These Should be on Your Radar Screen (Marc Chandler)

Monday, January 21st, 2013

by Marc Chandler, Marc to Market

The US dollar begins the week mostly firmer. The notable exception is the Japanese yen, which has seen some position adjustment ahead of the outcome of the BOJ meeting tomorrow. In Asia, and Europe thus far, the dollar has found support near its five day moving average and the 38.2% retracement of its latest leg up (from Jan 16), both of which come in near JPY89.30. The recovery of the yen took a toll on Japanese stocks. The Nikkei lost 1.5% and posted an outside down day (trading on both sides of Friday’s ranges and finishing below Friday’s low).

The euro has been confined to an exception narrow range of about 15 ticks on either side of $1.3315. A break of support in the $1.3260-80 area would lend credence to our argument that a top of some import is being carved out, with a potential double top at $1.34. Sterling saw follow through selling on top of the pre-weekend losses. The euro traded at 10-month highs against sterling above GBP0.8400, but is reversing lower near midday in London. A modest bounce in cable seen in the European morning ran out of steam near $1.5900, which likely now marks the upper end of the new range.

Equity markets are mixed, with the MSCI Asia-Pacific seeing a 0.2% decline, dragged down by Japanese shares, and to a lesser extent Taiwan, Korea and Malaysia. European bourses are higher with the Dow Jones Stoxx 600 advancing almost 0.5%, led by utilities, basic materials and technology. While the US market is closed today, before the weekend the three main gauges, Dow, NASDAQ, and S&P 500 closed at 5-year highs. This week’s earnings feature technology giants Apple, Google, IBM, and United Technologies.

There was a potentially important development in the US fiscal drama. Some Republicans in the House of Representatives are proposing a three-month extension on the debt ceiling to give more time to negotiate a long-term deal. It is not yet immediately clear if the measure has sufficient Republican support–remember Bohener’s Plan B?–or if Obama will agree to it, after having the lack of interest in a short-term fix. Still it shows some fluidity of the situation and should ease what little concern that had really been that the US would default.

In a very tight election in Lower Saxony, the real winner, regardless of the formation of the new state government is the Free Democrat Party, and by extension German Chancellor Merkel. Merkel’s CDU party depends on a coalition with the FDP, but over the past year, the FDP has been trounced in most state elections. The conventional view that the national election later with year would result in another grand coalition was predicated on the inability of the FDP to deliver. Some feared it would not even meet the 5% threshold to secure parliamentary membership. In Lower Saxony, the FDP defied expectations and received almost 10% of the vote, more than twice what the opinion polls suggested. Yet, FDP party head and Economics Minister Roesler offered to resign and threw his support toward Bruederle, the head of the party’s parliament caucus, who is regarded as more dynamic and with some hope he can revive the party’s fortunes. A formal leadership decision in May. The SPD and Greens eked out a surprise victory, but Steinbrueck, the SPD candidate for Chancellor, apologized for his gaffes in the national campaign, which may have cost the SPD votes in the local contest.

The most anticipated event of the week is tomorrow’s conclusion of the BOJ meeting. The pressure on the BOJ from the new Abe government is widely recognized and with its recent economy assessment, in which most regions were downgraded, the BOJ cannot be content either. There is, therefore, little doubt the BOJ will take action. However, the impact of some of the measures that have been discussed like open-ended QE or a 2% inflation goal is questionable. What does open-ended QE mean when the BOJ has increased the amount of assets it is buying repeatedly ? How is a 2% inflation goal credible when it has failed to achieve its 1% goal? Similarly, a cut in the interest paid on reserves is possible, but it is not clear how that would be inflationary or stimulative. Our fundamental and technical analysis warns that the market is vulnerable to disappointment or a “sell the rumor buy the fact” type of activity. There has been some position adjustment today as the dollar still has not been able to sustain a move above JPY90. In terms of intent, the imagery we still think apropos is blowing (hot) air underneath the (yen’s) parachute to increase the likelihood of a soft landing and reduce the antagonism that its strategy engenders.

There are two aspects of the technical condition of that are worth underscoring. First, we think there was significant deterioration of the major foreign currencies, with sterling convincingly violating a 7-month uptrend line, the dramatic weakness of the Swiss franc, and new multi-week lows for the Australian and Canadian dollars. The euro has fared best, but technically appears vulnerable. Second, we note that implied volatility in the currency markets has trended higher in recent weeks. Before the weekend, 3-month euro vol reached its highest level since Oct. It reached a low in late Nov near 6.4% and now is near 8.6%. 3-month yen vol is at its highest level since Sept 2011 near 11.2%. On the eve of the election announcement in mid-Nov, it was near 7%, having bottomed a month earlier near 6.55%. Sterling vol is at its highest level in four months near 7.3%. It bottomed in middle of last month near 5.25%.

The euro area finance minister meet today. Cyprus aid package is not ready and it won’t be for at least a couple more months. Greece is progressing towards another tranche amid fresh call from the IMF than even if the country stays on track, it will need another 9 bln euros of assistance (perhaps in the form of further official sector concessions, Merkel has hinted in the latter years of its current program). There may also be some discussion of Spain. Perhaps the one notable action from the Eurogroup is that Juncker who has been the leader, with mixed reviews, including last week’s gaffe about the euro, is stepping down. His likely replacement, the new Dutch Finance Minister Dijsselbloem, has been widely tipped.

A more pressing issue for investors is the implication of the repayment of LTRO funds by the banks starting next week. Speculation that it would tighten financial conditions saw euribor yields rise sharply. ECB’s Coeure tried to calm market anxiety by indicating that he did not expect an impact on Eonia from the settlement. The implied yield of the March 13 Euribor futures contract has been trending higher since early December. The backing up in money market rates in Europe did not coincide with a stronger euro. We anticipate some stabilization in euribor in the days ahead, awaiting indications of the size of the repayments. Forecasts generally seem to range between 100-200 bln euros of the roughly trillion euros outstanding.

In addition, we draw your attention to the following events and data: Australia’s Q4 CPI on Tuesday could sway expectations for the RBA meeting in early February. Presently there is about a 40% chance of a 25 bp rate cut discounted. Although the headline pace of inflation likely accelerated, the core rate appears stable and has not been an obstacle to easier RBA policy. The release of the BOE minutes will likely reaffirm market expectations that a resumption of QE is not imminent, even though the economy appears to have contracted in Q4 (first estimate released on Friday, Jan 25). Europe reports the flash PMI readings in Thurs. A critical issue is if Germany, which appears to have contracted in Q4, is in a recession (as defined by two consecutive quarters of contracting GDP (though note that technically, a recession in the US is determined by National Bureau of Economic Research and it uses a broader definition).

In emerging markets, we note that the tone of Mexico’s central bank statement was more dovish than expected before the weekend. It effectively removed any lingering threat of a hike, though we do not expect a rate cut either. Israel goes to the polls and barring a significant surprise, we do not expect much of a market reaction, though note that the dollar has found bids ahead of 1-year lows near ILS3.70. Three emerging market central banks meet this week, Turkey, the Philippines and South Africa. The only action we expect is a 25 bp rate cut by South Africa. The rand has been the weakest since the start of the year, losing 4.5% against the dollar, but many have their sights on the ZAR9.0, the high from October and again in November.

About Marc Chandler

Marc Chandler has been covering the global capital markets in one fashion or another for nearly 25 years, working at economic consulting firms and global investment banks.

Tags: Canadian Economy, Currency
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Housing Hyperbole (Bradley)

Friday, January 11th, 2013

January 10, 2013

By Tom Bradley, Steadyhand Investment Funds

Having been early and loud with my concerns about Canadian housing prices, I’m following with interest the daily coverage of the residential real estate market. I have a few thoughts on what I’ve read so far.

Not a big deal … yet

Despite all the front page coverage, the weakness in the market hasn’t amounted to much yet. A few markets, or pockets, are down meaningfully, but the overall price declines can’t be described as anything worse than a ‘flat’ market. I expect it will get a lot weaker, but the declines so far are no worse than some of the lulls we’ve had during this long run.

More interesting to me is the lower sales volumes. When houses aren’t moving, it’s often a precursor to lower prices. But again, we shouldn’t read too much into the current slowdown. Recent volumes are being compared to some pretty rarified levels. I’m sure my real estate agent friends won’t agree, but today’s turnover isn’t that bad. There are still houses selling in less than a week.

Blame Flaherty

In every article about the softening market, the changes to the mortgage insurance rules by CMHC are mentioned in the first five or six paragraphs. Finance Minister Flaherty is always being blamed for the slowdown. Well, certainly the changes have prevented some transactions from getting done, but let’s not forget, a mortgage with a 25-year amortization and 2-3% interest rate is a pretty sweet deal. I think the real estate industry needs to give its head a shake. Does our housing market really need 35-40 year mortgages and near-zero rates to stay healthy?

There are a few other reasons why the market might be slowing down. Even if CMHC reversed the rules tomorrow, we’d still be in a situation where:

• House prices have grown much faster than incomes for more than a decade.
• The buy vs. rent ratio is out of whack (in favour of renting).
• Consumer debt levels are at all-time highs.
• And the housing affordability index is on the expensive side, even though near-zero rates are being used in the calculation.

The only thing we should blame Mr. Flaherty for is not doing something sooner. Former Bank of Canada governor David Dodge had it right when he went ballistic in 2006. When CMHC increased the allowable amortization period to 35 years and permitted interest-only mortgages, he said, “Particularly disturbing to me is the rationale you [CMHC] gave that ‘these innovative solutions will allow more Canadians to buy homes and to do so sooner.’” Mr. Dodge said that these new practices were more likely to drive up prices and make houses less affordable.

Recovery from what?

I think it’s telling that although we really haven’t had any meaningful weakness yet, there are already some industry people calling for a recovery. It’s telling because it reveals how programmed we are for steadily rising prices. To call for a turnaround when prices only started weakening a few months ago is absurd. As of December 31st, Toronto condo prices are up 7% year over year, not down.

An overvaluation in the housing market can play out in any number of ways. Higher unemployment and rising mortgage rates would likely mean a significant, early 90’s type fall. An okay economy and continued low rates might allow prices to stay near current levels for a number of years. And there are all kinds of other possible scenarios.

The ‘prices leveling off’ scenario is the consensus right now. In the paper yesterday there were two bank CEO’s and the head of a real estate company predicting “relatively stable” price levels, a “soft landing” and “flat sales volumes” year over year. As I’ve said before, long-running, extreme economic cycles very rarely end without a severe reversal. In fact, I can’t think of any. Of all the possible scenarios, I think it’s heroic to predict that house prices are going to flatten out after they’ve been rocketing up for more than a decade.

What I said in a June, 2006 blog posting about the U.S. housing market seems apropos for Canada in 2012: “I thought the U.S. housing boom would have ended a couple of years ago. I’ve been wrong on that. But by going on longer and climbing to greater heights than many of us expected, it has made a long and ugly retrenchment all the more likely.”

My views may prove to be early or just flat out wrong, but the point here is that we shouldn’t be too hasty in drawing any conclusions, especially based on short-term stats and self interested predictions. We’re in the early innings of a fascinating game.

Copyright © Steadyhand Investment Funds

Tags: Bradley, Canadian, Canadian Economy, Canadian Market
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2013 Investment Outlook and Portfolio Strategy (Alfred Lee)

Wednesday, January 9th, 2013

BMO ETF Portfolio Strategy Report

A New Year, and More Market Resolutions

by Alfred Lee, CFA, CMT, DMS
Vice President, BMO ETFs
Portfolio Manager & Investment Strategist
BMO Asset Management Inc.
alfred.lee(at)bmo.com

In this report, we highlight our strategic and tactical portfolio positioning strategies for the first quarter using various BMO Exchange Traded Funds.

• The fiscal cliff drama finally came to an end on New Year’s day. A compromise deal was reached that prevented an end to spending cuts and an increase in taxes to the middle class. The House of Representatives voted 257-167 to approve the fiscal cliff bill, which allows tax increases to individuals and households making US$400k and US$450k respectively. Over the quarter, the focus of investors will shift towards the already breached U.S. debt ceiling, giving Congress roughly two months to raise its legal borrowing limit.

• The Federal Reserve Board (Fed) announced a fourth round of quantitative easing1 (QE4) at its December FOMC2 meeting, to replace Operation Twist3 which expired at the end of 2012. This rendition of the monetary easing measure was given thresholds, allowing the Fed to keep rates low as long as unemployment remained above 6.5% and inflation expectations remained below 2.5%.

• The power transition in China was also completed over the quarter, paving the way for the country’s new regime. While modernizing China’s infrastructure will continue, it is unlikely it will occur at the same rapid pace of 2009-2010, potentially placing headwinds on commodity related sectors of the S&P/ TSX Composite Index (S&P/TSX). As a result, we continue to favour the lower beta trade for Canadian exposure. The failure of the S&P/TSX in following the 4.3% one day surge of the Shanghai Composite Index on December 14 may provide evidence for this thesis.

• With the growing middle class in emerging markets, the focus of their economic policies continues to shift towards consumer consumption and away from commodity intensive projects. Direct exposure in emerging market equities may therefore be more favourable than indirect exposure through Canadian equities. It is possible that the correlation between the S&P/TSX and emerging market equity stocks will decline in coming years, as developing nations have less of a demand for our base metal exports. Many investors have also started reallocating to emerging market equities, which could lead to tailwinds for the asset class.

• Although the European economies continue to remain in a malaise, there have been some positive developments. The OMT4 programme has been a game changer over the short-term, as most European sovereign credit spreads remain well below their one-year averages. Certainly, European stocks can outperform in the first quarter of 2013 and even throughout the year, however from a portfolio management context, returns in this area could come with heightened volatility, particularly since it is the region that is most likely to produce a tail-risk event5. The post crisis era, has favoured more defensive-oriented investments with higher risk-adjusted returns. For that reason, we continue to avoid direct exposure to European stocks, despite the opportunities. Similar to the theme we highlighted back in 2011, we believe multi-nationals provide indirect exposure to the European economy.

Things to Keep an Eye on…

Despite the high debt to GDP ratio of the U.S., the U.S.’s low interest rate policy will continue to encourage carry-trades, where investors borrow in U.S. dollars to fund purchases in riskier assets. During market sell-offs, the U.S. dollar rallies as carry-trade borrowings are paid back. For this reason, the greenback will likely remain inversely correlated to risk assets, making non-currency hedged U.S. equity ETFs less volatile over the long-run.

Recommendation: We have recommended an overweight to U.S. equities since the end of 2010. In that time, U.S. equity indices have outperformed and we continue to believe they provide the best risk-adjusted opportunities amongst broad based equity areas. We now recommend switching from the BMO S&P 500 Hedged to CAD Index ETF (ZUE) to the non-currency hedged exposure to U.S. equities through the BMO S&P 500 Index ETF (ZSP) as a way to lower overall portfolio volatility.

The Fed’s recent announcement of QE4 likely means a prolonged period of low interest rates. This will partially dictate the Bank of Canada’s monetary policy, which will cause yielding assets to continue outperforming growth related investments. A quicker than expected North American recovery, however, could place upward pressure on interest rates. With yields at historic lows, investors should also look for interest rate protection in rate sensitive yielding investments.

Recommendation: Preferred shares have been in high demand given their tax efficient yield and low volatility attributes. With the risk of rising rates, albeit low, we recommend rate reset preferred shares, which provide better protection to rising rates than straight perpetual preferred shares. Investors can obtain diversified exposure to a portfolio of rate resets through the BMO S&P/TSX Laddered Preferred Share Index ETF (ZPR).

As previously mentioned in this report, we believe commodity related sectors of the S&P/TSX may continue to face heightened volatility with emerging markets being less reliant on reflationary policies. Our core position in Canadian equities, the BMO Low Volatility Canadian Equity ETF (ZLB) has significantly outperformed the S&P/TSX. Since the launch of ZLB on October 27, 2011, its 17.5% total return has easily outpaced the 4.3% total return of the S&P/TSX over the same time period.

Recommendation: Outside periods of unconventional monetary policy, particularly quantitative easing, lower beta trades have outperformed those of a more cyclical or higher beta nature. Our 9.0% position in ZLB has been one of our most efficient equity exposures, offering high risk-adjusted returns. We recommend defensive oriented ETFs over traditional market-cap weighted ETFs for broad based Canadian equity exposure.

Changes to the Portfolio Strategy:

Asset Allocation:

• With continued geo-political risk stemming from a number of regions, in addition to continued macro-economic headwinds, asset allocation remains important in the portfolio construction process. Our strategy for the first quarter of 2013 remains predominantly defensive in the equity portion of our portfolio, with targeted positions in key cyclical areas for growth opportunities. Our view remains that higher yielding non-Canadian credit plays will continue to provide better risk-adjusted returns than certain areas in equities. Fixed Income:

• Our strategy for fixed income remains unchanged for the first quarter of 2013. The BMO Aggregate Bond Index ETF (ZAG) provides low cost exposure to the broad Canadian bond universe, while more targeted fixed income ETFs provide a further tilt toward our preferred duration and credit exposure. We continue to favour corporate bonds as a slowly strengthening Canadian economy could result in a tightening of corporate spreads. With interest rate futures currently pricing in a zero probability of rates increasing by 0.25% or more in the next six-months, we recommend overweighting mid-term corporate bonds for higher yield. Until rates look close to rising, we continue to recommend the BMO Mid-Corporate Bond Index ETF (ZCM) as a tactical tilt in the fixed income portion of our portfolio. Equities:

• The underlying macro-economic backdrop in the U.S. continues to improve. Economic data in unemployment and housing in the U.S. has shown signs of improvement. We remain positive on U.S. equities, but are switching our 10.0% exposure in the BMO S&P 500 Index Hedged to CAD (ZUE) to an 8.0% position in the non-currency hedged BMO S&P 500 Index (ZSP), as the currency exposure of the U.S. dollar will provide us with an inverse correlation to risk assets. We have pared back our exposure to U.S. equities by 2.0%, as we have increased our exposure to emerging markets.

• We are slightly decreasing our exposure to the BMO Covered Call Canadian Banks (ZWB). Overall, the Canadian banks are more stable than their global counterparts, but have gone on a considerable run since early June. Consequently we are decreasing our position in ZWB by a slight 1.0%. Our position in preferred shares also provides us with exposure to the Canadian banks, but higher up the capital structure. Although financials remains our largest sector overweight, Canadian banks account for a small position of this allocation.

• The Shanghai Composite Index, an emerging market laggard in terms of equity performance over the last two years, had a one day gain of 4.3% on stronger manufacturing data. Lower inflation in many emerging market countries, may allow for more accommodative monetary policy. Should we get a soft-landing in China, this will be positive for the broader emerging market countries. Though Chinese stocks may face headwinds, there are attractive opportunities in the broader emerging market equities. We are initiating a small position of 3.0% in the BMO Emerging Market Equity Index ETF (ZEM).

• The fourth quarter of the year has historically been a seasonal strong period for technology stocks. However, tech stocks continue to run up against headwinds. While the longer-term potential for technology stocks remain positive, from a tactical perspective, we our eliminating our 3.0% position in the BMO Nasdaq-100 Hedged to CAD Index ETF (ZQQ) as its underlying index, the Nasdaq-100 Index, registered a double-top formation, which usually precedes a short-term sell-off. Non-traditional/Alternative:

• Preferred shares have many characteristics that are beneficial to a portfolio, such as non-correlated returns to bonds and equities, tax efficient yield and lower volatility compared to bonds. As mentioned on the previous page, we prefer rate resets given they are less sensitive to rising interest rates. We are initiating a 5.0% position in the BMO S&P/TSX Laddered Preferred Share Index ETF (ZPR). In addition to being a portfolio of only rate resets, the portfolio utilizes a laddered approach, where the portfolio is divided in five equal term buckets, organized by reset year. The laddered structure allows an equal portion of the portfolio to reset to the current interest rate environment each calendar year, providing an additional layer of protection against rising rates. • We continue to like gold given the ongoing expansionary monetary policy and lower relative interest rates in the U.S. However, the seasonality for gold tends to be the most significant in the last two quarters of the year. Consequently, we are trimming our position in the BMO Precious Metals Commodity Index ETF (ZCP) by 2.0% to 5.0%, still leaving us with a sizable position.

Footnotes:

1. Quantitative easing: An unconventional monetary policy used by some central banks when traditional measures have not produced the desired effect. Money supply is typically increased in an effort to promote increased lending and liquidity.

2. Federal Open Market Committee (FOMC): A committee within the U.S. Federal Reserve that is in charge of determining monetary policy for the country. It makes key decisions on interest rates, money supply and unconventional monetary measures through open market operations.

3. Operation Twist: A program initiated by the U.S. Federal Reserve (Fed) to push down long-term rates by reinvesting the proceeds of selling short-term U.S. Treasuries in issues of longer maturity. By doing so, the Fed aims to stimulate the economy by lowering long-term borrowing costs by flattening the yield curve.

4. Outright Monetary Transactions: A European Central bank program, which enables them to purchase sovereign bonds issued by European member states in the secondary market.

5. Tail-risk: The risk of an outlier or improbable event occurring. Statistically, the event is said to be three standard deviations away from the mean under a normally distributed curve.

DIsclaimer:

The Dow Jones Industrial AverageSM is a product of Dow Jones Opco, LLC, (“Dow Jones Opco”), a subsidiary of S&P Dow Jones Indices LLC and has been licensed for use. “Dow Jones®” and “Dow Jones Industrial AverageSM” are service marks of Dow Jones Trademark Holdings, LLC (“Dow Jones”) and have been licensed to Dow Jones Opco for use for certain purposes. BMO ETFs based on Dow Jones indexes are not sponsored, endorsed, sold or promoted by Dow Jones Opco, Dow Jones or their respective affiliates, and Dow Jones Opco, Dow Jones and their respective affiliates make no representation regarding the advisability of trading in such product(s).

”S&P®” and “S&P 500®” are trade-marks of Standard and Poor’s Financial Services LLC and “TSX” is a trade-mark of TSX Inc. These and other associated trade-marks and/or service marks have been licensed for use by BMO Asset Management Inc. None of the BMO ETFs are sponsored, endorsed, sold or promoted by any of its aforementioned trade-mark owners and the related index providers or their respective affiliates or their third party licensors and these entities make no representation, warranty or condition regarding the advisability of buying, selling or holding units in the BMO ETFs.

Nasdaq®, OMX®, NASDAQ OMX®, Nasdaq-100®, and Nasdaq-100 Index®, are registered trademarks of The NASDAQ OMX Group, Inc. (which with its affiliates is referred to as the “Corporations”) and are licensed for use by BMO Asset Management Inc. The BMO Nasdaq 100 Equity Hedged to CAD Index ETF has not been passed on by the Corporations as to its legality or suitability and is not issued, endorsed, sold, or promoted by the Corporations. THE CORPORATIONS MAKE NO WARRANTIES AND BEAR NO LIABILITY WITH RESPECT TO The BMO Nasdaq 100 Equity Hedged to CAD Index ETF.

This communication is intended for informational purposes only and is not, and should not be construed as, investment and/or tax advice to any individual. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.

BMO ETFs are managed and administered by BMO Asset Management Inc., an investment fund manager and portfolio manager, and separate legal entity from Bank of Montreal.

Commissions, management fees and expenses all may be associated with investments in exchange traded funds. The indicated rates of return are the historical annual compound total returns including changes in prices and reinvestment of all distributions and do not take into account commission charges or income taxes payable by any unitholder that would have reduced returns. Please read the prospectus before investing. Exchange traded funds are not guaranteed, their value changes frequently and past performance may not be repeated. ® BMO (M-bar roundel symbol) is registered trade-marks of Bank of Montreal, used under licence.

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Merk 2013 Dollar & Currency Outlook (Axel Merk)

Tuesday, January 8th, 2013

by Axel Merk

Sidetracked by the discussion over the “fiscal cliff” and possibly a New Year’s hangover, it’s time to face 2013 in earnest. Is the yen doomed? Will the euro shine? What about Asian and emerging market currencies? Will gold continue its ascent? And the greenback, will it be in the red?

Before we look too far forward, let’s get some context:

• “Central banks hope for the best, but plan for the worst” was our theme a year ago. With everyone afraid of the fallout from the Eurozone, printing presses in major markets were working overtime. We argued this would benefit currencies of smaller countries – be that the so-called commodity currencies or select Asian currencies – that feel less of a need to “take out insurance.”
• While we were positive on the euro when it approached 1.18 versus the U.S. dollar in 2010, arguing the challenges are serious, but ought to be primarily expressed in the spreads of the Eurozone bond market. Then in the fall of 2011, we grew increasingly cautious because of the lack of process: just as it is difficult to value a company if one doesn’t know what management is up to, it’s difficult to value a currency if policy makers have no plan. In the spring of 2012, when we were most negative about the euro, we lamented the lack of process in a Financial Times column. European Central Bank (ECB) chief Mario Draghi appeared to agree with our concerns, imploring policy makers to define processes, set deadlines, hold people accountable. After his “do whatever it takes” speech in July 2012, he took it upon himself to impose a process on European policy makers in early August ¹. We published a piece “Draghi’s genius” where we called for a bottom in the euro. We were inundated with negative feedback in the immediate aftermath of our analysis from professional and retail investors alike, confirming that were not following the herd, nor buying something that’s too expensive.
• While we liked commodity currencies in the first half of the year because of printing presses in larger economies working overtime, we grew a little cautious as the year moved on, partly because of valuations. Each commodity currency has its own set of dynamics, as well as their own Achilles heel: in the case of the Australian dollar, we had some concerns about its two tier domestic economy (not all of Australia was benefiting from the commodity boom), but also about the perceived slowdown in China.
• We studied the Chinese leadership transition with great interest; while 2012 may have been a year in transition, more on the dynamics as we see them play out below.
• Back in the U.S., we squandered another year to get the house in order. The fiscal cliff was a distraction; we need entitlement reform to make deficits sustainable. Europeans have no patent on kicking the can down the road. But unlike Europe, the U.S. has a current account deficit, making it more vulnerable should investors demand more compensation to finance U.S. deficits (that is, higher interest rates).
• Japan: the more dysfunctional the Japanese government has been, the less it could spend, the less pressure it could exert on the Bank of Japan. Add to that a current account surplus, and all this “bad news” was good news for the yen. Countries with a current account surplus don’t need inflows from abroad to finance government deficits; as a result, the absence of economic growth that keeps foreign investors away is of no detriment to the currency. Conversely, countries with current account deficits tend to pursue policies fostering economic growth to attract capital from abroad. However, in late 2012, we published a piece “Is the Yen Doomed?” What happened? Japan was about to have a strong government. More in the outlook below.

We believe the currency markets are well suited for decision-making based on macro-analysis. Just as throughout 2012 the themes were evolving, please keep in mind that our 2013 outlook may be outdated the moment it is published, as we update our views based on new information or a new analysis of old information. Still, those who have followed us over the years are well aware that we like to shift our views within a framework. Please consider our 2013 outlook in this context:

• We believe the yen is indeed doomed. We remove the question mark. Prime Minister Abe’s new government sets the stage, but key to watch are:
  • Abe’s government will appoint the three top positions at the Bank of Japan, as the governor and both deputy governors retire. Recent appointees have already been more dovish. Japanese culture is said to prefer talk over action, but the time for dovish talk may finally be over (despite their dovish reputation, the Bank of Japan barely expanded its balance sheet since 2008; in many ways, of the major central banks, only the Reserve Bank of Australia has been more hawkish).
  • Japan’s current account is sliding towards a deficit. That means, deficits will start to matter, eventually pushing up the cost of borrowing, making a 200%+ debt-to-GDP ratio unsustainable.
  • Abe’s government is as determined as it is blind. Abe believes a major spending program is just what Japan needs. As far as the yen is concerned, Abe may be getting far more than he is bargaining for.
  • But isn’t everyone negative on the yen already? Historically, it’s been most painful to short the yen; as such, many have not walked their talk. We expect some fierce rallies in the yen throughout the year. Having said that, the yen looks a lot like Nasdaq in 2000 to us. Not as far as technicals are concerned, but as far as the potential to fall without much reprieve.
• The euro may be the rock star of 2013. Boring is beautiful. Sure, there are plenty of problems, but the euro is morphing into yet another currency, but is still priced as if it had a contagious disease. While the Fed, the Bank of England, the Bank of Japan are all likely to engage in further balance sheet expansion (we refer to it as “printing money” as assets are purchased by central banks, paid for by entries on computer keyboards, creating money out of thin air), there’s a chance the ECB balance sheet may actually shrink. That’s because some banks have indicated they will pay back early part of the €1 trillion in 3-year loans taken from the ECB. Some suggest the ECB might print a boatload of money should the “Outright Monetary Transaction” (OMT) program be activated to buy the debt of peripheral Eurozone countries. Keep in mind that the OMT program would be sterilized, likely by offering interest on deposits at the ECB. As such, the OMT would lower spreads in the Eurozone and, through that, act as a massive stimulus. In our assessment, however, such a stimulus is far less inflationary than central bank action in other regions. It’s no longer a taboo to be positive on the euro, but most we talk to are at best “closet bulls.”
• The British pound sterling. The Brits are getting a new governor at the Bank of England (BoE) in the summer, the current head of the Bank of Canada (BoC), Carney. One of the first speeches Carney gave after his appointment was made public was about nominal GDP targeting. Carney will have a chance to replace many of the current BoE board members. That’s the good news, as the old men’s club is in need of a makeover. The not-so-good news is for the sterling. British 10 year borrowing costs have just crossed above those of France. We’ll monitor this closely.
• As the head of the BoC, Carney was particularly apt at talking down the Loonie, the Canadian dollar, whenever it appeared to strengthen. If Macklem, his current deputy, is appointed, we may get a real hawk at the helm of the BoC. We are positive on the Loonie heading into 2013, but will monitor developments closely, as there are economic cross-currents that, for now, Canada appears to be handling very well.
• Staying with commodity currencies, we are cautiously optimistic on the Australian dollar (China better than expected; monetary policy more hawkish than priced in) and New Zealand dollar (more hawkish monetary policy on better than expected growth). We continue to stay away from the Brazilean real and leave it for masochistic speculators looking for excitement.
• We are positive on Norway’s currency (joining the above mentioned rock star, with greater volatility), yet cautious on Sweden’s (priced to perfection is not ideal when things are not perfect, even in Sweden).
• China: the new leadership has indicated that liquidity for the Chinese yuan may be their top currency priority. That’s great news, as we believe it implies policies that attract investment, not just from the outside, but also with regard to a development of a more vibrant domestic fixed income market. We are more positive on China than many; more on that, in an upcoming newsletter (click to sign up to receive Merk Insights)
• Korea, Malaysia, Taiwan: all positive, benefiting from both internal forces, but also beneficiaries of actions in other large economies. If we have to pick a favorite today, it would be Korea, but keep in mind that the Korean won is the most volatile of these currencies.
• Singapore: we continue to like the Singapore dollar. A year ago, we started using it as a substitute for the euro (rather than using the U.S. dollar as the safe haven currency). The currency may well lag the euro’s rise, but the lower risk profile of the currency makes it a potentially valuable component in a diversified basket of currencies.
• Gold. We expect the volatility in gold to be elevated in 2013, but consider it good news, as it keeps the momentum players at bay. We own gold not for the crisis of 2008, not for the potential contagion from Europe, but because there is too much debt in the world. We think inflation is likely a key component of how developed countries will try to deal with their massive debt burdens, even as cultural differences will make dynamics play out rather differently in different countries. Please see merkinvestments.com/gold for more in-depth discussion on our outlook on gold.

And what about the U.S. dollar? While much of the discussion above is relative to the U.S dollar, the greenback itself warrants its own analysis:

• Investors in the U.S. should fear growth. The spring of 2012 saw the bond market sell off rather sharply as a couple of economic indicators in a row came out positively. Bernanke wants to keep the cost of borrowing low, but can only control the yield curve so much. That’s why, in our assessment, he is emphasizing employment rather than inflation, in an effort to prevent a major sell-off in the bond market before the recovery is firmly established. Growth is dollar negative because the bond market would turn into a bear market: foreigners’ love for U.S. Treasuries might wane, just as it historically often does during early and mid-phases of an economic upturn as the bond market is in a bear market.
• Good luck to Bernanke to raising rates in 15 minutes, as he promised he could do in a 60 Minutes interview. Sure he can, but because there’s so much leverage in the economy, any tightening would have an amplified effect. At best, we might get a rather volatile monetary policy. But we are promised by the Fed that this is not a concern for 2013.
• Both of these, however, suggest volatility will rise in the bond market. Remember what got the housing bubble to burst? An uptick in volatility. That’s because leveraged players, momentum players run for the hills when volatility picks up. And a lot of money has chased Treasuries, praised as the best investment for over two decades. We don’t need foreigners to sell their U.S. bonds for there to be a rude awakening in the bond market; we merely need a return to historic levels of volatility. Why is this relevant to a dollar discussion? Because a bond market selloff makes it more expensive for the U.S. to finance its deficits. Please see our recent analysis of the risks posed to the dollar by a bond market selloff for a more in-depth discussion on this topic.

Please sign up for our Webinar on Tuesday, January 15, 2013, that focuses on our outlook for this year. Please also sign up for our newsletter to be informed as we discuss global dynamics and their impact on gold and currencies.

 

Axel Merk

Axel Merk is President and Chief Investment Officer, Merk Investments.

Tags: Canadian, Canadian Economy, Canadian Market, Merk
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How Big is Canada’s Oil Subsidy to the US? (Rubin)

Tuesday, January 8th, 2013

by Jeff Rubin

Consider the tale of Suncor and Canadian Natural Resources, two of the largest oil sands producers in Alberta. Outwardly, they may appear quite similar. Each produces hundreds of thousands of barrels a day from the oil sands. And most of that oil eventually ends up in the same place—gas tanks across the continent. The path it takes to get there, however, is another story. The difference is a microcosm of the predicament Canada’s energy industry currently faces.

Over the last few years, Suncor’s emphasis has shifted from exponential production growth to milking the full value of what it digs out of the ground. Fortunately for Suncor, it processes nearly all of the bitumen it pulls from the oil sands in its own refineries.

On the other hand, CNRL, like most oil sands producers, exports raw bitumen to the United States. In so doing, however, the company also transfers an enormous amount of wealth from its Canadian operations to American refiners in the Midwest.

In the refining business, the difference between what a refinery pays for its inputs (like crude or bitumen) and the price it gets for finished products (like gasoline or diesel) is known as a crack spread. The glut of oil coming from Canadian producers means Midwest refineries are enjoying crack spreads up to five times larger than those seen by American coastal refineries, which pay world prices for their feedstock.

Investors have certainly noticed what such large crack spreads mean for the bottom line. CNRL, which lacks its own refineries, is forced to sell its raw product at a heavy discount, thereby missing out on those juicy refining margins. Suncor, on the other hand, is able to capture the huge crack spreads through its downstream refining operations. In 2012, CNRL’s stock fell more than 20 percent, while Suncor’s gained more than 10 percent.

The issue is writ large in the price differential between West Texas Intermediate (WTI) and Brent crude. Although WTI is often quoted in North America as the price of oil, Brent is actually the global benchmark for crude. Unfortunately for Canadian producers, lately the spot price of Brent has been as much as $25 a barrel higher than that of WTI.

While Canadian oil sands producers are the main victims of this price gap, they’re also, somewhat ironically, its principal cause. Without more pipeline infrastructure to offload oil to other markets, oil sands crude, as well as shale oil from the Bakken play in North Dakota, has no where else to go. More production from these places only boosts supply, further lowering the price of WTI.

Aside from a few hundred thousand barrels a day from wells offshore Newfoundland that get Brent prices, virtually all of Canada’s 2.4 million barrels a day are priced off WTI.

An even bigger concern for Canadian oil producers than the discount between WTI and Brent is the price differential between WTI and Western Canadian Select—the benchmark price for western Canadian oil exports to the US. It’s trading around $60 a barrel, a third less than WTI and 45 percent lower than Brent.

Do the math on some 2 million barrels a day of heavily discounted oil exports and suddenly you’re talking about an enormous wealth transfer from Canadian oil producers to American refineries. (Note, the subsidy is pocketed by US refiners, not motorists, who don’t see the Canadian discount when filling up at the pumps.) What if Canadian oil was getting world prices? At the current Brent-Western Canadian Select spread of roughly $50 a barrel, you’re in the neighbourhood of $100 million a day. That equates to foregone revenues of more than $35 billion over the course of a year.

It’s not just shareholders of companies like CNRL who are getting squeezed by this wealth transfer. The Alberta government loses royalties, while Ottawa (and the rest of Canada by extension) misses out on cash from corporate income taxes.

The rest of the oil sands industry may need to take a page from Suncor’s playbook. Before rushing ahead to double oil sands production to 3 million barrels a day—and sending billions more in de facto energy subsidies to US refiners—investors and the Canadian economy may be better off if producers figure out how to capture more value from what they’re already digging out of the ground.

Copyright © Jeff Rubin’s Smaller World

Tags: Canadian, Canadian Economy, Canadian Market, Oil Sands, rubin, Shale
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David Rosenberg: 35 Charts For 2013

Wednesday, December 26th, 2012

First, here is Rosie’s Investment Outlook for 2013:

1. We remain in a classic post bubble ‘fat-tailed’ distribution curve, where the range of possible outcomes is much wider than in past recovery phases. This will remain the case in 2013, and until such time as all the major global debt imbalances have been fully resolved.
2. Near-6% U.S. output gap: 3%+ global gap. The world is still awash with excess capacity across labour and product markets. As such, disinflation themes will keep trumping inflation themes. This puts preservation not just of capital, but of cash flows, front and centre in terms of core investment strategies.
3. Fed likely to keep rates near 0% through 2018 (according to our analysis): Interest rate volatility minimized; long-short credit strategies should remain core to any bond strategy.
4. $1.7 trillion in cash on U.S. corporate balance sheets: Even though yields have plunged in the past year, corporate bonds remain a solid investment given prospective low default risks, especially given still-wide spreads relative to the government sector
5. Fed to replace Operation Twist with outright bond buying: Treasury yields to head even lower, making dividend yield and ‘bond proxies’ in the equity market that much more alluring.
6. Real interest rates to remain negative: This is a very powerful positive thrust for the precious metals complex, and should help establish a firmer floor under the stock market given the implications for “discounted’ earnings growth (i.e. a lower cost of capital).
7. Stephen Harper around until April 2015 (at the least), Barack Oba ma around until .lanuary 2017: Along with diverging monetary policies, the stark political divide is bullish for the Canadian dollar
8. Geopolitical tensions — Middle East, China’s political transition. Greek default risks. LS_ fiscal issues, high and rising youth unemployment rates in Europe and
9. Japan-China rift: Exposure to raw materials is a good hedge against these recurring flare-ups.
10. U.S. energy self-sufficiency: Still a forecast, but this has positive implications for the manufacturing renaissance story.
11. Malthuslan population dynamics: That two billion more people to feed in the next 35 years means we need 70% more food: an agrarian revolution is in its infancy stages.

Next, below are the 35 charts that best encapsulate Rosie’s thoughts about 2012 and his view on 2013 and onward, but first his overarching views:

The Fed has also completely altered the relationship between stocks and bonds by nurturing an environment of ever deeper negative real interest rates. Therein lies the rub. The economy and earnings are weak, and getting weaker, but the Interest rate used to discount the future earnings stream keeps getting more and more negative, and that lowers the corporate cost of capital and in turn raises the present value of expected future profits. It’s that simple.

…

Beneath the veneer, there are opportunities. I accept the view that central bankers are your best friend if you are uber-bullish on risk assets, especially since the Fed has basically come right out and said that it is targeting stock prices. This limits the downside, to be sure, but as we have seen for the past five weeks, the earnings landscape will cap the upside. I also think that we have to take into consideration why the central banks are behaving the way they are, and that is the inherent ‘fat tail’ risks associated with deleveraging cycles that typically follow a global financial collapse. The next phase, despite all efforts to kick the can down the road, is deleveraging among sovereign governments, primarily in half the world’s GDP called Europe and the U.S. Understanding political risk in this environment is critical.

…

With regard to global events, we continue to monitor the European situation closely. Euro zone finance ministers have given Greece an additional two-year lifeline and the Greek parliament just passed another round of severe austerity measures, which I think will only serve to make matters worse there from an economic standpoint, but I doubt that the creditors are going to let Greece go just yet. So this never-ending saga remains a source of ongoing uncertainty, but at the same time. Is a key reason why the Fed and the Bank of Canada will continue to keep short-term interest rates near the floor, and all that means is to build even more conviction over income equity and corporate bond themes.

…

As for something new, after a rather significant slowdown in China for much of this year that put the commodity complex in the penalty box for a period of time, we are seeing some early signs of visible improvement in the recent economic data out of China and this actually has happened even in advance of any significant monetary and fiscal stimulus. And while the Chinese stock market has been a laggard, if there is one country that does have the room to stimulate, it is China (make no mistake, however, China’s economic backdrop is still quite tenuous, especially as it pertains to the corporate sector – excessive inventories, stagnant profits, rising costs and lingering excess capacity are all challenges to overcome).

 

Keep in mind that much of this slowing in China was a lagged response to prior policy tightening measures to curb heightened inflationary pressures – pressures that have since subsided sharply with the consumer inflation rate down to 2% (near a three-year low) from the 6.5% peak in the summer of 2011 and producer prices are deflating outright. What is providing a big assist to this sudden reversal of fortune in China is a re-acceleration in bank lending as a resumption of credit growth and bond issuance has allowed previously- announced infrastructure projects out of Beijing (railways in particular) to get incubated.

 

The nascent economic turnaround we are seeing in China, if sustained, is Positive news for the commodity complex and in turn resource-sensitive currencies like the Canadian dollar, which I’m happy to report has hung in extremely well this year even in the face of all the global economic and financial crosscurrents. Just consider that the low for the year for the loonie was 96 cents – you have to go back to 1976 to see the last time intra-year lows happened at such a high level.

…

To reiterate, our primary strategy theme has been and remains S.I.R.P. – Safety and Income at a Reasonable Price – because yield works in a deleveraging deflationary cycle. Not only is there substantial excess capacity in the global economy, primarily in the U.S. where the “output gap” is close to 6%, but the more crucial story is the length of time it will take to absorb the excess capacity. It could easily take five years or longer, depending of course on how far down potential GDP growth goes in the intermediate term given reduced labour mobility, lack of capital deepening and higher future tax rates. This is important because what it means is that disinflationary, even deflationary, pressures will be dominant over the next several years. Moreover, with the median age of the boomer population turning 56 this year, there is very strong demographic demand for income. Within the equity market, this implies a focus on squeezing as much income out of the portfolio as possible so a reliance on reliable dividend yield and dividend growth makes perfect sense.

…

Gold is also a hedge against financial instability and when the world is awash with over $200 trillion of household, corporate and government liabilities, deflation works against debt servicing capabilities and calls into question the integrity of the global financial system. This is why gold has so much allure today. It is a reflection of investor concern over the monetary stability, and Ben Bernanke and other central bankers only have to step on the printing presses whereas gold miners have to drill over two miles into the ground (gold production is lower today than it was a decade ago – hardly the same can be said for fiat currency). Moreover, gold makes up a mere 0.05% share of global household net worth, and therefore, small incremental allocations into bullion or gold-type investments can exert a dramatic impact. Gold cannot be printed by central banks and is a monetary metal that is no government’s liability. It is malleable and its supply curve is inelastic over the intermediate term. And central banks, who were selling during the higher interest rate times of the 1980s and 1990s, are now reallocating their FX reserves towards gold, especially in Asia. With the gold mining stocks trading at near record-low valuations relative to the underlying commodity and the group is so out of favour right now, that anyone with a hint of a contrarian instinct may want to consider building some exposure – as we have begun to do.

Source: Gluskin Sheff

Tags: Canadian, Canadian Economy, Canadian Market, Rosie
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The Bank of Canada Has Barked, But Will It Bite?

Monday, December 3rd, 2012

The Bank of Canada Has Barked, But Will It Bite?

December 2012

by Ed Devlin, Richard Clarida, PIMCO

• As Canadian consumers have increased their mortgage debt and bid up housing prices, the potential for a disorderly unwinding of these imbalances rightly concerns the Bank of Canada.
• PIMCO believes that the bank’s next policy move will be to raise interest rates, but with the traditional aim of fighting inflation rather than reducing home prices and consumer debt.
• We expect the Bank of Canada to continue tightening mortgage credit and using moral suasion to damp the housing boom and discourage consumers from taking on more debt.

What is the correct policy response to a prospective asset bubble? This question has been the focus of considerable academic research, especially since the financial crisis of 2008. Recent communication from the Bank of Canada (BoC) suggests it is considering hiking policy rates in response to the recent surge in household debt and home prices. If it does, this could represent a decisive change in its inflation-targeting strategy for monetary policy. At a minimum, it would get the attention of public policymakers worldwide owing to Bank of Canada Governor Mark Carney’s position as chair of the G20 Financial Stability Board (FSB).

Governor Carney gave an important speech last month titled “Uncertainty and the Global Recovery” in which he put investors on alert that the Bank of Canada stands ready to deflate a potential Canadian housing bubble by raising the overnight rate. He was clear that capital flight into Canada that distorted the value of the Canadian dollar and lowered longer-term interest rates is factored into setting monetary policy. He also said “if” the Bank of Canada were to “lean against emerging imbalances in household debt,” it would clearly communicate this and its implications for returning the economy to the target 2% inflation rate (i.e., provide an estimate of the delay to get back to the inflation target via the flexible inflation-targeting regime of the Bank of Canada).

Although Governor Carney will leave the BoC in June 2013 to become governor of the Bank of England, his successor at the BoC will likely grapple with the same macroeconomic situation and is likely to follow a similar course, in our view.

“Old Normal” conventional wisdom: react to asset price volatility

Prior to the 2008 financial crisis, price stability and financial stability were widely viewed as complementary (not in conflict). The credit markets were broadly viewed as efficient. Securitization was seen as a helpful tool to diversify credit risk among many sophisticated investors. While policymakers such as former BoC Governor David Dodge were concerned about global imbalances, not much research was done on the unintended consequences of monetary and/or currency policies on credit markets.

Former Federal Reserve Chairman Alan Greenspan widely espoused the view that it was very hard to tell (ex-ante) whether asset price appreciation was caused by speculation or reflected fundamental changes such as advances in technology. The role of central banks was to focus on the real economy and price stability, and to use monetary policy (ex-post) to deal with the confirmed bursting of an asset bubble if it had adversely affected the real economy or inflation, rather than use monetary policy pre-emptively by tightening. Current Fed Chairman Ben Bernanke validated this view in his seminal article with Mark Gertler, “Monetary Policy and Asset Price Volatility.” The U.S. Federal Reserve’s responses to the 1987 stock market crash, the bursting of the technology bubble and the 9/11 attacks were broadly seen as successful validations of this approach.

New Normal theory: macro-prudential policy response

The 2008 financial crisis, however, showed there can be a conflict between price stability and financial stability. Policymakers and academics have since spent considerable time studying and implementing “macro-prudential” policies, which aim to mitigate risks to the financial system as a whole.

The Canadian government’s four rounds of mortgage credit tightening over the past four years are good examples of macro-prudential policies. The main objective has been to mitigate the rise in consumer indebtedness and house price appreciation to prevent future shocks to the Canadian financial system.

BoC’s concern about the household sector warranted
The Canadian financial system in 2012 is suffering from some of the same financial market distortions that were evident in the U.S. and other developed markets before the crisis. Specifically, domestic policy to promote home ownership and policies of foreign governments have combined to lower mortgage rates and increase household indebtedness.

Since the crisis, the Canada Mortgage and Housing Corporation (CMHC) has rapidly expanded the amount in mortgages it guarantees, thereby lowering mortgage rates (see Figure 1). Also, several major central banks (the Fed, the Bank of England and the Bank of Japan) have zero interest rate policies and are engaging in quantitative easing (QE), in which the central bank buys government bonds to depress interest rates. This has caused capital flight into Canada where the policy rate is 1% and the BoC is not engaged in QE. This capital flight (see Figure 2) into Canada is depressing bond yields and lowering mortgage rates.

As a result, Canadian consumers have increased their mortgage debt and bid up housing prices (which in turn causes builders to build more houses), as shown in Figures 3 and 4. The unwinding of these imbalances could be disorderly, and this rightly concerns the Bank of Canada.

New Normal reality: implementing macro-prudential policies
Canadian Finance Minister Jim Flaherty and Governor Carney are trying to slowly let the air out of the household debt balloon, which is a difficult task. The government has already tightened mortgage credit four times (see Figure 5). It is hard to know how much of an effect the previously announced macro-prudential tightening has had and how much more it will have in the future.

What does PIMCO think the Bank of Canada will do?
In our view, the recovery in Canada is still fragile and the Bank of Canada will need to see stronger growth data before considering a rate hike to “lean against emerging imbalances in household debt.” The bank is appropriately proactive in communicating the framework for such a macro-prudential rate hike. Its communication strategy is also a moral suasion tool to encourage consumers to be prudent in taking on more debt.

Before the Bank of Canada uses the blunt tool of monetary policy for macro-prudential reasons, we believe the federal government will try at least one more round of mortgage credit tightening, which could involve:

• Increasing the minimum down payment from 5%
• Increasing the risk weighting of mortgages on bank balance sheets
• Decreasing the amortization period (again)
• Decreasing the amount of CMHC guarantees available (again)

If the Canadian economy manages to sustain 2%-2.5% real growth, as the Bank of Canada forecasts, the current estimated output gap of 0.67% will close, and we believe the bank will hike rates because of concerns about inflation over the intermediate term. A traditional Taylor Rule analysis, which gauges how a central bank should set short-term interest rates to achieve both economic stability and its inflation goal, currently justifies the Bank of Canada’s tightening bias (see Figure 6). This analysis also supports our view that the next BoC governor will likely follow the same path as Carney would have based on the outlook for inflation and the output gap in Canada.

To be clear, our baseline forecast is that the Bank of Canada will eventually hike rates mainly for traditional concerns about inflation and the business cycles and will also talk tough on consumer debt (more moral suasion). This is different than hiking for macro-prudential reasons because it will not delay getting back to the inflation target. Said another way, this would not be a macro-prudential tightening of monetary policy because there is no conflict between the policy required for price stability and that required for financial stability.

Canada would not be the first central bank (post crisis) to mention housing when raising rates. On October 28, 2009 the Norges Bank Executive Board increased rates in Norway by 0.25 percentage points to 1.5% and stated: “[I]nterest rates are low, resulting in renewed growth in household consumption. At the same time, house prices are rising. Over time, household borrowing may surge again…”

What are the implications for other countries?
If the Bank of Canada hikes rates for traditional concerns about inflation and combines the rate rise with moral suasion language about the housing market, the implications for other countries will be limited.

If the Bank of Canada hikes rates for macro-prudential reasons (i.e., delaying getting back to the inflation target in order to promote financial stability), this could have significant implications for other markets. The message from global FSB Chair Carney is that if a country has substantial household imbalances, then hiking rates (despite a below-target inflation forecast) is appropriate. Countries such as the U.K. and Australia may be more inclined to tighten monetary policy than current market forward rates imply. If this macro-prudential tool is used, a number of questions would naturally follow. How much tightening is appropriate? How does a central bank know when it has done enough macro-prudential tightening? How is financial stability measured? It would take some time to determine frameworks to answer these questions.

Investment implications: position for reflation
Given PIMCO’s baseline forecast of a fragile 1.5%-2% in real growth in Canada over the next year, we do not expect the Bank of Canada to increase interest rates to “lean against emerging imbalances in household debt.” If household imbalances continue to build, we expect another round of macro-prudential tightening of mortgage credit. In the short-term, we do not see a major bear market in Canadian rates but expect the market will gradually anticipate the next move being a modest tightening cycle in Canada. With break-even inflation (BEI) rates at approximately 2% (the Bank of Canada target), we prefer real return bonds to nominal bonds as nominal bonds do not provide enough compensation for inflation risk.

If we are wrong and the Bank of Canada hikes rates to “lean against emerging imbalances in household debt,” then we should see sharply higher rates in Canada. In addition, there could be spill-over effects in other major markets such as Australia, the U.K. and possibly the U.S. The two main effects would likely be higher nominal rates as the increased probability of earlier rate hikes gets priced in and higher volatility due to increased uncertainty over the new policy goals.

********

All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Real Return or Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise.

Tags: Canadian, Canadian Economy, Canadian Market
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David Winters: Why He’s Finding Great Investment Opportunities Globally

Monday, November 26th, 2012

 
Great Investor David Winters, portfolio manager of the top rated Wintergreen Fund, will explain why he is finding numerous investment opportunities around the globe and why investors shouldn’t believe the bearish view that the “cult of equity is dead.”

Consuelo Mack WealthTrack - Originally aired October 5, 2012

CONSUELO MACK: This week on WealthTrack, five star fund manager David Winters takes on the investment crowd and parries and thrusts his way through the stock bears and inflation deniers. Wintergreen Fund’s Great Investor David Winters is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Central bankers are clearly worried about global growth. From the U.S., to Europe, to Asia, we have seen unprecedented levels of easing in recent weeks. By independent research firm ISI Group’s count, there have been more than 250 stimulative policy initiatives announced over the past 13 months. The firm also points out that we are less than 100 days from the famous fiscal cliff in the U.S., when numerous Bush era tax cuts expire and automatic spending cuts take effect if Congress and the White House can’t reach a budget compromise. If they don’t, estimates are that GDP growth could be reduced by as much as 3.5%, sending the economy into recession.

Meanwhile, stocks have rallied strongly this year largely because of all of those central bank actions, which have given some investors confidence that the world will continue to muddle through the challenges of a widespread economic slowdown. Individuals, however, are still not participating in large numbers. Retail investors continue to favor bonds over stocks- a winning move for them until this year, and a trend we’ve been tracking for months.

This week’s guest disagrees with such bearishness and believes investors are missing several attractive opportunities around the world. He is Great Investor David Winters, portfolio manager of the five-star rated Wintergreen Fund, which he has been managing since he launched it in 2005. The go anywhere, invest in anything value-oriented fund has outperformed its category and the markets since its inception. Wintergreen is a sponsor of WealthTrack but David is clearly here on his own merit. I began the interview by asking David about what he considers a major investor misconception, phrased by great bond investor Bill Gross at PIMCO as “the cult of equity is dying.”

DAVID WINTERS: I think it’s wrong. I think the notion that stocks are never going to go up again creates an enormous opportunity for the few of us left who are working on equities and actually do the work, and I think it’s a misconception that’s forced the public even further from the equity market and institutions, and the reality is there’s this enormous disconnect between price and value which creates future opportunities.

CONSUELO MACK: So there is a shift on both the institutional level and the individual level away from stocks and, as you know, the new term for stocks is that it’s the risk asset, and Treasuries are the risk-free asset, another perception which you strongly disagree with.

DAVID WINTERS: Well, you know, people think it’s been such a bad period for 10 years that this is going to be forever like this, and so in that timeframe, Consuelo, rates have come down, and the only way to have made money was, except certain well-selected securities, has been to own bonds. So people now have their money in 20 basis points and 18 basis points securities, you know, Treasury securities. People lose purchasing power on a daily basis. I think inflation is very real. You have food prices going up, fuel prices going up. You need to get your hair done. Prices go up, and if you have your money not growing over time, you get crushed. So here you’ve got the public believing and institutions believing equities are dead. They believe that putting all your money in bonds when rates go up and you have the impact of inflation. We think what’s perceived as a risk-free asset is actually an incredibly risky asset.

CONSUELO MACK: So cash, in fact, and cash equivalents you told me is one of the riskiest assets now. Let me ask you, because if you were to talk to Federal Reserve chairman, Ben Bernanke, he would basically say that inflation is very mild. It’s benign, and it’s under our target rate, and yet, again, another misperception.

DAVID WINTERS: For most individuals, their cost of living is going up, and this circles back to this ‘equities are dead’ fallacy, because if you own the right businesses with a global footprint that grows free cash flow, has a nice yield, those businesses become more valuable over time, and they have the ability not only to raise prices but to sell more units, and so the well-selected equities, which is what we do at Wintergreen Fund to the best of our ability, it protects you from inflation, the erosion of principal which is really, I think, the biggest risk out there.

CONSUELO MACK: So it’s interesting, because you just mentioned that we had come through a decade which is called the lost decade, and so when people look at the market indices, and they’re saying, you know, the S&P and the Dow are below what they were at their height, their peaks from 2007, whatever it was, but when I look at Wintergreen’s results, and you look at individual securities, in fact, that many people haven’t lost money. They’ve made money. So this kind of disconnect again, between the market and individual securities, historically, I mean, how big is the gap as far as you’re concerned?

DAVID WINTERS: I’ve never seen anything like this and, you know, part of it is you have so many people who’ve had a bad experience, and there is relatively few of us who’ve had a good experience so that we remain optimistic, constructive, and believe that you take advantage of this disconnect. There’s companies out there which trade at massive discounts to their asset value that are well run with good management.

CONSUELO MACK: Give us some examples of investing in Wintergreen.

DAVID WINTERS: Well, you know, one that I’m talking about it Canadian Natural Resources.

CONSUELO MACK: A long-time holding of the Wintergreen Fund.

DAVID WINTERS: Right, and in this environment it’s certainly gotten beaten up, but if you look at what recent transactions for oil assets have been and what CNQ trades for, it trades at one third of those recent trades, and the oil’s in Canada. It’s a great country, rule of law, and so there are a number of examples where we can take advantage on behalf of the Wintergreen investors that they can own these assets at a really low price with bright future. That’s the other thing, is that people extrapolate what’s happened, that things will never get better, and we know from our own lives that the country is so much better than it was 20, 30, 40 years ago, and I think the future’s bright. And the other big misconception is that people have repatriated their money home, whether the U.S., to Canada, to Japan, but really the big opportunities are international.

CONSUELO MACK: That’s a very interesting point, because certainly if you talk to a number of other value investors, the theme has been that the U.S., the big brand name U.S. companies are the best value in the globe and, therefore, invest with the big name U.S. companies.

DAVID WINTERS: Well, we think there’s… you know, we’ve actually bought more in the U.S. in the last year or so because the market is in the state it’s in, but there are so many great companies all over the world, whether they’re in Monterrey, Mexico or Zurich or Kuala Lumpur, and I think most investors don’t have the flexibility of thought to be willing to look everywhere, and today we think that, you know, I feel like a kid in a candy store with $100 in my pocket, and my parents aren’t watching.

CONSUELO MACK: That is a great image. I can you see you as a little kid. I have to admit, ever since I started interviewing on WealthTrack, you have had this same kind of optimism about the kind of companies that you’re finding, and one of the things that you always say you’re looking for a trifecta, and that bears… it’s really important for our viewers to understand, you know, what do you mean by a trifecta? What do you look for in the companies that you invest in?

DAVID WINTERS: Well, I’m a value investor, global value investor, and I’m fortunate to know how to do all kinds of things, you know, liquidations, bankruptcies, activism, but what we’ve really learned as time has evolved, that you need three things. One, you need a company with good underlying economics, and hopefully economics that are improving and that again takes the risk out.

CONSUELO MACK: So a good growing business.

DAVID WINTERS: Yes, and then you got to have management who’s focused on all shareholders, not just themselves and that who wants to create value, and the third thing is a low price, and today there’s lots of low prices, and so I think that this is a great time. And I don’t know what the market’s going to do in the short term or securities prices, but if you use the trifecta as a filter and you really get in and do the work, I think you take out the risk, and you create a lot of upside.

CONSUELO MACK: But why are there more opportunities today? I understand the price equation of it, but I mean, looking over your 20 some odd years of investing, you know, why are there more opportunities today, aside from the fact that the market has been down over the last 10 years or whatever? Is there something else going on?

DAVID WINTERS: I think there’s a number of things going on. As we started the conversation, you have the death of equities. People really believe market’s never coming back, that business is never going to grow, that if you plant another crop as a farmer, it’s never going to, you know, and it’s just not true.

CONSUELO MACK: Right, eternal drought.

DAVID WINTERS: It’s just not true, and the reality is most of the companies in the Wintergreen portfolio are doing really well, and you just have less competition.

CONSUELO MACK: So that’s an important point, is the notion that there’s less competition. So in fact, as we see people not only withdrawing from equities but also switching to passive indexes instead of in a way from active managers, has there been a real marked decline in the number of people doing stock analysis? I mean, is that another part of this change in the markets?

DAVID WINTERS: Yeah, I think basically there are fewer people doing the work, and people’s timeframes have been compressed, and they don’t want any price fluctuation, and if you go back to the essentials, you go back to what Benjamin Graham wrote in “The Intelligent Investor” in 1949, it was Mr. Market. Today we say Mr. or Ms. Market, and you take advantage of the fluctuations, but what’s happened, because it’s been so difficult, is people have just fled and so it’s like being a fisherman with lots of hungry fish, and there’s no more fisherman around.

CONSUELO MACK: David, let me ask you about the macro environment, because we are looking at a lot of uncertainty. You know, it just seems like there’s a crisis du jour, whether it’s political or economic, and so how, as a portfolio manager, do you deal with those macro uncertainties?

DAVID WINTERS: Well, you’ve got to I think select what’s really important and also what you can control, and most of it as individuals, we can’t control, but what we can control is how we react, and if we react by saying, “What can I do to find an opportunity in this mess?” that’s, I think, been the key way that we’ve thought about it, and there are a lot of problems in the world, but there’s a lot of good things in the world, and so what we focused on is what’s good and how can we make money for the Wintergreen investors by focusing on these opportunities.

CONSUELO MACK: The companies that you’re investing in, they’re multinational companies. They do business all over the world. I mean, what’s the sense from the managers that you talk to about what their feeling is about the prospects for business globally?

DAVID WINTERS: Well, I think there are certain examples where things are slowing down, yet the well-run companies continue to invest for the future and figure out what they’re going to do when the sun comes up tomorrow morning, and I think a well-run company doesn’t give up or worry about this quarter. They build for tomorrow, and so we’ve tried to find those types of managers who are focused. I give you a little example. The Schindler elevator and escalator company announced that they built their first foreign company, elevator company, building a factory in India. So the Schindler company, they haven’t stopped. They’re getting more orders. They’re busy, and I think ultimately not only are they doing well now, but when things do improve, they will have laid the groundwork to sell more elevators and escalators and more maintenance. So that’s where we’re focused.

CONSUELO MACK: You are so optimistic again, and you seem to be focused where the growth is occurring. One of the major areas, again, that’s in the headlines is China, and China, they’re saying that its growth is slowing. It’s had a housing bubble. What’s your view of China and the opportunities that are still there for companies?

DAVID WINTERS: You know, people worry about China, and many people have never been there. And I was there for a month earlier in the year, and I can’t tell you I know exactly what’s going to happen, but I do know that you’ve got a lot of people, and they all want to look good. It’s just a basic human emotion, and the Chinese are just like everybody else. So you know, that’s why we like Richemont that owns Cartier. You know, we like Swatch that sells low, medium and high-end watches. You know, our largest position is Jardine Matheson, and it’s a Bermuda-based company, but they’re in Hong Kong, and they have great businesses, and they experience that things are slowing down a bit, but they keep investing for the future.

Nestlé. Nestlé just bought or is in the process of buying Pfizer’s infant milk formula business. You know, in China it’s the one child policy. People love their children. They will do anything for their babies, and if they need infant milk formula, Nestlé will sell it to them, and so I think that there’s so much we can’t know and we don’t know, but what we do know and what we focus on at Wintergreen is what’s the knowable, and how can we make money off of it, and we know that as the Chinese get richer, there are certain things that they’re going to do, and so I don’t know about this quarter. I don’t know about the politics, but I do know they want to eat better, and they want to have a good time, and they want to look good.

CONSUELO MACK: So there are some markets that you’re not investing in right now. I mean, you’ve basically avoided Euro zone companies, and you’ve avoided Japanese-based companies. So talk to us about where Wintergreen isn’t right now and why.

DAVID WINTERS: Europe’s in a big mess, and I think that ultimately however this plays out, they’re going to print money just like we have, and you’ve got this construct which ties everybody together at least for now, and it’s going to be like a giant tax on the corporations and the people. So we’ve looked, and we’ve owned a lot of European companies in the past, and we’ll probably own them in the future, but right now we just don’t need to be in the middle of the storm.

And Japan, you know, I love Japan, but they have such issues that they haven’t been able to grapple with, that it’s a tough place to invest and produce returns. So again, the day will probably come when we’ll back in Europe and back in Japan, but right now, there’s other places to invest where the weather is better, and we think there’s more money to be made.

CONSUELO MACK: Let’s talk about some of the places that you are investing, and one of the kind of hallmarks of the Wintergreen Fund’s portfolio is that you are invested, have large positions in a number of tobacco companies, so BAT and Altria and Philip Morris. So tell us about…

DAVID WINTERS: Well, you know, we don’t advocate smoking, but the cigarette companies are huge free cash flow generators, and especially the international ones, BAT and Philip Morris. Philip Morris raised its dividend 10% yesterday. It yields 3.8%. So you get paid to wait and also governments get a lot of tax dollars from these companies, and then there are certain companies like Altria, which is a U.S. company, that’s a complete special situation, because they own 27% of SAB. They have a little wine business. They have a liquidating finance business. Yields five percent, and something eventually is going to happen these excess assets. So we like companies where there’s very little risk, and there’s a lot of upside. And another example would be Berkshire Hathaway, and everybody talks…

CONSUELO MACK: Right, not tobacco, but railroads which you’re a major fan of railroads, right?

DAVID WINTERS: Absolutely, and Berkshire put in a buyback 110% of book, and we added to the position at I think 112% of book, so we have two percent down side really and a lot of upside, and so that’s why, again, we get so excited about the market today. The market, investments, individually well-selected investments, because the risk/reward, because of what’s happened, and the way that people perceive it- equities are dead, bonds are riskless, never invest internationally again- they’re the wrong lessons. So for us at Wintergreen, it’s like, okay, come on.

CONSUELO MACK: The last time I talked to you, we talked about Google. What’s your view on Google right now?

DAVID WINTERS: We still own it and, you know, it’s really a media company, and everybody uses it basically, and they’ve got lots of cash and free cash flow. You know, we don’t love what they did with the high vote- low vote stock, but it’s not an expensive company.

CONSUELO MACK: Not expensive.

DAVID WINTERS: Not expensive, and they have this fabulous business that it doesn’t appear that anybody can ever catch that, and that may change, but for now, as somebody used to invest in newspapers, television, et cetera, I think Google’s the best media company out there.

CONSUELO MACK: Apple. Do you have a view? And I look at Apple, and I see what a huge impact it’s had on the S&P500 index and the NASDAQ and what a spectacular performer it’s been. What’s your view on Apple?

DAVID WINTERS: It’s a great company and, you know, they went from being almost broke to being this huge success, and they make fabulous products, and they have lots of cash, and you can do the analysis.

CONSUELO MACK: A hundred billion dollars in cash.

DAVID WINTERS: And you can strip out the cash and see what you’re paying for it. The problem with an Apple or most of the technology companies, is the product cycle is so short, and I can’t tell you whether the next product is going to be widely received. So if we don’t know, we don’t participate.

CONSUELO MACK: So what’s the best idea in your portfolio now? Do you have one?

DAVID WINTERS: I don’t know if it’s the best, but it’s one that I think is- it’s newer, and I think it really fits us- is MasterCard, and why we like MasterCard is every time the card is swiped, they get a little fee, and there’s an enormous amount of transactions every day. Seventy percent of the business is global, and I think it’s 85% of the world still does every transaction in cash.

CONSUELO MACK: Which amazed me when you told me that statistic.

DAVID WINTERS: And even if it’s higher or lower and small transactions in out-of-the-way places, over time people are going to use plastic. It’s just more convenient.

CONSUELO MACK: Cash, what role cash plays in the Wintergreen portfolio? It’s always played an important role. So what are the cash positions now and why are you keeping them wherever they are?

DAVID WINTERS: Cash has come down actually, because we’ve been a buyer. We found a lot to do because of what’s going on.

CONSUELO MACK: And it’s come down since when?

DAVID WINTERS: Oh, I don’t know. This year. We probably are 12% in cash, and we’ll probably continue to move things around a little bit, buy and sell. We always want to have cash, because it gives us the ability if something awful happens or if something great becomes available even without anything awful happening, that we can be a buyer, and we don’t have to liquidate something else. We run the money as if it were- and it is- you know, I have essentially all my own money up. My niece has all her own money up and so on, and you know, and my best friends. So we really try to be very, very careful, and you want to be in a position to be a buyer when others are sellers, and there are so many sellers.

CONSUELO MACK: So around 12% now, so in kind of the historical scheme of things, is that midpoint to what you normally are or…?

DAVID WINTERS: Probably mid, yeah, and it could drift lower. I mean, it depends on prices really, and what opportunities those three great misconceptions give us, because there are very few people doing security analysis, thinking long term and investing long term, so we’re in the minority now, which is good.

CONSUELO MACK: Good to be in the minority. So David Winters, thank you so much for joining us from Wintergreen Fund. We really appreciate your being here.

DAVID WINTERS: Great to be here.

CONSUELO MACK: At the end of every WealthTrack, we try to leave you with one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is: think like a contrarian and selectively invest against the crowd. David Winters just mentioned that he is in a minority by doing individual security analysis, and thinking and investing long term. Current investor sentiment is anti-stock and anti-active management so maybe it’s time to re-consider some long-term oriented, actively managed global stock mutual funds for your portfolio. Among Morningstar’s favorites are the ones run by this week’s guest David Winters and recent guest, Matthew McLennan; they are the Wintergreen Fund and First Eagle Global Fund. Both have earned five star ratings for their performance and management.

I hope you can join us next week, our guest will be another Great Investor, but one who has generated his share of controversy by making huge bets in financial stocks and other unloved securities in recent years. A rare interview with Morningstar’s fund manager of the last decade, Fairholme Fund’s Bruce Berkowitz, is in your future. If you would like to watch this program again, please go to our website wealthtrack.com. It will be available as streaming video or as a podcast. You can also see additional interviews with WealthTrack guests in our new and improved WealthTrack Extra feature. And that concludes this edition of WealthTrack. Thank you for watching. Have a great Columbus Day weekend and make the week ahead a profitable and a productive one.

Tags: Bill Gross, Bonds, Canadian, Canadian Economy, Canadian Market, Us Treasuries
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Resist The Hype (Visscher)

Monday, November 26th, 2012

by Steve Visscher, Mawer Investment Management

Just for fun I googled “China’s economy”. It yielded pages and pages of articles discussing the impressive growth rate of the Chinese economy. Even after growth has slowed in recent years, much has been written about how China’s growth remains amongst the highest in the world. Strangely, I found very little coverage of how Chinese stocks have performed. The evidence might surprise you.

From 2000 to 2007, the Shanghai Shenzen Index approximately tripled in value. Those were great times. Then the global recession hit in 2008 and all of that positive growth very quickly disappeared. Global markets bottomed in March of 2009, before quickly recovering later in the year. China followed a similar path.

But after 2009, China began to diverge. Global equity markets had positive returns in 2010, and 2011, and are well on the way to healthy gains in 2012. China’s Shanghai Shenzen Index has had negative returns in each of these periods.

We think this highlights the disconnect between the health of an economy, and the return potential of the companies within it. Identifying China as a “fast growing economy” does not take any great skill or insight. Any investor can read the economic data and reach that same conclusion.

But a rapidly growing economy does not automatically make Chinese companies attractive investments. It doesn’t mean they are well-managed companies. It doesn’t mean they have acceptable levels of risk. And it does not mean they are attractively priced. In fact, some investors become so enamoured with the media attention towards a “hot” economy that they compromise their philosophy or discipline just to make sure they can participate. This behaviour simply exacerbates the problem. Overvalued companies become more overvalued. High risk ventures or poorly managed companies receive more capital, rather than less.

In time, reality sets in. This helps explain why so many of the best-performing companies in recent years were headquartered in “troubled” economies like Europe or the U.S., while investments within the world’s “leading” economies have lagged. This has happened before and is bound to happen again.

Resist the hype to invest directly in the latest hot region or sector – it may not pay off as expected.

Steven Visscher

This blog and its contents are for informational purposes only. Information relating to investment approaches or individual investments should not be construed as advice or endorsement. Any views expressed in this blog were prepared based upon the information available at the time and are subject to change. All information is subject to possible correction. In no event shall Mawer Investment Management Ltd. be liable for any damages arising out of, or in any way connected with, the use or inability to use this blog appropriately. This blog is only intended for distribution to Canadian persons.

Tags: Canadian Economy
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David Rosenberg: “The Fed, Having Used Its Bazookas, Is Now Down To Firecrackers”

Thursday, November 22nd, 2012

Below is David Rosenberg’s take on the current oversold market rip squeeze fest, and where we go from here:

Oversold equity markets are recovering to start off the week and defensive plays like core government bond markets are seeing some profit-taking in the process. US fiscal policymakers said all the right things at Friday’s 70 minute meeting and investors are taking solace from early prospects that we won’t fall off the cliff (President Obama said in an interview overnight in Bangkok that “I am confident we can get our fiscal situation dealt with”). Platitudes matter in a market seemingly on tenterhooks. Gifts matter too. The President gave John Boehner a bottle of Brunello di Montalcino as an early birthday present is a classic display of the horse trading that will take place to bring a short-term deal to fruition (see page 4 of today’s FT). Mr Boehner would be well advised to split the vino with his GOP backbenchers who don’t seem to share the President’s view that he has a strong mandate to pursue higher top marginal tax rates on income and capital. Either way, austerity is coming our way, it’s just a matter in what manner and by how much, and whether it becomes an orderly or disorderly process. The fiscal cliff is really a bit of a ruse in that respect, but the key here is that years of fiscal profligacy is coming to an end and the Fed at this point, having used its bazookas, is now down to firecrackers. The economic outlook as such is completely muddled and along with that the prospect for any turnaround in corporate earnings.

In the near-term, investors don’t seem to be in a mood to take any chances in terms of facing a higher tax bite on their winnings— see Investors Rush to Beat Threat of Higher Taxes: Weighing on Markets on the front page of today’s NYT (if left unchecked, the top rate on dividends will jump to 39.6% from 15% and capital gains go to 20% from 15%. And there is the additional 3.8% surcharge on most forms of investment income to help defray the costs of Obamacare). While we continue to favour income-equity, utilities are down 9.4% from the October highs and the telecom sector is down closer to 11%, so at the margin, there does seem to have been some effects from the expected tax shifts (ordinarily, these sectors would be outperforming based on the decline in bond yields over the past month, but this time around they have just performed in line with the market).

Moreover, the dividend-payers may have, at least for a short while, become victims of their own success as the S&P Dividend Aristocrats index, for example, hit an all-time high last month and have generated a net 164% return from the March 2009 lows and that compared to +117% for the overall market. The average yield in the investment grade corporate bond space, another area we have favoured, has been cut in half to 2.7% and have generated a decent 10% return year-to-date. There is a great article on page 8 of the FT today on the interest rate outlook and the most insightful comment came from the CIO of BlackRock (Rick Rieder), who said:

We have never seen in history the population ageing and living longer in such a fashion, not just in the U.S. but around the world, and that raises the question of how high growth can go…. we are in the midst of a major defeveraging in the entire developed world, which is going to continue in 2013 and 2014.

That led the writers of the column to conclude, rightfully in my view, that we are in for a “world of slow growth where demand for secure debt outstrips supply and keeps rates low for the foreseeable future.” A portfolio manager at PIMCO (Mark Kiesel) also claims this (and I wouldn’t argue the point, either):

If you look at the past 10 years, corporate bonds have had a higher return than equities with a third of the volatility investors are looking at earning 4-6 per cent from a diversified portfolio of corporate bonds and that’s roughly what you will get from owning equities based on the outlook for earnings and the economy.

The direction and level of interest rates are much more important for income-equity than tax changes are— history is clear about that, despite the near-term disruption. At the same time, disinflation, a very accommodative Fed, superb corporate balance sheet fundamentals and tremendous liquidity all suggest that credit spread strategies will offer superior returns in the future, especially relative to cash which the Fed has already told you is going to be a losing strategy for the next three years in real after-tax terms.

One word we liked above is “diversification” which is more essential in a fat-tailed world where the range of outcomes is extremely wide compared to cycles in the past when the distribution curve was far thinner than is the case today. The more we are out of our comfort zone. the greater the need to have a diversified portfolio. And within that, the combination of disinflation, deleveraging and demographics — the market outlook in 3D — augurs for exposure to income strategies across the various asset classes. Cash flow is king in this sustained 0% short-term interest rate environment. If you like Treasuries, the price for safety is a lack of yield (though potential for capital gain), but the article on page C2 of today’s WSJ reaffirms my view that we are potentially in for even lower yield activity ahead (see A Year-End Migration to Treasuries), which when all is said and done, will make corporate bonds and other spread product appear that much more alluring from a relative coupon perspective.

Meanwhile, in addition to eased fears over the fiscal cliff, there is some hope that a Cairo-led cease fire will occur in the Israel-Gaza flare-up and there is additional hope that the upcoming meeting among Eurozone financial officials will resolve the current spat with the IMF over Greece’s debt targets. So with investor risk appetite whetted a bit, we have the European stock markets up more than 1%. Asia was up as well but by less, but the real hidden gem yet again was Japan with a 1.4% gain and this followed the 3% advance last week as other markets declined substantially. Japan is operating on its own set of dynamics and the fact that the yen has managed to embark on a weakening path is highly constructive for the country’s large-cap exporters. The election on December 16th promises to usher in even more dramatic moves to weaken the yen and stimulate monetary policy — including a move to lift the BOJ’s inflation target from 1% to 3%. As an aside, U.S. dollar/yen at 82 is widely viewed as the cut-off level for profitability among Japanese industrial companies — we are just about there. Domo!

In other markets, we see the U.S. dollar struggling as it tests the 100-day moving average. Gold is bid. The commodity-based currencies are faring better as well, as is sterling on the back of some better home price data that were released earlier today. If we do see some sort of market revival in the near-term, the one sector to keep an eye on is technology which has faltered significantly and badly lagged the old-economy machinery stocks during the recent setback (see Tech Sets Correction Course on page C1 of today’s WSJ). Tech has slipped now for six weeks in a row, which is a strength we have not seen since 2008 (in addition to Apple, we have seen the likes of Google, IBM, Intel, and Dell all disappoint during the latest earnings reporting season). Margins have been squeezed and are now down to the lowest level in over two years (17% from 19% a year ago). No doubt earnings expectations are being trimmed — the flip-side of sitting on so much cash is reduced growth prospects — but the next question is the extent to which a bleak future is already more than priced in. After all, how many times in the past has the tech sector traded at a P/E discount (11.7x on year-out earnings forecasts) to the overall market (12.5x)?

One last word here on the fiscal cliff. Once we get past that issue, we will confront the inherent inability of the Democrats and the GOP to embark on any grand bargain to blaze the trail for true fiscal reforms. The U.S. has not had a rewrite of its tax code since 1986, which was the year Microsoft went public and a decade prior to Al Gore’s invention of the Internet. The tax system is massively inefficient and leads to a gross misallocation of resources that impedes economic progress — rewarding conspicuous consumption at the expense of savings and investment. It is the lingering uncertainty over the road to meaningful fiscal reform that is really the mot cause of the angst — the fiscal cliff is really a side show because who doesn’t know that we are going to have a Khrushchev moment?

Everyone at the White House and Congress is well versed about 1937-38. But it is what happens next that matters most for those that have to plan for the long-term — not just tax shifts around an end-of-year calendar date. To this end, have a look at the WSJ front page article today — Investment Fails off a Cliff: US Companies Cut Spending Plans Amid Fiscal and Economic Uncertainty. So I have some news for you: avoiding the fiscal cliff allows a very short window to catch a breath of relief. CEOs realize that averting the fiscal cliff will likely mean a quid pro quo for a slate of tax-code changes in the future and nobody is going to know for a long time how those changes are going to affect them. This is the exact opposite of what we had on our hands in 1980 when Ronald Reagan provided a framework of fiscal reform that ushered in sharply lower marginal tax rates, pledged to work with a Democratic House that was populated with “Reagan Democrats”… do “Obama Republicans” exist?), and the certainty and clarity over the fiscal policy roadmap the President ushered in was so powerful that this alone allowed the recovery and bull market to take hold fully four years before the tax shifts were legislated. This is how vital it is for the government to part the fiscal clouds as soon as possible — avoiding the fiscal cliff does not assure that.

What the country needs is a credible long-term fiscal plan. Only then will capital investment embark on a sustainable uptrend and take the rest of the economy with it. An economy reliant on such an unproductive asset as housing for its prosperity is not that comforting for those of us who believe that what provides a much more enduring IR is renewed growth in the nation’s productive private sector capital stock. That begins with business spending.

In a U.S. holiday-shortened week (Happy Thanksgiving!), the noise around the fiscal cliff will take a back seat to an array of housing indicators, Bernanke’s sermon tomorrow at the Economics Club of New York (12:15 PM) on the economy and how Black Friday (Thursday?) shopping goes. In Canada, Finance Minister Flaherty talks about the Canadian economic outlook at the Toronto Board of Trade on Thursday at 11:30 AM (as our American friends get ready for a day of Turkey, pumpkin pie and some NFL).

Tags: Canadian Economy, Rosie
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