SECOND QUARTER 2009 – RETROSPECTIVE AND PROSPECTIVE

IRRATIONAL EXUBERANCE

“You can’t depend on your eyes when your imagination is out of focus.” — Mark Twain

“Contradiction is not a sign of falsity, nor the lack of contradiction a sign of truth.” — Pascal

Alan Greenspan coined the term “irrational exuberance” around ten years ago. At the time, he was referring to the high prices being attributed to stocks in the capital markets; particularly technology stocks. Prices appeared to have no relationship with the underlying fundamentals of companies’ prospects in terms of earnings, profitability or many other metrics. He was widely criticized and maligned for taking this stance by market participants who wanted to see the good times keep rolling. Then came the “Tech Bust” in the year 2000 that was followed by painful equity market conditions for the next three years.

We playfully titled our last edition of Retrospective and Prospective “Where’s the Bottom?”. Little did we anticipate that the equity markets would take off over the next three months producing some of the best gains in over a decade. The S&P/TSX Total Return Index advanced by 20.0% while the S&P 500 advanced 15.9% and the EAFE (Europe, Asia and Far East) MCSI recorded a 25.9% gain! Due to the advance of the Canadian dollar, the latter two returns were significantly reduced in Canadian dollar terms to 6.9% and 16.1% respectively.

So what happened? What were the fundamentals supporting this rapid appreciation in the world markets?

Certainly the pundits picked up on Mr. Bernanke’s talk about “green shoots”. Market participants desperately looked for any instances of positive news to support this garden metaphor hoping that the shoots do not turn into weeds or get trampled upon.

More sophisticated commentators latched onto the so-called “second derivative”. In calculus, the first derivative measures the degree and direction of change, while the second derivative measures the rate of change. So, although many economic conditions (GDP, house prices, manufacturing output, etc.) continued to deteriorate, these commentators grasped onto the fact that the rate of deterioration was slowing down in many instances. This is a lot like stating that although the boat is sinking, it is not sinking as fast as it was before.

Looking back, it is hard to discern much in the way of positive news during the quarter. We witnessed the largest bankruptcies in history with the downfall of Chrysler and General Motors. The ripple effects of these failures on the North American economies will be profound as parts suppliers and other related industries cause distress in many communities. One of the most disturbing aspects of the automobile industry’s demise was the disregard for the contractual rights of the Chrysler bondholders. The consequences of this action on the integrity of the capital markets could prove to be a large drag on economic expansion going forward.

A much decapitated Chrysler emerged quickly from bankruptcy, but General Motors continues to be dissected as various parties try to buy the choice parts. The remainder of the global auto industry reported continuing declines in sales and profits during the quarter.

Housing prices continued to decline, although not at as great a pace as in the past year (Green Shoot?). The financial and industrial sectors shed employees at a pace not seen in decades. In the US, we entered the quarter with official unemployment at 6.5% and exited at 9.5%, well beyond Obama’s worst case scenario of 8%. If the workers that have stopped looking were to be included, the number would be in the low teens.

Governments continue to spend at a dizzying pace. The long term inflationary implications of all this debt accumulation are frightening.

The International Monetary Fund issued dire predictions for global economic growth forecasting total losses of 4.2 trillion in the financial sector alone. In the meantime, governments around the world scrambled to propose more onerous regulation of the financial industry in terms of oversight as well as operational requirements. An offshoot of this included greater regulation of consumer credit and consumer protection that will lead to more restrictive credit.

So where was the good news?

Companies with the financial wherewithal were on the prowl for assets selling at bargain prices. This activity was most apparent in the automobile industry with firms such as Fiat and Magna bidding for parts of General Motors and Chrysler. The mining industry also witnessed some attempts at consolidation, sometimes on a mega-scale (Xstrata and Anglo American). In the financial sector, Blackrock scooped up Barclays Global Investors, one of the world’s largest asset managers. We saw further evidence of consolidation in the oil industry (PetroCanada and Suncor, Sinopec and Addax Petroleum) as well as in many other industries.

Some of the troubled financial firms in the US paid back the TARP (Troubled Asset Relief Program) funds received last year as they have been able to strengthen their capital positions. The Bank of America reported a profit and a few companies such as Research In Motion even had positive earnings surprises. Commodity prices rose sharply during the quarter and shipping rates increased after a long decline.

All of this activity is building a base for an eventual economic recovery. How far ahead that recovery may be and the pace at which we may get there are unknown. However, we fear that it will be a longer process than most pundits predict. Meanwhile, we will continue to act like the predators, scooping up undervalued assets when we can identify them in a disciplined, systematic manner.

SECOND QUARTER 2009 FIXED INCOME COMMENTARY

The second quarter was largely a story of hope where, in response to tentative signs of economic stabilization, the flight to government securities seemed to abate and the perception of credit risk steadily diminished.

We are as pleased as other investors to see this improvement. Nevertheless, we cannot but remain cautious given our recent experience when markets seemed all too ready to discount various forms of risk.

Keeping in mind the extent to which the current economic improvements hinge on a worldwide orgy of government bailouts, restructuring and spending, bond investors and pundits have rushed to their dictionaries to look up the word “hyperinflation”. This of course in expectation that the boat loads of stimulus being deployed all around the world will in due course ignite a major inflationary conflagration. Not to dismiss this too quickly, no less an authority than Milton Friedman, the Nobel prize winning economist, has stated some years ago “inflation is always and everywhere a monetary phenomenon”. In plain language, if there is too much money to go around, or credit becomes too easy, prices start to go up. Needless to say, with the tentative improvements in the economy, this is not yet of immediate concern, still cautious forward thinking is definitely called for.

In light of current and expected U.S. deficits and borrowing, recently more than once comments have been made about the possibility of supplanting the U.S. dollar’s role as the world reserve currency with an alternative; possibly using the International Monetary Fund’s Special Drawing Rights or a basket of currencies. These comments have been downplayed by various major foreign holders of U.S. Treasury securities given that the value of their holdings would likely be negatively impacted by such ruminations. Despite this, it is sobering to reflect on the implicit loss of credibility of the U.S. dollar that this concept is even being considered.

Regarding future borrowings, Timothy Geithner US Treasury secretary stated “there is enough demand for future US debt sales”. He wisely remained silent on the question … “at what interest rate?”.

The impact of concerns regarding the likely course of borrowings was clearly visible as rates on government bonds tended to rise over the course of the quarter. We believe that unless another economic calamity materialises, resulting in a renewed flight to quality, higher interest rates can be expected going forward.

The total return performance of the bond market for the second quarter was an increase of 1.3%. The ten year Government of Canada bond yielded 3.4% at quarter-end, up six tenths of a percent over the course of the quarter. The interest rate premium paid by corporate borrowers, compared to federal issues, moderated in line with a continued easing of credit concerns.

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