SECOND QUARTER 2008 – RETROSPECTIVE AND PROSPECTIVE

“An economist’s guess is liable to be as good as anybody else’s.” — Will Rogers

Another turbulent quarter has passed during which investors have been buffeted and bruised by excessive price gyrations in the stock and bond markets. As recently as June 18, the Toronto Stock Exchange(TSX) closed at an all time high, only to fall four percent from that peak by the quarter end. After touching $1000.00 per ounce in March, Gold fell to nearly $850.00 at the end of April and continued to roller-coaster to close the quarter at close to $930.00. The TSX is the only major global index to post a positive return thus far this year! However, if you removed energy, a few fertilizer stocks and Research in Motion, the TSX would also be negative.

What is driving this volatility and what should investors look forward to in the coming months? The following is our take on the four key variables that investors should watch:

1. Oil: Oil, and fertilizers, have been the primary driver of the Canadian market’s out-performance relative to its international peers over the last year. Fertilizer stocks have been spurred by the natural calamities that have afflicted Asia and the US mid-west. Speculative fever pushed the price of oil to over $140.00 per barrel in the Second Quarter from a start just above $100.00. Pundits have been calling for prices to advance even further. Jeff Rubin at CIBC has forecast that oil will exceed $150.00 in the next year and reach $200.00 in the next two years. Furthermore, he predicts that prices at US pumps will reach $7.00 per gallon in that period! Even at current pump prices, consumers are altering their driving habits as retail volumes are lower than normal. Surprisingly, there does not appear to be a shortage of oil at this time. Inventories are not severely out of line and production levels have not declined so precipitously as to warrant the current price levels. Although $150.00 per barrel is not that far a reach from current levels, investors should look for oil to generally retreat from these levels over the coming months as evidence of slowing economic activity becomes evident.

2. Inflation: Finally, inflationary concerns are beginning to get the attention that is long overdue. There has been a lag between the increasing commodity prices and consumer prices. As fears of the credit crunch built, the Federal Reserve chose to cut rates in an attempt to maintain confidence and support consumer confidence while ignoring the inflationary pressures of higher food and energy prices. Higher transportation and material costs are catching up at the consumer level making it unpalatable to ignore inflation any longer. US inflation estimates have increased to the 4% to 5% range, up over 1% in the last six months. Canadian inflation is estimated at around 1% lower than that in the US, masked by the strength in the buying power of the Canadian dollar. The federal Reserve has hinted that interest rate decreases may no longer be feasible. Look for modest interest rate increases in the months ahead as the authorities walk a tightrope between inflationary concerns and a stalling economy.

3. Consumer Spending: The North American consumer is facing the perfect storm; rising unemployment, falling house prices, more expensive credit and rising inflation. Stagflation is a word not used since the late 1970’s and early 1980’s. In the US, recent statistics indicate that house prices are falling at a rate over 15%. As the sub-prime mortgage crisis continues and record numbers of homeowners find their homes in foreclosure, rising unsold inventories are causing prices to crash. In Canada, we have not had the same problem with sub-prime mortgages outside of the effect on some of the financial institutions. However, rising unemployment in central Canada, particularly in the automotive sector, combined with tightening credit, will be felt in the housing sector particularly on a regional basis. Look for higher levels of unsold inventories and longer sales periods as an indication of worsening conditions. Compounding consumer concerns, high energy costs are causing the value of their second largest asset, the automobile, to tumble. As consumers postpone major purchases due to the prospect of uncertain times, look for consumer spending to be under pressure.

4. Equity Markets: As mentioned at the beginning of this piece, the TSX is the only major world index to report a positive return this year. The Shanghai is down 48% so far this year. The Tokyo Nikkei Index is down 12%. London’s FTSE Index is down 14% and Germany’s DAX Index is down 20%. The positive momentum of the TSX index has been drives by a very thin slice of the overall market. As evidence of a slowing global economy becomes evident, the TSX in particular is vulnerable to decline as only this small portion of the index has been supporting the index. Rather than despair, investors should be utilizing this period to build positions selectively as opportunities arise. Canadian financial institutions have been bruised in this environment along with their US counterparts despite their stronger capital position and reduced exposure to those forces impeding the US firms. Many of the Canadian oil and gas firms are generating compelling cash flows and a few of the income trusts are paying attractive distributions. Selectively, firms offering consumer staples or productivity enhancing products and services will prosper in this environment. This is a time to be vigilant and selective, but savvy investors will escape the worst scenarios while positioning for future returns.

This describes conditions as we see them at this juncture. We wish that we could be more optimistic in the immediate future, but longer term, we remain positive. In any event, we are sure that our assessment is “as good as anyone else’s”.

FIXED INCOME COMMENTARY

Fixed income markets continued to shift their focus from credit concerns toward a resurgence in inflation. In the absence of headline grabbing financial disasters, the more immediate issue had become the impact of rising oil, food and commodity prices in general. While consumer prices in Canada have remained at a still acceptable 2.2%, they have spiked to an uncomfortable 4% plus range in the United States.

Inflation pressures are materializing and are being taken seriously by central banks around the world. While the Federal Reserve has not yet raised rates, comments made subsequent to their recent meeting clearly indicate that they are sensitive to this issue. This places the Fed in a difficult position where they try to balance the conflicting pressures of a slowing economy and rising inflation. Perhaps more important than the current level of inflation is the fear that inflation expectations will become embedded in the economy. Once this psychology gains a foothold, it takes painfully high interest rates to break the cycle. Markets are therefore beginning to expect that before the year is out, the trend setting U.S. Fed Funds rate will be raised.

In Canada, expectations were firmly focused on a quarter percent rate cut at the Bank of Canada’s meeting in June. Therefore, it came as a shock when the Bank passed on the rate cut and instead noted the lack of need for further cuts as well as remarking on commodity price pressures in their announcement. Given that this decision was taken against a backdrop of a still relatively tame price environment in Canada, it is evident that the Bank is also becoming cautious in their view on inflation.

Credit issues of course haven’t disappeared. The housing market in the U.S. continues to post dismal results and many financial institutions are expected to require further capital infusions. There is anecdotal evidence that banks are tightening lending criteria even to their prime customers in an ongoing effort to preserve capital and improve their risk exposure. In the last month or so, yields on corporate bonds started to increase once again relative to riskless government issues, a clear sign of the market’s mounting concern regarding credit risk.

Overall therefore, we foresee higher interest rates over the rest of the year. We expect the bond market to be rocked by conflicting pressures of a slowing economy, rising inflation and the possibility of further financial turmoil related to the fallout from credit problems. In light of this, we continue to stress high quality, government backed, bond issues with shorter maturity dates.

The total return performance of the bond market for the second quarter, as measured by the PC Bond Universe Bond Index (formerly Scotia Capital Universe Bond Index), was a decline of 0.72%. Yields on the ten year Government of Canada bond increased by over a quarter percent in Q2 to yield 3.74%.

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