FOURTH QUARTER 2007 – RETROSPECTIVE AND PROSPECTIVE

“The way to make money is to buy when blood is running in the streets.” — John D. Rockefeller

“I had plastic surgery last week. I cut up my credit cards.” — Henny Youngman

On the surface, 2007 appeared to be a fairly good year for equity markets. The total return of the MCSI World Index was 9.0%. Canadian stocks did even better with the S&P/TSX recording a 9.8% increase. In the US, the S&P 500 total return was 5.5%. However, the strength of the Canadian dollar was the spoiler. The MCSI World Index and S&P 500 total returns were -7.1% and -10.6% respectively when expressed in Canadian dollars! Looking behind the numbers, an even less robust picture of the Canadian market emerges.

Energy stocks posted a rather modest 8.2% return in Canada, despite a 57% increase in the price of crude oil. Weaker natural gas prices, adequate inventories and margin pressures from higher operating and capital costs (due in large part to the strong Canadian dollar) held back stock gains in this sector. The 30.3% gain in the materials sector was supported almost entirely by large takeover activity during the year. Noteable amongst these takeovers were Alcan, Aur Resources, Miramar and LionOre. Outside of Teck Comminco and American Barrick, little remains of Canada’s large capitalized mining behemoths. If it were not for these takeovers and gold related companies, the performance of the materials sector would have been lackluster at best as the prices of aluminum, copper, nickel and zinc declined. The largest group in the TSX, Financials, posted a negative 1.6% return for the year due the growing credit concerns. The buoyant performance of the TSX was in large part driven by the Information Technology (IT) sector that reported a 48.2% return driven almost completely by Research In Motion (RIM) that appreciated 131%. At the close of 2007, RIM was the third largest company by market capitalization on the TSX! IT was also marginally helped by the takeover of Cognos. Other takeovers of note that contributed to the overall market performance included BCE, Stelco, Dofasco, Ipsco and Primwest Energy.

Credit concerns continued to dominate the financial world throughout the fourth quarter of 2007. The Canadian, US and World stock markets posted negative returns for the last quarter of 1.3%, 4.1% and 3.1% respectively when expressed in Canadian dollars. Week after week, another crisis hit the news!

The most noteable loss so far, Citigroup, the largest bank in the US took a $10 billion charge relating to leveraged loans and mortgage-backed securities. Subsequently, Citigroup shored up its balance sheet by selling $7.5 billion in equity to the investment arm of the Emirate of Abu Dhabi. Merrill Lynch took $8.4 billion in writedowns relating to collateralized debt obligations (CDO’s) and other sub prime assets and leveraged loans. Both of these actions resulted in the early retirement of the CEO’s! Other remarkable writedowns were taken by such global leaders as Morgan Stanley, Credit Suisse, Deutsche Bank, The Royal Bank of Scotland and a host of other notable financial institutions.

Financial markets reeled from comments by Hank Paulson, America’s treasury secretary, that the slowdown in the housing market concurrent with the crisis in the credit and mortgage markets posed a “significant risk” to the US economy. The Treasury pressured Citigroup, Bank of America and JP Morgan Chase to set up a fund to purchase assets from structured investment vehicles (SIV’s) worth up to $100 billion. Other banks have been reluctant to support this fund.

Canadian financial institutions have not been immune to this global phenomena. Canadian banks took writedowns of $1.9 billion with respect to the third quarter credit related issues, but these were mostly offset by gains from the sale of VISA and Master Card operations. To put these writedowns in perspective, they represent less than 1.3% of shareholders’ equity and the Canadian banks are among the strongest capitalized banks in the world. Further writedowns are anticipated into next year as credit problems persist. The Canadian financial sector should be able to manage these issues.

Housing prices continue to decline in the US. 2007 will be the first year since 1991 that this has occurred. Many of the “sub-prime” and “initial incentive-rate”mortgages will be due for renewal over the first two quarters of 2008 causing more repercussions in the credit markets as more of these mortgages go into default.

The US consumer is facing a tough environment. Mortgage and credit card debt are at extremely high levels just as housing prices are declining and inflationary pressures build. Oil prices touched new high levels in the fourth quarter before closing at close to $96 per barrel, an increase of 57% for the year. Food prices will increase as the cost of subsidies to corn combined with drought conditions, pollinization shortfalls from declining bee populations, escalating fertilizer prices and other factors begin to take effect.

The US dollar was one of the weakest currencies in 2007 and that will raise the price on imported goods to US consumers. The Canadian dollar flirted with an exchange rate of $1.10 against the US dollar before settling close to par at year end. While this is beneficial to Canadian consumers, the effects on Canadian manufacturing and Canadian companies operating abroad will be profound. Largely in response to the weak US currency, gold recorded the highest price appreciation in decades, up 31% for the year, closing at $837 per ounce.

Looking forward, significant opportunities are likely to present themselves to long term investors in the first half of 2008 as this tumultuous period continues.

As already stated, Canadian financial stocks are presenting opportunistic pricing for long term investors. Although credit concerns will continue to overshadow these companies in the near term, the capital base of this sector is strong and the operating earnings power of the financial firms remains mostly intact. Export oriented Canadian manufacturers are facing a difficult period, whereas US export manufacturers have improving prospects.

Overall, we anticipate that economic concerns will constrain market returns for the foreseeable future but the volatility created by these concerns will continue to present opportunities for astute investors.

FIXED INCOME COMMENTARY

It is sobering to reflect on 2007 and how the concerns of the bond market have shifted. In the early part of the year the risk of rising inflation and the risk of interest rate hikes were front and center. By the end, crumbling credit markets had grabbed the spotlight.

The parade of ongoing revelations of credit writedowns by financial institutions continued through the fourth quarter. While none of these events seem to have dealt a debilitating blow to any of the institutions affected, the mere fact that there does not seem to be an end in sight, continues to breed uncertainty. This state of affairs is amply reflected in the increased rates corporate borrowers have to pay.

The time will come when the fact will have to be faced that many structured securities tied to sub-prime home loans are permanently impaired and lenders will have to take their losses. Nevertheless, there appears to be a wishful thinking that sub-prime mortgage loans and other instruments of ill advised lending, can be made right by central banks cutting interest rates.

Both the Federal Reserve and the Bank of Canada have cut rates during the quarter in the face of uncertainty with the resultant decline in liquidity. In the U.S. particularly, there appears to be a conundrum developing where the credit crunch combined with a slowdown in economic activity argue for further interest rate cuts, at a time when recent data suggests, inflation is picking up. The outcome of these contrary pressures will have a definite impact on interest rate policy going forward.

Our approach of focusing on short-term high quality instruments has paid dividends as we managed to avoid getting caught up in the credit meltdown. Going forward, we remain cautious as we expect that there will likely be further unpleasant surprises in the new year. In light of this, we expect to continue with our strategy of concentrating on quality. As the credit debacle plays out and corporate bond yields settle in to steadier levels, we expect to acquire high quality domestic instruments that while untainted by credit concerns, nevertheless have sold off in the overall market retrenchment. Similarly, as the cross currents of interest rate policy play out and the more normal situation of longer term bonds yielding higher rates re-establish themselves, we will likely consider longer term securities.

The total return performance of the bond market for the quarter, as measured by the PC Bond Universe Bond Index (formerly Scotia Capital Universe Bond Index), was 2.7%, bringing the year to 3.7%. Yields on a ten year Government of Canada bond decreased over the quarter to yield 3.99%.

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