“The house of delusions is cheap to build but drafty to live in.”- A.I. Housman

“Anyone who lives within their means suffers from a lack of imagination.”- Oscar Wilde

It all seemed so easy. The elixir of low interest rates and successive rounds of quantitative easing by the central banks created an environment wherein stock and real estate prices have risen, private equity and credit deals proliferated, corporations lowered their cost of capital with low rates and sub-prime borrowers regained access to capital. Until this quarter, investors were content to drink this elixir as markets steadily climbed out of the depths from 2008. The politicians taking credit and the central bankers implementing these policies cannot be accused of a lack of imagination.

Geopolitical events continued to buffet investors’ concerns. While the fight between the Ukraine and Russia appeared to abate to some extent, conditions in the Middle East continued to deteriorate as the US started to pressure allies to support renewed intervention. Ongoing concerns in the South China Sea remained prevalent while investors’ attention was diverted to the potential fallout from the Scottish vote on independence and a surge of pro-democracy activity in Hong Kong. In addition to these events, a resurgence of the deadly Ebola virus appeared toward the quarter end.

In September, markets deteriorated as investors sought to protect profits earned to date.

Canadian Dollar US Dollar
Q1 Q2 Q3 Q4 YTD Q1 Q2 Q3 Q4 YTD
Toronto Stock Exchange 6.1% 6.4% -0.6% 12.2%
S&P 500 5.9% -1.4% 6.1% 14.1% 1.8% 5.2% 1.1% 8.3%
MSCI EAFE* 4.0% -0.6% -1.8% 1.5% 0.0% 2.9% -6.4% -3.6%
91 Day T-Bill 0.2% 0.2% 0.2% 0.7%
DEX** 2.8% 2.0% 1.1% 5.9%
CDN/US dollar -3.9% 3.5% -4.7% -5.1%


* Europe, Asia and Far East Index

** Canadian Bond Universe Index

As investors began to bolt from the equity markets, they sought a safe haven in the US dollar. The Canadian dollar depreciated 4.7% against the US dollar in the quarter, largely reflecting softening energy and commodity prices. Against other currencies, the Canadian dollar performed relatively better as they were hit even harder. Are we witnessing a race to the bottom as governments try to spur economic activity and exports through lower currency values? Certainly, it will be difficult to raise interest rates significantly in this environment.

Inflation has yet to appear despite the expansion of central bank balance sheets by some $US7 to $US8 trillion since 2007. Government deficits continue to exacerbate already extremely high debt levels globally. France will post a 4% deficit this year while Japan will post close to 8%. In the US, the deficit is approaching 6%; slightly ahead of the UK (5.3%) and Spain (5.5%). As a result of these accumulating deficits, Japan now has over a 250% debt to GDP ratio! Debt to GDP is through 100% in the US and through 90% in the UK. In Canada, we are approaching 90%. How long will the bond markets continue to allow these debts to expand at these low interest rates? Yet, in many countries, deflation remains a valid concern as some prices fall. In the longer term, demographic headwinds in the developed economies will certainly contribute to these deflationary concerns.

In Europe, economic stagnation has yet to be conquered by attempts to stimulate growth in part by devaluing the Euro. Signs of slowing growth in the emerging economies and especially China have put pressure on commodity prices. With this in mind, energy prices have hit a near perfect storm in the short term with fears of waning demand at a time of record production and high inventories. In Canada, Energy and Materials were the worst performing sectors this quarter declining 7.3% and 10.5% respectively.

Market volatility has picked up in this environment. There has been greater activity in mergers and acquisitions and Initial Public Offerings (IPO’s). The largest IPO ever was floated in the quarter as Alibaba went public raising $25 billion. Despite this renewed level of activity, markets retreated sharply in the latter month of the quarter. During these market declines, emerging markets and smaller companies have been the hardest hit.

Is this the pullback that we referred to as a possibility in the last quarter?

To a large extent, we think that it is just that; a pullback. As noted previously, valuations were running somewhat ahead of fundamentals. We had been taking some profits and building cash positions. As the US economy continues to expand, Canada will be a beneficiary. We are sticking with our valuation discipline and monitoring many situations seeking opportunities to deploy cash.

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