Potential financial accidents

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1 February 1, 2015 INVESTMENT STRATEGY NOTES Nick Majendie, CA Director, Wealth Management ScotiaMcLeod Senior Portfolio Manager, with responsibility for advising the Anchor Potential financial accidents Stock market outlook In our January 15 Anchor Note, we outlined our 2015 Market Outlook. In brief summary, we concluded that there is potential for at least high single-digit total returns for the Canadian equity market over the next year barring any accidents. However, we said that these gains could well be front end loaded with the positive aspect of lower oil prices being evident first and the negative side being delayed until the fall/winter. We also said that, at this stage, we believe the risk/reward still favours Canadian equity markets despite the recent weakness in the commodity sectors, which have been responding to strength in the U.S. dollar but would recommend becoming increasingly defensive beyond the first few months of Regardless, we also reiterated that the strategy that we pursue of emphasizing quality bonds and stocks and, in particular, equities with strong balance sheets and predictable free cash flow and dividend growth would likely continue to be an appropriate strategy, combining decent upside with more moderate risk. This is even more appropriate now if our view is correct that long term bond yields in North America will be flat to down in the short term combined with the fact that TSX dividend yields have not been close to, or even above, Canadian GOC 30-year bond yields since the late 1950s - other than for brief periods after Q The potential for flat to down bond yields in Canada has been reinforced by the Bank of Canada s surprise move to lower its policy interest rates by 25 basis points to 75 basis points. Bloomberg surveyed 25 economists prior to the announcement and not one predicted a cut on January 21. Both Canadian bond and stock markets responded very positively although the Canadian dollar fell sharply by a cent and a half on the day of the announcement and further since. Barring any accidents : what is the biggest risk? In our January Anchor Note, we listed numerous potential risks. On the geopolitical front they include, Russia, the Middle East and the Eurozone/Greece. On the economic front they include, Russia, Venezuela, Nigeria, Iran, China and those emerging economies with hefty U.S. dollar denominated debt. The sharp reduction in oil prices over the last six months lies behind much of the economic risk for the oil producing nations. Nevertheless there has been a clear disconnect between financial markets and economic performance, which, whether in North America or globally, has generally been weaker than any post-recession recovery since the Second World War. The major reason for this has been the abundant liquidity provided since 2008 by the worlds major central banks, which has boosted the value of financial assets but not demonstrably improved economic growth rates. In several past Anchor Notes, we have observed how this surfeit of liquidity from quantitative easing since the Great Recession reminded us of the period between 2002 and In the early stages of that recovery, the economy benefitted from central bank easing and in the latter stages from the shadow banking system. Since 2008 through to current times, there has been an unprecedented amount of quantitative easing by all of the worlds central banks. This analogy

2 put us in mind of the warnings from William White for three years leading up to the Great Recession. William White is a Canadian economist educated at the University of Windsor and the University of Manchester. In 1994, he joined the Bank of International Settlements (BIS), the Swiss-based bank of central banks, as manager in the Monetary and Economic Department. From May 1995 to June 2008, he served as its Economic Adviser and Head of the Monetary and Economic Department. He is now with the International Monetary Fund (IMF). He predicted the financial crisis of before 2007's subprime meltdown. According to Wikipedia, he was one of the critics of Alan Greenspan s theory of the role of Monetary Policy as early as He challenged the former Federal Reserve chairman's view that central bankers can't effectively slow the causes of asset bubbles. On Aug. 28, 2003, White made his argument directly to Greenspan, at the Kansas City Fed's annual meeting in Jackson Hole, Wyoming. White recommended raising interest rates when credit expands too fast and forcing banks to build up cash cushions in fat times to use in lean years." Greenspan was unconvinced that this would work and said: "there has never been an instance, of which I'm aware, that leaning against the wind was successfully done." 1 More recently (September 2012), in a paper for the Federal Reserve Bank of Dallas, entitled Ultra Easy Monetary Policy and the Law of Unintended Consequences, White reaches the following conclusions: The case for ultra-easy monetary policies has been well enough made to convince the central banks (of most major developed economies) to follow such polices. They have succeeded thus far in avoiding a collapse of both the global economy and the financial system that supports it. Nevertheless, it is argued in this paper, that the capacity of such policies to stimulate strong, sustainable and balanced growth in the global economy is limited. Moreover, ultra easy monetary policies have a wide variety of undesirable medium term effects the unintended consequences. They create malinvestments in the real economy, threaten the health of financial institutions and the functioning of financial markets, constrain the independent pursuit of price stability by central banks, encourage governments to refrain from confronting sovereign debt problems in a timely way, and redistribute income and wealth in a highly regressive fashion. While each medium term effect on its own might be questioned, considered all together they support strongly the proposition that aggressive monetary easing in economic downturns is not a free lunch. Looking forward to when this crisis is over, the principal lesson for central banks would seem to be that they should lean more aggressively against credit driven upswings, and be more prepared to tolerate the subsequent downswings (as White pointed out to Greenspan in 2003). This could help avoid future crises of the current sort. Of course the current crisis is not yet over, and the principal lesson to be drawn from this paper concerns governments rather more than central banks. What central banks have done is to buy time to allow governments to follow the policies that are more likely to lead to a resumption of strong, sustainable and balanced global growth. If governments do not use this time wisely, then the ongoing economic and financial crisis can only worsen as the unintended consequences of current monetary policies increasingly materialize. 2 Having, as mentioned, predicted the 2008/2009 Financial Crisis repeatedly for three years in advance, William White remains highly concerned about the risks to the global financial system. As documented by Buttiglione, Lane,

3 Reichlin and Reinhart in their paper, Deleveraging? What Deleveraging?, global debt to GDP ratios are still growing. Total U.S. debt to GDP stands at 334%, the 17 economies in the Eurozone at 460% and Japan at 655%. 3 In a Bloomberg sponsored speech at the same January 2015 World Economic Forum in Davos, Larry Summers, the former U.S. Treasury Secretary, said that: Deflation and secular stagnation are the threats of our time. The risks are enormously asymmetric. There is no confident basis for tightening. The Fed should not be fighting against inflation until it sees the whites of its eyes. That is a long way off. Mr. Summers added that the world economy is entering dangerous waters as the U.S. expansion enters its seventh year, matching the average length of recoveries. Nobody over the last fifty years, not the IMF, not the U.S. Treasury, has predicted a recession a year in advance, never. Worries about the underlying weakness of the U.S. and global economy were also repeated at the Davos Bloomberg meeting by Bridgewater s Ray Dalio, who maintained that the central bank strategy of ever lower interest rates and evermore debt creation has reached its limits. Mr. Dalio drew the analogy of the global economy from when the dollar was surging, creating a short squeeze for those who had borrowed in dollars during the previous economic expansion. Back then we could lower interest rates. If we hadn t done so, it would have been disastrous. We can t lower interest rates now, he said. We re in a new era in which central banks have largely lost their power to ease. I worry about the downside because the downside will come. Our interpretation of what these various experts are saying is that the risks of another global financial crisis and consequent recession are increasing rather than declining and with it the potential for a deflationary outcome. Our Majendie Deflation Monitor is a proprietary index of 17 different indicators, which we have been keeping since Since that time, it has only triggered the danger reading of 60 (out of 100) once between September 2008 and March Its current reading is 43. We will be watching it closely over the coming year to track the risks of deflation, which, should it become more widely evident, would require a much more defensive investment posture than we currently carry. The Majendie Deflation Monitor is perhaps the key one out of ten steps we use in the Anchor Defensive Income fund to reduce volatility and manage risk. It prompts significant changes in asset mix when financial conditions are fast deteriorating. Portfolio changes There were no changes in the Anchor funds in the last two weeks. Nick Majendie, CA Director, Wealth Management, Senior Portfolio Manager, ScotiaMcLeod PLEASE NOTE: IMPORTANT DISCLOSURES AND DISCLAIMERS ARE CONTAINED ON THE FOLLOWING PAGE.

4 i The Bank of Nova Scotia is the parent company of Scotia Capital Inc. ( SCI ) and is therefore a related issuer of SCI. Scotia Managed Companies Administration Inc., a wholly-owned subsidiary of SCI, is the manager of the Anchor. ScotiaMcLeod, a division of SCI is the portfolio advisor to the Anchor. Nicholas L. Majendie, who is employed by ScotiaMcLeod, provides portfolio advice to the Funds Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. These Anchor are distributed under a Simplified Prospectus. The Simplified Prospectus, Fund Facts and Annual Information Form are available from ScotiaMcLeod or on Anchor hold securities of the following issuers referred to in this note: N/A Nick Majendie, who provides portfolio management advice to the Anchor, personally holds securities of the following issuers referred to in this note: N/A This publication is intended only to convey information. It is not to be construed as an investment guide or as an offer or solicitation of an offer to buy or sell any of the securities mentioned in it. The author is an employee of ScotiaMcLeod, a division SCI, but the data selection, analysis and views expressed herein are solely those of the author and not those of SCI. The author has taken all usual and reasonable precautions to determine that the information contained in this publication has been obtained from sources believed to be reliable and that the procedures used to summarize and analyze such information are based on approved practices and principles in the investment industry. However, the market forces underlying investment value are subject to sudden and dramatic changes and data availability varies from one moment to the next. Consequently, neither the author nor SCI can make any warranty as to the accuracy or completeness of information, analysis or views contained in this publication or their usefulness or suitability in any particular circumstance. You should not undertake any investment or portfolio assessment or other transaction on the basis of this publication, but should first consult your investment advisor, who can assess all relevant particulars of any proposed investment or transaction. SCI and the author accept no liability of whatsoever kind for any damages or losses incurred by you as a result of reliance upon or use of this publication in contravention of this notice.

5 The statements in this newsletter may contain statements related to future financial performance of certain securities, indices or the Anchor Managed funds that may constitute forward-looking statements. These statements may be identified by words such as expect, look forward to, anticipate, believe, seek, estimate, project, potential, predict, or words of similar meaning. Such statements are based on the current expectations and certain assumptions of the author, and are, therefore, subject to certain risks and uncertainties. A variety of factors, many of which are beyond the author s control, affect the performance of the securities and capital markets indices and therefore the performance of the Anchor funds and could cause the actual results, performance or achievements of the securities, indices or the Anchor funds to be materially different.