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Investing against the odds

It is a custom in the press to spend the first part of a new year predicting what will happen in the remainder of the year. Keeping the custom, I am going to do it, at considerable risk to my reputation as a conservative, reasonably trustworthy guy.

What to do?

At the moment, we are at a rare point in the investment world in which the current or running yield on government bonds or Guaranteed Investment Certificates (GICs), bank accounts and anything else that is well insulated from turmoil is in a range from almost nothing to about three per cent for five-year commitments. Take off inflation that the Bank of Canada wants to hold at about 2.5 per cent and some tax, and even that five-year three per cent return looks like a long run loser.

So what to do? Stock dividends from Canadian chartered banks and utilities, pipelines and life insurance companies are three to five per cent and these offer a dividend tax credit that pushes their yield up by a quarter to 3.75 per cent to 6.25 per cent. That’s not bad in tough times, but there are risks. Banks are leveraged lenders and could cut their dividends if they have massive losses. Insurance companies are leveraged on their stock portfolios. If you’ve followed the decline of Manulife shares since 2008, when they averaged $40 per share to now when they are at $11 and change, you know what I mean. Pipelines and utilities are more solid shots and, as heavy borrowers in the bond market, they are actually able to translate low interest rates into higher earnings.

But things could change. Iran has been threatening to shut down the Straits of Hormuz, through which much Middle East oil flows. If they do that, they would drive the price of oil up to an estimated US$125 per barrel. That’s good if you own oil companies but bad if you depend on oil at a reasonable price to run your combine.

“The developed world’s economy is still weak, so there is a lot of vulnerability to rising oil prices,” says Sal Pellettieri, a former hedge fund manager and now private investor in Winnipeg. “Oil is up 32 per cent in the last three months, and oil stocks are up 16 per cent. The play is on the commodity, because the market does not believe that these high oil prices are sustainable.”

Oil could be the fulcrum on which the teeter totter of stocks versus bonds tilts. If oil were to stay well over US$100 per barrel, say US$125 to US$150, a global recession would be a sure thing. Stocks would tumble, headline inflation that includes energy costs would rise, and central banks would try to push down interest rates to compensate for the rising Consumer Price Index. That would push up the prices of existing bonds, the interest payments on which would look more attractive. Long bonds could turn in another banner year.

Bonds in 2011

In 2011, U.S. Treasury bonds with maturities of 10 or more years gained 25.6 per cent. The Canadian all-bond index called the DEX gained 9.6 per cent for the year. Investment grade bonds in Canada and the U.S. gained in price as European fixed income investors fled Greek, Spanish and Italian bonds and headed for cover to relatively safe countries like Canada and Australia, each a AAA credit.

The U.S. gained from the flight from jeopardy in Europe not because its public debt is well managed, but because U.S. Treasury bonds are the deepest and most liquid market in the world. If you are the manager of, say, US$50 billion in insurance company reserves and you need to store US$10 billion for a couple of weeks, only the U.S. T-bond market can take the money in one day’s transactions. Any other market would blow up with that kind of a sudden inflow. That’s what’s happened to the Swiss bond market where money seeking refuge has driven up the value of the Swiss Franc, much to the horror of Swiss exporters trying to sell to their largest European markets that use the beleaguered Euro.

Bet on the underdog?

It is a law of capital market that all sectors revert to the mean. What’s more, they tend to do so in yearly moves. Just playing this concept, which is a statistical reality, you could put money into 2011 underachievers. Top candidates: Asia-Pacific stocks that were down 14 per cent last year. A recession in China driven by the nation’s overbuilt housing sector (sound familiar, eh?) could wreck that plan, however. Canadian small cap stocks that were down 11 per cent in 2011 could have a bounceback if the larger stock indices go up.

Emerging markets stocks that were down 15 per cent in 2011 could also head up if the developed markets return to health.

Global economy

The two factors driving the global economy will determine much of what happens in stocks and bonds. Betting on bonds is risky, for after a banner year in which long government issues beat everything else, some give back is likely. The recessionary scenario is a shot in the dark. To bet on a further fall in interest rates, you have to assume that Iran will choke off a lot of world oil tanker traffic and maintain the chokehold for a few months. One hesitates to say that the regime in Tehran is reasonable, but they should recognize their own interests in keeping oil flowing.

The expansionary bet is easier to make. There is a good chance that the wizards of finance in Frankfurt, where the European Central Bank is based, and in Brussels, where the bureaucrats of the European Union run things, will work out a deal to keep the Euro in business and the 17 European Union countries that use the Euro solvent. Except Greece, the bonds of which are now priced to yield almost 39 per cent — a theoretical return that assumes default. The faultless German sovereign long bonds called Bunds, by comparison, yield 2.5 per cent.

What to do with off-farm money? Trying to forecast what Iranian mullahs may do in 2012 is impossible. Likewise, a bet on U.S. T-bonds or Government of Canada bonds tied directly to interest rate policy of the two governments is tough.

“You would have ague that the yield on Government of Canada bonds would fall to one per cent for 10 years to replicate last year’s performance,” says Chris Kresic, partner and co-lead for fixed income at Jarislowsky Fraser Ltd. in Toronto. “You would only see that in a deflationary or recessionary environment. Historically, real yields have been about 2.5 per cent, so even now with two per cent nominal yield on the 10-year Canada, the market is pricing in 0.5 per cent deflation for the next ten years. The Bank of Canada target is two per cent inflation, so I find it hard to believe you will get the deflation figure.”

The most conservative bet one can make in this environment of unpredictable religious figures in the Middle East in charge of world oil prices and the statistical improbability of a second year of hot bond performance is, paradoxically, to straddle the risks. Investment grade corporate bonds pay 300 to 400 basis points more than Government of Canada bonds of similar term. (There are 100 basis points in one percentage point). Even if interest rates rise, they won’t go up much and the yield premium on investment grade corporate will be intact. There is usually a good bump up in yields at the five year mark, so buying a seven- or eight- or 10-year bond carries a nice premium.

An alternative is to buy common stocks with four per cent to five per cent dividends from Canadian chartered banks and utilities. Dividends rise over time and therefore compensate shareholders for some of the risk of being in stocks.

There is no sure thing in a troubled world. The most important goals are, first, not to lose money and second, not to lose sleep. Mid-term investment grade corporate bonds and solid Canadian bank and utility stocks with stout dividends are conservative plays in a trouble world. For off-farm investments, they are about as safe as any investment other than cash or cash-equivalent short term bonds that pay zilch. †

About the author


Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.



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