2013 looks to be the year of the enigma when stock markets flourish in spite of economic news that gives little reason for joy.
An armchair investor can look ahead with a degree of confidence that a broadly based investment strategy in Canadian large cap stocks and some exposure to American and global stocks will produce a good return.
Powering the rally
It helps to look under the hood to see what is powering this rally, for it is not obvious why a weak economy should support a strong investment market. In fact, corporate profits in Canada and the U.S. are up, driven by returning consumer confidence and, for capital-intensive industries, very low interest rates.
Corporate bonds have done very well as yield-hungry investors have bought up investment grade issues with yields to maturity of 3.5 to 4.5 per cent depending on term and rating. Big companies have been able to borrow at exceptionally low rates. Cheap money will strengthen their balance sheets and fatten shareholder dividends for years to come.
In bonds, corporate investment grade issues continue to have yields of 3.5 to 4.5 per cent or so to maturity. Provincial bonds have lower running yields, say 2.5 to 3.5 per cent for terms of five to 30 years, but their prices may rise in 2013 if only because they lagged Government of Canada issues in 2011 and corporate bonds in 2012. That would mean investors could buy an Ontario bond, get, say, a 2.8 per cent running yield and capture a capital gain of two per cent or so, if provincial bonds return to market favour. The downside is that if Canada remains mired in slow growth, then provincial finances may sour, provincial deficits may grow, and the prices of Ontario bonds could weaken further.
The wild card: China
The wild card in this mildly bullish outlook is China. If it has a hard landing and tumbles into a severe recession, then demand for Canadian resources will shrivel.
For off-farm investments, it’s fair to ask what’s reliable. For the next few years, bonds will pay modestly. When interest rates rise, government bonds and investment grade corporate bonds with terms over 10 years will suffer.
There is also a question of expectations. As David Rosenberg, the chief economist of Bay Street money management firm Gluskin Sheff notes, we are in a zero return environment in which there is vast excess capacity in the world, especially in the U.S., no threat of inflation, where safety and a zero return on assets is a reasonable baseline and in which every other return over insured bank accounts and government bonds has some risk of failure.
At the end of December, the U.S. Fed resumed outright bond purchasing. That has the effect of driving down short U.S. interest rates, but given that they are mostly below one per cent, there is not going to be much downside to this move.
Where to put your money
With all of that noted, the question — the bottom line — is where to put your money?
Dividend paying common stocks, such as BCE Inc. with its five per cent yield, bank stocks with yields of 3.5 to 4.5 per cent, shares of regulated electrical utilities with yields of four to seven per cent, and large cap consumer staples companies like grocery stores with yields of two to four per cent all look good.
Dividends represent 80 per cent of returns on common stocks. They are a backstop if stock prices tumble. The biggest companies almost never cut dividends, for if they did, their future costs of raising money would soar. Investors would no longer trust them. No chartered bank cut its dividend in the 2008-09 credit crisis and none is likely to do so in the foreseeable future. Note that this forecast does not apply to large American banks nor to big European banks, which seem to have a rare ability to be where trouble lies.
Where not to go
Where one should not be in 2013 and onward is the corresponding question.
I would suggest that speculating in housing is a bad idea. Buying a home for yourself and perhaps for resale after the kids are grown is reasonable. But speculation is not, for the ability of young families to buy homes is declining. The way our parents got retirement money was often through sale of homes to people just starting out. Now that does not work, for the price of housing in most cities has risen faster than individual incomes.
There is a house construction revival, very mild and meek, in the U.S. It will be sustained only if the U.S. economy returns to strength. This is a double bet a conservative investor would not take.
A final word: Diversify. A November, 2012 survey by Bloomberg of economists’ predictions on interest rates trends since 2001 showed that 97 per cent of the economists’ trend forecasts were wrong. We are in a time in which conventional macroeconomics does not work. Interest rates are now controlled by central banks, not markets. To survive in this climate, you need, in poker-speak, a full house of investments: farm land, dividend-paying common stocks, perhaps some investment grade corporate bonds with terms of seven years or less — they won’t suffer too much when interest rates rise, a hefty bank balance, and a lot of patience.
This time of troubles will end, for every trend is just that, a temporary thing. Until then, defensive investing and diversification will separate the winners from the losers. †