QUARTERLY MARKET COMMENTARY – SECOND QUARTER 2011

QUARTERLY MARKET COMMENTARY – THE FUTURE APPROACHES

“I have seen the Future — and it was being repaired.” — Mel Calmen

“Every calamity is a spur and a valuable hint.” — Ralph Waldo Emerson

The second quarter of 2011 was not kind to Canadian investors as the securities on the Toronto Stock Exchange generally gave up the gains that were achieved in the first quarter.

The Toronto Stock Exchange Total Return Index recorded a loss in the second quarter of 5.1%, reducing the gain for the year to date to a miserly 0.2%. Almost a quarter of that quarterly loss, or 1.1% is the result of the precipitous decline in two stocks: Research in Motion and Sino-Forest. The US market fared better in the second quarter as the S&P 500 total return managed a meagrely positive advance of 0.1% bringing the first six months to a more respectable 6.0%. The bad news for Canadian investors was that the advance in the value of the loonie reduced the US returns to a negative 0.5% in the quarter and a positive 3.5% for the six months. Many of the other global markets struggled in the second quarter as indicated by the EAFE (Europe, Asia and Far East) Index with a return of 0.3% for the quarter and 3.0% for the year to date. As the Canadian dollar was strong relative to many of the world’s currencies, the EAFE return was reduced to a negative 1.0% for the quarter and year to date.

Returns remained lacklustre in the fixed income market. The 91day T-bill index recorded a return of 0.2% for the second quarter bringing the six-month return to 0.5%. The bond market return for the quarter was 2.5% bringing the year to date to 2.2%.

From an investor’s perspective, we have basically gone round trip for the year to date. In our last commentary, we discussed many of the factors concerning investors in the first quarter and these same factors continued to dominate market behaviour in the second quarter.

The tragedy unfolding in Greece as they are forced to address years of overspending and under- producing dominated much of the news. Whether or not a default on the debt is officially recognized, participants in the financial markets are adjusting to the realization that a default will have effectively occurred as holders of the debt will end up with securities of lesser value. The current negotiations are all about minimizing the loss as far as the investors are concerned. These negotiations will be protracted and it may not be entirely apparent when a resolution is in place until well after the fact. In the interim, investors will continue to have concerns over the state of the economy in other parts of Europe particularly Portugal, Ireland, Italy and Spain.

Many of the world’s supply chains continue to be disrupted by the carnage left behind in the wake of the tsunami in Japan. In particular, many plants integral to the supply chain in automotive, electronic and technology industries were severely damaged and it will take time rebuild or create alternative conduits.

As the Chinese grapple with inflationary pressures in their economy, domestic interest rates have been increased. Investor’s concerns over the degree to which this could stem global economic growth prospects have been reflected in commodity prices. During the quarter, the prices of oil, natural gas, silver, nickel and wheat all declined. Oil prices dropped precipitously when importing countries released sixty million barrels from strategic reserves. Coupled with the stronger Canadian dollar constraining export, these factors all weighed on the Canadian stock market.

Despite all of these headwinds, there were some positive developments in the quarter. Merger and Acquisition activity continued (Vivendi/Vodaphone, Johnson & Johnson/Synthes, Barrick Resources/Equinox, Teva/Cephalon, Micosoft/Skype, Texas Instruments/National Semiconductor, etc.) as firms position themselves for the coming years. Worldwide stock exchanges attempted consolidation (NASDAQ, Intercontinental, NYSE Euronext, Deutsche Bourse, Australia, Singapore, London, Toronto). Several notable initial public offerings were launched (Glencore, LinkedIN, Renren).

As we enter the third quarter, the end of quantitative easing and stimulus spending in the US at a time when house prices continue to fall and unemployment remains stubbornly high is of concern to investors as politicians play gamesmanship with legislation. Debt levels are dangerously high and growing but the bulk of that growth has been in the public sector. Private sector debt in the US has been partially reined in on the consumer side and corporate balance sheets are in reasonable condition. As is painfully evident in Europe, this massive increase in public debt will inevitably lead to unpopular choices: higher taxes and/or reduced program spending.

With all of the above in mind, we expect that the third quarter will be indecisive in terms of market direction. The world’s economic and geo-political maladies are going to take years to sort out. Business activity reflects an environment wherein strongly financed companies with the leadership to take advantage of opportunities, have sufficient confidence to do so.

Investors should act no differently.

QUARTERLY MARKET COMMENTARY – SECOND QUARTER 2011 FIXED INCOME

“He who lives by the crystal ball soon learns to eat ground glass.” — Edgar R. Fiedler

During the quarter, investors’ attention focused on two major concerns: the apparent “soft patch” that the U.S. economy had encountered, and, the possibility of a Greek debt default with all of the consequences that would transpire.

A stubbornly high unemployment rate with continued declines in housing prices has focused investors’ attention on the slow pace of recovery in the U.S. Taken in conjunction with weaker than expected economic indicators, the overall picture is that of a fragile economic recovery that may potentially slide back into a recession.

With the cessation of stimulus from the soon to expire second round of quantitative easing and the inability of politicians in Washington to agree on an increase in the national debt limit, the resolution of fiscal concerns is becoming less certain. A surreal atmosphere is developing from the persistent wrangling about the debt ceiling while nothing is being done about reigning in the ever-growing deficit monster. The U.S., like the troubled countries of Europe, is spending more than it takes in. As anyone who has maxed-out their credit cards knows, eventually there is a day of reckoning.

In the case of Greece, there is little doubt that they will be unable to repay their debt and that a default, official or not, will occur. The key is how to restructure the debt without having to legally declare a default and how to avoid a ripple effect to other countries with high sovereign debt loads.

If the charade of an orderly reorganization of Greek debt fails, banks, many of them European, will have to take extra reserves against the newly encumbered Greek debt. Given that many of these banks have already required financial assistance, they would be hard pressed to approach their governments for yet another bailout. Many of these governments themselves have financial difficulties, so the question is: “How much of this mess will once again land on the shoulders of the German taxpayer, the apparent European lender of last resort?”

Any cutbacks the Greek government would like to do, even with the best of intentions, will most certainly run into severe resistance from the population that will be asked to make dramatic adjustments to their entitlements and expectations. Unemployment, especially amongst the youth, is reaching critical levels. It is not surprising then that there have been mass demonstrations and violence. It is worthwhile to remember that governments can only lead where the people are willing to follow!

Bond yields remained low during the second quarter. Investors’ concerns regarding Europe have resulted in a renewed flight to perceived quality that up until now has been to the favour of the US. This may well come to an end as investors take notice of the increasing borrowing levels of the U.S. and the resulting fears of inflationary pressures.

The total return performance of the bond market as measured by the DEX Universe Index for the second quarter was a gain of 2.5%, largely the result of the flight to quality in government bonds. The ten-year Government of Canada bond yielded 3.1% at quarter-end, a decline of 0.2% over the course of the second quarter.

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