Not that 2007 was all bad—in fact, the year held a lot of positive news. Globally, most economies experienced solid growth in gross domestic product, with emerging China and India continuing to thrive as global economic hot spots. In addition, our beloved Canadian equity market continued to shine. But along with the positive fundamentals, signs of stress began to appear in the world markets, prompted by extreme events in key areas of the global economy and by the subprime mortgage crisis in the U.S. Central banks continue to keep a close watch on the market, with some injecting liquidity in an effort to dampen the effects of the crisis.
Here in Canada, the collapse of the asset-backed commercial paper (ACBP) market surprised many investors, and the full impact has still not been assessed. While the ACBP crisis has knocked the wind out of the bond market in Canada, there has also been significant merger and acquisition (M&A) activity and a number of mega private equity deals, which took some of Canada’s biggest blue-chip firms out of the equity market. Oil prices are also on the rise again, breaking new records in response to the voracious appetite for energy in highgrowth areas such as India and China. And perhaps the biggest homegrown story of 2007: the once-lowly loonie has continued to hit new highs against many world currencies and has finally reached—and indeed, surpassed—parity with the U.S. dollar. With so much going on in Canada and around the world, everyone’s looking to 2008 to see how these extremes will play out.
Outlook for the Loonie
Let’s start by looking at the Canadian dollar. For a few years now, the rising loonie has made global investing challenging for Canadian plan sponsors, which have watched the rise in currency take a bite out of the returns on their global assets. With the abolition of the foreign property rule, the steep climb of the loonie has been particularly challenging for pension funds looking to bump up foreign holdings beyond the old 30% cap. Looking forward, the dollar could remain at higher levels for some time, provided that Canada remains strong in key domestic indicators such as earnings, employment, consumer spending and the housing sector.
If this happens, we’ll see both winners and losers. Importers and wholesalers will benefit from the increased value of the currency, as will Canadians who plan to visit the U.S. Consumers and companies with U.S. dollar debts will also continue to see some benefits. However, the high dollar will take a toll on other areas of the economy—specifically, the manufacturing, tourism and hospitality sectors, auto parts makers, lumber and paper companies, exporters of farm products and companies focused on minerals, wood products or energy priced in U.S. dollars.
Although the Canadian dollar looks as if it will stay strong in 2008, there are some signs that it could be heading down. Many experts suggest that the recent heights hit by the loonie are too high, supported by speculation rather than fundamentals. And while the Canadian economy looks great right now, the subprime woes south of the border could exert downward pressure on our currency if the U.S. economy—which represents 78% of Canada’s exports—continues to slow and interest rates keep declining. Slowing growth in the U.S. and the rest of the world could ultimately drag the loonie down as the environment for Canadian exports and manufacturing becomes less competitive, possibly leading to inflation and unemployment here at home.
The rise and fall of the loonie is not without benefits for investors, however, provided that they’re prepared to look beyond Canadian borders. With the dollar still flying high, foreign assets are now cheaper than ever to buy—at least until the Canadian dollar starts to fall again. For 2008, the case for diversification outside of Canada will be extremely strong: investors who take advantage of the high dollar to invest globally will realize an additional payoff on the currency side when the dollar finally comes down from its lofty heights to more realistic levels in the future. It could be payback time for plan sponsors and other investors hard hit by the loonie’s steep climb.
Canadian Equity Market
Although global assets are becoming more attractive and accessible to Canadian investors, the bullish outlook for the Canadian equity market in 2007 is set to hold fast in 2008. Indeed, it has been a star performer for the last five years, returning 18% versus just 3.6% for the S&P/TSX 500 and 11.04% for the MSCI EAFE. Admittedly, the subprime crisis led to volatility in August of this year, with the S&P/TSX 60 taking its worst hit since the technology bubble burst. But the market bounced back quickly, showing its resilience and building on alreadyimpressive gains made during the year.
Despite this stellar performance, risks remain in the Canadian marketplace—and after a year or two of steady M&A activity and big private equity deals, the equity market could be getting riskier. In 2007, the domestic equity market shrank as major Canadian companies were culled from the investment landscape. Notably, the first part of 2007 witnessed the disappearance of major players from the S&P/TSX, as foreign companies snapped up blue-chip Canadian firms such as Inco, and a consortium of pension funds took over mega-firm BCE Inc. with the goal of taking it private.
For Canada, whose equity market has always been highly concentrated in a few key sectors, this has meant even greater shrinkage. As of Aug. 31, 2007, 74% of the S&P/TSX was concentrated in just three sectors: financials, energy and materials. Compare that to other global markets such as the S&P 500 at 48% and the MSCI EAFE at 51% for the same sectors, and it’s easy to see how overweighted Canada has become.
In terms of market capitalization, Canada represents just 3% of the global market and is sorely lacking in key sectors and companies such as consumer, global financial, pharmaceutical and technology.
M&A activity has come to a halt in Canada for the time being, as the high dollar makes it more expensive to acquire Canadian companies, and the credit crunch makes it more difficult to get financing for those big deals. In fact, the trend could be reversed in the near future as Canadian companies start shopping outside of Canada for new acquisitions, fuelled by the high dollar relative to other currencies. The same opportunities hold true for plan sponsors, and 2008 might just be the year they take an even bigger leap into global equities.
Global Equity Markets
However, global equity markets have also experienced the extremes of 2007 and will likely continue to do so in 2008, as the effects of the credit crunch reverberate through the world markets. The subprime fallout remains one of the biggest risks to global markets for the year ahead, as all eyes turn to the U.S. to see whether or not the economic powerhouse will fall into a full-blown recession. This could put considerable downward pressure on consumer sentiment in the near-term, which will likely have a huge effect on countries heavily dependent on exports to the U.S., including Canada and emerging economies such as China and India.
But while a U.S.-led recession is a possibility, it is by no means a probability. Equity markets will remain susceptible to further shocks from the subprime shakeout and to additional volatility due to extremes in oil prices and currency fluctuations. However, there’s also a lot of growth in the cards.
Emerging economies such as China and India are experiencing huge growth, with even greater growth on the horizon. These countries are also driving global growth in the energy sector, and companies that serve these areas of the world are likely to find new prospects for expansion and revenue generation. Firms in sectors such as materials and producer durables could experience positive results next year, along with large-cap multinationals with overseas growth prospects.
Risk Lessons
Finally, plan sponsors and money managers around the world are learning a hard lesson from the subprime fallout: there is no such thing as a risk-free investment. As investors discover that even money market funds are susceptible to shocks, bond yields have been destabilized—particularly in Canada, as we experience the near-freezing of the ABCP market. As liquidity dries up, plan sponsors will have a tough time on the fixed income side of their portfolios as they face the challenge of widening spreads. Going forward, uncertainty will taint the bond market both in Canada and around the world even though credit concerns appear to be resolving themselves, helped by central banks, aggressive writedowns by U.S. lenders of at-risk balances and financial institutions revaluing their loan books.
Whether or not 2008 holds further volatility remains to be seen. But it will be more important than ever for plan sponsors to look to the long term and stay the course in their path to global diversification. Focusing on specific companies with the right fundamentals will still be your best bet for 2008, along with a global perspective that can add the necessary diversification to weather volatile periods in the market.
Sadiq S. Adatia manages investment programs for Russell Investments Canada. sadatia@russell.com
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