Investing in Uncertain Times

Unprecedented measures taken by governments and central banks around the world—especially in the U.S.—appear to have addressed the immediate financial crisis by unfreezing the credit markets. What we are currently experiencing is an economic crisis that is the fallout of the credit crisis.

The concerns surrounding the global economy mean that there are not many asset classes that show great promise. Global markets have responded to the economic crisis with wild fluctuations and decreases in value across all asset classes. Bonds, commodities and other alternative investments did not, as many investors had hoped, serve as a cushion against plummeting stock prices.

A conservative estimate of the year-todate returns of a typical Canadian pension plan with a standard asset mix shows them down more than 20%. Moving into 2009, portfolio rebalancing will prove to be the main challenge. Even under the most optimistic scenarios, it is highly unlikely that we will return to the recent global growth rates of more than 5% per annum. Investors should expect growth—and hence, investment returns—to be subpar for a while before gradually returning to the long-term trend rates.

Outlook for 2009

United States – There is almost universal agreement that the U.S. economy is now in recession. The financial crisis continues to dampen lending conditions, sector liquidity and earning prospects, and there is likely more de-leveraging to come in 2009. U.S. credit conditions have tightened sharply, which will likely have a continued effect on consumers and corporations.

American consumption—the engine that has seen the U.S. and the global economy through previous tough patches—is poised for decline in 2009. Consumers in the U.S. have had a negative savings rate for years. Despite a small bump in the second quarter of 2008 precipitated by the federal government’s stimulus package, spending is down and consumer confidence is at its lowest point in the past 10 years. Fear of job losses is also stifling consumer spending. At this point, it is clear that there will be consumer retrenchment. The important question now is, How severe will it be?

Despite the negative sentiment, not all of the news is bad. While more pain is expected (negative growth rates in the first quarter of 2008, and for the first and second quarters of 2009), the U.S. economy is coming from a strong starting point. Corporations generally have strong balance sheets, and unemployment is at historically low levels. This, combined with the stimulatory monetary and fiscal policies, is giving the U.S. economy the best opportunity to recover from its current challenges.

Canada – The Canadian economic outlook is slightly better, although not particularly rosy. External pressures, such as weak U.S. demand and falling global commodity prices, will affect the Canadian economy in the short term. Domestic demand has been comparatively resilient so far, but prospects are a bit softer due to a cooling housing market and potential employment slips. While Canada will likely avoid a recession, Canadians will still feel a pinch. The good news for Canada is that it is the only G7 country running a budget surplus, its corporations have very strong balance sheets (especially the banks), and it has record-low unemployment rates.

Regionally, Western Canada’s energyand materials-dependent communities will suffer because of the drop in commodity prices. Commodities have had a five-year run-up and, by the end of October 2008, most had given back much of those gains. A weaker Canadian dollar may provide a partial reprieve to manufacturers in eastern Canada, but this will likely be offset to some degree by slowing U.S. demand.

Canadian GDP growth will be low (between 0.5% and 1.0%) for 2008 and for the first half of 2009, crawling slightly higher for the second half of 2009 and for 2010. Canada will probably avoid a recession, and there will be a gradual return to more sustainable growth trends.

Europe – The European Union (E.U.) looks extremely vulnerable to a prolonged downturn. Due to the structure of the E.U., Europe has had a slow, fragmented fiscal response to the crisis. And the European Central Bank (ECB) has reacted very slowly on the monetary policy side, based on the erroneous perception that it was an American problem, which further exacerbated the issue. This means that the economic fallout from the financial crisis will be looming over the eurozone for longer than the U.S.

In addition to the slower monetary and fiscal response, Europe did not start from as strong a position as the U.S. It is still integrating some weaker, less efficient member states from eastern Europe. Europe is also more dependent on exports than the U.S., because its domestic demand has been consistently disappointing. One mitigating effect, however, is the historically low level of unemployment.

The economic outlook for Europe, then, is several quarters of subpar growth, falling exports and rising unemployment. Further monetary and fiscal policy response is needed to mitigate the severity of the economic slowdown.

Japan – Of the G3, Japan is in the worst position by far. It has never meaningfully recovered from the recession in the ’80s and ’90s. Despite some outstanding global companies, Japan’s economy as a whole has not experienced any consistent growth for 30 years.

The ability of the Japanese authorities to offset the effects of the global financial crisis on Japan is almost nil. From a monetary point of view, interest rates are virtually zero and, fiscally, the authorities have explored all options open to them to stimulate the economy. To make matters worse, the yen has strengthened significantly, which will hurt exports. Japan’s economic outlook is weak and entirely dependent on the recovery of the rest of the world.

Emerging Markets – Emerging markets are diverse, and the current economic crisis will affect them in different ways. China and India, the juggernauts of world economic growth in the past few years, will experience slowdowns, but they will continue to show growth. China, which introduced a massive stimulus package in November, will slow to approximately 7% to 9% growth in 2009. However, that is still impressive economic performance relative to other economies. Other emerging economies will have their fortunes tied precipitously to the ups and downs of the commodity markets—for example, Brazil and Russia.

Asset Class Forecasts

Looking at individual asset classes, there are some opportunities but also much uncertainty for investors. Commodities – Global commodity prices have come under pressure, reflecting the expectation of a significant decline in demand from developed and emerging economies. Oil and gas, base metals and grains all suffered sharp declines during the third quarter of 2008. Accordingly, the S&P GSCI Commodity Index ended the period with a painful 28.6% decline.

After spiking to almost US$150 per barrel in July, prices for crude oil fell to below US$70 in October. While the correction was expected, the pendulum may have swung too far. Gold retained its lustre with investors, as many kept it to hedge against the volatility in the credit markets. But despite its continued popularity, gold and gold stocks have been battered in the second half of 2008, partially due to the strength of the U.S. dollar.

Commodities are not a sure bet in 2009. Slowing global demand means that many commodity prices will stagnate or decline further. While oil seems undervalued right now, it is highly dependent on an economic recovery to return to a sustainable price, in the US$80 to US$85 per barrel range.

The outlook for gold is trickier. While there are some supply shortages, a major resurgence is not imminent, as inflation is receding. That said, gold will likely lead the charge for commodities when they rebound. For now, we remain neutral on commodities and gold until we see some sign of economic recovery—most likely by the third quarter of 2009.

Currencies – Currencies also experienced substantial volatility. In particular, the U.S. dollar has undergone significant instability in 2008. It started off the year weak compared to a number of major currencies, then strengthened as American investors fled global markets and repatriated their investments. The rise and fall of the U.S. dollar is an indication of institutional investors’ predilection for risk aversion and a flight to safety. The U.S. dollar will remain volatile for the remainder of 2008 but will likely remain strong throughout 2009, despite the weak U.S. economy.

Up until the last quarter of 2008, the Bank of England and the ECB have been reluctant to cut their interest rates as a way to fight perceived inflation pressures. This has helped to maintain their currencies at high levels compared to most currencies throughout the year. The ECB has since reduced its interest rate by 50 basis points and has clearly stated that it might cut rates again in the near future. Meanwhile, the Bank of England aggressively cut its rate by 1.5% on Nov. 6, 2008. The action of the central banks quickly sent the euro and the British pound lower. We expect further cuts, and we expect to see the euro and the British pound stabilized at $1.15 and $1.38, respectively, against the U.S. dollar.

While Japanese stocks have performed poorly, the yen has appreciated significantly in 2008 due to the unwinding of the carry trade amid increased risk aversion. Investors who borrowed in yen and invested in higher-yielding currencies, such as the euro and the New Zealand and the Australian dollar, are cashing out their investments to pay back their debts. The sudden demand for the Japanese currency has pushed its value higher, where it will stay until the carry trade trend is reversed. At that point, we expect the yen to retrace to roughly 115 versus the U.S. dollar.

Emerging market currencies should be avoided until recovery is in sight. They are generally affected the most in turbulent times when investors are pulling out of these countries.

The Canadian dollar also had a volatile year in 2008. The loonie hovered around parity with the U.S. dollar for the first six months of the year but has since dropped to the US$0.80 to US$0.90 dollar range. This correction was not a surprise to many analysts, many of whom said that the loonie was overvalued and that its rise was triggered by speculation rather than fundamentals. The loonie will remain weak in the near future as the Bank of Canada cuts rates and oil prices stay low.

It could bottom out at about US$0.75 before recovering and stabilizing at US$0.80. A potential upside of a weaker loonie is that it could potentially bolster competitiveness and recovery in the Canadian manufacturing, agriculture, tourism and hospitality sectors.

Real Estate – Real estate and real estate income trusts look dangerous moving into 2009. Further tightening of credit markets and a gloomy outlook for residential and commercial property make long positions on this asset perilous.

The U.S. real estate market still has to purge the excesses created by subprime market activity. And existing home sales are still declining, pushing prices lower. Another devaluation of U.S. homes in the 20% area in certain regions is possible. Globally, the U.K., Irish and Spanish markets have been hurt the most.

In the emerging markets, even though China’s GDP is still running at 8% to 9% growth, signs of a slowdown in the real estate market are apparent and are pushing commodity prices even lower.

In Canada, the real estate market is also seeing some signs of slowdown. The activity in the residential property resale market seems to be running out of steam. The commercial property market is still in relatively good shape, but it is not certain that this will continue. This asset class, which makes up a sizable portion of Canadian pensions, is not likely to recover any time soon, so we maintain an underweight in this area.

Equities – Contagion from the U.S. crisis has infected economies around the world. Some European banks have suffered the same tragic fate as their American counterparts and have required coordinated bailouts or nationalization to survive. European and Asian stock markets have been mercurial, suffering precipitous drops. The MSCI EAFE Index (composed of developed economies in Europe, Australasia and the Far East) has turned in a year-to-date loss of 44.9%.

Reverberations from the south have affected equities, the credit market and monetary policy in Canada. The S&P/TSX Composite Index has been incredibly volatile, dropping 28.8% of its value since the beginning of the year. Canada’s financial services have generally fared better than American and European banks as a result of heavy regulation and limited consumer options in banking products. In fact, Canada ranked No. 1 on the national banking systems report from the World Economic Forum. Commodity and information technology stocks have taken the brunt of the damage on the TSX.

Emerging markets have had mixed results, but the contraction is being felt across the sector. Overall, the MSCI Emerging Markets Index plunged 27% for the whole of the third quarter in 2008, leaving this star performer of 2007 back in the lurch with a humbling 50% year-to-date decline. Countries that are heavily dependent on commodities have been especially hard hit by the economic slowdown. The MSCI Russia Index has been one of the weakest performers, plunging 65.7% since January. The MSCI Brazil Index has tumbled 54.9% in 2008.

It is still too early to make a prediction on equities for 2009. The wild fluctuation of global stock markets makes any increase in holdings precarious. Canadian and U.S. stocks offer the most promise, while stocks from the eurozone and Japan are likely to continue to struggle in 2009. Emerging markets may be tempting, given their dramatic contraction in 2008, but their resurgence is too dependent on commodities for investors to take on significant long positions. If the global economy is revamped and demand for commodities rises, emerging markets will surely come back onto our radar screens.

Fixed Income – There are not many asset classes that show great promise moving into 2009. One of the potential bright lights could be fixed income instruments, especially at the long end of the curve where the yield remains attractive. While default remains a serious risk, the high rate of return is attractive compared to feeble short-term interest rates.

Fixed income instruments have to be looked at from two different angles. First, in terms of rates, we expect low nominal and very low real rates to remain for at least the next two years. Yield curves will stay relatively steep, but we anticipate a flattening soon in the U.S., then in Canada, then later in Europe and in the U.K., when each country is finished with rate cuts.

Second, fixed income must be viewed in terms of credit—and this is where we see the biggest opportunity in 2009. In recent history, equity markets have led the economy by on average six months— which, in turn, has been led by credit—so we expect to see the first signs of recovery in the credit markets. The current levels of credit spreads, which represent the credit risk premium of corporate bonds, are at all-time highs. This means that there is good incentive to own corporate debt issued by companies that will survive the financial and economic crisis. Good credit research will be essential in order to differentiate between companies that will survive and see their spreads contract, and those that will not.

The Year Ahead

This year has been scary for investors, and the credit crisis has left them bruised and battered. Aside from government-backed cash instruments, there were very few safe havens in 2008. Much uncertainty lies ahead in 2009, and a protracted recession through 2009 in the U.S., Europe and Japan—combined with a slowdown in other countries, including emerging markets—is widely expected.

The U.S. will most likely emerge from recession first, thanks to early prompt fiscal and monetary actions. We expect equities to retest their lows and remain weak at the end of 2008. They may start to do better by the end of 2009, again led by U.S. markets. Canada should recover in tandem with the U.S. Meanwhile, long-term bonds in the U.S. and in Canada, coupled with shortterm instruments in Europe and in the U.K., seem to offer the best protection leading up to 2009. A well-positioned asset allocation, combined with help from a potentially calmer market, may help investors recapture some of their 2008 losses.

Peter Lindley is vice-president and head of investments and Tony Beaulac is vice-president, global asset allocation, with State Street Global Advisors Ltd. (Canada).

peter_lindley@ ssga.com; tony_beaulac@ssga.com.

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© Copyright 2008 Rogers Publishing Ltd. This article first appeared in the December 2008 edition of BENEFITS CANADA magazine.