Quarterly Investment Commentary
Fall 2011
Suite 213 5455 152nd St.

Surrey BC Canada

Tel (604) 576 - 8908

Recession Fears:
What’s an investor to do?
In This Issue:


Interest moderate


rates are at generational lows as central banks try to create an environment conducive to growth.

Recession: Valuations: Bonds:


recession appears to be priced into the market. Current valua-

tions of stocks are pricing in a slowing economy. Are overbought by

he past three months have been the toughest for investors since the last quarter of 2008 when the financial crisis deepened after the collapse of Lehman Brothers. When the crisis and corresponding recession ended in 2009 it was believed by many that with governments and central banks around the world united in maintaining an accommodative economic policy the financial storm had passed. Instead, what has happened is that the financial crisis has gone from being a mortgage debt crisis to a sovereign debt crisis. Rather than things getting back to normal, the global economy has been thrown into the much talked about new normal.

most measures and only an economic worst case scenario would make them attractive at these levels.

Visit to view our latest commentary

The phrase "new normal" is used to denote a new era in which economies grow much slower than what many had become accustomed to. The reason for this period of slow growth results from the need by consumers “...seldom in hisand governments alike to tory have corpobegin paying down the rate balance massive accumulation of debt that we witnessed sheets been as over the last few decpristine as they ades. So, rather than investing and consuming, are now…” consumers and governments are cutting back. However, Notably missing from the over indebted list are corporations. In fact, seldom in history have corporate balance sheets been as pristine as they are now, with cash representing a record high percentage of corporate assets. The borrowing capacity and incentive to borrow for corporations is also

significant with interest rates at their lowest since the 1950s. Corporations can now borrow cheaply for expansion, stock buybacks or for acquisitions of competitors.

Interest Rates

As usual, the arguments from the economic bears are easier to observe: European debt crisis, deleveraging consumers, Asian slowdown, etc. After all, it is easier to see the dangers in volatile times than the opportunities. the optimists point to such metrics as the yield curve (the relationship between short term and longer term interest rates). When short term interest rates are equal to or exceed longer term interest rates a recession has often followed.
Continued on page 2

pg 2
Continued from page 1

Generally, in such an interest rate environment, lending activity tends to decline as the profitability that comes from it erodes. This acts as a brake on the economy. If we look at the state of the yield curve as shown in the chart below, we can see that we have the steepest yield curve in two generations. However, as is usual with the capital markets, there is a ―but this time is different‖ as-

The level of debate and consideration of economic policy is at perhaps a modern day low point and the markets have noticed. The debt ceiling debacle in August shows how little the politicians seem to understand the issues. Worse, some investors fear that perhaps they do understand and are simply risking it all for political grandstanding with their constituents. Part of the reason that Standard & Poor’s stripped away the AAA rating of US

Source: St Louis Fed

pect to note: the central reason that the yield curve is this steep is because of the US Federal Reserve has wrestled down interest rates through various policy measures down and controlled. Therefore, some argue that it is artificially steep.

The Fed & Politics Don’t Mix
Unfortunately for the Federal Reserve, it has come under attack from an unprecedented number of critics that includes investors, economists and even politicians. It has become good politics to take aim at the Fed from both Democrats and Republicans energized by voters languishing from the weak economy. For now, it seems as if The Fed has done about all it can do for the economy. It seems as if Ben Bernanke is rolling the world’s economic boulder up the hill all by himself. Some help has to come from the White House and Congress. Therein lies the problem.

government bonds is because they could not see how the legislative process will produce a reasonable and meaningful debt reduction strategy. In all honesty, whether the politicians admit it or not, tax increases are going to have to be part of the solution but spending cuts will have to be the lion’s share of any reduction in debt and deficits.

Reasons for Confidence
In recent weeks, markets have taken some confidence from economic data pertaining to jobs (steady), manufacturing (expanding), credit spreads (holding) and retail sales (rising). Though the markets are weighing the probabilities of a recession, data would suggest measuring the odds of recession is more difficult now. Additional measures that should help the economy are a drop in oil prices, fixing the disruption of the Japanese
Continued on page 3

pg 3
Continued from page 2

global supply chain following this year’s earthquake, and a fall in global commodity prices. This later will ease the inflationary pressures that have been rising across the world. In recent weeks, some of the emerging market nations have begun to cut interest rates again. Interestingly, China and India remain vigilant on the inflation front whereas Brazil has begun cutting interest rates. When 2011 began, most strategists maintained a bullish outlook for the year because the third year of a presidential term has historically provided impressive stock market returns (see chart this page), a surprising U-turn in tax cut policy from the White House, and the continued after effects from the Fed's Quantitative Easing Program (QE II) .

The Challenges
From our perspective, our concerns were that QEII would have unintended consequences, the economic data was continuing to surprise on the downside and corporate profit margins were approaching the all-time highs seen in 2007. Currently, corporate profits as a percentage of GDP in the US are at an all-time high and maintaining these levels will be difficult.

Likewise, for the US economy, The Economist magazine states that the average US household has seen its inflation adjusted income stuck at the levels of 1989. For the lowest income households, incomes are on par with those of the late 1970s. This is in part due to low income households tending to have lower levels of education that leave them without the skills required to compete in a more globalized economy. It should also be noted that US state and local governments have been reducing their employment roles as they continue to work towards reducing their own budget deficits. To help offset this, President Obama has proposed a jobs bill, but it has little probability of passing the Senate or the US House of Representatives.

As unemployment has continued to remain stubbornly elevated, wages as a percent of GDP are at the lowest European Woes level since 1955 while corporate profits are at the largest The risk priced into stocks reflects concerns share of GDP since 1950. One reason that about Europe and a slowing global economy. US consumers have been reluctant to ramp “...the data of these is all but up credit again is that they want to pay down would suggest The latterInvestor confidence priced into equity markets. in European potheir debt levels and the statistics seem to measuring the litical leaders is seldom overflowing – but the bear this out. As US consumers pay their debt down, Canadians have run up conodds of reces- divisions amongst European politicians prevent them from confronting their common chalsumer debt to alarming levels. Even the Orsion is more dif- lenges in a forceful manner. ganization for Economic Co-operation and Development (OECD) has mentioned the ficult now” The debt crisis facing much of Europe has debt levels of Canadians as posing a challenge to Cancaused fear to ripple across the globe. ada’s economic prosperity going forward. Canadian debts have risen as incomes have remained largely stagnant.
Continued on page 4

pg 4
Continued from page 3

The decline in global equity markets has likely incorporated providing dividend yields that exceed Treasury bond interthe downside of a recession. By some measures equity marest rates – something which has not happened since the kets are the cheapest we have seen since the 1970s. By early 1950s. The equity risk premium is elevated such other measures, the market is at worst fairly valued. Historithat investors are being compensated for taking risks in cally, recessions have brought about a decline in markets equities. In short, risk should be on. The problem is and corporate earnings by approximately one Europe. This muddies the waters to “...investors who fa- say the least. third. At this point, a moderate recession would be quite tolerated by the markets. A significant, protracted economic decline would obviously pose a challenge. It seems that the global economy has faced down some significant challenges and continues to grind along at a somewhat subdued pace but a recession could possibly be avoided as recent data point out.

vor bonds to equities at current valuation levels may find that there is risk in safety...”

In Summary

A resolution to the challenges facing Europe would lift the most significant anchor weighing down upon the global economy. Germany and France are leading European efforts to get a grip on the debt problem but there is a significant disagreement amongst them. This comes from the fact that French banks are much more exposed to European sovereign debt than German banks and therefore, France wants to see a more comprehensive solution to the crisis. At this point, Greek bonds are priced for default. There is no way for Greece to payback the money it owes – especially, as its economy shrinks under the IMF and EU imposed austerity program.

Stock market valuation indicators point to equities being attractively valued and especially so relative to bonds. investors who favor bonds to equities at current valuation levels may find that there is risk in safety and thus, we believe that equities are the better alternative for investors given the attractive valuations. For bonds to offer more upside than downside from these levels would require a severe economic decline and a deflationary undertone to the economy—something that the data thus far does not support.

Fall Speaker Series

Opportunities & Risks
As we have maintained a cautious approach since the turn of the year – recognizing that the markets were likely underappreciating the risks going forward in 2011, investors must now begin to take stock of the opportunities that the broad based global selloff in equities has provided. While there are considerable risks to the macro landscape, equity markets are showing the cheapest valuations in perhaps thirty years. Not only is the market providing compelling valuations on a price/earnings (P/E) and price/book (P/B) basis, stocks are
The information in this newsletter is current as at September 30, 2011, and does not necessarily reflect subsequent market events and conditions. This newsletter is published for information purposes only and articles do not provide individual financial, legal, tax or investment advice. Past performance is not indicative of future performance. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance. The statements and statistics contained herein are based on material believed to be reliable, but are not guaranteed to be accurate or complete. Particular investments or trading strategies should be evaluated relative to each individual’s objectives in consultation

Dallas Texas Nov 13th Houston Texas Nov 18th Simon Fraser University Nov 30th Contact us to learn more

with their legal, investment and/or tax advisor. Pacifica Partners Inc. is not liable for any errors or omissions in the information or for any loss or damage suffered. Pacifica Partners Inc. and/or its officers, directors, or representatives may hold some of the securities mentioned herein and may from time to time purchase and/ pr sell same on the stock market or otherwise. No part of this publication may be reproduced without the expressed written consent of Pacifica Partners Inc. Pacifica Partners is a Registered Investment Advisor in the US and a Portfolio Manager in certain Canadian Provinces. © 2011. Pacifica Partners Inc. All rights reserved.

Contact us:
Suite 213, 5455-152nd Street Surrey ● BC ● Canada ● V3S 5A5
Tel: Fax: Toll Free: Email: 604.576.8908 604.574.2096 1.877.576.8908

Sign up to vote on this title
UsefulNot useful