I’ll start my first marketing column of 2009 with a look back at 2008 and then a look forward to the year ahead

Written January 10, 2009

What a volatile year 2008 was for all markets. The TSX composite index plunged 40 per cent from start to finish of 2008, while the Dow industrials lost 36.2 per cent, the biggest drop since 1931 when the Great Depression sent the blue-chip average reeling 40.6 per cent. Standard & Poor’s 500 index recorded the biggest drop since its creation in 1957, down 40.9 per cent year-to-date.

In Asia, Japan’s Nikkei 225 stock average is down 42 per cent, its worst annual performance ever as a strong yen and the global downturn hit key exporting stocks. South Korea’s Kospi fell 40.8 per cent for the year, its biggest decline since plunging 50.9 per cent in 2000. It’s the same story all over it seems, as recessionary forces have worked their global magic.

Stock markets, though, have rallied with the start of 2009.

Looking back

The commodity rally of the first half of 2008 certainly caught world attention, sending the energy sector, corn, soybeans, wheat, canola, barley, peas and more to all-time highs.

The financial uncertainty and economic turmoil of those record prices contributed to a then record-setting price plunge in the second half of 2008. Other world issues also influenced the most volatile year ever seen in the ag industry.

At midpoint 2008, with the whole commodity market sector tapping its zenith in terms of price highs, a process of unwinding quickly developed. This hammered the sector down with the rest of a deteriorating stock market and any other kind of risk asset.

Commodities until end of June start of July had avoided the debacle of the unwinding of the credit instruments and mortgage industry highjinks. The commodities were the last to go down, which is sort of characteristic of where they should fit into the cycle.

And as the year wrapped up, grain traders focused on short-covering to square positions, but kept a close eye on trade in crude oil and the currency sector. Grain and oilseed markets also turned their attention to drought conditions in South America.

Hindsight is 20/20

I, like everyone else, wish we were smarter back in the summer. But history was being made, with markets reacting quicker and more harshly than at any time in history. Everyone got hurt. No one was spared.

This is a classic case of everything being priced at the margin. We had a six-year commodity bull market because demand was always a little stronger than supply. In agriculture, we saw that as almost a perfect storm through 2007 and midway through 2008.

What started better than two years ago with the biofuel buzz, then transitioned in emerging Asian food demand (with incomes and gross domestic product growth rates accelerating) and was goosed with ag production shortfalls in 2007. (That year had drought in former Soviet Union states and Australia, wet harvest in Europe and yield declines in North America.)

Producers around the world responded to record high prices with a phenomenal 2008 crop. Global ending stocks are projected to rise. While not too burdensome from a historical context, ending stocks are enough to send markets into a tailspin, especially when interwoven with the sudden turn into economic recession where demand and credit started to seize up.

Going forward with uncertainty

I believe we are going to get back to that original vision of too much demand and not enough supply. It’s likely to start the moment we pull out of this global recession. Before that happens, the road immediately ahead remains fraught with uncertainty.

Coming out of this recession, there will not be a dawning of a new world unless we first solve the banking crisis. In other words, the banks have to move. But once we do that, there will not be a global economy unless there is more consumption of commodities.

Right now we are cancelling capital spending projects in all directions. Oil exploration and resource development have slowed or halted: no new mines, acres pulled from production, and acres seeded may be less productive if fertilizer use is cut.

In recovery, we still have to muddle our way through challenging times near-term. This means rational thinking and selling into what may still yet be only shallow rallies for now. But I believe that in the not-too-distant future, we will again witness a grinding down of commodity supplies as demand starts to surge higher. That’s not today, and likely not six months from now either, but it’s coming.

So commodity prices in 2010 or 2011 could yet run higher than we ever thought they were going to go because of what has been, and is being done now, to arrest the process of resource development.

The next commodity bull market could very well make the first commodity bull market look somewhat tame.

Government fixes

In terms of government response to the current recession threat, where money is seemingly being doled out willy-nilly, is that the right thing to do?

Under the economic theories of John Maynard Keynes, in times of such economic duress, governments are supposed to run deficits. You want stimulus projects that put people to work rather than just paying them welfare, and you also want a taxation policy of the

Rather than being driven by optimism, today’s bond bubble is driven by fear. The worry is that things will get worse and that government bonds are the only safe deal you can get.

There is a government bond bubble on North American markets. The sign of the bubble is prices so steep that, if you buy a treasury bill due in a couple of months, you will make just two to four basis points if you are an insurance company or a very lucky investor. Small players might get just one basis point. A basis point is 1/100 of one per cent. So if you buy a 90-day U. S. T-bill for just under $100,000 (they are sold on a discount basis), you will make a fat $200 to $400. You do better in a Canada Deposit Insurance Corp-guaranteed bank account. So why would anyone bother with the T-bill?

Size of deposit, for one thing. If you are a pension fund or a company with serious money kicking around, a GIC with a $100,000 maximum CDIC guarantee won’t be of much help. You don’t want to lock up money for months or years, so you need the T-bill. In Canada, the return on T-bills is still a meaningful amount, about 1.8 per cent for 90 days. We have not had a financial crisis anything like what is happening in the U. S.

The fallout from the U. S.-based financial crisis is global and has sent frightened investors and corporate treasurers into the market for the safest and most liquid investments. Ironically, given that the U. S. is the author of most of the crisis, the world seems to prefer U. S. government debt. The world’s taste for bonds shows up in long maturities, too.

Go out to 30 years and you can get 3.60 per cent on a U. S. T-bond. In Canada, 30-year bonds pay 3.97 per cent. These yields are at or near historic lows. “We are in a period of excess valuation,” says Michael

McHugh, vice-president for fixed income and bond portfolio manager at Dynamic Funds in Toronto. No kidding.

Most of the bubbles in history have been equity bubbles. They have been generated in the market for things to own — tulips in the 17th century, shares of the South Seas Company in the 18th, American railways and canals in the 19th, and dot com stocks not so long ago as the 21st century began. Each bubble was characterized by a belief that the sky was the limit for some business that was in every case part of the Next Big Thing.

A bond bubble is different. Rather than being driven by optimism, today’s bond bubble is driven by fear. The worry is that things will get worse and that government bonds are the only safe deal you can get. So investors trade yield for safety.

In late November, the Bank of Montreal sold a preferred share issue with a 6.50 per cent annual dividend, which works out to 8.45 to 9.43 per cent for most investors in high brackets — depending on province, of course. Scotiabank common has a 6.1 per cent yield and is selling well below its highs of $55 reached in March 2007. At time of writing, Scotiabank common shares are trading at $30.78, about where they were in 2002. But there is substantial risk that the shares could go lower and at least a theoretical risk that dividends could be cut. So the near zero interest on a T-bill looks good to a really fearful or very prudent (pick the one you like) investor.

Let’s look at what government bond buyers are passing up. In the U. S. market, a JP Morgan Chase 4.75 per cent bond due March 1, 2015 has recently been priced to yield 6.35 per cent to maturity. The issue is senior debt with an AA-rating from Standard & Poor’s. A Wells Fargo 5.58 per cent bond due Dec. 11, 2017, has recently been priced to yield 6.21 per cent to maturity. It has a slightly higher AA rating from S&P. Both of these banks are in the “too big to fail category,” yet each is paying about double the rate for T-bonds of similar term. And that, says Mario de Rose, fixed income strategist at Edward Jones & Co. in St. Louis, Missouri, implies that at some point, overpriced T-bonds will drop. “The long bonds will produce losses for those who bought them at recent highs,” he explains.

When the fear subsides and the frenzy to hold government bonds ends, short treasury bill yields will decline. Holders of bills bought with a few basis points of yield will have no losses, for the bills are virtually cash. They will be able to roll their bills into new issues with higher yields. Holders of U. S. bills may have an exchange gain, but I would bet that if the precondition for the end of fear is a revival of the global economy and a concurrent rise in the value of Canada’s commodity-based currency, the U. S. greenback will be declining.

Holders of long government bonds with many years of interest payments will suffer major

losses when the fear ends, the bond bubble pops, and inflation and interest rates start rising. If they have not been wise or nimble enough to sell, they will sustain significant losses, probably in a range of six per cent of bond value for each 1.0 percentage point rise in interest rates.

Those who have bought dirt cheap corporate bonds issued by companies with solid balance sheets will do much better. Corporate bonds may suffer from rising interest rates, but they are likely to gain even more from rating upgrades as credit worries subside.

WHAT TO DO?

We are not out of the woods yet and it could be premature to start buying anything with equity risk. Corporate bonds have equity risk in the sense that cash flow issues and debt-to-equity ratios affect credit standing and the value of the company’s capital, which includes bonds.

Moreover, the entire bond market continues to be under severe pressure from the U. S. government’s need to finance several trillion dollars of bailouts. Investors have rushed to buy 10-year Treasury bonds, pushing their yield down below 3.0 per cent Moreover, prices of 10-year bonds, with their longer periods of interest payments, move much more than prices of two-year bonds. The result of the migration of risk-averse money into the 10-year bond means not only that the payoff for this paper is sinking, but that the choice between safety and making some money is even more stark.

Andrew Allentuck is author of “When Can I Retire? Planning Your Financial Life After Work,” to be published by Penguin Group Canada in January 2009.

losses when the fear ends, the bond bubble pops, and inflation and interest rates start rising. If they have not been wise or nimble enough to sell, they will sustain significant losses, probably in a range of six per cent of bond value for each 1.0 percentage point rise in interest rates.

Those who have bought dirt cheap corporate bonds issued by companies with solid balance sheets will do much better. Corporate bonds may suffer from rising interest rates, but they are likely to gain even more from rating upgrades as credit worries subside.

WHAT TO DO?

We are not out of the woods yet and it could be premature to start buying anything with equity risk. Corporate bonds have equity risk in the sense that cash flow issues and debt-to-equity ratios affect credit standing and the value of the company’s capital, which includes bonds.

Moreover, the entire bond market continues to be under severe pressure from the U. S. government’s need to finance several trillion dollars of bailouts. Investors have rushed to buy 10-year Treasury bonds, pushing their yield down below 3.0 per cent Moreover, prices of 10-year bonds, with their longer periods of interest payments, move much more than prices of two-year bonds. The result of the migration of risk-averse money into the 10-year bond means not only that the payoff for this paper is sinking, but that the choice between safety and making some money is even more stark.

Andrew Allentuck is author of “When Can I Retire? Planning Your Financial Life After Work,” to be published by Penguin Group Canada in January 2009.

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