Review: Income Portfolio In the most recent quarter we only made one change to the portfolio s investments. Namely, we re-invested the proceeds of the maturing Bell Canada Bond, plus a portion of the portfolio s cash balance, in a Guaranteed Investment Certificate maturing in 4 years. These changes helped to increase the portfolio s regular annual income stream by 4.00% or $168.75. Portfolio Thoughts: There appears to be a blanket of calm spreading to all world financial markets (both stock and bond) and this calm has helped stock markets to steadily and consistent rise. The sample portfolio's investment values remained relatively constant during the quarter. Portfolio investment parameters: Even though we believe financial and economic cycles are unknowable in advance, we still need to make certain assumptions about future out comes and cycles. With this in mind, below are a few of our investment assumptions. Inflation will remain low and stable Interest rates will remain stable and at current levels Canadian and American economic growth will remain at sub-par 1.0% - 2.0% levels European economic growth will remain weak (Germany) with the majority (France, Italy, Spain, Greece, Portugal) of individual economies moving into recession in 2013. The contraction phase of the credit cycle remains intact and will continue into 2014 Individuals will continue to focus on debt reduction as a top priority Corporations will continue to renew and refinance debt at today s depressed interest rates. Corporate underwriting issues will remain weak as corporate coffers are brimming with cash and new opportunities/reasons to invest decrease. The liquidity injected by governments and central banks (Quantitative Easing, etc) has become a permanent fixture in financial markets. This liquidity, without an improvement in velocity, will help to keep interest rates low and it will not add inflationary pressure to the system. The liquidity injected by governments and central banks will support financial asset values (stocks, bonds and commodity futures, etc) for the foreseeable future. Governments and central banks have shifted the dynamics of financial markets. Specifically, they have become the dominant players in the bond and asset-backed securities markets. Private investors have been pushed out as their interests and these dominant parties have trampled private investor ownership rights. Yield Curves have been flattening and dropping to lower levels for the past 4 years suggesting economies are slowing and, as in the case of a number of
large European countries, on the verge of recession. Governments in the developed economies will continue to struggle with operating deficits and rising debt levels. Taxation corporate and individual, will increase over the next few years as governments struggle with deficits and the diminishing returns from spending/austerity cuts. Financial markets around the world are enjoying the calm that comes from having survived the worst of the financial crisis, which appears to have peaked in 2012. Time will tell if this is simply the transition phase to full economic recovery (as the market currently expects) or into a smoldering economic crisis. Note: We are still uncertain about the economic recovery aspect, thus, we continue to remain defensive in the portfolio s asset allocation. Financial markets and investors have entered a phase of calm (or numbness) that should last into the next few quarters. Thoughts and Concerns: Bond markets and interest rates: Governments now the dominant investors: Central Banks (Britain, Japan, Eurozone, United States, etc.) have been buying trillions in bonds, Mortgage-Backed and Asset-Backed Securities, for years now. They have become the biggest players in these markets and their presence has distorted market characteristics and pushed private investors to the sidelines. Foreign governments, through their Central Banks and rescue schemes, have also distorted the markets for domestic bank bond issues. These distortions can be confusing for investors if they continue to view the markets as normal. Europe: For example, the 10-year Greek bond yield has declined to the lows of three years ago and investors happily point to this as a sure sign Greece has recovered. But what these investors are missing is the non-existent market for Greek bonds. After two rounds of Greek bond restructuring, European governments and their agencies now own over 90% of Greek government and bank bonds. There is no private market for Greek bonds, no private buyers, only the ECB and it s rescue schemes. So Greek bond yields have declined, while the country s debt to GDP continues to deteriorate each quarter growing to 153% in 2012 and forecast to rise to 184% by the end of 2014. Their unemployment rate has steadily risen over the past three years approaching 26% (55% for those under 25 years of age); their economy continues in recession contracting by double digits, etc. And yet the lower Greek bond yields are interpreted as a sign Greece is recovering. Spain, Italy, Portugal and Ireland s bonds also suffer from the same distortions. North America: The U.S. Federal Reserve continues to purchase $85 billion, plus, each month ($1.02 Trillion per year) of U.S.
Treasury bonds and Mortgage-Backed Securities. The Federal Reserve, in its efforts to boost growth, will add about $45 billion of Treasuries a month to the $40 billion in mortgage debt it s purchasing, effectively absorbing about 90 percent of net new dollar-denominated fixed-income assets. - BloombergSo if a single buyer purchases 90% of new bonds does this dominance cause distortions in the market? We think the market is not as healthy or balanced as it was 4 years ago, when multiple buyers competed to buy and sell, and investors need to be aware that data points generated today may not have the same causal relationships as they did in the past. Interest rate levels today may not indicate the same economic outcomes as they did in the past. Permanent liquidity: Many investment commentators continue to ring alarm bells about the financial risks from all the governments liquidity injections, over the past four years, and the turmoil that will inevitably result when the trillions of dollars are withdrawn from the financial system. We believe we are past the point of no return when it comes to the liquidity injections. The financial system, investors and governments have become addicted and comfortable with all the new money in the system and we doubt central banks will ever be in a position to reverse course and withdraw the money. We believe the financial landscape has been altered and the liquidity is now a permanent fixture for investors to factor into their decisions. As a result, here we are years down the road and inflation data has continued to decline, bond interest rates continue move lower and gold bullion prices are not making new highs - demonstrating a lack of concern about inflation as a risk. Interest rates: We continue to expect interest rates to remain stable and low. This view is, we believe, is supported by the following observations, Consumers continue to focus on saving and paying down their debts credit card, mortgage, etc., thereby decreasing the demand for new loans and mortgages. This relatively new focus should keep consumption and spending growth at low levels, further suppressing economic growth and reducing any risk of inflation. Consistently high levels of unemployment and the declining participations rate of workers will continue to act as a drag on economies. Government liquidity injections are more permanent and the abundance of money acts as a downward pressure on interest rates. Boomer demographics support low interest rates. As Boomers get ready to retire they naturally shift from
accumulating and growing their asset base houses, retirement investments, etc. to preserving and living off their asset base. This shift should add to the decrease in the demand for loans and help to keep interest rates low. Flattening yield curves: As mentioned above, we note the Canadian bond yield curvesare once again flattening indicating the economy is slowing and financial markets are not at all concerned with a threat of inflation. In fact the flattening of the curve and the lower long-term yields curves seem to indicate inflation will continue to decline, not increase. For example, below are the interest rate spreads (1 year to 30 Year bonds) and the 30-year yield for the past few years. 2010 Interest spread = 3.31%, 30-year = 3.96% 2011 Interest spread = 1.88%, 30-year = 3.57% 2012 Interest spread = 1.58%, 30-year = 2.50% 2013 Interest spread = 1.24%, 30-year = 2.34% As can be seen the spreads are decreasing, causing the yield curve to flatten, and the overall trend for Canadian interest rates is down. Even with all of the talk of interest rates rising, the bond market would appear to disagree. Note: For a discussion on Yield Curves, visit our Classroom Bonds section. Stock market valuations: Stock markets around the world continue to reach higher and higher levels. With anemic economic and corporate earnings growth rates, stocks appear to be rising as investors are willing to pay higher and higher valuation multiplies for shares. The assessment of stock market values is more often in the-eye-of-the-beholder.valuation is subjective at best and always includes a large level of human estimation For example, here are a few of our questions or thoughts on current valuations A market trading at 15 times earnings, is it over or under-valued? Is it better to use a price-to-earnings multiple based upon trailing earnings, earnings forecasts or the Case-Shiller normalized earnings ratio? What level of growth in corporate revenues and earnings will be acceptable to investors? Will a 2.00%, 4.00% or some other level become the new yardstick? If analysts expectations are set to a low level (like the current 2.5% for 4 th Quarter 2012) then it should be easy for companies to exceed those expectations and stock prices should rise. In this environment price-to-earnings (P/E) ratios should be able to expand easing the path for higher stock prices. We also wonder how market valuations will change if interest rates begin to rise. One investment theme gaining popularity is that stock prices will rise because interest rates will be increasing because the economies are growing and this is good. We are
not so sure history supports this theme. There is no guarantee stocks will rise, in fact, they might just go down as interest rates rise. In addition, if the economy does gain strength then many central banks will begin to reverse their loose monetary policies and this may cause some money to be reversed out of stock and bond markets adding downward pressure to valuations. A second theme voiced by stock market investors is that an asset rotation cycle is taking hold. They say investors are beginning to sell their bonds and buy stocks, thus helping stock market values rise further. We are not big believers in this theme as we view it as flawed causal relationship. Basically, ask yourself - Who is buying all those bonds that bondholders are selling? & Who is selling all those stocks that investors are buying? If one investor is selling (stocks or bonds) another investor must be buying and visa versa. Finally, we believe the large amounts of liquidity injected into financial markets, by central banks and governments, is one of the biggest factors influencing today s asset valuations. This liquidity has caused distortions in both stock and bond markets. Summary: Although the worst of the financial crisis feels like it is behind us and world stock and bond markets have breathed a collective sign of relief, InvestingForMe would still like to see stronger signs of economic growth in North America and Europe. We would like to see efforts shift from managing a financial crisis to managing economic growth. It is no longer enough for central banks and governments to flood the financial system with liquidity; they must now deal with the problems that remain within the banking systems and their respective economies. Portfolio Changes: At present, we are comfortable with the portfolio s current asset allocation and it's focus on safe, income producing investments. No changes are contemplated at this time.