Smart Money

Our regular summary of the capital markets. Check back each month for new updates.

Smart Money

January 21, 2020

A Hectic Start to the New Year, Except in Stocks

Market Recap & Box Score

With the first 20 days of 2020 in the books, global markets have continued their 2019 ascent with the S&P 500, TSX and MSCI World indices rising 4.4%, 3.3% and 3.5%, respectively.  While we had cited a lack of retail and institutional participation as a reason for optimism in 4Q19, it seems that narrative has flipped as we enter the early innings of 2020.  According to the CNN Fea...

With the first 20 days of 2020 in the books, global markets have continued their 2019 ascent with the S&P 500, TSX and MSCI World indices rising 4.4%, 3.3% and 3.5%, respectively.  While we had cited a lack of retail and institutional participation as a reason for optimism in 4Q19, it seems that narrative has flipped as we enter the early innings of 2020.  According to the CNN Fear & Greed Index, a 7-indicator reading of investor sentiment, the 21-Jan-20 reading hit 86 out of 100. This is a remarkable rise from the 30-range in September 2019.  Moreover, it indicates extreme greed and a high level of complacency.  Interestingly, gold has maintained its upward momentum, rising 5.1% for the month.  Equity markets are broadcasting a calm signal, but gold’s shine reflects political turmoil in the middle east and the expectation for falling real rates, which boosts demand for the metal.  Fears of reflation could be suppressing expectations for real yields in the future which is typically the true influence on the price of gold.

Elsewhere in metals, the meteoric rise in the price of palladium has been attention-grabbing.  Palladium is a key component of catalytic converters.  Eighty-five percent of mined palladium is used to turn toxic pollutants to carbon dioxide and water in exhaust systems.  As governments like China clamp down on vehicle pollution, automakers have increased its usage. Coincidently, consumers are moving from diesel-powered cars which utilize platinum to carry out the same operation, to gasoline which uses palladium.  As demand has increased, the supply has flatlined as palladium is primary mined as a by-product of platinum and nickel mining, rather than a focused end product.  As automakers scramble to secure inventory, the price of palladium has risen 22.5% in Jan-20, which comes off of an incredibly strong 2019 where its price appreciated 53.6%.  In total, palladium is up 3.3x over the past three years.  Speculators have surely driven some of the momentum; nevertheless, palladium has been in a deficit since 2012 and without additional supply or a substitute product, we could continue to see strength.

Oil continues to defy expectations, falling 5.0% for the month, despite an escalation of tensions in the Middle East following the killing of Qasem Soleimani, the Iranian leader of the Islamic Revolutionary Guard.  The assassination and subsequent bombing of US command posts in Iraq temporarily boosted the oil price by 3% but it has since fallen 8.6% as of 20-Jan-20.  Both sides of the conflict have declared that a diplomatic conclusion to the dispute is preferred. As such, some market participants have cited this as the reason for oil’s composure.  In addition, the possible absence of Soleimani’s military influence provide hopes that middle east tensions may moderate in the future.  However, the situation is nowhere near solved.  Iran’s persistently threatens to withdraw from the Global Nuclear Deal if European countries refer Tehran to the UN Security Council for violating the 2015 pact.  In the meantime, Canadian oil, measured by Western Canadian Select, has fallen 13.9% during the period.  This drop has once again pushed the spread with WTI to a 40% discount – back to where it was in late 2018.  The combination of record high inventories following a recent outage on the Keystone pipeline, and a Canadian National rail strike has cast doubt on Canada’s ability to reliably access the homeland’s oil.  Record-breaking cold weather in Western Canada has added fuel to the fire.  Two large crude producers were obligated to declare force majeure when they couldn’t fulfil their contracts due to an inability to process crude at extreme low temperatures.  Natural gas is a key ingredient in the conversion of bitumen to synthetic crude, and freeze offs have restricted the supply available to producers.

More recently, reports of a new Chinese coronavirus (the virus responsible for SARS in 2003) have made headlines and are impacting global markets.  On 20-Jan-20, the World Health Organization announced it would convene a meeting to declare a world health emergency.  The virus started in the Wuhan province of China, where 258 confirmed cases and six deaths have been reported.  The virus has already spread, and it is poised to worsen as the Chinese New Year (25-Jan-20) travel rush begins.  Global markets have taken note, with the iShares MSCI Emerging Markets Index down 2.2% on 21-Jan-20.

December 18, 2019

The Highs & Lows of Cannabis

Smart Money

Outright prohibition of cannabis began in the United States in the 1920s.  However, over the past several years cannabis legalization has been rapidly occurring across the United States, at the state level.  In Canada, it is already legal for both recreational and medicinal purposes. The cannabis sativa plant has almost 500 natural components; as many as 70 of which are cannabinoids, ...

Outright prohibition of cannabis began in the United States in the 1920s.  However, over the past several years cannabis legalization has been rapidly occurring across the United States, at the state level.  In Canada, it is already legal for both recreational and medicinal purposes. The cannabis sativa plant has almost 500 natural components; as many as 70 of which are cannabinoids, chemicals that are unique to the plant.   The push for legalization is led in large part by the medical discovery in the early 1990s of the endocannabinoid system, a complex cell-signaling system inside the human body.  The possible applications for the constituents of cannabis are plentiful and vary across many industries, including healthcare, beverages, manufacturing, beauty & cosmetics, farming and more.   Accordingly, growth in the cannabis sector could push upwards of 10 times over the next decade.  Unfortunately, cannabis stock prices have crashed by over 70% from early-2019 peaks.  Valuations are now in line with peer groups that have nowhere near the growth potential.

In the lead up to the Canadian legalization of cannabis for recreational purposes in 2018, the enthusiasm for cannabis stocks mimicked technology during the Dot-Com bubble in 2000. Nearly all the publicly listed companies operated without revenue, nevertheless speculation elevated prices without regard to fundamentals.  However, capital support and investment from behemoth companies such as Constellation Brands, Anheuser-Busch and Altria, to name a few, fueled the excitement in the sector.  Through 2018 and 2019, fundamentals improved, and firms reported sales growth ranging from 10x to 200x the levels earned in 2016.  Despite the progress, profit expectations have not materialized and share prices have fallen precipitously.  Access to capital and regulatory restrictions on interstate growth and acquisitions have also been harmful to valuations.
In the United States, cannabis remains illegal under federal law for any purpose as it is classified as a Schedule I substance, a category reserved for substances with a high potential for abuse and no accepted medical use. Despite the federal classification, the United States is the fastest growing market for cannabis as individual states have legalized cannabis for both medicinal and recreational purposes. The confusing system means that a business head-quartered in a legalized state, may simultaneously violate federal laws and be non-compliant in neighbouring states. The tangled legislation restricts capital and products from flowing across interstate borders.
As at December 2019, 40 states have allowed some form of legalized cannabis.  State legalization has grown from just 17 at the end of 2010. Adoption has accelerated in large part due to the amendments of the Cole Memorandum, named the Rohrabacher-Farr amendment which bars federal prosecution of individuals who comply with their state’s medical cannabis laws. The rapid growth has created additional pressure for the federal government to address the legal discrepancy. This sets the stage for cannabis to be used as a political weapon in the 2020 election.
Current Democratic front-runner, Elizabeth Warren, introduced the Strengthening the Tenth Amendment Through Entrusting States Act (STATES Act) in June 2018. This legislation prohibits Federal interference with cannabis corporations operating legally within state guidelines. The STATES Act enjoys the most bipartisan support, this includes backing from President Trump. Further, in December 2018, Trump signed the omnibus Farm Bill, which redefined hemp as an agricultural product rather than a Schedule I substance. Hemp is a strain of the Cannabis sativa plant species that is grown specifically for industrial uses of its derived products.

On September 25, 2019, the House of Representatives voted in favour of the SAFE Banking Act, a bill aimed at giving clarity for financial regulations across the United States. If approved by the Senate, US operators would gain access to capital and can purchase common social services for employees such as insurance. The Bill however has not made it through the Senate, and if it is pushed until 2020 the process for approval will reset. Current Senate Banking Committee Chair Mike Crapo has been steadily softening his once hardline position on the subject. State Attorney Generals are pushing for change, as it is becoming more difficult to oversee the industry with no financial guidelines.

In addition to the momentum for legislative changes in the United States, there is a global push for rescheduling cannabis by the United Nations. In early 2019, the World Health Organization called for the whole marijuana plant to be removed from its most restrictive category of a 1961 convention. Such a shift by the United Nations would be a positive catalyst as additional nations would likely be more inclined to scale back or repeal their prohibition laws. It should be noted, however, that legalization for non-medical reasons would still violate global conventions and the vote which was scheduled for March 2019 was postponed with no clear indication on a new vote date.

Within a 24-month time frame, the cannabis industry has transitioned from stretched valuations to panicked selling. The thoughtless flogging is reminiscent of the beating undertaken by Amazon and Booking Holdings (formerly Priceline Group) when the Dot-Com bubble went bust.  When Priceline IPO’d in 1999, it soared to a $23 billion market value. But by 2002, tanking tech stocks devalued its market cap to about $150 million. Today, the company’s value is approximately $85 billion.  It would be reckless to suggest that Booking/Priceline history will repeat with the whole cannabis complex. Nevertheless, sentiment is approaching extreme negative levels at a time when growth is accelerating and structural impediments are fading.  We anticipate that momentum will shift, as legislation and access to capital improve, and today’s investors will enjoy favorable outcomes in the long-term.

The Highs & Lows of Cannabis

December 17, 2019

OPEC Cuts, Stalling Shale Boost Oil Prices

Market Recap & Box Score

The 2019 calendar years is shaping up to be the strongest year since 2013 for the S&P 500. North of the border, the TSX should post its strongest year since 2009.  The results would have seemed unthinkable during Q4 of 2018 as markets were crashing and a recession was all but guaranteed.  For the month ending 17-Dec-19, the S&P 500 and MSCI World indices gained 1.3% and 0.6%, ...

The 2019 calendar years is shaping up to be the strongest year since 2013 for the S&P 500. North of the border, the TSX should post its strongest year since 2009.  The results would have seemed unthinkable during Q4 of 2018 as markets were crashing and a recession was all but guaranteed.  For the month ending 17-Dec-19, the S&P 500 and MSCI World indices gained 1.3% and 0.6%, while the TSX was flat.

Equity strength continues to defy expectations despite lingering recession concerns.  However, the economic slump sentiment seemed to subside when the employment survey from the US Bureau of Statistics was released on 06-Dec-19. The jobs market showed a very healthy gain of 266,000 (vs. expectations of 187,000) nonfarm jobs in November, along with an unemployment rate at 3.5% and a 3.1% bump in hourly earnings.  While employment data has historically been a fairly backward-looking statistic, the news seemed correlated with a 1% rise in the S&P 500 for the day, and a break above the previous high for the month.  A secondary, or perhaps primary, driver for the market was the Fed’s declaration that it would allow inflation to run above the 2% policy target. The justification that the rate has remained below target for enough time that allowing it to run above will bring the average to 2%.  Readers may now wonder why a plan to let inflation rise may be good for markets, especially if they have read our past commentaries, but in this case it comes down to the lens with which a participant wants to view the market.  In the short-term, this translates to sustained accommodation and zero quantitative tightening.  If history repeats, this means prolonged asset inflation and a rise in equity markets.  We won’t beat a dead horse, but if market participants decide to apply a longer-term lens, the implications of higher inflation could signify lower corporate margins, additional consumer stress through higher costs if wages don’t keep up, and the inevitable Fed scramble to temper expectations through make-up tightening down the road.  It is easy to see the forest for the trees, but 2019 does not provide much of a reason to expect an imminent change in focus.

Speaking of inflation … ok, fine, just a couple more shots at said horse … rates and commodities seem to have started to sniff out a pickup during December.  The US 10-year and 30-year yield both rose 10bps for the month as the yield curve steepened, meaning longer-term yields are rising via a perceived pickup in growth or inflation, while the short-term continues to be suppressed through dovish Fed policy.  Elsewhere, copper climbed 5.3%, while weakness in the CRB US Spot Raw Industrials index reversed course, rising 2.6%.  This one is fairly noteworthy as it includes things like steel, tin, burlap, cotton, cloth etc., in addition to copper, which is a diversified gauge of key economic inputs.  Now one month does not a trend make.  However, employment has historically been a lagging indicator, these commodities are a fairly accurate leading indicator, and can help form judgements of how things may unfold in the coming months.

Moving on to oil, WTI demonstrated strength during the month and moved through the $60 ceiling, up 4.6%.  Helping drive the move was the result of December’s OPEC meeting.  The 14 country cartel agreed to cut an additional 500K barrels per day, bringing the total cut to 1.7MM barrels per day, above consensus.  Media outlets have suggested that the improved trade situation between the US and China could also impact expectations for global growth, and in turn demand for oil.   Possibly related and likely more impactful, persistent negativity surrounding the trend in US shale oil productivity.  Global supply has been profoundly impacted by shale over the past few years. Accordingly, weakness should be bullish for oil prices in the long-term. Shale basins lose 70% of production after year 1, and 35% of the remainder in year 2.  The short life cycle of shale operations means that the taps could turn off even quicker than anticipated.  Rapid depletion and tighter lending standards within the industry have caused concern for the US’s ability to grow production and pace global supply growth.  As a result, there has been renewed enthusiasm in the narrative north of the border, with the S&P/TSX Energy Index rising 6.5% for the period.