As Canada risks stagflation, insiders stick with the basics

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August 4, 2015 - On Sunday, Prime Minister Stephen Harper decided to get an early start on his campaign, making an expensive early election call which will cost taxpayers up to an extra half billion dollars according to the Canadian Taxpayers Federation. Although we doubt that the extra costs have been factored into the incumbent government's razor-thin balanced budget projections, it may end up as a rounding error in any event. We say that in light of the fact that crude oil is now trading near US$45 per barrel, well below the current budget survey assumptions of US$54 for 2015 (projections get even more optimistic in subsequent years). Given that the mining, oil and gas area represents more than 25% of Canada's goods producing industry GDP, the summer retrenchment in crude is shaping up to be a material hit to Ottawa's balanced budget scenario.

The Prime Minister has been quick to blame falling global oil prices for Canada's economic woes. While the negative impact of falling crude is uncontestable, the vulnerability of the Canadian economy to falling oil prices was likely made worse under his hand-picked central bank governor. Shortly after assuming the reins of the Bank of Canada, Stephen Poloz removed the tightening bias at the central bank. This tilt towards a looser policy took place at a time when crude oil was trading near US$100 and investment in the resource sector was roaring. In fact, in the three calendar years before Mr. Poloz took over at the bank, annual real growth in mining, quarrying, and oil and gas extraction net capital stock averaged 6.1%, well above the economy's non-residential long-run average of 2.7%. Mr. Poloz took over at the central bank in June 2013. In that year, fixed capital stock in the resource area soared another 6.6%.

 

Instead of taking a cautious approach in light of a possible over-investment scenario in the oil patch, Mr. Poloz pushed the loonie lower which helped to boost liquidity in the sector. While the subsequent sector pullback could not have been avoided by the central bank, the unintended consequences of the Poloz loosening was to throw fuel on an already intense fire.

As investors are all too aware, following a buildup of global crude supplies over the past year, the oil and gas investment flame has petered out. Although our Energy sector indicator continues to indicate that the group is undervalued, sentiment remains well below the optimism we saw in early winter when insiders jumped in with significant conviction. At this point we would suggest the positive insider signal in the Energy sector is most appropriate for long-term investors who are prepared for a 3-year plus holding period. Identifying companies with solid governance combined with capable and committed management will be key.

The repercussions of the Bank of Canada aided investment binge are now being felt beyond the oil patch as Canada looks set to enter a technical recession. Meanwhile, underlying inflation remains strong with core CPI sticking above the Bank of Canada's midpoint range now for 11 months. The combination of sputtering growth and underlying strong inflation suggests Canada may now be entering a period of stagflation. As we mentioned last week, insiders are reacting by favouring stocks in the basics food area, namely the Consumer Non-Cyclicals sector. Our indicator is on the rise now and is above the 200% level at which point there are two stocks with key insider buying for every one with selling. As such, we are upgrading the sector to undervalued.

Our Technology Indicator is also on the rise on the back of the collapsing loonie. Insiders are signalling that on balance a falling loonie is good for shareholders of Canadian tech companies as firms become cheaper for foreigners to buy. With the indicator now near 70%, we are upgrading the sector to fair-valued.

The other big mover this week has been sentiment in the Basic Materials sector. Our Basic Materials Indicator is back over 500% led by a jump in gold stock buying as share prices sagged. For investors who have avoided the gold group, now might be a good time to start putting together a shopping list. Market consensus continues to believe that the Federal Reserve will tighten monetary policy even in the face of some weakening economic data out of the United States. While the American central bank may well plow ahead, the risk of them backtracking will grow if labour market data starts to stall.

The chances of the American economy slowing down may be starting to weigh on insiders in the Consumer Cyclicals area which includes a number of companies that export into the world's largest economy. With our indicator slipping to 80%, we are downgrading it to fair-valued.

With the threat of stagflation looming on the horizon and an uncertain path for the Fed, investors might do well to follow the lead of insiders and stick to the basics while keeping an eye out for bargains in the bullion area.

Last week, the INK Canadian Insider (CIN) Index rose 1.22% while the S&P/TSX Composite Index advanced 1.99%, helped by a 4.39% jump in the S&P/TSX Capped Energy Index. The INK CIN Index has a slightly lower weighting in oil and gas names than the TSX Composite. Year-to-date, the INK CIN Index is up 2.54% while the TSX Composite is down 1.12%.

 

An earlier version of this post appeared before the market open on INKResearch.com.

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