FIRST QUARTER 2010 – RETROSPECTIVE AND PROSPECTIVE

THE RECESSION IS OVER…FOR NOW

“We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.” — Winston Churchill

2010 had a shaky start!

The positive momentum that characterised the last few months of 2009 carried through into the early part of January. Then fears began to surface with respect to the fragility of the recovery causing equity markets to correct through mid-February. Since that time, another reversal of sentiment resulted in a recovery of the lost ground that resulted in a modest gain for the quarter.

The net result has been a gain of 3.1% on the Toronto Stock Exchange. The US market improved 5.4% in US dollar terms, but the 3.1% appreciation in the Canadian dollar resulted in a more modest 2.3% gain in Canadian dollar terms. Other global markets followed a similar pattern as measured by the MCSI EAFE (Europe, Asia and the Far East) Index that recorded a gain of 0.9% in US dollar terms but a decline of 2.0% in Canadian dollars. However, it should be noted that a significant difference was apparent between Europe and Asia. Expressed in Canadian dollars, the MCSI Europe index posted a loss of 4.6% and the European Monetary Union members faired even worse with a decline of 7.6%! In contrast, Japan posted a gain of 5.1%, the remaining Pacific region had a gain of 0.1% and the Far East alone was up 4.0%.

In our view, the following factors can account for the erratic behaviour in the global stock markets: increased business confidence as evidenced by a pick-up in mergers and acquisitions, the precarious conditions in the financial markets due to growing doubts regarding the sustainability of the economic recovery and continued uncertainty resulting from political pronouncements and interference.

The activity in mergers and acquisitions picked up as companies in stronger financial condition exhibited the confidence to purchase assets from weaker competitors. AIG sold two of its crown assets; Prudential purchased AIG’s Asian insurance business for $35.5 billion and MetLife bought Ailco, another of AIG’s foreign insurance operations. AIG was one of the largest recipients of bailout funds from the US treasury over the last two years. Schlumberger, one of the world’s largest oil service companies, bought Smith International, a major competitor for $12.4 billion. Novartis, a Swiss firm, paid $26.1 billion to acquire Alcon, a contact lens product firm from Nestle. Consolidation in the international beer markets was evident as Heineken, a large Dutch brewer, bought a Mexican rival, Femsa for $7.6 billion. One of the more interesting acquisitions in the quarter was Kraft’s purchase of Cadbury for $15.4 billion. This acquisition was controversial for two reasons: in the UK it ignited protectionist fever while in the US, Warren Buffet, a director of Kraft, publicly chastised management stating that it was a bad deal for Kraft to make. Kraft sold its frozen pizza business to Nestle for $3.7 billion.

In the automotive industry, Ford sold Volvo to Geely, a Chinese manufacturer for a fraction of their cost. On the other hand, GM decided to phase out the Hummer brand as no acceptable bids were received. In North America, both Ford and GM took advantage of Toyota’s public recall problems and posted strong gains in sales. Toyota in the quarter had its executives humiliated before congress while newspapers continued to headline recalls. There has been a notable absence of coverage on domestic brand recalls.

The financial industry exhibited some anecdotal evidence of improvement as several major banks posted improving profits: Barclays, Well Fargo and BNP Paribas and most of our Canadian banks for example. However, many other banks continued to languish such as Citigroup and Societe Generale. The US government has announced their intention to sell the 7.7 billion shares of Citigroup that they took during the bailout. In the meanwhile, politicians continue to float random ideas on the future of regulation in the financial community. In Europe, proposals range from taxing financial transactions to dramatically increasing capital requirements for financial institutions and restricting trading in derivatives and commodity markets. In the US, various taxing schemes have been mentioned as well as limiting proprietary trading (where banks trade for their own account, not just for customers) and restrictions on pay or bonuses. Here the only certainty is that financial reform will cost the banks, and hence consumers, more.

The stock markets have also been jolted by the fiscal calamities emerging, particularly in Europe. Greece’s inability to pay its mounting debt burden has caused investor concern with regard to other countries with large fiscal imbalances; most notably Portugal, Italy, Ireland and Spain. The Euro depreciated by 6% relative to the US dollar and nearly 9% against the Canadian dollar. As governments continue to attempt to solve the debt crisis by piling on yet more debt, longer term concerns are turning to the UK and the US. The added burden of health care will do little to temper concerns about the US economy.

Debt crisis often result in interest rate hikes as lenders demand better compensation for the risk of lending. Higher rates could potentially cause another setback in the US housing market.

All of these uncertainties will continue to suggest erratic behaviour in the world markets as investors vacillate between optimism and fear. Value investors need to be ready to take advantage of changing valuations as opportunities will undoubtedly occur.

FIRST QUARTER 2010 FIXED INCOME COMMENTARY

Subsequent to the sharp increase at year-end, interest rates declined in the early part of the quarter. The respite didn’t last and by March an upward bias manifested itself once again.

During this period, issues related to sovereign debt moved to the forefront. Concerns regarding the credit worthiness of Greece escalated as fears that they would default were prevalent.

The ability of the Euro zone to deal with countries facing major deficit issues or potential defaults appears inadequate. One proposal has been that a European Monetary Fund should be established as a mechanism to deal with such cases. While this might be an appealing “made in Europe” solution, the negotiations required to establish such an organization and the consequent implementation likely take far longer than the current situation would allow.

The complexity of the issue is exacerbated by political considerations that are at odds with the fiscal and economic fundamentals. The Greeks are loath to give up their benefits and accept the sacrifices necessary to deal with their deficits. At the same time, German taxpayers, who would likely face a large part of the burden of a bailout, are reluctant to become lenders of last resort in the European community.

It is not only Greece, but the rest of the PIGS (Portugal, Ireland/Italy, Greece, Spain) that may require debt restructuring solutions. As it stands there appears to be agreement that there is need for some IMF (International Monetary Fund) involvement. However, the final outcome of the Greek crisis is far from clear. Overall these are sobering developments for the Euro, which only a short while ago was touted as a possible reserve currency in waiting.

While the Federal Reserve continued to preach a gospel of an “extended period of low interest rates”, the market started to have doubts about the wisdom of accepting the paltry rates being posted for Treasury securities. A telling development was the reaction to the Greek crisis. Instead of the customary flight to quality, treasury securities being auctioned started to command higher rates. The issue of sovereign debt and deficits is starting to attract closer scrutiny, even in the case of the United States.

At the same time, the Bank of Canada indicated that interest rate hikes were in the offing if the current economic improvements continued. Market observers appear confident that the Bank of Canada will likely begin raising rates in the second half of the year.

The total return performance of the bond market for the first quarter was an increase of 1.26%. The ten-year Government of Canada bond yielded 3.6% at quarter-end, remaining essentially unchanged when compared to the year-end level. Continuing interest in corporate debt issues allowed their yields to decline against those of Provincial issues. During the course of the quarter there were periods where the yield posted by the overall corporate index actually yielded less than the provincial index. Given the difference in the credit worthiness between corporations and the provinces, this is an abnormal event and it is expected to normalize going forward.

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