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Second Quarter 2010

August 18, 2010 • Print This Article

"Only thing we have to fear is fear itself", Franklin D. Roosevelt, First Inaugural Address, 1933.

These famous words, spoken during the Great Depression, resonate following what has been termed as the worst economic downturn since the '30's. In search of headlines, the media have focused on economists such as David Rosenberg and Paul Krugman, who are calling for a double dip recession. They believe that recovery has been fostered by government stimulus and that the recovery will not survive the removal of stimulus.

We believe that the reality is somewhat different. We believe that the recession was precipitated by a freeze up in credit, due to the sub-prime debt crisis and the failure/near failure of many US and European banks and insurance companies. Massive coordinated government intervention was required to stop the implosion of the global financial system and resulted in the effective nationalization of many financial institutions. As credit has become more available, economies have begun to recover. We do not believe that credit conditions will become as restrictive as they were in 2008. It is interesting to note that Canada's banking system was the least impacted by sub-prime debt and flawed lending practices. It is not a coincidence that the Canadian economy is the fastest growing economy in the developed world.

Corporate profits appear to be expanding. The financial reform legislation was recently signed into law in the U.S. and Basel III, which should be ratified by the Basel Committee on International Banking Supervision in late 2010, will set the benchmarks for capital levels, self dealing, exotic products, derivatives, etc. Hopefully the regulations will help prevent future financial meltdowns and will set the guidelines should any individual banks or insurance companies fail and to cushion the impact. The clarity provided by the new rules, especially around capital levels, may allow Canadian banks to resume dividend hikes and pursue acquisition opportunities internationally.

It should also be noted that corporations have rebuilt balance sheets. In the U.S., almost $2 trillion of cash is sitting on balance sheets making little interest. Eventually shareholders will want these funds put to work. Investment in equipment and software, mergers and acquisitions, share buy-backs and dividend increases should help prop up markets over the next couple of years. The optimists point to this hoard of cash and postulate that the corporate sector is well positioned to take over from governments to support economic expansion going forward.

We believe the most likely scenario is for growth to slow down as governments reign in spending. Interest rates should stay at very low levels for longer then many analysts predict. This should allow banks to maintain loan spreads and profitability and preventing a double dip recession. Job growth in the US will remain muted as companies having excess capacity are finding ways to do more with less.

Canada, with a stable credit environment and with the raw materials that the world requires, should continue to perform well compared to other developed countries. Growth should continue in Asia and South America. China is attempting to slow its economy with more restrictive lending regulations and currency revaluation. However, we believe growth should remain at relatively high levels supporting economic expansion in other Asian countries and supporting commodity prices.

The anticipated 10-15% correction has occurred. The question remains: "Is this a normal correction or the beginning of a second leg downward of a bear market?" Uncertainty and conflicting economic data have prompted many to seek the perceived safety of bonds and cash. Volatility has increased as equity markets vacillate between fear and greed (risk on, risk off). As managers, we tend to be longer term investors and remain unmoved by short term market trends. A focus on income and an overweight position in Canadian holdings and cash/near cash have helped protect accounts from much of the recent decline.

We believe that as fears of a renewed recession diminish, the US Dollar should decline in value as funds flow out of the "Safe Haven" into less liquid, higher risk currencies, including the Canadian Dollar.

In an extended, slow growth environment, inflation should stay contained. Investors should begin to put more of a premium on income. High dividend paying common shares should perform relatively well. Investors and corporations will eventually start to put record high cash levels (paying little to no interest) to work by investing in higher risk, higher income paying assets. Dividend yields on Canadian banks and utilities are well above interest yields on 10 year Government of Canada bonds.

The fundamental question that income dependant investors, pension funds and institutions need to answer is, what is the best asset class to provide income and growth?

  • Is it cash making nothing?
  • Is it bonds in a low yield environment where recovery may eventually lead to inflation, higher interest rates and capital loss?
  • Is it high dividend paying equities, in companies with upward trending earnings, strong balance sheets and with track records of increasing dividends?

As managers and investors we believe high dividend paying equities will outperform. As a result, we hold a relative overweight position in equities concentrating in high dividend yielding issues. We believe a relative underweight position in bonds is warranted with a concentration in the short end of the bond market. We continue to favour the Canadian equity market over the US equity market, as we believe the US economy will continue to be held back by relatively sluggish consumer spending and long term structural weakness facing the housing market.

Filed under: Quarterly Reports

The opinions, estimates and projections contained herein are those of the author as of the date hereof and are subject to change without notice and may not reflect those of Mackie Research Capital Corporation ("MRCC"). The information and opinions contained herein have been compiled and derived from sources believed to be reliable, but no representation or warranty, expressed or implied, is made as to their accuracy or completeness. Neither the author nor MRCC accepts liability whatsoever for any loss arising from any use of this report or its contents. Information may be available to MRCC which is not reflected herein. This report is not to be construed as an offer to sell or a solicitation for an offer to buy any securities. Member-Canadian Investor Protection Fund / member-fonds canadien de protection des ├ępargnants.

Mackie Research Capital Corporation (MRCC) makes no representations whatsoever about any other website which you may access through this one. When you access a non-MRCC website please understand that it is independent from MRCC and that MRCC has no control over the content on that website. The content, accuracy, opinions expressed, and other links provided by these resources are not investigated, verified, monitored, or endorsed by MRCC.


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