Market Commentary May 2012

Whoever said that April was the cruelest month likely didn’t have any money invested in the global equity markets in May. Equity markets were hit particularly hard, with the MSCI EAFE Index dropping by more than 7% during the month. The S&P 500 fell by 6% in U.S. dollar terms, while closer to home, the S&P/TSX Composite Index dropped by 6.1%.

Europe was again hit very hard, with the MSCI Europe Index sinking by 12.1% as concerns over the debt crisis continue to mount. This time around, investors focused their attention on Spain, particularly the country’s banks which are in serious trouble since the country’s property bubble burst in 2008. Many banks are on the verge of failure and without a bailout plan will go under, dragging the country with them. In Greece, despite their best efforts, a coalition government could not be formed, forcing the country back to the polls. These events, coupled with the recession that is crippling the region, spurred the selloff.

For Canadian investors, the drop in the Canadian dollar helped to mute losses. The dollar fell from $1.0117 to $0.9663 during the month. This had a noticeable impact on returns. For example, the S&P 500 dropped by 6.0% in U.S. dollar terms, but once the impact of the falling dollar was taken into account it was a more modest 1.6% decline. The dollar dropped largely due to the precipitous drop in commodities. With Europe in recession, China slowing down and emerging worries over the health of the U.S. economy, investors sold off commodities, fearing a slowdown in demand. Brent crude was off by 14% and gold dropped by 6%.

The commodity selloff was also a big contributor to the drop in the Canadian equity markets. The S&P/TSX Diversified Mining Index was down nearly 17% and the energy index was off by nearly 11%. Real estate and REITs were the only bright spot, both posting a modest gain of 0.2% in the month. Investors were also worried about the high levels of debt that many consumers are carrying combined with worries that the housing market may finally be slowing in certain markets.

Understandably, bonds, the traditional safe haven in times of uncertainty, were higher in the month. The DEX Universe Bond Index rose by more than 2.1%, with the safe haven government bonds outperforming corporate bonds. Real return bonds were very strong, gaining more than 4.6% in the month.

Looking ahead, we expect more of the same. With Europe in the mess that it is, a solution, or rather a series of solutions has to be implemented before there can be any real improvement. Until that is fixed, investors will tend to focus more on the headline risks in the economy, rather than focusing on the strong corporate fundamentals that many companies have today.

From a portfolio positioning standpoint, our view hasn’t changed from previous months. We are still suggesting that investor focus on Canadian and U.S. equities as we believe that there is still too much risk in Europe. We are also suggesting that investors focus on high quality companies that are generating attractive shareholder yields, which includes such things as strong free cash flows and attractive dividends.

For fixed income, interest rates will eventually be moving higher, but it appears that recent events have pushed that out a quarter or two from earlier estimates. We would expect that the Bank of Canada may move rates higher by 25 basis points by year end, but that likely won’t happen until late into the fourth quarter, if not first quarter of next year. Within the fixed income portion of portfolios, again, our emphasis is on quality. We suggest that investors focus on high quality corporate bonds which will provide better downside protection when rates do move higher, but may also provide the potential for some better capital growth opportunities when compared to Government bonds.

For the month of May, the best and worst performing funds were: