FOURTH QUARTER 2009 – RETROSPECTIVE AND PROSPECTIVE

WHERE DO WE GO FROM HERE?

“Politicians are the same all over. They promise to build bridges, even when there are no rivers.” — Nikita Khrushchev

We entered 2009 with a great deal of angst!

In 2008, the Canadian and US markets suffered declines of 33% and 37% respectively. This dismal performance was followed by a decline of nearly 10% in Canada and over 18% in the US during the first two months of 2009. In March, the markets turned direction. Investors, desperate for any sign of good news, latched onto any release that could be construed as positive and drove the market to close up 35% in Canada and 26% in the US for the year. In the fourth Quarter, the market advanced 4% in Canada and 6% in the US. The European, Asian and Far East markets advanced 2% for the quarter and 32% for the year as measured by the MCSI EAFE Index in US dollar terms.

The Canadian dollar strengthened considerably against the US dollar as investors perceived a strengthening in the US economy that would support higher commodity prices. The 15% advance in the relative value of the Canadian dollar diminished foreign returns dramatically. In Canadian dollar terms, the S&P 500 advanced 8% and the MCSI EAFE advanced 13%.

In 2009, there was a lot of seemingly positive news that captured investors’ attention. Most of the major world economies arrested their declines and even showed signs of growth by year end. In particular, investors focussed on the US economy that was at the epicentre of the global financial crisis.

In the US, the free-fall in housing prices stabilized in many of the major centres and home sales actually increased during a few months. After GM and Chrysler emerged from bankruptcy, automobile sales improved although the primary beneficiaries appeared to Toyota, Ford and other brands. Many of the previously troubled banks reported sizeable profits; J P Morgan Chase, Wells Fargo, Morgan Stanley and Bank of America to name a few. In the fourth quarter, Bank of America announced that it was going to pay back the $45 billion in aid that it had received.

So, why the continued angst?

Unemployment remains at extremely high levels. During the year, the US shed some 7.2 million jobs since the crisis began. GM came out of receivership but still managed to lose over $1 billion in the subsequent quarter. The company’s new CEO quit after eight months indicating trouble at the board level. Personal bankruptcies continue to occur at record levels reflecting both the employment situation as well as the degree to which consumers are over-extended. Some 130 US banks have ceased operations and over 550 remain on the FDIC’s (Federal Deposit and Insurance Corporation) watch list. CIT, a major lender to small businesses in the US failed.

Globally, other problems persisted. Iceland and Latvia’s economies continue to retract. Dubai defaulted on some $26 billion in debt that it was forced to restructure. Ireland had to make drastic cuts to public sector payrolls.

Much of the positive news last year was fuelled by massive government spending in the form of “stimulus” and fiscal easing (increasing the supply of money) by central banks that have gone to great lengths to keep interest rates low in order to maintain some semblance of credit in the economy.

Last quarter, we outlined a number of headwinds that will continue to mitigate against a rapid recovery:
• The retrenchment of the consumer
• Deleveraging on the corporate and personal fronts
• Volatile commodity markets
• Greater intrusion by governments and regulation
• Rising protectionism
• The push and pull of deflationary and inflationary forces

These factors will continue to play a role, but of greatest concern is the intervention by government as politicians continue to grandstand with faux derision against the business community while usurping a greater role for themselves. The window for continuing to build massive public debt on the back of huge deficit financing at artificially low cost will eventually close. Interest rates will have to go up to compensate debt-holders.

In this environment, the economic recovery remains fragile. At best, it will be a slow climb to lift employment and stabilize business confidence. Markets will continue to be volatile and value investors should have an edge in seizing opportunities and harvesting profits. We will continue to maintain our vigilant and cautious approach in the stewardship of our clients assets.

FOURTH QUARTER 2009 FIXED INCOME COMMENTARY

“We pay the debts of the last generation by issuing bonds payable by the next generation.” — Laurence J. Peter

While interest rates remained at a low and stable level for most of the quarter, improving economic indicators and the rising differential between short and long term interest rates, signalled that interest rates may soon be climbing.

Dubai’s debt moratorium and the debt rating cut of Greece served as ample reminders that even sovereign debt can come under pressure as a result of high deficits and excessive debt. International credit rating agencies have indicated that sovereign debt ratings are not inviolable and may be cut. It is widely perceived by market participants that the rating agencies and investors are sending a warning to the US authorities regarding their fiscal imbalance which has been exacerbated by the various stimulus and bailout packages.

In the United States the $700 billion financial services bailout program has been extended until next October. While this does indicate continued caution on the part of the Obama administration, realistically it is only a way to maintain operational flexibility should some or all of the funds be required. In fact, administration sources have indicated that it is unlikely that more than about $550 billion will be deployed and generally an orderly wind down of the various stimulus packages is likely.

The expectation that interest rates are poised to rise appears to have been confirmed by the level of bond issuance activity domestically in the last few months. Over the course of the last quarter and particularly towards year end, there was a flurry of issuance by corporate and provincial borrowers heavily biased towards longer term debt. Clearly issuers felt that with market demand for quality issues remaining firm and given the uncertainty regarding interest rate levels going forward it was time to lock in the exceptionally low rates presently available.

Heading into the new year we are faced with a number of issues. Can governments continue to borrow at low rates, especially as credit rating agencies have warned about their profligate ways? Can they make progress towards balancing their books without untenable tax hikes? Can they unwind the extraordinary levels of stimulus before it becomes fuel for inflation? Keeping in mind that rising interest rates, tax hikes or a too precipitous winding down of the stimulus program could serve to strangle this fragile economic recovery. All in all, quite a policy conundrum!

The total return performance of the bond market for the fourth quarter was a decline of 0.2%. The ten- year Government of Canada bond yielded 3.6% at year-end representing an increase of 0.3% over the course of the quarter. By way of context, at the beginning of 2009 they had yielded 2.7%. The interest rate premium paid by corporate borrowers compared to federal issues, as measured by the DEX index, continued to moderate and is now barely above that of provincial bonds. Typically, the spread is much larger. Given the difference in the fundamental credit worthiness between provinces and corporations, to us this is one more caution sign regarding the likely upward pressure on rates.

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