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Third Quarter Review Don’t Fight the Fed. Equity markets rebounded in the third quarter: mostly on optimism that central bank intervention would revive a sluggish global economy and mitigate ongoing uncertainty in the euro zone. Notably, both the European Central Bank (ECB) and the U.S. Federal Reserve (Fed) took additional (and extraordinary) steps in their efforts to revive anemic economic activity. Investors seemed willing to dismiss somewhat mixed economic data and instead followed the old maxim: “Don’t fight the Fed”. All major markets advanced during the period, with Canada leading the way on the strength of rising commodity prices. The Canadian dollar was also stronger and therefore the gains in foreign markets were offset somewhat by the conversion to Canadian-dollar returns. For some time the ongoing euro-zone debt crisis has been a major depressant on the global economy and, in particular, stock prices. What has been missing to this point has been any firm commitment by the ECB to stand behind the euro. That changed in late July when ECB President Mario Draghi announced they would do “whatever it takes” to preserve the currency. His statement buoyed investor confidence. Further, last month the ECB announced that, effectively, they will be turning on the printing presses, much to Germany’s dismay. Specifically, the ECB vowed they will purchase an unlimited amount of bonds of struggling euro-zone members. Stock Marty Zweig markets rallied strongly on this news as, basically, it puts a cap on rising bond yields in both Spain and Italy. In America, Fed Chairman Ben Bernanke, concerned about weak employment growth, announced that the Fed would purchase $40 billion per month of mortgage-backed-securities indefinitely until a recovery is firmly established. Further, he extended their commitment to keep interest rates at current levels until 2015. Other central banks announced more modest measures, but Australia surprised markets in early October with a ¼ point drop in their interest rates. Canada was a primary beneficiary of these policy decisions as both gold and oil prices rallied on the news. On the one hand, commodity prices rose on improving sentiment for the global economy. On the other, concerns about Europe and the U.S. printing more money pushed some investors into “hard” assets like gold. In fixed income markets, bonds were relatively flat across the yield curve with all returns under 1% for the quarter. Overall, yields remain at extremely low levels, particularly on Canadian and U.S. government bonds. In the current environment, GICs continue to provide an attractive return premium over both government and even high-quality corporate bonds. Following are the returns for the major indices for the period ended September 30, 2012: rd Canadian Short Term (DEX 30-Day T Bill) Canadian Bonds (DEX Short Term Bond) Canadian Stocks (S&P/TSX Comp.) U.S. Stocks (S&P500) Non-North American Dev. Stocks (EAFE) Emerging Markets Stocks (MSCI Emerging) N Page 1 All returns in Canadian dollars. Source: SS&C Technologies and PalTrak 3 quarter actual 1 year actual 3 year annualized 5 year annualized 10 year annualized 0.2 0.7 7.0 2.7 3.2 4.0 0.9 2.2 9.2 23.3 7.7 10.7 0.7 3.4 5.5 10.0 -0.8 2.6 1.2 4.9 0.2 0.8 -5.5 -1.5 2.1 4.5 9.8 3.0 3.2 11.6 Outlook Leadership is solving problems. Very respectable market returns have unfolded in the first nine months of 2012, despite a complicated, even worrisome global environment. The future looks no less challenging for governments, other policymakers and consumers alike. There is little debate that global economic growth will be constrained for years to come as all participants must accomplish massive debt reduction to ensure their future prosperity. This is a tricky proposition since debt deleveraging by its nature means less spending, which means fewer goods purchased, which means fewer jobs needed, and so on. It sounds like a classic Catch-22. The question investors have is whether stocks can continue to thrive in such an environment. We would say that as long as everyone keeps their noses to the grindstone, so to speak, there is a good case to be made. Let’s look at the facts: First of all, we are finally seeing encouraging signs of monetary leadership in Europe, starting last June when the ECB announced its plan to monitor, insure, recapitalize or shut down banks as needed. More recently they introduced “outright monetary transactions” (OMTs), whereby the ECB directly purchases the sovereign bonds of a struggling member country by offering much lower rates than would be otherwise available in the open market. OMTs will be financed through a new bailout fund called the European Stability Mechanism. Prior to this, both Spain and Italy have had to finance their ten-year government bonds above 7%, an unsustainable level. Those same rates have now declined towards 5%. This is very important as interest on debt is becoming the largest expense for governments. For instance, if either Germany or the U.S. had to issue bonds at 7% versus the 1½%-2% they now enjoy, it would be calamitous for them too. These big announcements are merely the beginning of a long, arduous process which will require step-by-step action, but the agreement on a rough plan for such major issues is a refreshing first step in the right direction. Page 2 Colin Powell The U.S. will also require some groundbreaking policy leadership after the November 6th election. In order to avoid a future debt crisis of their own, leaders face the Herculean task of finding ways to keep the economy recovering, yet at the same time formulating credible plans to not only balance the budget but ultimately reduce debt. Almost certainly, the new Congress will have to address the touchy issue of “entitlements”, such as Social Security and Medicare, for example. But even before then, the lame-duck Congress must deal with the socalled “fiscal cliff”, a looming crisis of its own making. You may recall that in August of 2011 when faced with the debt ceiling impasse, Congress set the “far-off” deadline of December 31, 2012 to reach a bipartisan deal on deficit reduction….and now here they are with no deal. If no agreement is reached before year end, drastic, even arbitrary, spending cuts and tax increases (expiry of the Bush-era tax cuts) will automatically occur and almost certainly tip the U.S. back into recession. No one actually expects that to happen, but uncertainty lingers in the market and many businesses have delayed their own spending plans until it is resolved - plans that would boost growth and employment, by the way. Next year and beyond, markets will be focused less on who resides in the West Wing and more on whether there is a functioning Congress on Capitol Hill, one where, once again, bipartisan compromise and negotiation result in good governance. The heat is really being turned up as Washington grapples with finding ways to make meaningful progress on the deficit. “Problem identification” is a leading indicator of policy change and though it may be messy, deficit reduction will occur, if for no other reason than because the consequences of doing nothing are worse. A second reason to be constructive on stocks is this: monetary policy continues to be both supportive and creative. In the U.S., where interest rates are now at rock bottom, the Fed has found other unconventional ways to stimulate growth, such as the recently announced round of Quantitative Easing (QE3). Importantly, the Fed has also committed to keeping interest rates low for years to come. Similarly, in Europe, the ECB has maintained low interest rates and announced a number of other helpful initiatives (as discussed above). Clearly monetary policy has done its part to lay the foundation for economic recovery globally. While central banks still have some additional means at their disposal, it is now mostly up to governments to address their serious fiscal imbalances that otherwise threaten sustainable growth. Third, businesses are strong and profitable. In the headline news cycle this important fact is forgotten. Profits are at all-time highs and companies have stockpiles of cash. This is largely the result of cutting costs rather than increasing revenues, and without a pickup in future sales, further profit growth may be limited. Aggressive expansion of operations and hiring has been hampered by the weak global environment. Again, as governments repair their balance sheets, business decision-makers will pursue innovation and expansion, as they always have. In the meantime, investors are the direct beneficiaries: companies are using some reserves for dividend increases and share buybacks. Finally and perhaps surprisingly, valuations on stocks are cheap despite the recent run-up in prices. This is due to the worries we have discussed above which all boil down to frustration and uncertainty in the marketplace. European stocks are among the cheapest, given their more depressed economies and perceived political risk. Importantly for Page 3 investors, yields on stocks continue to outpace the yields on “credit-worthy” bonds. With additional dividend increases, this premium should widen further. As always, there is risk in owning stocks. Currently, the risks include: continued gridlock in Washington, any number of possible threats on the euro, as well as things we haven’t mentioned like a faster-than-expected slowdown in China or a pre-emptive strike on Iran. Setbacks are inevitable, but as we have noted many times in the past, risks and returns are related. These risks are well-known in the marketplace, and relative to bonds, the return potential is very favourable. With respect to bonds, yields are expected to stay very low for the foreseeable future. Milestone’s strategy is to maintain the highest quality issues using short- to mid-term maturities. This ensures capital preservation in almost all imaginable environments. The risk of loss is very low and the return potential is also very low, so in this environment, the main purpose of the asset class is to provide portfolios with essential price stability. In many respects, we are operating in an environment that sometimes feels like maneuvering through a minefield. Some “explosion” or other will likely cause temporary setbacks, but will not ultimately stop markets moving forward if the fundamentals are there. Progress through the minefield seems too slow and it is slow, but it is progress nevertheless. Therefore, investors must ensure that the asset class weightings in their portfolios are properly positioned to stay on course according to their carefully constructed risk parameters, such as time horizons, risk tolerance and risk capacity. This sounds like an old saw, but it’s true.