QUARTERLY MARKET COMMENTARY – THIRD QUARTER 2011

QUARTERLY MARKET COMMENTARY – WHEN TIDES AREN’T RISING

“Practical politics consists in ignoring facts.” — Henry Adams

It is said that a rising tide raises all boats. Unfortunately, the tides of the third quarter were decidedly not rising. Investors the world over were caught up in the tragedy unfolding in Europe, and more particularly Greece. Whether or not a default is officially declared, investors will take substantial losses on their exposure to Greek debt. Fears of the contagion effects these losses will precipitate throughout the European banking system and beyond, have captivated headlines. Additional concerns regarding the sluggish and debt ridden American economy have also contributed to investors’ malaise. Given the increasing prospects of slower economic growth and perhaps the possibility of another recession, the prices of equities and commodities declined reflecting diminished expectations.

The Toronto Stock Exchange Total Return Index recorded a loss in the third quarter of 12.0% resulting in a loss for the year to date of 11.9%. The US market declined even more recording a loss of 13.9% for the quarter and a loss of 8.9% for the year to date. The decline in the Canadian dollar mitigated the US return numbers resulting in a loss of 6.1% for the quarter and 3.9% for the year thus far when expressed in Canadian dollars. Markets around the globe struggled in the third quarter as indicated by the EAFE (Europe, Asia and Far East) Index with a loss of 19.6% for the quarter and 17.2% for the year to date. As the Canadian dollar weakened relative to many of the world’s currencies, the EAFE loss was reduced to a negative 12.3% for the quarter and 12.8% for year to date when expressed in Canadian dollars.

The Canadian fixed income markets fared much better in the third quarter as a result of yields generally declining where investors sought safer harbours. The effect of the rally was most apparent in the overall bond index that recorded a return of 5.1% for the quarter bringing the year to date return to 7.4%. The more meagre returns in shorter maturities are reflected in the 91day T-bill return of 0.3% for the quarter and 0.8% for the year thus far.

It is interesting to note the degree to which the global markets all moved in lockstep during the quarter. In August, when the Federal Reserve stated that interest rates would be held close to zero for at least two years, stock markets responded positively around the world. The markets simultaneously sold off when US economic indicators reported slower growth than expected and when the German Bundesbank expressed concerns about participating in a Greek bailout. Not too many years ago one of the primary maxims of investing was that diversification through investing across differing geographic markets would provide some insulation from your investments all rising and falling together.

What has happened to cause the markets around the world to act much more in concert than in the past? A recent article* in The Economist sheds some light on the subject [* Reference: The Economist, September 10, 2011, All in the same boat, page 82].

Globalization has a lot to do with this phenomenon. The volume of world trade has risen considerably over the last number of years. In 2001, world trade represented around 24% of global GDP (Gross Domestic Product) whereas now it is approaching 30%. Much of the growth in the emerging economies relies on the developed economies purchasing their products. Multinational companies are by definition dependant on the economic wellbeing of the economies in which they participate. A study by BNP Paribas noted that 20% of the revenues of companies in the Dow Jones Industrial Composite are derived from emerging markets, 36% of the FTSE 100 (UK) company revenues are generated in North America and 14% of listed Korean company revenues come from Europe.

The globalization of investment management has also been a factor. When the Federal Reserve or European Central Bank makes a statement, fund managers around the world react. As clients contribute or withdraw funds in one market, fund managers may be buying or selling in others causing the foreign market direction to mimic the managers’ domestic market. It is somewhat ironic that in the quest for diversification, global markets have become more correlated as a result.

Within this turmoil on the markets, businesses carried on. While there were some earning disappointments (Cisco, UBS, Porsche, Royal Bank of Canada, Imperial Oil), there were other positive surprises (Apple, IBM, CIBC, Crescent Point Energy). Merger and Acquisition activity continued (Hitachi/Mitsubishi, SAB Miller/Fosters, Google/Motorola Mobile).

It will take some time to correct some of the excesses that have built up in the developed economies. High debt levels will take time to be reduced, when and if politicians are finally forced to face the fact that going further into debt will not solve this problem. Structural unemployment will persist for some time as the labour markets adjust the bifurcation of the highly skilled workforce and the lesser skilled through technology and global pressures.

We anticipate another volatile quarter is likely through the end of the year and perhaps beyond. Valuations have been significantly lowered over the last quarter and we have selectively been making purchases where we determine good opportunity exists. Going forward, we anticipate that more opportunities will arise as market volatility is exacerbated by the great uncertainty with respect to the pace of economic growth as the world waits for the tides to turn.

QUARTERLY MARKET COMMENTARY – THIRD QUARTER 2011 FIXED INCOME

“You cannot spend your way out of recession or borrow your way out of debt.” — Daniel Hannan

The themes that pervaded our second quarter commentary continued through the third quarter. The US economic recovery continues to be sluggish and the problems in Europe, more particularly Greece, are still with us.

US economic indicators continued to signal a very modest recovery, that in the absence of concrete evidence to the contrary, many commentators have surmised that the economy is drifting back into recession territory. Unemployment hasn’t moderated, and with the CPI (Consumer Price Index) rising to 3.8% in the quarter, inflation has become a concern.

Inflation indicators have been rising in the US, Canada and Europe. At a time of slow economic activity and excess productive capacity, a moderate level of inflation is not an immediate concern. Nevertheless, central bankers tend to get uncomfortable once inflation rates move past the 3% level. Combine this trend with the slow pace of economic activity and fears of stagflation, (high inflation and slow economic growth) like that experienced in the 1970’s, come to mind.

The Federal Reserve has stated that the current low interest rate policy will likely be maintained at least until mid-2013. In order to continue stimulating the economy while being constrained by already low short-term interest rates, the Federal Reserve opted to modify the interest rate structure. This will be accomplished through an action dubbed “Operation Twist”, whereby short-term government debt is being sold and the proceeds are used to buy long-term debt, driving down long-term interest rates. It is unclear as to how much effect this will have on the economy. With interest rates so low, it is not the high cost of borrowing that is holding back the recovery. Both Consumers and business owners are avoiding and paying down debt as fears of deteriorating economic conditions take hold.

No one but the most wildly optimistic gambler expects Greek government debt to be paid back at anywhere near their original borrowing terms. The concerns are; how messy the default will be, to what extent other countries might follow and what the fallout will be for the banking system. While this painful situation continues to develop, politicians do not seem to be able to come to terms with the need for quick and decisive action.

In face of these risks, investors continued to warehouse their cash in government bonds, thereby driving interest rates further down. The enthusiasm for corporate issues was far more muted given the heightened risk awareness of investors.

The total return performance of the bond market as measured by the DEX Universe Index for the third quarter was a gain of 5.1%. The ten-year Government of Canada bond yielded 2.2% at quarter-end, a decline of 0.9% over the course of the third quarter.

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