Interest Rates and Markets

The Canadian rates have gone up by thrice this year by 0.75% in April to curb strong growth experienced year-to-date to August 2001. The Canadian economy grew by 5% in the 1st half. It is expected to grow by 3.5% in the 3rd Quarter and slow down to 3% in the 4th Quarter. The 2003 growth is expected to come at 3.4%. The consumer spending has held up so far this year but is beginning to slow down. The interest rates south of the border have not changed this year in view of weak profit recovery. Recent stock market steep declines indicate that the Federal Reserve Board ('Fed') may reduce the rates by 0.25% on November 16 or before. The US economy, after a strong growth in the 1st Half, is expected to grow by 3.00% in the 2nd Half and 3.5% in 2003.

The long-term rates have continued to come down, primarily because strong flows from equities into bonds in the 3rd Quarter. They are now at a 40 years low. In 3rd Quarter, $47 billion moved out of the equities and $37 billion moved into bonds. The inflation in US is expected to remain at low level, thus keeping a lid on the long-term rates in the next 3-6 months. However, the rates in Canada and Europe will inch up due to inflationary concerns, with Canadian rates expected to rise by 2% by end of 2003.

The current market risks are:

  • Weak profit recovery. Although the profits are recovering, the recovery is slower than the market expectations,
  • Continued weakness in business investments,
  • Geopolitical risks due to threat of war with Iraq. It appears that this risk has been factored into the market prices, and,
  • The concerns due corporate scandals and bankruptcy of Enron, Worldcom etc. have been diminishing after arrest of several miscreants and introduction of strict laws governing financial reporting, the excutives’ behaviour and corporate governance.

The US Dollar has recovered somewhat against the Canadian Dollar and the Euro due to “safe haven” effect rather than the fundamentals. However, it continues to rack up huge current account deficits. The intermediate term outlook for the US Dollar continues to be unfavourable. This indicates a lower weighting in US equities than one would otherwise have.

The market performance this year was:

Market Index 2001 % Change* Jan-Sep 02 % Change*
Bonds SMU 6.1 4.8
Canadian Equities TSE 300 -10.6 -20.1
US Equities ** S&P 500 -8.5 -30.0
International Equities MSCI EAFE -18.6 -24.3
* Net change, after 2% Annualized MER

Depending on the asset allocation, the benchmark portfolio was down 8-13% for the January –September 2002 period.

The Market and Economic Outlook

The market sentiment has been extremely negative causing the market to sell-off at the slightest negative news. As indicated above, there has been a huge move out of the equities into bonds. The fact that markets continue to sell-off despite growing economy, strong economic stimulus provided by tax cuts, low interest rates and government spending is indicative of the market bottoming out. It is difficult to say when the markets will turn, but all professional investment managers are now moving to equities from cash and bonds due to compelling valuations.

The individual investor continues to be nervous about high equity valuations. While the valuations in the technology sector have remained high the broader valuations are 30-40% lower than normal based on current interest rates. The valuations in EAFE and emerging markets more attractive compared to those in US.

Although the intermediate term (5 years) return expectations are modest (8-10% for equities), the equities can easily bounce back by 20-30% as they have done in November 01 and August 02.

As indicated above, the long-term bond rates are at their lowest. The declining bond yields are indicative of an impending recovery. As the equity market turns, there will be a rush of money from bonds to equities, causing a drop in the bonds. Once the money flows stabilize, so will the bonds, as the inflationary expectations are benign. The high-yield bonds, which behave like equities, are expected to do rebound, out-performing the treasury and investment grade corporate bonds. The Small Cap sector generally does better coming out of a recession because of their reliance on the bank borrowings and quicker adaptation to the changing economic conditions. In general, equities are expected to strongly outperform bonds.

Portfolio Strategy

  • Maintain equity allocations at the target range. Maintain a 40%, 30%, 30% allocation between, Canada, US and EAFE equities. The reasons are - Canadian economic growth has been higher this year, and is expected be strongest of the developed countries; the valuations in EAFE are more attractive than in North America; and, you never bet against the US market!
  • Maintain the 20% exposure to Small-Mid Cap equities in both Canada and US. Although the small cap sector has given-up a large part of the gains of the earlier 2002, it is still in positive territory compared to (20%) for the broad Canadian equities.
  • Maintain approximately 10% exposure to high-yield bond. They have under-performed the regular bonds in the past 6 months due to equities sell-off, but are expected to rebound. With a current yield of 8.5% their risk outweighs potential reward.
  • Reduce bond exposure by 5-7% splitting the proceeds equally between High Yield Bonds and money market funds. The portion in the money market funds will be put into equities once the equity recovery is established.