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MDPerspectives May 2012 Modest growth in investor confidence amid continued volatility Policy-makers remain central to shoring up confidence in economic growth There was no fear that investor optimism would grow unchecked in the first quarter of 2012, but compared with the very start of the year, investors were feeling confident enough to send most major indices higher over the quarter. We see signs that investors are growing ever more prepared to focus on positive fundamentals and, at the same time, are becoming less susceptible to reacting to the latest headlines. However, investor patience will no doubt be tested in the second quarter as markets continue to deliver volatile performance. 10-year benchmark government bond yield is hovering near 2.0%, while Bank of Canada core inflation came in at 2.3% in February, implying a negative real yield for these bonds. The news headlines have also become somewhat more encouraging. The eurozone still faces challenges, but, for the time being, appears to have avoided an economic meltdown. The U.S. economy continues to send signals that it is on the mend, with job growth trending in the right direction. The Bank of Canada’s Business Outlook Survey for the first quarter found 58% of firms expect their sales to increase over the next 12 months—the best result since early 2010. Capital markets also inched toward a more optimistic outlook as the quarter unfolded. One important indicator of this was that stock movements were The S&P/TSX Composite Index was up 4.4% in the first quarter. U.S. markets fared even better, setting the pace for global equity markets. The S&P 500 Index was up 12.6% in U.S. dollar terms and 10.5% higher in Canadian dollars in the first quarter. It hit a four-year high in March. The MSCI World Index finished 11.6% higher in local currency terms and up 9.8% in Canadian dollars. The MSCI Europe, Australasia and Far East (EAFE) Index was up 11% in local currency terms and 8.9% higher in Canadian dollars. Canadian fixed income, specifically government of Canada bonds, continue to be attractive to both local and international investors. The Canadian Highlights } U.S. consumer picture slowly improving } International trade grew for two consecutive months } Tax-wise investing: Understanding asset allocation for the incorporated physician Financial Practice Living md.cma.ca less correlated with other assets than during the second half of last year. In 2011, as nervous investors worried about European defaults, different investments moved in concert. Market sentiment alternated—often daily— between optimism and pessimism. On days when optimism dominated, riskier assets like commodities and stocks rallied together. On days when investor fears peaked, almost any investment that was perceived as risky would decline in value. Meanwhile, emerging-market economies continued to report gross domestic product (GDP) results for 2011 that reinforce a story of growth that outpaces developed markets. At the same time, this growth has slowed since March 2010, easing emerging-country inflation pressures. Inflation remains a key concern because, if emerging economies show signs of overheating, authorities will likely raise interest rates to dampen growth—something that would likely reduce demand for exports in the long run from countries like Canada. On the aggregate, inflation in the emerging-market economies continued to decline, providing further flexibility in terms of monetary policy. Chinese inflation declined to 3.2% in February from 4.5% in January, and is currently well below the target rate of 4%. Inflation in Brazil and Russia declined to 5.8% and 3.7% in February from 6.2% and 4.2% in January. While inflation declined for the majority of emerging economies, India experienced an increase of 7.5% in February, up from 5.3% a month earlier. One of the more worrisome risks for inflation is that energy, particularly oil, may get more expensive because of escalating tensions in the Middle East. In this environment, we still believe the global economy will continue to expand at a two-speed pace, with emerging economies leading the way. Comparing first-quarter GDP annual growth against the same period in 2011 illustrates this point. First-quarter GDP was 2.2% higher in Canada and 1.6% in the United States. Meanwhile, China’s GDP expanded by 8.9%, year over year, in the first quarter. Over the same time frame, India’s GDP expanded by 6.1%. Longer term, Canada is well positioned to prosper in this two-speed economy. Over time, Canadian resource companies will continue to benefit from the stronger growth trend expected in emerging economies compared with developed markets. But, for now, investors are more focused on policymakers’ efforts to contain Europe’s debt crisis. Whether our view of a two-speed recovery, with only moderate growth in advanced economies, plays out will depend on three factors: policy-makers, U.S. consumers and international trade. Together, they hold the key to understanding this year’s growth picture. Policy-makers—including politicians, central bankers and key bureaucrats—will continue to be the most important factor in keeping the global economy on the path of continued growth. It is also important to note that policy-makers need to do more to convince investors that their measures to stimulate the economy and address the European crisis are going to deliver on their promise. Policy-makers will remain under intense scrutiny Policy-makers will continue to have significant influence on both economic and market conditions. The uncertainty resulting from the need for unusual levels of intervention will be an important influence on market participants. They will continue to look for ongoing reassurance of a return to stability in the global economic environment. Reform-minded political leaders in Greece, Spain and Italy should help reduce political shocks to the market and provide needed reassurance about a return to stability. Greece faces a general election on May 6, however, which could leave the two main parties unable to form a government. In that case, current Prime Minister Lucas Papademos, a former vice president of the European Central Bank and labelled a “technocrat”, might be forced to remain in power to resolve the situation. This may not be unwelcome news if the market sees Papademos as the one person who can actually deliver on promises of reform. In mid-February, Papademos won cabinet approval for deeper budget cuts needed to secure a second package of international financial aid. Spanish bond yields faced renewed pressure. The Spanish minister for the economy, Luis de Guindos, has said Spain may sell off public real estate. De Guindos continues to stress the country’s commitment to reform. Spain remains under intense pressure from Europe to curb spending, because of growing fears that the European Union’s fifth biggest economy may need a bailout. 2 M D P E R S P EC T I VE S Italy’s borrowing costs are also rising, with the yield on the 10-year bond at 5.6% in early April. Markets are waiting to see if Prime Minister Mario Monti, another economist by training, like Papademos, who was appointed to lead a technocratic cabinet focused on reforms, can deliver. He has angered many with his plans for labour reform. The idea of a more flexible job market, along the lines of what is seen in North America and the United Kingdom, has given markets hope that Italy is on the right path. Closer to home, gridlock in the U.S. political system has eroded consumer and business confidence. While there is potential for more uncertainty from lawmakers, investors seem content to focus primarily on economic data until after the presidential election, slated for later this year. U.S. consumer picture slowly improving U.S. consumers remain the world’s most important economic engine. Spending by U.S. consumers accounts for about 70% of U.S. GDP, and this spending in turn accounts for about 20% of global GDP. Without sustained demand from U.S. consumers, the global economy cannot continue to expand at a sustainable rate. Housing and employment are the two keys to helping consumers recover. Minutes from the U.S. Federal Reserve’s last meeting showed policy-makers backing away from the need to begin a third round of monetary stimulus to boost the economy as the recovery gradually improves. The March slowdown in hiring will likely prove to be temporary, but job growth was still strong enough for the unemployment rate to edge down to a three-year low of 8.2% in March. The U.S. economy, in its third year of expansion, is better equipped to overcome rising energy costs and a slowdown in European economic growth. Growing business optimism, based on improving sales and profits, may give business leaders the confidence to take on staff more quickly. Home prices are a key component of consumer wealth. Housing starts in the United States were near a three-year high and building permits rose in February. This added to growing sentiment that the industry that sparked the financial crisis is finally stabilizing, though at a low level. Demand for previously owned houses advanced in February to the highest level since May 2010, according to economists surveyed by Bloomberg. Of course, the U.S. housing market will not turn around in a matter of months. But these recent developments suggest that a slow recovery could be unfolding. Home prices are a key component of consumer wealth. Housing starts in the United States were near a three-year high and building permits rose in February. This added to growingsentiment that the industry that sparked the financial crisis is finally stabilizing, though at a low level. 3 M D P E R S P ECT I V E S International trade grew for two consecutivemonths World trade volume grew by 0.9% in January, following a revised rise of 0.9% in December, according to data released in late March by the CPB Netherlands Bureau for Economic Policy Analysis. Imports expanded strongly in most advanced and emerging economies, most notably in Japan. But in emerging Asia, imports declined. European imports grew for the first time since August. Regional differences are also more stark when it comes to exports, with strong figures for the United States and Japan, a decline in emerging Asia and a continuing decline in Europe. These trade figures are largely in keeping with our central scenario of two-speed economic growth. We still believe the global economy will continue to expand, with emerging economies leading the way. Cautious optimism tempered by expectations of volatility We are tempering our cautiously optimistic stance about economic growth, as the ongoing global economic recovery grinds along. We continue to expect the global economy to grow slowly over the next four or five years. Volatility will remain a fact of life, given the many uncertainties facing the world. Looking beyond the headlines and focusing on investment fundamentals remains the correct approach. We continue to encourage you to work closely with your MD advisor to focus on your portfolio’s purpose and time horizon, with a view to rebalancing so that your current mix of investments matches your long-term strategic asset mix. Now is an ideal time to revisit your longterm financial plan and ensure that you are up to date with the appropriate strategic asset mix. To make sure that you are in the best position to keep your financial future on track in the face of emerging economic opportunities, talk with your MD advisor, or call MD at 1 800 267-2332 to be put in touch with an MD advisor near you. n Tax-wise investing: Understanding asset location for the incorporated physician As an investor, you are already familiar with the concept of asset allocation: the investment strategy that attempts to balance risk and reward by adjusting the percentage of each asset in an investment portfolio according to your risk tolerance, goals and investment time frame. And you likely already know that once you have selected the appropriate asset allocation for your situation, the next step is to implement the appropriate asset location, or choosing where to put each kind of investment. That is because different types of assets give rise to different forms of investment gains, such as capital gains and dividends (for equities) and interest income (for bonds and other fixed income)—and each of these is subject, in turn, to varying tax treatment. In brief: Interest is generally taxable at your highest marginal rate as it is received, while both capital gains and dividends receive preferential tax treatment, compared with interest income. Beyond asset allocation— to asset location The varying tax treatment of different kinds of investment return means that tax-wise investors will locate their assets in accordance with the tax treatment they will get in different kinds of investment accounts. As a general rule, you would probably opt to hold investments that produce interest income in registered accounts, such as RRSPs, which allow you to defer tax on this income until you begin to withdraw from the account—and you would put investments that are expected to produce capital gains and dividends in nonregistered accounts. Of course, these general rules have exceptions. Our advisors can provide helpful insights to apply to your specific situation and preferences. Impacts for the incorporated physician So, how does all of this affect the physician who is incorporated? At the most basic level, adding a corporate investment account means you have one more location to house your assets. As a general guide, while maintaining the same overall portfolio risk and adhering to the overall asset allocation strategy you have already selected, tax-wise, investing for the incorporated physician will continue to guide us to put investments that are expected to produce capital gains in your non-registered accounts—which now includes your corporate account. How we can help In addition to the asset location decision, there are a number of other important tax implications associated with investing inside your professional incorporation. Whether you have made the decision to incorporate or not, it can be useful to understand how incorporation can affect your asset location decisions. MD has the in-house expertise and tools to help guide you through these issues—which can be important, as getting the right input at the outset could save you thousands of dollars in taxes over the course of your investing life. We are also experienced at working with your professional tax advisor to apply the proper insights to your specific situation. We will help define a strategy to set you on the right course. Contact your MD advisor today. n Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. To obtain a copy of the prospectus, please call your MD advisor, or the MD TradeCentre at 1 800 267-2332. MD Physician Services provides financial products and services, the MD family of mutual funds, investment counselling services and practice management products and 4services M D P Ethrough R S P ECT I VMD E S group of companies. For a detailed list of these companies, visit md.cma.ca. the 4 M D P E R S P ECT I V E S INV-12-00204 The information contained in these documents is not to be considered investment advice. Please consult your MD advisor before making investment decisions or implementing any investment strategy.