August 08, 2011

Market Update - August 9, 2011

The media has recently been reporting countless reasons why we should be fearful of another global recession and concerned about our investments. We wanted to take a moment to put the current concerns in context for our clients and explain how we are addressing risk in your portfolio.

Markets have retreated significantly, with the TSX declining another 4% Monday and the S&P 500 dropping 5.5%. The recent weakness in the stock markets has been widely reported as being due to the downgrade on U.S. government long-term debt from AAA to AA+ by S&P.  Although this may have served as a catalyst for Monday’s decline, the more significant concerns in the market are fears over debt levels in Europe which have spread to the larger economies of Italy and Spain as well as recent disappointing global economic news. Concern has increased that we may be entering another recession and interest rates may have to increase in the United States at a time when the government’s ability to respond to a slowdown is limited.

What has not been widely reported is that while the stock markets have declined, bond markets have enjoyed a significant rally. The Dex Universe Bond index has increased 3.8% since the end of June. The downgrade by S&P was widely expected and we do not expect it to push up yields in any meaningful way which was, to some extent, confirmed by the lack of response from the bond market on Monday. On a positive note, it has put the fiscal situation in the U.S. under more of a spotlight and should, hopefully, push the politicians into a more credible long-term plan to deal with their debt and deficits.

On the economic front, the last month has seen a significant revision in global growth prospects. These revisions have led to corrections in major equity markets globally and declines in interest rates for most developed bond markets. These concerns around growth expectations are somewhat of a reaction to policy tightening in many regions of the world.

Emerging market countries have been leading the global economy higher since the end of the last recession. Unfortunately, price increases in these markets have led to persistent inflation with wage increases becoming routine. To battle this inflation, we have seen a tightening in monetary policy over the past year. In Brazil, overnight rates have increased from 8.5% to 12.5% while in China, short term rates have been increased from 2% to 6%. Though these increases have had only a modest impact on economic performance to date, the market is concerned that a more significant slowdown is underway. Although we expect to see some slowing of growth from the recent lofty levels in the emerging markets, we still expect these markets to be a key engine that keeps global GDP on an upward trend.

In Europe, the ECB has increased interest rates twice this year despite stresses within the periphery countries of Greece, Portugal, and Ireland. Last week’s stock market declines were precipitated by a lack of confidence in the Eurozone’s ability to manage larger debtor countries such as Italy and Spain. Recent economic data has shown only a modest softening in the industrial heartland within core Europe.  However, the stock market has started to discount much slower growth throughout the Eurozone due to continued concerns around peripheral debt levels and the potential impact from weakening emerging economy exports.

In the U.S., most signs are pointing to an environment of continued slow economic growth, and the recent market volatility has increased the downside risk to these expectations. Our economy is closely linked to the U.S., as well as to the rest of the world, so our stock market has fallen in tandem.

The market is concerned that we will see a recession and with the recent economic weakness, the risks of a recession have increased. However, our base case scenario is for the U.S. economy and Europe not to enter a recession but rather to see a low level of growth in their economies despite their fiscal situation and debt levels.

What have we been doing in your portfolio?

At the end of the last quarter, given the heightened economic risks we are facing, we reduced the risks and moved to a more defensive position in client bond portfolios. We accomplished this by increasing the quality of corporate bonds (e.g. we sold some junior bank tier 1 bonds and bought senior ranking bank bonds) and selling some corporate bonds for provincials. We are also positioned defensively from an interest rate perspective to protect bond portfolios from a sudden increase in interest rates.

On the equity side we examined our exposure to Europe both in Canadian and Global client portfolios. In the Canadian portfolio, the exposure to Europe is small and the Global equity portfolio is significantly underweight the core Eurozone market. We estimate that clients’ direct exposure to the countries experiencing significant debt problems (Portugal, Ireland, Italy, Greece and Spain) is less than 2% of the International equity portfolio.

The best way we know to manage risk is to buy stock in, or lend to, companies that can grow with strong balance sheets and good profitability, trading at attractive valuations. In doing so, we assess whether the expected returns are compensating for the risk. Over our 29 year history we have found that this approach has worked best, and has provided good protection without foregoing return. If a company increases its intrinsic value and shares are bought cheaply enough, a patient investor is always rewarded.

Recent economic concerns are surfacing at a time when fiscal and monetary policy levers are limited. Debt levels are high and interest rates are already low. What we are facing is a lack of confidence in the institutions that are responsible for these levers. 

A broad market correction punishes both strong and weak companies. We are using market declines as an opportunity to add to companies where expected returns over the next 3-5 years have improved and where we have high levels of confidence that the company’s business model can weather a period of uncertainty. We plan to maintain the equity exposure in client portfolios.

As always, please contact your Portfolio Manager or Investment Funds Advisor if you have any questions about this topic or your portfolio.

 

The article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.