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Second Quarter 2011

July 1, 2011 • Print This Article

The Markets

Equity markets around the world are vacillating between the ups based upon strong corporate earnings and attractive equity valuations, and the downs, based on political turmoil. Overall, we are constructive about the stock market's second- half prospects. However, uncertainties on both sides of the Atlantic may need to be resolved favorably for markets to gain positive momentum.

It is important to note that equities have climbed from the March 2009 lows without a substantial correction. Although corrections are unsettling, they are essential for the overall health of the market. Corporate earnings cannot continue to grow exponentially and growth must in time slow down. We may be entering a period of sideways markets and increased volatility.

Canada, in comparison to much of the rest of the world, appears to be a bastion of stability both political and economic. Although we are not unaffected by the travails south of the border and in Europe, we do have much to be grateful for as investors. Our banking system continues to be seen as the soundest in the world. Our banks have the ability to expand at a time when many other financial service companies have been forced to divest. Bank of Nova Scotia, Bank of Montréal and TD Bank have made significant acquisitions over the past two years that should reward investors as the global economy recovers. Canada's materials and oil and gas sectors appear to go from strength to strength and should continue to out perform as demand for raw materials remains robust from the developing world and commodity prices remain elevated. International trade should benefit through lobbying and coordination by a business friendly government.

In Europe the sovereign debt crisis continues. The Greek parliament ratified austerity measures to allow for a second tranche of bailout funding. Politically, the other European countries cannot allow their taxpayers to bear the entire burden of the cost of a bailout/debt restructuring. The intransigence of the rating agencies has put a Greek deal in doubt and could potentially impact the debt of Spain and Italy and could lead to an escalation of interest rates in other EU countries. If this was to occur, the future of the EU experiment would be in great peril.

Events in Europe and the Mideast have resulted in funds flowing into the perceived relative safety of the US Dollar, keeping the Dollar artificially high and interest rates artificially low. At the end of the quarter, the end of QE2 had not had a significant impact on bond yields as funds poured in from overseas to purchase Treasuries. Of great concern for the US markets and economy is the gridlocked negotiations on the increase of the US debt ceiling. The Republican hard line on no tax increases and the Democratic aversion to cutting entitlement spending will take the debate to the 11th hour. Until a deal is reached and there is some clarity on the U.S. budget plan going forward, companies may wait to commit to expansion, hiring and growth plans.

Increased corporate profitability is not reflected in share prices, leading to a market that is undervalued by most metrics. Dividend yields are higher then either Government bond yields, or in many instances the yields on the underlying corporate debt. P/E ratios are at the low end of the historic norms. Corporate balance sheets are flush with cash and corporate debt ratios are at historic lows. In the event that Europe muddles through and the U.S. increases the debt ceiling (hiking taxes and cutting entitlements) there could be a substantial equity rally.

Bond yields in the U.S. are artificially depressed by fear of Greek default and resulting contagion. If Europe solves its sovereign debt dilemma, funds will return to Europe, the yields on U.S. Treasuries will rise and the US Dollar will fall. If a debt ceiling is not increased, there could be a technical default leading to higher US interest rates and a lower US Dollar. If a deal is reached on the debt ceiling, as is anticipated, the impact on the Bond market and Dollar should be muted. As the economy continues to slowly recover, interest rates should slowly rise as companies begin to expand and hire and inflation gradually reappears.

If these events occur, equity markets should rally considerably. As current risks in markets are resolved, bond yields should rise. However, the risk of failure by either the EU or the U.S. to rectify their issues prescribes a cautious stance. As always it is important to remember that a well balanced portfolio will be able to absorb corrections in asset classes. Dividends should continue to provide stable and predictable income going forward.

- AG

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 épargnants.

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