THIRD QUARTER 2006 – RETROSPECTIVE AND PROSPECTIVE

Worry appeared to be the dominant theme in the third quarter of 2006.

Fears of an economic slowdown snowballed throughout the quarter, fueled by concrete evidence of house price declines in the US. The weakness in the housing sector will inevitably spill over into the construction and consumer spending sectors of the economy. The domestic automotive industry continued to suffer from an unsustainable cost structure and declining market share. More job cuts at Ford and GM were announced in addition to offers to buy early retirement benefits from employees in exchange for reduced health and pension benefits. Coupled with massive public sector spending leading to equally massive deficits, the future of sustained market resilience in the US is becoming less likely. However, thus far the party has been kept alive primarily through an easing of monetary policy as the federal reserve took a holiday from increasing interest rates in light of the evidence of a slowing economy. Towards the end of the third quarter, weakening energy commodity prices may cause some fear of the economy re-heating, leading to further rate hikes were it not for the fact that other economic indicators are pointing towards a slowing of the economy.

In Canada, the quarter had a different tone. The wall of worry seemed to build more aggressively as the quarter progressed. This phenomena was particularly exacerbated at the end of the quarter with a sharp correction in energy prices. During the quarter, concerns of an economic slowdown in the US and potentially on a more global basis caused jitters in the commodity sectors. All this activity was happening at a time when, after a long sustained period of strength in commodity prices, some of our largest and most valuable assets (Inco and Falconbridge) went into the hands of foreign purchasers.

At the end of the quarter, investors were shaken by the collapse of Amaranth, the largest hedge fund to fail since the fall of Long Term Capital in the late 1990’s. Amaranth made (un-hedged) bets on the direction of natural gas prices and lost billions of dollars in a very short time. Competing funds, smelling blood, forced the demise of Amaranth by shorting markets were Amaranth was exposed. Following the crumbling of Amaranth, these competitors had the opportunity of buying up some of Amaranth’s positions at sharply discounted prices. Unlike the fall of Long Term Capital, the market in alternative investments is much larger and more sophisticated today so that this failure was much easier to absorb.

So, what did these events mean to the markets. In Canada, the S&P/TSX Total Return managed to produce a positive 1.9% return despite a decline of 2.3% in September. Over the quarter, there was a definite rotation as Telecommunications (+25.3%), Information Technology (+23.3%), Financials (+9.5%) and Utilities (+6.0%) took the leadership away from Health Care (-10.9%), Energy (-9.5%) and Materials (-0.2%). The bond market had a much better run increasing 4.8% in light of the more benign interest rate environment. South of the border, the US markets ignored the bad news and advanced 5.7% as measured by the S&P 500. The Canadian and US dollar exchange rates were little changed over the quarter.

Looking forward, we expect more of the same uncertainties to permeate the markets until some clear economic direction is in sight. We will continue to capitalize on opportunities in this volatile environment.

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