Quarterly Market Commentary – Forth Quarter 2011


“The future ain’t what it used to be.” — Yogi Berra

As we leave 2011, the myriad of issues that preoccupied investors throughout the year, continue to cloud the outlook for 2012.

The developed economies continue to struggle with excessive and growing debt. Europe has been the focus of the most critical issues as several countries teeter on the precipice of default. Both the European and North American economies are suffering from the highest rates of unemployment in a decade. In the US, political gridlock is preventing cohesive political action to address the fiscal problems that continue to grow. In an election year, we are unlikely to see any decisive action to break the gridlock. The emerging economies are feeling the effects of the constrained demand for their products while dealing with domestic needs for continued growth in employment as inflationary pressures build. The Middle East is plagued with political upheaval and civil unrest that has the potential to disrupt energy supplies to the rest of the world.

Yet, as of year-end there appeared to be some indications that we might still avoid Armageddon and look forward to better markets next year.

After two successive negative quarters, the Toronto Stock Exchange Total Return Index managed to record a gain in the fourth quarter of 3.6% reducing the loss for the year to date to 8.7%. The US market was more exuberant than Canada’s as the S&P 500 total return for the quarter was up a substantial 11.8% pulling the year’s return to a positive 2.1%. The advance of the Canadian dollar in the quarter reduced the quarterly return to Canadian investors to 8.7%. However, over the year the Canadian dollar depreciated against the US dollar enhancing the annual return to 4.4%. Other global markets as measured by the EAFE (Europe, Asia and Far East) Index also had a more positive tone in the quarter recording a gain of 2.9% in US dollar terms, but negative 0.1% to Canadian investors after taking into account the appreciation of the Canadian dollar. For the year, the EAFE Index was down 14.8% in US dollar terms and down 12.9% in Canadian dollars.

The Canadian fixed income markets reported a positive fourth quarter due to yields which continued their downward trend as investors continued to seek safe harbours. The effect of the rally was most apparent in the overall bond index that recorded a return of 2.1% for the quarter bringing the year to date return to 9.7%. The more meagre returns in shorter maturities are reflected in the 91day T-bill return of 0.2% for the quarter and 1.0% for the year.

So, what factors would lead us to conclude that 2012 could be a better year?

After months of dithering, European officials came up with a plan prior to Christmas whereby the European Central Bank (ECB) will provide banks with a series of loans and loosen collateral requirements on subsequent liquidity facilities. This may take some of the pressure off the more immediate needs of countries like Spain and Italy. It is hoped that by providing cheap funds the banks will be able to mitigate the effects of diminishing deposits, more costly bond auctions and the frozen interbank lending market. Sufficient spreads should be available to make the higher yielding sovereign debts relatively more palatable to some purchasers. While the longer-term effects of this action may be inflationary, it will buy time to work out a more orderly plan to attack the major fiscal and monetary concerns.

Investors should take some solace in the possibility that the immediate pressures in Europe have been dissipated to some extent and that a more comprehensive plan to address these issues could develop. In the US, retail sales over the Thanksgiving weekend were surprisingly strong illustrating the resilience of the US consumer. The most recent employment figures in the US are suggesting that there may be better job prospects ahead, and the rapid decline in housing prices appears to have been arrested.

We do not expect a panacea for investors in 2012, but there is room for cautious optimism. The developed economies will be in a period of austerity and restraint for some time as governments and individuals address unsustainable debt levels. These actions are going to result in some labour unrest and dislocations in economic activity. The markets are likely to remain volatile throughout this period of adjustment. However, valuations are more attractive now for investors seeking to position their portfolios for longer-term gains in quality companies that will endure and benefit from better profitability in the next business cycle.

In conclusion, despite the many geopolitical and fiscal problems pervading the world economies as we enter 2012, there is opportunity through careful security selection to achieve better returns going forward.


“Blessed are the young, for they shall inherit the national debt.” — Herbert Hoover

During the fourth quarter, fixed income market’s attention was largely focused on developments, or more accurately, the lack of developments dealing with the European debt crisis. European leaders time and again issued soothing statements regarding their unified stance to support their countries and their banks through co-ordinated efforts. The reality has been that actual action was extremely limited. No concentrated efforts to deal with the accumulating mountain of debt, has been evident. The European community is based on consensus decision making with each individual country’s agenda being influenced by domestic considerations making consensus all but impossible achieve.

In an attempt to stabilize the European financial system the European Central Bank, through various operations, tried to provide longer-term liquidity to commercial banks that were finding it difficult to borrow in the open market. In order to further ease these liquidity constraints, central banks around the world (Federal Reserve, European Central Bank, Britain, Canada, Japan and Switzerland) provided short-term support to the interbank market.

While investors have positively received these actions, it is hard to fathom as to how this can be interpreted as good news over the long run. It is clear that European banks are faced by tighter borrowing opportunities as their credit worthiness is coming under scrutiny. The longer-term issue of collecting one hundred cents on the euro on their various sovereign debt holdings is becoming doubtful.

Countries inflating themselves out of debt have a long and sordid history. However, in the case of Europe, this is an unlikely solution given that the printing presses are not under the control of any one country. Also, the adamant refusal of Germany to entertain any proposal that even hints of abetting inflation is evidence of the poor prospects for such a course of action. Given Germany’s experience with hyper-inflation in the ’30s, one cannot blame them!

Any approach utilizing rigorous tax collection, deficit control and slashing of public spending will be resisted by the highly indebted southern countries, where a rigorous enforcement of this prescription would be resisted by the public who would face major cuts to their standard of living for an extended time.

Unfortunately, the solution to this conundrum is not clear. The tradeoffs among various courses of action have run into resistance from one country or another over the past number of months. Most solutions seem to be focused on not letting countries default, at least in the legal sense, and at the same time maintaining the banking system’s integrity through providing cheap liquidity. None of this solves the fundamental issue of government deficits and too much public debt.

The total return performance of the bond market as measured by the DEX Universe Index for the fourth quarter was a gain of 2.1%. The ten-year Government of Canada bond yielded 2.0% at quarter-end, a decline of 0.2% over the course of the quarter.

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