Figure 2: Residential Investment as a Percentage of GDPAs at March 31, 2013. Source: Statistics Canada and Bloomberg Finance L.P.6.9%2.6%2.0%3.0%4.0%5.0%6.0%7.0%8.0%2.0%3.0%4.0%5.0%6.0%7.0%8.0%19811982198319841985198619871988198919901991199219931994199519961997199819992000200120022003200420052006200720082009201020112012Canada United States
5(0413)(0413)A Revolution in the Energy SectorThe second factor that makes us optimistic about U.S. growth is the growing supply of domestic energy.The energy industry is undergoing a revolution as new extraction techniques are developed, allowing the U.S.to lower its dependence on foreign oil and natural gas and to come increasingly closer to energy self-sufficiency.For example, horizontal drilling has allowed companies to extract previously inaccessible natural gas from shalerock, and the stores of shale gas are meaningful, with shale gas expected to provide 50% of U.S. natural gas by2020 (up from just 16% in 2009).3Overall, increasing U.S. energy production and declining consumption,which is resulting from both energy-efficiency initiatives and recession-induced consumer cutbacks,have resulted in a 60% decline in net energy imports since 2008.4As domestic energy production increases, three sustainable structural changes occur:• Prices fall. Falling prices have a tremendous impact on consumers. From 2008 to 2012, natural gasconsumption costs declined 64%, or $140 billion.5Because natural gas is used in the creation of electricity,these cost reductions are felt almost universally, with both consumers and businesses benefitting from lowercosts. To put the figures into perspective, those cost savings ($140 billion) more than offset the cost impactof January’s payroll tax hike ($125 billion).• Energy imports fall. Falling energy imports improve the U.S.’s balance of trade account, which is positivefor the U.S. dollar. (Remember that in Volume VII we discussed how the demand for energy provideda dramatic increase in the value of the Canadian dollar, which had a large role to play in Canada’s decadeof outperformance. A strengthening U.S. dollar makes a repeat of that unlikely.) Indeed, we are already seeingthe improvement in the U.S.’s balance of trade, which is translating into a lower U.S. current account deficit.• Employment increases. Rising employment due to increasing energy production has wide reaching benefits.Businesses in the energy, manufacturing and financial sectors are all expected to gain significantly.The impact of these changes is therefore likely to be broad based, contributing to both economic growth andto the earnings of U.S. companies. Equity market tailwinds may include both the earnings growth noted aboveand expansion of the price-earnings multiple, if the energy renaissance increases investors’ confidence in thesustainability of the recovery.
(0413) 6Canadian Conundrum: The Flip Side of the U.S. RenaissanceWhile U.S. consumers are benefitting from lower energy prices and the U.S. economy is being boostedby investment in its energy sector, momentum in Canada is swinging in the other direction. Canadian energyproducers have been hurt by lower pricing for their product and, perhaps more importantly, there are signs thatinvestment in the energy sector, which has been a key driver of Canadian economic growth over the past decade,may be slowing. Both of these dynamics have the potential to depress earnings for Canadian companies.There has always been a price differential between light and heavy oils, with heavy oil selling at a discountbecause it requires additional refining, but the differential expanded over 2012. For example, the discountfor Western Canadian Select (heavy oil) stretched to 50% in 2012, up significantly from the norm of 20%.6These costly price differentials, which are being created by the increasing domestic oil supply in the U.S. andby inadequate transportation infrastructure, mean that although Canada is producing a lot of oil, it is notbeing well compensated for it.Canadian hopes for clearing infrastructure bottlenecks are currently pinned on the Keystone and Northern Gatewaypipelines. However, approval for these pipelines has been delayed due to significant environmental concerns.While there are a number of alternatives, including shipping by rail, they will not fully replace the capacity offeredby Keystone and Northern Gateway.If unsatisfactorily addressed, these oil price differentials could have significant economic and market consequencesbecause the energy sector is a major component of the Canadian economy and stock market. Indeed, this is alreadyhaving a meaningful negative impact on profitability, as demonstrated by the Canadian oil and gas extractionsector’s 2012 earnings, which dropped to their lowest levels since 1999.7
(0413)(0413)Our ViewHeadlines around the world have been dominated by U.S. monetary and fiscal policies. And there’s no denyingthat in the wake of the global financial crisis the U.S. continues to face some significant structural headwinds –including elevated levels of government debt, the aftermath of the fiscal cliff and political gridlock. However,we still believe that U.S. companies are strong and offer good opportunities for investors. Indeed, manyU.S. corporations are healthier than ever, a fact reflected in recent impressive stock market returns. In spiteof this already strong performance, we see potential for further stock market growth as the economy improves.We think this economic improvement will be driven by a number of factors, but two that stand out are theimproving housing industry and the energy renaissance that is taking place in the U.S. We are optimistic that withcontinued strength in these two areas, economic growth will improve, and we remain confident in the WealthAsset Allocation Committee’s current overweight position in U.S. equities and its preference for U.S.over Canadian equities.While some Canadians may have concerns about the fiscal fitness of the U.S. and could be tempted to staywith the tried and true home brand, the fact of the matter is that Canada is unlikely to repeat its outperformanceof the 2002-2012 decade. We believe the Canadian dollar is close to fair value, meaning we do not see another35% increase in its value helping to boost investor returns (as happened then). In addition, while the U.S. housingand energy sectors are poised for growth, in Canada both areas will face challenges going forward. We thinkthat Canadian investors would do well to consider investing at least a portion of their assets in high qualityU.S. companies with the potential to boost their dividends over time.7About the authorsBruce Cooper, CFAVice-Chair, Equities, TD Asset ManagementCo-Chair, Wealth Asset Allocation CommitteeBruce is Vice-Chair of equities at TDAM. He leads the fundamental equity, quantitative equityand fund of funds teams within TDAM.Ken Miner, CFAVice-Chair, Fixed Income, TD Asset ManagementCo-Chair, Wealth Asset Allocation CommitteeKen is Vice-Chair of fixed income at TDAM. The TDAM fixed income portfolio management teamwas awarded the Canadian Morningstar®Fixed Income Fund Manager of the Year in 2010 and 2011.TD Wealth Asset Allocation CommitteeThe Committee is composed of ten individuals from different areas of TD Wealth Managementbusinesses with unique investing skills and experience. The Committee was formed in 2009 to:• articulate broad market themes• provide macro asset allocation direction• identify major risks on the horizon