Here’s What We’re Thinking, November 8, 2011

The Investment Committee of the Portfolio Advisory Group meets weekly to formally discuss markets, sector allocation and investment recommendations. Below is a brief synopsis of our current market view.

Here’s What We’re Thinking…

• With Italy now taking center stage in the European debt crisis, and the November 23rd deadline for targeted spending cuts from the U.S. Super Committee fast approaching, November will likely prove to be another volatile month for stocks.
• The euphoria surrounding the recent plan to address the eurozone debt crisis quickly faded last week after Greek Prime Minister George Papandreou called a referendum on the European financing package that was effectively a vote on its ongoing membership in the European Monetary Union. Equities firmed later in the week as it became apparent there would be no referendum and Papandreou agreed to step down paving the way for a coalition government. Talks between Greek political leaders to choose an interim prime minister are continuing, but a decision is expected to be reached shortly.
• The brinkmanship between European officials is making matters worse, but should ultimately give way to a series of credible solutions that should address the region’s debt and economic woes. As encouraging as the European agreement so far is in principle, it is clearly just the first step in a multi-step program to resolve the European debt crisis.
• Greece has taken a backseat to Italy over the past week, and is fast becoming the next trouble spot in Europe. The yield on Italian 10-year bonds reached a euro-era record of 6.74% on Tuesday. There has also been a sharp sell off at the short end of the curve with two-year yields also topping 6%. The yield curve is beginning to look a lot like the Greek, Irish, and Portuguese bond curves before things took a turn for the worse. Italy is widely viewed as “too big to fail, too big to bail”. In the end, we believe that Italy has the ability to deal with its problems. The government’s decision to invite inspectors from the International Monetary Fund to supervise its efforts to address its debt problems is encouraging.
• In a surprise move last Thursday, the European Central Bank, now under new leadership, cut its benchmark interest rate by a quarter percentage point to 1.25%. Mario Draghi used this first meeting in his new job to show that he was prepared to be more pro-active than his predecessor.
• Also rocking markets last week was news that MF Global Holdings, the holding company for the broker-dealer run by Jon Corzine, filed for bankruptcy protection after making some bad bets on European sovereign debt. Global securities and investment firm Jefferies Group Inc. (JEF-NYSE) was also dragged into the mud on concerns that it is going to follow in the footsteps of MF Global. The MF filing and 20% drop in Jefferies last Thursday are somewhat reminiscent of Bear Stearns and Lehman Brothers and clearly underscores the fact that investors are on edge.
• On a positive note, fears of a U.S. and global recession have faded. Economic data from both the U.S. and China have been more encouraging, suggesting the U.S. economy will muddle along and China will avoid a hard landing.
• Last Friday’s U.S. job reports proved better than expected, however the Canadian employment report was very disappointing. Canada lost 54,000 jobs in October and the unemployment rate rose to 7.3% according to Statistics Canada. The loss was a surprise to economists who on average had forecast the economy to create 15,000 jobs.
• U.S. corporate earnings season is nearing its conclusion with 88% of S&P 500 companies having reporting third-quarter financial results. Adjusted earnings for the index are U$25.47, representing a better-than-expected 16.5% year-over-year increase. Corporate guidance was more subdued, but third-quarter earnings nevertheless should lend support to this market.
• With the positive news flow surrounding earnings season largely behind us, the market will focus on Europe and the outcome of the upcoming Super Committee meeting on November 23rd. The Committee was tasked with cutting the deficit by U$1.2 trillion over 10 years. If they are unable to reach a deal by Thanksgiving, or if Congress is unable to pass the plan by Christmas, automatic spending cuts will be triggered starting in 2013. Failure would heighten investor concern that the U.S. is incapable of tackling its long-term debt problems.
• Despite the significant stock market rally, equities remain the favoured asset class versus bonds. That said, we expect equity market volatility to continue and recommend profit taking to lock in recent short-term gains. For buyers building longer term portfolio positions, we expect the market will provide a better entry point so there is no rush to buy at current levels.
• One of a few exceptions would be gold which technically looks very attractive. Both gold bullion and gold equities should perform well in the current environment.
• Commodity cyclicals and industrial stocks offer the most upside potential in the event equities rally again, but they also will likely continue to exhibit the greatest volatility.
• Many high quality dividend paying stocks at current levels do not offer much capital appreciation potential but will provide investors with the most downside protection if the market retreats; and the steady dividend income generated remains an important component in portfolio total returns.
• Given our outlook for an extended period of slow economic growth, whether falling into outright recession in North America or not, equities are expected to trade in a range for the next several years.
• We are inclined to take some profits on holdings that have performed well. In turn, emphasizing the need to be more tactical in the current environment, this capital could be selectively rotated into stable names that are more reasonably valued. We place particular emphasis on the word “selectively” given the fragile situation in Europe and we continue to encourage a focus on larger-cap companies with sound balance sheets.
• For fixed income exposure, the current low rate environment offers little value in the mid to long end of the curve and we recommend investors remain short duration at this time. From a sector weighting perspective, investors should be underweight Canada’s and overweight provincials, municipals and corporates. The recent narrowing of high yield spreads leaves us at a point of indifference on these credits. With the Canadian dollar expected to outperform most major currencies over the coming year, we recommend Canadian investors remain in Canadian dollars for their fixed income holdings.

For more information on how these ideas pertain to your investment portfolio, please contact Bev or Danielle.

Summarized by Paul Danesi – Director, Portfolio Advisory Group

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