Ultra low interest rates Why are they occurring and what do they mean?

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1 David s Perspective Ultra low interest rates Why are they occurring and what do they mean? In a global world there are inter-connections that affect us without the need for a direct source from our own local landscape. As we continue to muddle through the recovery from the US centered financial crisis of 2008, we are faced with an investment landscape that has a different dimension - namely one of low interest rates. Aren t they supposed to be returning to normal? Won t we ever be able to put our money to work in a guaranteed fashion and clip a 4% coupon return? A quick review of the investment landscape shows that if we take the opportunity to lend out money for 10 years to the countries around the world today, we would receive quite small interest payments. How small? Loaning the money to Switzerland would earn a 0.48% interest rate; Hong Kong comes in at 0.96%, Germany is at 1.16%, the United Kingdom and the United States are at 1.5% and 1.53% respectively, and Canada comes in with a princely 1.60% figure. Ouch! In simple terms, we would have to wait for 45 years to double our money with the Canadian government or - wait for it years if we choose to commit the funds to Switzerland! Let s examine the issues behind these low interest rates and identify the sign posts for change. In general, there are two key reasons for these low interest rates. First we are experiencing a weak global economic recovery. We seem to have excess capacity in the global economic system and these excesses create an expectation of lower prices in the future. If people develop lower price expectations for future spending ideas, then the process tends to encourage people to delay their spending decisions. We have long observed this kind of behaviour in the computer and electronics markets. Why purchase the current latest and greatest model television or stereo now, when it will be cheaper 12 months from now? The interest rate landscape remains low and has recently headed even lower in the wake of disappointing economic reports from the United States, as well as the slowing figures for global purchasing activity noted above. Among the developed countries, the Canadian economy is one of the economies most dependent on the energy industry. Slower economic activity is softening demand for oil and this has created negative expectations for the Canadian economy. Further, we see that the European difficulties persist with the focus of the attention shifting towards Spain, the 4 th largest economy in Europe. While the European authorities have spent much effort (and time) treating the economic challenges of several smaller countries (notably Greece), the larger economies of Spain and even Italy have not seen their economies rebuild or recover as quickly as was expected. Secondly, there is a general change from increasing government spending to government austerity. One of the first reactions to the 2008 global financial crisis was a series of

2 spending programs from government sources as a means to step in and keep economic activity going while the private sector got back on its feet. These programs have largely run their course and the next steps involve cutbacks to those spending programs in light of the challenged financial positions of those countries. These measures are described as austerity programs and have brought Europe into a recession (two successive quarters of declining economic activity). When recessions occur, interest rates tend to fall because there is a reduced demand for borrowing. What do lower interest rates mean to Canadian investors? Low interest rates are one of the key ingredients fueling our elevated prices for real estate. There are some cities where real estate has become too expensive for the wages of Canadian families (Vancouver in particular); the bulk of the rest of Canadian real estate remains somewhat overpriced as well. Higher prices for real estate have given Canadian homeowners a sense of confidence to engage in consumer spending. Mark Carney (the Governor of the Bank of Canada and a key participant in the determination of future Canadian interest rate levels) continues to warn Canadians that we should not increase our economic dependence on the increasing value of the homes that we live in. Canadians need to reduce their tendency to borrow from home equity lines of credit to finance personal consumption. The low interest rate landscape in Canada is fuelling additional interest in companies that make a point of sharing their profits with investors through regular payments (a process known as paying dividends to investors). Investors are taking the opportunity to purchase dividend paying companies in a variety of industries in Canada - namely the financial services, telecommunications, energy, and utility industries. As a result, we are observing that several of these Canadian industries are becoming quite expensive compared to their long term historical valuations. I continue to encourage our investors to broaden their reach and shift their focus towards purchasing companies from other countries that have a broader representation of dividend bearing companies from different industries; two examples that fit this category include the United States and the Asia- Pacific region. There is a perception that low interest rates are a short term by-product of the current environment and that they will dissipate shortly. Several political and economic leaders have popularized this perception using the rationale that economic growth will recover in the near term. History shows, however, that the average length of time that it takes for an economy to recover from a serious storm like the 2008/2009 global recession is 6 years for real estate prices, 3.5 years for stock market prices and about 4 years for declines in employment and economic output. It is quite conceivable that we may need more time to work through the imbalances and repay the debts. In the event that growth does not recover quickly, central bankers will continue to adopt a variety of measures that are geared to stimulate the economy. The major tool that central bankers use to influence economic activity is the interest rate policy. The primary response to the sluggish recovery from central banks in developed countries has involved

3 extending the low interest rate landscape. The thinking is that as consumers get their debts under control and repaid, their economic contributions will increase. The downside for the short term is that these debt repayments do not add to the overall level of economic activity. By the same token we are not expecting prices to increase (i.e. inflation) until we come out of this low interest rate environment. Sign Posts for Change The following actions and/or changes will be good indicators that we have weathered the storm and can anticipate a return to more normal interest rates and levels of economic activity. In no particular order: a) the US Federal Reserve will stop buying long term bonds; b) the members of the European Union will have developed, agreed to, and implemented a cohesive plan to integrate their fiscal spending decisions across the different countries on the continent; c) we will see a return to stability, both in employment levels and residential real estate prices in the United States. When we look at the historical success of central banks to create inflation within an economy, their track record is quite impressive. Almost all occurrences (except in Japan from 1990 until the present day) have had an inflationary outcome. My point here is that it may take a longer period of time than a year or two. Some pessimists have suggested that it is North America s turn to go through a Japanese scenario. Japan suffered through 17 consecutive years of declines in their residential real estate values and has had ultra-low interest rates (under 1%) for the past 16 years. I do not subscribe to the concept that North America is locked into a Japanese style period of stagnation since: a) residential real estate prices appear to be stabilizing in the US; b) loan growth is starting to occur (in the US); c) there are new policies to encourage immigration to North America an action which helps to add demographic fuel to economic growth. What to do in the present conditions I am optimistic that the prices we pay for companies today represent reasonable value and that there is a margin of safety that can outweigh the daily variations in their share prices. I continue to add selectively to North American investments since the relative strength models continue to show that US equities are leading at this point in time. On the bond front we are staying focused on bonds that mature within 10 years since I am concerned about locking in low interest rate returns for longer periods of time. If you have had a portfolio review discussion in the past 12 months and followed our advice, then our strategy of avoiding European financial services companies and emphasizing dividend paying companies to complement the short term bond positions

4 will have helped to mitigate a portion of the losses from the general stock market conditions. We continue to advocate US stock market exposure for client portfolios with greater than 3 year timelines; we initiated this approach in the middle part of January What about Europe (again)? Europe has much work to do to straighten out the financial workings of their 17 country combination. Although we are entering our third spring/summer season of uncertainty about the European financial issues, there has been little constructive progress in dealing with the structural deficiencies of their current working arrangements. They have failed to make the swift, decisive and concrete changes that could expedite the healing process. In all fairness, this is a tall order when you have to navigate 17 different political processes to make a comprehensive decision for everyone! One positive attribute to report is that the TED spread is not signaling that the European regional issues are boiling over into the US economic landscape (as we saw in the spring of 2010 and the fall of 2011). How their experiments with central sharing of financial decisions work out, remains to be seen. I am encouraged to see many European companies that are trading at low prices with attractive dividend payments. However, I remain on the sidelines in terms of adding these ideas into client portfolios until we have greater visibility on the big picture front for Europe. My commitment I strive to offer the best service and advice for your financial affairs with an eye to ensuring that we are providing value. My style of business is conservative because I am investing your serious money. I appreciate your confidence. Please feel free to invite any of your friends or colleagues to contact me if they wish an assessment of their portfolio or financial planning advice. As always, please contact us if there are any elements of your strategy that you wish to discuss. Thank you to those who have provided feedback on the format and the content of these Perspectives. Please continue to share. David David Hogg CFA FCSI Vice President and Associate Portfolio Manager BMO Nesbitt Burns Inc. and BMO Nesbitt Burns Ltée provide this commentary to clients for informational purposes only. The information contained herein is based on sources that we believe to be reliable, but is not guaranteed by us, may be incomplete or may change without notice. The comments included in this document are general in nature, and professional advice regarding an individual s particular position should be obtained. BMO Nesbitt Burns Inc. and BMO Nesbitt Burns Ltée are indirect subsidiaries of Bank of Montreal and Member-Canadian Investor Protection Fund. BMO (M-bar Roundel symbol) is a registered

5 trademark of Bank of Montreal, used under licence. Nesbitt Burns is a registered trademark of BMO Nesbitt Burns Corporation Limited, used under licence.