Week 14 - Current Thoughts

Here are a couple of current thoughts that you might be having. I actually took this from a letter to clients recently. Enjoy.

Interest Rates

Hopefully we are seeing the world’s major economies emerge from the depths of recession. Some are doing it faster than others but data from all over the world seems fairly positive. Whenever this happens we turn our attention to interest rates, which are still near all-time lows. If our economy strengthens, then it should follow that inflation becomes a concern and hence interest rates will rise. I think this is the case, although I don’t think it will happen as rapidly as some might expect. In my opinion, you might see our central bank raise rates by 1% or so over the next year but that might be about it, for a few reasons:

1) The U.S. dollar. Because our largest trading partner is directly south of us, we do not want to have a dollar that is worth much more than theirs. They will pay for things we make in U.S. dollars, while we make them by paying for the materials in Canadian dollars. I would expect our government to be cautious when considering further rate hikes.

2) Our economy. I don’t think it’s as strong as one might be led to believe by the data. In the U.S., you could look back as far as 10 years before seeing any kind of meaningful economic growth. Before this recession, Americans were refinancing their homes based on higher property values and spending this ‘found money’ on ‘stuff’, like TVs and cars. Any job growth from this housing bubble was unsustainable, as we later found out and now the unemployment rate is at about 9.5% in America. Before then, it was the internet bubble. During this time, it was not uncommon for stocks to trade at enormous premiums, which again tricked the investor into thinking they were worth more than they really were. Prices were based on future promise, rather than current fundamentals. In either case, jobs were created based on unsustainable market conditions. For that reason, I don’t think we will see any meaningful job creation (and hence economic growth) in America until they can find a sustainable source of employment. They have been losing jobs for years to overseas competition and real replacement hasn’t happened. As Canadians, we should prepare ourselves for a decreased demand from the US, and hence a decreased level of job creation as well.

The moral of the story is that we are probably in for an extended period of relatively low interest rates. I wouldn’t be rushing out to lock in your mortgage today; I think you might be safe with that sweet variable rate for the time being. Don’t quote me on it though – my crystal ball has been known to falter, from time to time.

Sovereign Debt

This is the other topic that most of us have heard about in the last few months. Many European nations have been struggling with the recovery, having to implement stimulus packages for their economies that they really couldn’t afford. We need to think about countries the same way we think about companies – they have revenue (taxes) and expenses. If the expenses outnumber the revenues, then they will eventually be in trouble and need external support. This is nothing new, as it has happened all over the world throughout history.

What worries us is something called ‘contagion’. This term suggests that if one country defaults on their debt, then other countries that hold the first country’s debt could also default. This could be the case with Greece, Portugal and others but my thought is that we learn from our mistakes. I would be shocked to see anything meaningful come out of this situation, other than a big bailout from either the other members of the European Union or the International Monetary Fund. Either way, none of my clients are holding Greek bonds, so we really don’t have much to worry about. Even our international equity mutual funds would have zero exposure to Greek debt (although I’m sure a couple of them wouldn’t mind doing a little bargain hunting).

Income Trust Conversion

As you probably have heard, by the end of this year all income trusts must start paying corporate income tax, thanks to Jim Flaherty back in 2006. Because of this, many of us have been wondering what is going to happen to our beloved income generating investments. Here’s a very short answer that many people don’t seem to be considering:

“Income trusts are going to pay corporate income tax at the end of this year”.

That’s it. Nothing else about their business models have changed. Yes, they are going to convert to regular corporations for the most part. All else being equal, they could reduce their distributions by the exact percentage of tax that they now have to pay. In many cases, this could result in a stock that still pays a very handsome dividend, which is much more favourable from our tax perspective. Instead of ignoring the income trust universe, we have actually been trying to look at good examples of trusts that would make great companies, paying handsome dividends. I wrote about this last May, when we first started the process of identifying these trusts. Since April 1st, 2009, the income trust total return index is up more than 60%. I don’t think we’re in for another similar 12-month return but I do think there are great investment opportunities in this space.

That's all I have for now. I hope you enjoyed the column. It was a bit more technical than some others I have written. Have a great week.