May 2013

August 2013

Market Commentary
Central Banks Play Variations on a Theme
According to the story, Count Kaiserling, the Russian ambassador to the court at Saxony, was often ill and unable to sleep. Turning to Johann Sebastian Bach for relief, he commissioned one of the greatest composers of all time to write a soothing insomnia cure. Each night, Johann Goldberg, one of Bachs students, would play The Goldberg Variations for the count. This 1741 harpsichord masterpiece consists of an aria and a set of 30 variations. Despite its extraordinary beauty, Bach only ever wrote one piece in this form. that tapering would be gradual and dependent on upbeat data, the yields on 10-year U.S. Treasuries increased even more in July, starting the month at 2.47% and ending at 2.56%. Positive news is driving the Fed to consider early scaling back on its bond purchases. The manufacturing Purchasing Managers Index surged in July to 55.4 (a number greater than 50 signals expansion); initial jobless claims dropped, with unemployment reported at 7.4%. Growth in U.S. real GDP was modest at 1.7% in the second quarter. This was likely caused by the impact of spending cuts mandated by the U.S. sequester, which authorized the U.S. Treasury to withhold, or sequester, $85-billion in funds needed to run federal agencies.
Chart 1: ISM Manufacturing US ISM Headline Surveys

Variations on a theme is the best way to describe

whats playing out in macroeconomics today. Central banks around the globe are after anything but slumber, however: their aim is to jolt snoozing economies awake. The instrument theyre using is artificially low interest rates. While there are many variations on this theme, each with its own policy nuances and constraints, the common goal is to stimulate economic recovery. The U.S. Sings the Aria The U.S. Federal Reserve (the Fed) is currently pursuing two basic strategies. First, keep short-term interest rates low, a policy likely to linger for some time as the Fed tries to support economic recovery and improve the jobless numbers. Second, purchase massive quantities of assets, primarily government Treasury bonds, in order to keep interest rates low across a broad range of maturity dates. The Fed wants to stimulate corporate borrowing since highly attractive interest rates reduce the cost of capital for businesses; this, in turn, encourages companies to take on new projects, invest in equipment and hire more workers. This second strategy was never intended to be long term. Fed chairman Ben Bernanke has laid out a timetable for winding down phase three of quantitative easing (QE3) by mid-to-late 2014. We can expect two probable outcomes: Treasury yields will rise and volatility will increase. Although volatility declined slightly across a number of asset types (including U.S. Treasuries) in July, the financial market turbulence in late May and most of June is probably a harbinger of things to come. Despite the Feds repeated assurances

Source: Thomson Reurters Datastream

There are subtle signals that the recovery is firming. When banks want deposits, they post attractive rates. If they arent lending, they post rates that discourage deposits. Now, after years of shunning excess corporate cash, U.S. banks are competing for funds. This may be a sign that the banks are returning to their traditional and vital role as lenders. It could also be the catalyst that will halt the slowdown in the velocity of money the frequency with which a unit of money is spent in an economy and recently, an offset to the massive

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amounts of stimulus poured into the supply of money. If this is the case, we may be witnessing a major turning point for both financial assets and, ultimately, inflation.
Chart 2: Velocity of Money

are the second-largest financial sector, accounting for as much as $2 trillion in risky assets. The Chinese shadow banking system offers investment opportunities outside state-owned banks. In Canada, shadow banks would be venture capital firms, hedge funds and private equity. The Chinese wealth management vehicles, or WMVs, are unregulated and often dodgy investment options. China will have to provide more Western-style social safety nets before its citizens will be confident enough to reduce their rainy-day savings. Because the crossborder movement of money is tightly controlled, Chinese savers have few places to invest their money. The government will have to introduce new savings and investment vehicles in order to discourage people from speculating in housing and fueling a bubble. These changes cannot be accomplished overnight. Policy makers are addressing the slump in exports. It appears that these numbers will improve. Although exports to Europe fell from 24% to 18% of total exports, Europes economy appears to be coming out of recession. This is good news for Chinese exporters. There is a possibility, although distant, that the economic revival in Japan will boost demand for Chinese goods. While official attention seems to have focused recently on the struggling export sector, we believe that economic growth in China will continue to underperform in comparison to past quarters. Europe Second Verse Better than the First The eurozone appears to be emerging from recession at last. Noise about the debt crisis has certainly been subdued over the past 12 months. While weve seen a few political flare-ups like the one in Portugal, they have been minor and short-lived. The European Central Banks commitment in July of 2012 that it would do whatever it takes to keep the euro afloat seems to be working. That statement, backed by an open-ended bond purchase plan, helped ease the situation. Policy makers have also retreated from their hawkish, flawed view that austerity is the key to solving the debt crisis. The picture is encouraging, although it will be a challenge for the eurozone to achieve growth for the next few years. Canada Plays Along Central bank policy in Canada was steady as she goes as growth forecasts were revised slightly upward. A very positive 1.9% surge in retail sales was certainly welcome news. The oil-price increase helped drive up the Bank of Canadas commodity price index by more than 10% so far in 2013. (Julys collapse in potash prices

Source: Thomson Reurters Datastream

Most market watchers are waiting for increased corporate sales growth to prove that the recovery is solid. U.S. companies have sustained their profit margins, but they have largely done this by reducing interest expenses, lowering taxes and trimming workers. Year-over-year sales growth for the S&P 500 is now at a very modest 1.3%. Top-line revenue growth is essential. Companies that generate increased revenue in this tough environment will likely be rewarded with higher valuations. The S&P 500 index was up 6.1% for the quarter and 19.6% year to date. Chinese Central Bank Seeks Balance Central bankers in China have been forced to play a much different variation on the stimulus theme. During the post-2008 meltdown in the financial markets, the Peoples Bank of China pumped massive amounts of stimulus into its economy. Now the challenge is balancing a slowdown in investment with a desired boost in consumption. This high-wire act is proving difficult. Exports have slumped 3.1% year over year, the biggest decline since 2008. To stimulate consumption, several factors must be present. The Chinese central bank must liberalize interest rates, which means giving the market to more say in setting rates, letting them to rise and fall according to demand. Liberalizing rates would reward and encourage household deposits. This move would also support efforts to curtail excessive debt expansion in the shadow banking system. In China, shadow banks

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is not yet factored into the data.) A better growth outlook for Canada will have little impact on interest rates, however; our fate is closely tied to whatever happens south of the 49th parallel. Canadian central bankers simply have fewer notes to play in their variation of monetary policy setting and intervention. Our Strategy Weve recently done some fine-tuning to our asset allocations, but were sticking with our tactic of overweighting equities relative to bonds and continuing to favour U.S. equities over domestic. Interest rates will likely normalize (drift upward) over the coming quarters. As a result, our fixed income strategy involves shortening the average maturities of our bond holdings and sticking with higher coupons on the corporate side. The Last Word Bach may have found the musical form of theme and variations constraining, but modern jazz improvisers thoroughly embraced it. For central bankers around the world, having their jazz on means introducing stimulus policies and keeping interest rates low. The global impact of central monetary policy is evident everywhere as economies recover. The focus is also sharpening on the need for business and government to become better partners.

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