March 2010
“ Pray... we don’t get fooled again”
- The Who
Twelve months ago, investors held their breath as they waited to see the extent of the damage wrought by the bursting of the credit bubble. Predictions of a 1930s-style Depression were commonplace, and the associated “flight to safety” saw the US dollar rally and savings flood into moneymarket funds, with US treasury-bill yields falling into negative territory.
The landscape is very different today. The global economic recovery is underway, with all the major economies having registered positive growth in the second half of 2009. Credit market conditions are mixed, with large corporations enjoying strong demand for their bonds, while the US and European nations strain under the fiscal burden of the financial market bailouts and small businesses struggle with shrinking access to bank credit. Equity markets have recovered; investors that held on through the rollercoaster ride of the past two years have emerged with their finances largely intact. Admittedly, equity markets are no longer “cheap.” However, valuations are “reasonable” in most markets, and with underlying business conditions improving steadily, we expect that equities will yield solid, though unspectacular, 9%-12% returns for the year. The “normalization” of markets is reflected in the 2010 consensus forecasts for asset returns shown in the table below.
Recent market volatility is consistent with a de-leveraging world
Equity markets and interest rates are little changed from where they were last October. Indeed, the equity market’s behaviour has been consistent with our view that the general trend will be upwards, but subject to periodic corrections triggered by disappointing economic or earnings news as investors adjust to the moderate growth associated with the coming years of de-leveraging. The economic news has been encouraging. The US economy grew at an impressive 5.7% annual rate in the fourth quarter, and forecasts for 2010 continue to rise. US unemployment fell to 9.7% in January, and housing prices continued to claw their way back from the abyss. The ISM Manufacturing index rose for the sixth consecutive month in January to 58.4, its highest level since 2004.
However, the market’s advance was interrupted in the second week of the New Year by news that major US and European banks continue to experience substantial losses in their commercial loan portfolios. This was followed by the US Administration’s announcement of a special capital tax targeted at the largest US banks, and plans for restrictions on the activities in which banks can engage. These actions reminded investors that governments will be aggressively raising taxes to help combat their budget deficits, and that the future growth in bank earnings will be considerably slower than during the credit boom. The negative impact on investor psyches was compounded by: 
1) China imposing strict limits on bank lending, in the hope of curbing loan growth that was running well in excess of 30% per annum (see chart below),
2) Action taken by India’s Central Bank to combat mounting inflation pressures by increasing bank capital ratios by 75 bps in order to tighten monetary policy, and
3) The fiscal crisis in Greece, Ireland, Spain, and Portugal, whose profligate spending had undermined investor confidence. Credit rating agencies have warned that both the US and the UK risk being downgraded due to their severe fiscal challenges.
These events reinforce our view that growth in North America and Europe will be dampened by consumer de-leveraging and rising taxes, while price inflation remains in check. This environment should favour quality companies that have the financial strength to take market share from their weaker competitors. Investors will also favour companies that offer attractive, increasing dividends. Finally, this is an environment where stock selection will be paramount – where choosing the right companies will be more critical than choosing the right sector. This plays to the strength of Mackenzie’s investment teams, and active fund management in general.
Time to exhale
While the shift of savings out of moneymarket funds into longer-dated assets began last summer, the allocation to cash remains very high – comparable to the levels achieved in prior bear markets. Some pundits attribute this to a lack of confidence that the improving trend will persist. I think it highlights the desire of many investors to “regroup”, to re-examine the basic ideas that have guided their savings strategies over the past decade given the nausea experienced over the past two years. This is a sound first step in re-setting their investment plans. Some of the key lessons of the credit bubble collapse are:
Lesson #1: Markets are not efficient.
Academics have long argued that financial markets are efficient, which means that security prices fully reflect all known information and that it is not possible to outperform the market over time. Alan Greenspan was a fervent believer in “efficient markets” and thus saw no need for imposing control on lending practices or trying to prevent asset bubbles because “the market” would correct these problems. Investment professionals have generally subscribed to the contrary view, perhaps best espoused by Benjamin Graham, that “Mr. Market” is an irrational animal that is often given to flights of excessive euphoria or excessive pessimism and that the resulting inefficiencies can be exploited by disciplined investors. The experience of the past two years should put this debate to rest.
Lesson #2: A financial plan helps cope with volatile markets
Asset diversification is the single most effective tool for managing investment risk. Even in a low interest rate environment, bonds can play an important risk-mitigation role within a balanced portfolio – recall that in June 2008, 10 year Canada bonds yielded 3.68%. Chris Kresic, the Senior Vice-President who heads our Sentinel team put it best: “The value of having bonds is not just that you have an investment that will counter stocks when they are going down, but that you also will have the peace of mind to take the pressure off the urge to sell.”
However, having an investment plan is not enough – it needs to be reviewed regularly with a financial advisor. US academic research examining the practices of individuals in their personal retirement accounts found that most never changed their investment mix from its initial setting1. Thus, individuals who embraced a 100% equity strategy in their 20s were still fully invested in stocks as they approached retirement – imagine what this meant for someone who planned to retire at the end of 2008! It is advisable to reduce investment risk as your time horizon shortens, because the likelihood of experiencing losses rises and your ability to recover losses diminishes. The table above (see “Annualized”) illustrates how the probability of experiencing a loss rises with the allocation to equities, and as the time horizon decreases.
Lesson #2(a): Rebalancing is a discipline that enhances returns and reduces risk
Market behaviour in 2008-2009 was a helpful reminder of the benefits that accrue through regular rebalancing of the investment mix. In effect, rebalancing embeds the discipline of “buying low and selling high” within a financial plan. The virtue was evident over this two-year period: $1,000 invested in 60% Canadian equities/40% Canadian bonds would have been worth $991 at the end of 2009 without rebalancing, and worth $1,016 if the investor rebalanced at the end of 2008. The November 2009 issue of Mackenzie Professional features an article by Karen Bleasby, the Senior Vice-President who heads our Managed Asset Group, that explores this concept in greater detail. Archived issues are online at mackenziefinancial.com/professional.
Lesson #3: Currency matters
Any Canadian investor holding US securities over the past seven years is painfully aware of how currency movements have defined their investment experience. The Canadian dollar’s year-to-year fluctuations have been so acute as to effectively swamp the value added by fund managers. In effect, the relative success or failure of a global or US equity fund has largely been determined by whether or not the fund’s foreign exchange exposure was hedged. This is highlighted in the chart (above), which shows the differential in the annual return of the hedged and unhedged MSCI World Equity index. Academic studies show that where Canadian investors in global equities have low conviction on the future path of currencies, the optimal strategy is to hedge half of their foreign currency exposure in order to minimize risk.
We remain positive on the prospects for the Canadian dollar. Canada will benefit from growing demand for industrial commodities as global economic conditions improve. Canada is also likely to attract investment capital as corporations become more sensitive to the security of supply challenges associated with developing resource deposits in the third world. Canada’s economy was also shielded from much of the fallout from the credit bubble bust, and thus tax increases should be less of a burden on our growth than for Europe or the US. We expect the Canadian dollar to maintain its positive trend versus the US currency, interrupted periodically by investor “flights to safety” during periods of uncertainty – we forecast a range of 92 cents to $1.02 over the next 12 months.
Our dollar also appears well positioned against the Pound and the Euro. The UK is beset with many of the same problems as the US, with the added uncertainty of an imminent election. The fiscal and economic problems in Greece and Portugal, and the impact of the housing market collapse in Ireland and Spain, are likely to constrain the European economic recovery and weigh on the Euro.
The major emerging market economies are generally in better shape than their counterparts in Europe or North America, and their currencies are likely to be facing upward pressure – this may be a region where investors consider not hedging their currency exposure.
1 Quoted in Nudge by Richard B. Thayer and Cass R. Sunstein, Penguin Books, (p. 34).