Quarterly Market Commentary – Fourth Quarter 2012


“Whatever investment success we achieve will take place against a troubled backdrop, …felt like we were playing a great hand of cards in the basement of a burning building filled with explosives during an earthquake.” — Seth Klaeman author of “Margin of Safety”

As 2012 drew to a close, investors around the world feared that the politicians in the US were about to drive us all over the so-called “fiscal cliff”. This predicament arose from legislation put in place a few years ago that would have simultaneously caused the expiry of previous tax cuts to come into effect at the same time massive cuts in government spending would be mandated. The combination of these events could be enough to pull the US into another recession given the fragility of the current recovery. Canada would be particularly vulnerable to a recession if its major trading partner slipped into recession. Given the bipartisan divisions in the US, the politicians took us to the brink before reaching a compromise that will only postpone the hard decisions that need to be taken to address the gigantic budget deficit.

Despite the machinations of politicians globally, the world markets reported cautious but generally positive returns in the fourth quarter leaving surprising overall returns for the year.


Why do we say: “surprising overall returns”?

The Canadian stock market was carried primarily on the back of a strong performance (+12.8%) in Financials that comprise nearly 33% of the composite index. The two other major industrial sectors Energy (25% of the index) and Materials (19% of the index) recorded negative returns for the year: -3.6% and -6.9% respectively. With the exceptions of Information Technology (-3.2%) and Utilities (-0.8%), the remainder of the smaller industry groups recorded positive results for the year.

The negative fourth quarter in the US was driven largely by the negative sentiment emanating from the political imbroglio. As we enter 2013, this sentiment is likely to prevail as politicians face-off over the hard issues yet to be reconciled. Most immediately, the issue of increasing the debt ceiling will need to be dealt with within the first quarter. The rancour over the needed spending cuts will likely continue beyond the first quarter. Investors hope that the politicians’ fear of taking the blame for putting the economy in jeopardy will force compromises that will allow the private sector to continue to improve.

In Europe, political compromise is beginning to raise investors’ expectations that a calamity can be avoided. Greece has not yet left the European Union. To the surprise of many investors, the Greek exchange recorded one of the highest returns (+32%) globally in 2012. In fact, with the exception of Spain (-5%), the other “problem” countries posted positive returns: Ireland (+16%), Italy (+7%) and Portugal (+7%). The better results within the most troubled economies, is perhaps indicative of the risk embedded in these markets assisted by the fact that to date, bankruptcy has been avoided.

In Asia, only China (+1%) and Japan (+6%) of the major markets, posted returns below 10%.

As we head into 2013, there is reason to be more optimistic that better conditions will prevail as the year progresses. If the US can continue to inch its way out of the current fiscal mess, much in the way that Europe appears to be achieving, the underlying economy will continue to improve at a modest pace. As employment improves and housing markets stabilize, the US consumer will regain some confidence that they can spend again. US households are far ahead of Canadian households in de-leveraging their debt. Canada will benefit from more stable demand for commodities as excess inventories dissipate in China and other nations.

These improved conditions will still produce a challenging investment environment. Low interest rates have forced investors to seek yield through equity instruments while at the same time presented attractive opportunities for companies to access cheap debt. It will become more critical to closely monitor the condition of corporate balance sheets in order to protect investors from adverse events. The slow recovery will place an added element of risk on security selection, as short-term gains may not be sustainable in all situations.

Overall, 2013 offers the prospect of an improving global investment environment. We will continue to be vigilant and measured as we participate in these markets.


“Today there are three kinds of people: the haves, the have-nots, and the have-not-paid-for-what-they- haves.” — Earl Wilson

The fixed income markets were relatively tranquil throughout most of the fourth quarter until concerns regarding the “fiscal cliff” precipitated greater degrees of unease as the year-end approached. The “fiscal cliff” refers to the expiry of the Bush era tax cuts at the end of 2012, in combination with some mandated concurrent spending cuts.

While the concept of increasing tax revenues together with reduced spending would appear to be a good recipe to solve the US budgetary deficit, the abrupt introduction of these massive measures had the potential to cause the US economy to slip back into a sudden recession. The combined effect of these acts was estimated to reduce US GDP (Gross Domestic Product) by as much as 4% to 5%. In an economy that is only growing at about 2%, this would be problematic.

Clearly, everyone wanted to avoid such an occurrence. Following the presidential election in November, the intransigence of both political parties that held opposing views as to whether spending cuts or tax increases was the better option, reached a compromise at the last possible minute. In the end, the compromise agreed to only postpone the need to take more definitive action.

While this drama unfolded, the US was also approaching its approved borrowing limit as the federal debt accumulates. Unless the government can agree to increase this limit, the US could be in a position where it will default on its maturing obligations. Hence, the next two months will exhibit a continuation of the political infighting that characterised the last quarter. Investors remain in doubt as to whether a permanent solution is possible.

While investors have largely been focused on the problems in the US, the European economy remains fragile. The threat of dissolution of the Euro zone through the departure of one or more countries has not materialized. However, the more distressed European economies (Portugal, Italy, Ireland, Greece and Spain) remain in precarious financial condition. Germany will be facing a federal election in the latter part of the year that will severely test Angela Merkel’s resolve to support ongoing bailouts of the troubled economies.

While certain Federal Reserve members and the Bank of Canada indicated that higher interest rates will likely be coming, in this environment it is unlikely that it would be a significant increase in America, but European rates will prove to be more volatile.

The total return performance of the bond market as measured by the DEX Universe Index for the fourth quarter was a modest gain of 0.3%. The ten-year Government of Canada bond yield increased by a tenth of percentage point to 1.8%.

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