It was the best of times, it was the worst of times
In the opening line of Dickens’ classic A Tale of Two Cities, it was almost as if he was describing the first half of 2012 rather than the struggle of French peasants before and during the French Revolution when he wrote:
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us”
One could definitely make the argument that the first quarter of 2012 was the best of times. Equity markets around the world rose sharply and volatility was virtually nonexistent. Good news was everywhere. In the U.S., the beleaguered housing market was showing signs of a rebound and job growth chipped away at high unemployment, which in turn boosted consumer confidence. In Europe, the debt crisis was put on the back burner and investors instead focused on news that the European Central Bank had injected funds into the region’s banks, fueling expectations of an economic turnaround in the region.
While investors focused on the good news, troubles continued to simmer. In Europe, some minor steps were made towards solving the debt crisis with patchwork bailout deals arranged. Still, policymakers appeared reticent to admit the severity of the crisis and appeared reluctant to take the necessary policy actions to actually solve it. Meanwhile in Asia concerns were mounting over a slowdown in economic growth in China, which sent commodity prices tumbling, slowing the market gains for the S&P/TSX Composite Index in the first quarter.
Then, shortly after the clock struck midnight on the first day of April, the tone of the markets seemed to become more gloomy and fraught with worry – in other words, the worst of times. Volatility returned with a vengeance, as global equity markets were whipsawed with a ferocity that was reminiscent of 2008. Investor focus returned to the issues they chose to ignore during the first quarter, namely the European debt crisis and the economic slowdown in China.
In Europe, it was Greece, France and Spain that dominated investors’ attention. In Greece, investors were sent back to the polls yet again when coalition talks fell apart leaving the country with no government after the May election showed no clear cut winner. Concerns mounted that anti austerity parties would wrest control of the nation’s government.
In France, that scenario happened, as Nicolas Sarkozy lost the country’s election to socialist Francois Hollande, who created quite a worry with many of his election promises. Meanwhile in Spain banks received bailout funding from the government, but many concerns over the stability of the banking system remained. By the end of the first half, Europe was firmly in the grips of a recession, which was affecting economic growth around the world.
In China, economic growth has been slowing as demand at home falters and the European debt crisis drags on. Official estimates put the expected GDP growth for 2012 at 7.5%, the lowest level since 1990. This slowdown will have far reaching implications, particularly on the demand for commodities, which have been down sharply. This has hit very close to home as the S&P/TSX Composite Index is nearly half materials and energy stocks.
As we look towards the second half of the year, we are expecting more of the same. Many of the same issues that have affected the markets in the first half remain firmly entrenched. Europe continues to plod along, only making minor progress on their debt crisis, which will continue to weigh on growth in the region.
In China, economic growth is expected to remain positive, but well off the torrid pace set over much of the past decade. This will continue to put pressure on the demand and ultimately the price for commodities, particularly oil, which will weigh on Canadian equities. In the U.S., the economy is showing signs of recovery, but with the global headwinds of a slowdown, economic growth is expected to moderate. Given the global outlook, we don’t expect that interest rates will be moving higher in Canada during the second half of the year.
We expect that volatility will remain high. Given this, we remain focused on quality, both in equities and fixed income. For equities, we continue to avoid Europe as we feel that the risks are too high while the debt crisis is sorted out. Instead, our focus is on North American equities. We are focusing on actively managed funds that invest in high quality, dividend paying companies that have high quality management teams with a proven history of growing cash flow. We favour the U.S. over Canada slightly and are looking at funds that invest in stocks that offer high dividend yields, as they are expected to outperform in volatile markets.
For fixed income, again, the emphasis is on quality. Our focus is on funds that are actively managed and invest in a mix of government bond and high quality corporate credits. We expect that corporate bonds will outperform government bonds, however during periods of extreme volatility, government bonds will hold up better because of their safe haven status.
Our fund picks for the second half include:
PH&N Short Term Bond & Mortgage (PHN 250) – One of the best ways to protect your portfolio against the potential impact of rising interest rates is by shortening the duration of your fixed income holdings. This fund is a great way to do that because it invests in a mix of mortgages and short term bonds. It has a duration of 1.6 years compared to the broad DEX Universe Bond Index which has a duration of 6.7 years. The shorter the duration, the less impact a rise in interest rates will have on the value of your investment. While we don’t expect that rates will move substantially higher in the second half of the year, taking some steps to shorten duration over the next few months may prove beneficial over the long term.
PH&N Total Return Bond (PHN 340) – Corporate bonds have historically held their value better than government bonds in periods of rising interest rates. A big reason for this is corporate bonds tend to carry a higher coupon rate. With more than double the exposure to corporates than the DEX Universe Bond Index, this fund is better positioned for when rates do begin to rise. In addition, the managers have the flexibility to use some nontraditional strategies including investing high yield bonds, mortgages and derivative strategies, all of which are expected to help preserve value. Factor in one of the top bond management teams on the street, combined with a low MER and you have a winner for the current environment.
CI Signature High Income Fund (CIG 686) – If you are looking for a mix of income and capital gains, it doesn’t get a whole lot better than this fund. Managed by CI’s Signature Global Advisors, it invests in high yielding equities and corporate bonds. It pays a monthly distribution of $0.07 per unit, which is an annualized yield of approximately 6.1% at current prices. Performance has been strong, finishing in the first quartile every year except for 2008 and 2006 when it finished in the bottom quartile. It has a five year return of 3.8%, handily outpacing its benchmark and peer group. As of May 31 it holds 30% in foreign corporate bonds, 21% in Canadian equity and 13% in Canadian bonds. It also boasts an MER of 1.61%. We expect that this fund will continue to reward investors over the long term.
IA Clarington Canadian Conservative Equity (CCM 1300) – It has been shown many times that dividend paying stocks tend to hold up better in periods of market volatility and that over the long term, dividends make up a significant portion of a stock’s total return. That is the key reason why we like this fund for the current environment. With Europe expected to be a mess for some time and China in the midst of a slowdown, we expect that volatility in the equity markets will remain high. In that type of environment, this fund, with its emphasis on companies that pay a stable and growing stream of dividends, is expected to hold up better than most of its peers.
Beutel Goodman American Equity (BTG 774) – While not exactly setting a blistering pace on the economic growth front, it is widely expected that the U.S. equity markets will again be the best performer during the second half of the year. We are seeing strong corporate earnings, yet valuations particularly in the large cap space remain relatively low by historic standards. The Beutel Goodman American Equity Fund is well positioned for this environment. Its concentrated portfolio has a P/E ratio that is lower than the broader market and a dividend yield that is higher. Considering these factors, it is our expectation that this fund will continue to be one of the better performing U.S. equity funds on a risk adjusted basis.