THIRD QUARTER 2008 – RETROSPECTIVE AND PROSPECTIVE

STORMY WEATHER!

“There will be a rain dance Friday night, weather permitting.” — George Carlin

So far this year we have seen Arthur, Bertha Christobal, Dolly, Edouard, Fay, Gustav, Hanna, Ike, Josephine and Kyle threaten the North American coast while Bear Stearns, FannieMae, FreddieMac, AIG, Lehman Brothers, Merrill Lynch, Countrywide, Wachovia and Washington Mutual have threatened the foundations of the financial system.

Make no mistake…This is serious!

As the third quarter concluded, the US Congress was debating a program estimated to be in excess if $1 trillion to stabilize the financial markets. This follows $200 billion related to FannieMae and FreddieMac, $85 billion to shore up AIG and $180 billion to inject liquidity into the markets. Despite these interventions, housing prices continue to decline at close to a 15% rate and inter-bank lending rates continue to stress the financial system. With the threat of more bank failures the Federal Reserve and US Treasury have concluded that a more strategic solution is required in order to bring confidence back into the markets as opposed to the tactical intervention of dealing with crises as they occur. Twelve US banks have failed already this year.

Global markets have not been immune to the contagion emanating from the US financial debacle. Markets in the so called BRIC (Brazil, Russia, India, China) have plummeted as fears of a slowing world wide economy would inevitably decrease demand for their products. Concurrently, the commodity markets have also retreated. This latter point has not been good news for the Canadian market that has fallen around 25% from its peak of 15,154.77 on June 6.

In addition to the calamity in the financial sector, the oil and commodity sectors have retreated with the price declines of the underlying materials. Oil finished the quarter under $100.00 from close to $130.00 at the beginning. Significant declines have also occurred in copper ($3.60 to $2.80) and zinc ($0.55 to $0.37). Fertilizer stocks that had been among the prime drivers of the Canadian market also fell precipitously with the fears of slowing demand. Gold declined from around $950 per ounce to close to $750 before rebounding as fears of currency depreciation spurred demand.

A positive aspect of the retreating commodity prices has been the lessening of immediate inflationary concerns. Lower inflationary concerns have allowed authorities to continue to pump the financial system by lowering interest rates. In fact, with the seizing up of liquidity, the authorities now find themselves caught between worrying about deflation if they do not prime the market with lower rates and the longer term inflationary effect that that entails. Given the seriousness of the immediate crisis, it is likely that the authorities will continue to err on the side of lower rates and worry about inflation at a later date.

Financial distress combined with rising unemployment is already being reflected in lower consumer spending. There is no sign of this trend abating and analysts will be watching for the numbers to be released after “Black Friday”; the largest day for consumer shopping following US Thanksgiving and before Christmas.

Where should investors be positioned in light of these conditions? With short term bills only producing 0.3%, the return is negative after inflation is taken into account. Reacting to the violent swings in the market is likely to whipsaw day traders.

True investors should stick to a very disciplined approach. As this crisis unfolds many opportunities will be present for investors with a long term view and the staying power to take advantage of market opportunities. Companies with strong financial integrity will be in a better position to ride out what could be a protracted recovery. In our view, Canadian financial firms stand out on the global stage for their financial strength and superior regulatory environment. Opportunities will also be present in a number of energy, base and precious metal securities but vigilance will be required in monitoring market conditions.

THIRD QUARTER 2008 FIXED INCOME COMMENTARY

After the relative calm of the second quarter, credit concerns have returned in full force to haunt financial markets. The seemingly unending parade of historical names that had to be bailed out, went bankrupt or merged with stronger competitors is an indication of an unprecedented restructuring of the financial system.

Politicians have suggested that this was Wall Street’s fault and now it is Wall Street’s problem. Unfortunately the situation has gone beyond such narrow definitions. Given the interrelated nature of financial markets around the world, the damage has been spreading. Lack of confidence has resulted in a creeping paralysis in lending. While initially the lack of confidence was largely centered on inter- bank lending, given the concerns regarding some of their credit quality, the spreading contagion has now in turn extended to lending to commercial and retail entities as banks attempt to reduce their risk exposure and maintain their liquidity.

Previously noted concerns regarding an increase in inflationary pressures have been preempted by a spreading economic slowdown and reduction in commodity prices. Despite this development, the recently proposed trillion dollar U.S. rescue plan to bolster the wounded financial system, will have longer term consequences. The injection of such sums to purchase impaired securities from financial institutions will likely result in the deterioration of the value of the U.S. dollar. Similarly, credit concerns will result in higher risk premiums being demanded by foreign lenders from U.S. borrowers. The overall effect of these factors will limit the extent to which interest rates can decline, even in case of moderating inflationary pressures.

We expect continued volatility as the bond market reacts to credit concerns on one hand and to the influence of confidence inspiring government measures on the other. Episodes of flight to quality and the extended process of revaluation of credit risk by the market will take time. In the meantime, we expect to continue to focus largely on government guaranteed debt issues, as we have done for some time now. As evidence continues to accumulate regarding the financial strength and lack of major exposure to questionable securities by major Canadian banks, we expect to re-examine the case for accumulating modest positions in their securities with a view towards garnering higher yields.

The total return performance of the bond market for the second quarter, as measured by the PC Bond Universe Bond Index (formerly Scotia Capital Universe Bond Index), was a decline of 0.38%. The ten year Government of Canada bond yielded 3.75% at quarter-end, remaining essentially unchanged against Q2. It should be noted that this masks the increase in yields of non-federal bond issues, a clear indication of the flight to quality that we have seen over the course of the quarter. As an example, provincial bonds on average yielded 0.7% extra when compared to the Federal Government Bond Index yield at the end of Q2, it now yields 1.0% extra. Similarly, corporate bonds on average moved from plus 1.6% to 2.1%.

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