THIRD QUARTER 2009 – RETROSPECTIVE AND PROSPECTIVE

THIS TIME IT’S DIFFERENT

“History is the science of what never happens twice.” — Valery

“The most dangerous of our calculations are those we call illusions.” — Georges Bernanos

“The recession is over.” Ben Bernanke, Chairman of the Federal Reserve, made this pronouncement in recent weeks. Technically, he may be right but it is hard to have a great deal of certainty given that recent revisions to GDP (Gross Domestic Product) are still in negative territory.

Stock market participants continued to shun any suggestion of negative sentiment in the third quarter as evidenced by the market advances. The US markets advanced 7% as measured by the S&P 500 while the S&P/TSX advanced 11%. The European, Asian and Far East markets advanced 10% as measured by the MCSI EAFE index.

Admittedly, there was some good news and signs of improving trends in the quarter. The “Cash for Clunkers” program in the US caused a temporary lift to consumer spending resulting in a significant draw-down of excess inventories on car lots. GM emerged from bankruptcy and Chrysler was absorbed by Fiat. A number of the larger US banks such as Bank of America, Citigroup and Wells Fargo, reported a return to profitability and announced plans to repay government funds used during the crisis. Homes sales modestly improved and prices showed signs of stabilizing and even moving up in some regions. On the corporate front, firms with the wherewithal engaged in some merger and acquisition activity; Volkswagen took over Porsche, Disney purchased Marvel Entertainment, Dell bought Perot Systems, Ebay sold Skype, etc.

However. even if the recession is over, we see a number of significant headwinds that will diminish the prospects of a rapid or strong recovery. Some of the factors to consider are:
• 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

In the last 25 years, the savings rate of the US consumer has gone from 12% down to zero. In fact, with borrowing taken into consideration, savings touched negative territory. Unemployment is still rising, albeit at a slower pace. Incentives such as the “Cash for Clunkers” program are running out. When the artificial stimulus to create spending ends, there appears to be little prospect for spending growth to drive the economy to the extent that it has done in the past. Consumer spending is often stated as representing 72% of US GDP. However, that is a recent statistic following an explosive growth in spending. As the consumer retrenches, the impact on GDP will diminish.

Consumers will have less to spend as they need to address the debt built up during the spending binge of the last few years. Debt as a percent of disposable income has reached unsustainable levels. A large part of the spending boom was driven by leveraging the equity in homes. Today, many people are left with negative equity in their homes as prices have declined. The average equity held in US houses has fallen to 20% from 40% only 20 years ago. As long as interest rates remain as low as present, consumers have some time to rebalance their position. Fear of rising rates coupled with high unemployment will encourage consumers to cut back expectations. Corporations entered the crisis in somewhat better shape from a leverage perspective. However, tightening credit availability will cause many companies to de-lever their balance sheets.

The slowing of final demand and the growth of emerging economies will send mixed signals to the basic commodity markets. These conditions will result in erratic estimates of the final demand for these commodities. Price volatility will result making it hard for firms to plan and budget operations. In this environment, capital spending my be slower than otherwise and productivity improvements will be impeded.

No one who has read a newspaper in the last year can be unaware of the cries of government for more regulation and greater control of the economy. The massive spending programs by governments are already fostering larger bureaucracies. This intrusion by governments into the economy will create more red tape and obstacles to progress in the private sector.

In fact, many of the actions taken by governments are counter-productive. The “buy American” aspects of the US infrastructure initiatives are already hurting Canadian exporters. Recent tariffs imposed on selected industries threaten to create a trade war. All of these actions will only inhibit economic growth.

At the beginning of the financial crisis, a deflationary spiral was the big fear. Governments fought back with unprecedented spending programs. Despite these actions, there has been deflation in house prices, fuel, commodities, shipping rates, automobiles, etc. Many businesses and individuals have been seriously hurt. Although the deflationary forces are not entirely defeated, attention is now turning to the massive debts incurred by governments that will have to be paid back. The eventual inflationary impact of this huge expansion of the monetary base will inevitably result in higher interest rates. The cost of carrying debt will go up and taxes will have to go up to meet this demand. Again, these events will largely curtail the chances of a robust recovery.

In this environment, it will be a stock pickers’ market. Investors will have to do their homework to be ready to seize opportunities as they occur. Prudent and cautious execution will be needed to protect capital. We are well positioned with resources to take advantage of those opportunities.

THIRD QUARTER 2009 FIXED INCOME COMMENTARY

A curious development has taken hold of the bond market over the past quarter. Contrary to the expected rise in interest rates at a time of improving economic fundamentals and rising stock markets, rates remained relatively unchanged and, in the case of US treasury securities, actually declined.

The stock market was on a tear and the recovery’s green shoots seem to have sprouted over the course of the summer. The economic recovery is admittedly anaemic to some degree, as evidenced by the legions of unemployed. Nevertheless, the general consistency of improving economic numbers has generated some speculation that we were leaving the recession behind.

In spite of the improving fundamentals, government spending continued unabated with some calling for further stimulus in response to the somewhat lackadaisical pace of the recovery. When we combine these factors, the decline in the US dollar and the rapid increase in the price of gold, we would argue that investors should be demanding higher interest rates.

And it didn’t happen.

Investors have been sanguine about receiving miniscule returns of barely over 4% for long-term treasuries. So how do we reconcile this with the fundamental forces’ upward pressure on rates?

At the current paltry levels of price increases, inflation concerns are far from investors’ minds; even though the CRB index, which measures raw material prices, has been rising, albeit moderately, ever since February of this year.

There is no question that the Federal Reserve’s extension, although at reduced levels, of the purchase program for long-term securities has mitigated upward pressure on long-term interest rates. In addition, pronouncements regarding expectations that the current low interest rate regime will likely continue for some prices has also helped tame rate expectations. There are concerns that the pace of recovery may well be slower than expected and consequently, equity valuations have gotten ahead of themselves.

One thing is for certain, trillion dollar deficits cannot go on forever, and when investors change their collective minds about the level of interest rates at which they are willing to lend to governments, the adjustment will likely be swift and brutal. Bubbles burst suddenly. This continues to leave us as cautious as before.

The total return performance of the bond market for the third quarter was an increase of 2.7%. The ten-year Government of Canada bond yielded 3.3% at quarter-end, a decline of one tenth of a percent over the course of the quarter. The interest rate premium paid by corporate borrowers, compared to federal issues, continued to moderate.

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