2004 Investment Outlook

Margaret M. Samuel, CFA, Alternum Capital and Director, The Empire Club of Canada; David A. Brown, Chair, Ontario Securities Commission; Kevin M. Sullivan, CFA, CEO, GMP Securities Ltd.; Jeffrey D. Francoz, President, MMI Group Inc.; Barbara Stymiest, CEO, TSX Group; David E. Roberts, Senior Vice-President, Institutional Equities, Raymond James Ltd; Bruce J. Robb, CFA, Co-Head, Canadian Equity Research Sales, Merrill Lynch Canada Inc.; Chuck R. Powis, CFA, Managing Director, Institutional Bond Sales, RBC Capital Markets; Harry T. Seymour, President, Waterston Financial Inc. and Past President, The Empire Club of Canada; The Hon. Thomas A. Hockin, PC, PhD, President and CEO, Investment Funds Institute of Canada; Blake C. Goldring, CFA, President and CEO, AGF Management Limited.; Rev. Grant Kerr, St. Paul’s United Church; Paul Martin, CFA, Vice-President, TD Newcrest; Joseph J. Oliver, President and CEO, Investment Dealers Association of Canada; William F. White, President, IBK Capital Corp.; and David Fleck, Executive Managing Director, BMO Nesbitt Burns Inc.

Introduction by John Koopman

For most of us the future represents those halcyon days when our affairs will prosper, our friends will be true and our happiness is assured. Not so for that poor Toronto lady who was recently told by her doctor that she had but six months left to live. She said: "Well what do I do?" The doctor told her to marry an economist and move to North Dakota. She said: "But doctor, that won’t cure me, will it?" The doctor said: "No lady it won’t cure you but the six months will seem like forever."

Now we’re going to listen today to some very brave and some very talented economists. Firstly very brave because it is one thing to make predictions in the security of your living room after a drink when you have real doubt than anyone will remember what you’ve predicted. These three economists today are going to make predictions that will go down in the public record and they’ll be on the Internet for you to read a year from now. If you look back at past addresses to the Empire Club Financial Forum some of them have been very very good. You go back to Bob Dechert’s year as President, 2000. That was the height of the dotcom boom. We had Scott Penman here. Listen to what Scott had to say. I wish I had been here that year because I would have saved a lot of money. Scott said: "Are these gains and technology stocks real, will they last? The new tech IPO mania is just like the children’s craze Pokemon." Now Pokemon I understand because I have kids that age.

"But there are only very few people who really understand Pokemon. Just like these IPOs, they have no real value. It is simply an emotion mania. Today’s Internet stock is tomorrow’s Tickle Me Elmo." I wish I had listened.

He wasn’t the only one that year. The second speaker at that same Financial Forum, January of 2000, was Bill Eigen. He said: "Why do these dotcoms trade for 150 times sales. I don’t understand it and I won’t listen to any analyst that tries to tell me these valuations make sense. I’ve seen more new metrics to justify evaluations in the past few months than I’ve seen in my entire career. It’s not price to book anymore. For these IPOs it is price to press release issue." I hope all of you were at those lunches because I’ve been to most of them but that one I missed.

But there was a good side to that whole tech collapse and Ian Joseph pointed it out two years later when he spoke. What he said simply was: "You know, the good side of all this is that at least now I don’t have to pretend I know what acronyms like CDMA, CRN, ERP, IPAP and all that stuff really means."

So our guests are brave and they are also very talented. The average economist frankly can’t say hello in 10 minutes. Each of our three guests today has about 10 to 12 minutes. Our first guest is Mr. Frederick Sturm. He’s the Executive Vice-President and Chief Investment Strategist for MacKenzie Financial. He joined MacKenzie in 1981 and he is also a natural resource specialist.

Frederick Sturm

I am a technology guy and I can’t speak without some props.

I apologize to all those in the room who are at the far end. We have a screen set up on this side so it may be a little bit of a strain for you to see it, but I’m sure that my words will be helpful in understanding the pictures.

I am about to make a very bold prediction and I would like you to record this for all eternity because I know it’s going to be recorded for all eternity anyway. My bold number-one prediction is that stocks will be much much higher 36 years from now.

My economics professor warned me that, if you are going to predict, at least use a timeframe long enough that you’ll have lots of averages working in your favour.

We get so busy day by day and trade by trade that we sometimes forget about the long term. So I’m going to focus on what the long term really is and I have a chart here containing 200 years of data. We’re arguing that we’re going back into a normal return environment. Two per cent inflation, 5 per cent government bonds and stocks at 8.5 per cent. Not 18.5 per cent, not 28.5 per cent, but 8.5 per cent. Many people often say: "Well those numbers are uninspiring." But we forget that over time patient compounding works in our favour. All we’ve done here is multiply it out. Twenty years from now everything I buy will be 50 per cent more expensive so doing nothing is not an option. We will need to invest to accumulate a nest egg.

I’ve had the pleasure of taking over a fund called the MacKenzie growth fund, which launched MacKenzie Financial some 36 years ago. Ten thousand dollars invested a year ago is now worth $12,000. Invested three years ago it is worth $17,000 and if you had invested 36 years ago it is now worth $610,000. I always like to say throw a zero on the original investment and the result is really quite interesting.

But let’s focus a little narrower here and if we look at the average Dow Jones cycle going back over the last 100 years, this recovery has been actually quite normal. The surprise was the pull back at the beginning of the year but SARS and Iraq caused that. If this chart is perfectly followed then we might have some more gains in the first half of this year. Some kind of an 8 per cent pull back and then a retest and a rally to new highs as the year progresses.

It is important to ask what is going on to drive the market. So far, if we look at the stockmarket and ask what the stockmarket is telling us, the breadth and strength of the market has been impressive. Since the summer we have been using this table which goes back to 1970 and it basically makes the point: when 90 per cent of all the stocks are saying they want to join in the parade, the parade tends to go on for another six months to a year. That’s why we have been working very hard at MacKenzie over the last year to put this in front of our clients to help them with their investment plans.

We are starting this year with earnings going to new all-time record highs and the market is still one-third off. Here’s your chance.

So where will the power come from? It will partially come from money that is on the sidelines. By many measures, sentiment indicators are getting a little frothy and a little bit of a concern, but I’m suggesting watching what people do, not what they say. The money on the sidelines is still quite a mountain that hasn’t been spent yet. It is fuel for more gains.

Based on prediction number one, it still makes sense to have significant weighting in equities over the very long term.

Bull prediction number two. Long-term government bonds will post marginal total return losses this year but bond yields will be lower than today, two to three years out.

We have been using this chart comparing the changes in interest rates by the fed and comparing it to the trends in employment and we are now hearing quite clearly from the Central Bank that absent employment growth we won’t raise rates.

So based on prediction number two, I suggest continuing to focus on shorter duration and fixed income alternatives, but buy the bonds if they sell off. I think there is another positive trade coming in the bond market sometime over the next 12 to 18 months.

Here I get a little more technical and use a little more of the market language. This solid cyclical bull market will not change into a secular bull trend. Therefore I think at some point in the next two to three years from now stocks will be lower than today.

Let’s describe that. Why? What we have observed in history is that the pre-conditions for a secular bull require basically these kinds of things: low absolute valuations as a starting point, pent-up demand, reasonable expectations of political stability and the capacity for big output productivity gains. I don’t think we have the first three. You could argue that with the inclusion of China and India and all these people, who are now being liberated to work more productively, that we probably do have the fourth.

What is different this time is that because of the low interest rates consumers didn’t retrench as they have in the past. And we can see here every circled recession in the past started with a lot of cars getting older and people not buying houses and as a result there was a lot of pent-up demand. We don’t have that as a starting point here today.

And here is a valuation issue: every good secular bull market started with P/Es under 10 or 11 and we haven’t seen that. And we are in fact now on an across-the-board basis starting to see valuations that are on average getting a little on the rich side.

Twin deficits as you know are a big challenge. Why won’t we go into a secular market from this positive cyclical bull market? We still have a lot of issues that we have to deal with.

What does a bull market look like? Through 100 years of data we’ve looked at 33 bull market cases, one every three years or so. Half of them have been secular, half of them have been cyclical. Cyclical bull markets are good for about 50-per-cent gains.

So based on that prediction I suggest to you that individual stocks will post more gains, but be prepared to focus on quality and adopt a more conservative asset mix at some point this year.

Bull prediction number four: the demand for financial advice, professional advice, and money management will rise substantially over the next 10 years. Why?

Professor Foot was my demographics professor about 25 years ago and here you see the baby boom. It is moving into the savings years. They will need your advice. And in terms of the professional value added by a professional money management, here I show a chart of the Maxim MacKenzie Dividend Fund run by my partner. We all know that we are not always brilliant but to suggest that this industry is not adding value to people over time is just not fair.

So based on that prediction, even though we will have an inevitable pull back two to three years out, stick around. The next 10 years after that will be very solid growth.

So here’s my last prediction and I’ll rap it up quickly: the Middle East is going to face a very difficult social challenge and I want to talk about this a little more.

Here we’ve expanded the population data and it’s a mass of numbers. You can see on the very top line that China is bigger than all the western nations by a factor of two. Notice Saudi Arabia has about 22 million people, not far off Canada’s 30-odd million people. But let’s do some analysis on the numbers. On the top right hand corner you can see that 49 per cent of the population in Saudi Arabia is under the age of 20. Seventy-five per cent of the population in Saudi Arabia is under the age of 30. In many emerging markets the challenge is health care and many people unfortunately die young, so it is not unusual to see high numbers of youth. What you do see though is that the life expectancy in Saudi Arabia is very close, at 72 years, to the life expectancy in the western world. What it means is that over the next few years, for every one person who is retiring and vacating a job eight and a half new ones have to be created. And that economy just doesn’t have the wherewithal to absorb those people.

People without jobs and without homes create a difficulty for society. So based on that final prediction I think that for the balance of the decade you should have energy and gold as markers in a balanced way in your investment portfolios.

Thank you so much for your time.

Introduction by John Koopman

Thank you Mr. Sturm. I’m more with Yogi Berra. Yogi Berra once said: "Buy stocks. If they go up, sell them. If they don’t go up, don’t buy them." Our next speaker is Miss de Place Filippini.

Anne-Mette de Place Filippini

Mr. President, ladies and gentlemen: good afternoon.

I’m pleased to be speaking here at a time when the prospects for overseas investments look brighter than they have for some time. Yet in all but the most contrarian investors’ portfolios, overseas assets are relegated to a position of secondary importance.

It is a difficult time to be a fund manager in international equities right now, largely because there are very few Canadian investors who have become wealthy by owning stocks outside North America. The MSCI EAFE index, which covers world stocks in Europe, Asia and the Far East, has a rather dismal 10-year return of 4 per cent per year, somewhat less than a Canadian could have earned in a decent T-Bill fund over the same period.

It is with this track record in mind that I come to the subject of my 10 minutes today. I want to talk about the limitations of one of the most popular analytical tools in investing. This tool is employed widely to develop forecasts and to shape expectations for future investment returns. In Denmark, where I am from, it is called the bagspejl, and here in Canada we refer to this tool as the rear-view mirror.

Now where to we begin with our discussion of this rear-view mirror? Perhaps we should begin in the world where we find ourselves today. We are, of course, in a global economy defined by the undisputed pre-eminence of the United States. America’s economy is leading the world in growth with 8.2 per cent real annual GDP growth in the third quarter. The second-half recovery, long promised by Wall Street, is finally here (a couple of years after it was first predicted, but who’s complaining). Businesses around the world, in China, Mexico, Canada and Europe are all eager to grow their exports into the world’s greatest consumer market.

The world appears poised for another decade-long American-led expansion just as has occurred in the 1980s and 1990s. But, perhaps this isn’t the right place to begin.

Perhaps we should begin 15 years ago in Japan. The year is 1989 and we are sitting in the lobby of the Imperial Hotel in Tokyo. The Imperial Hotel lobby has never been this busy or felt so alive. If you listen very carefully you can hear Beethoven’s "Moonlight Sonata" tinkling on a piano. Japan has seen a period of massive economic expansion that has created 3.6 million jobs and wage growth of 19 per cent since 1984. Unemployment is almost non-existent at 2.3 per cent. Construction is booming. New construction is up 30 per cent from three years earlier. Land prices in central Tokyo are still going up on their way to reaching almost $6,000 per square foot (that’s $54,000 for a square yard).

A 100-yen coin has almost doubled in value against the U.S. dollar since the beginning of the decade. And students of business, including myself, were being tested on our knowledge of Japanese quality-control systems and the Toyota Way.

Into this fabulous Imperial Hotel lobby, imagine being sent with the mission of selling international equities to a Japanese investor. He is looking at the financial pages of a chart showing the 10-year compound return from the Nikkei at a towering 26 per cent per year (in Canadian dollar terms). Against this fantastic return, the American S&P 500 has returned 15 per cent per year and Toronto stocks only 8 per cent. We make our pitch. Our potential investor, being Japanese, is very polite. He nods and smiles and asks how long we consider long-term to be. Our Japanese friend does not seriously consider our international funds pitch. Using the rear-view mirror as his trusty guide, he sticks with his basket of profitable, world-beating Japanese equities.

We all now know how costly a decision this turned out to be. Our Japanese friend still clings desperately to the only investing tool he has ever used, the rear-view mirror, and has by now sworn off stocks for life.

It didn’t have to be that way. Even in 1989 there were a few cracks showing in the impenetrable armour of the Japanese economy. Interest rates had begun to rise. Imports into Japan were growing much faster than exports, and the trade balance with China recently turned negative. The cost-advantage of Japanese manufacturing was rapidly eroding due to growing wages and a rising currency. But then that was Japan.

Let’s talk about North America.

At the start of this talk I made a note of how well things seem to be going in North America, but I only just scratched the surface. The United States, with less than 7 per cent of the world’s population and 30 per cent of the world’s GDP has generated more than 60 per cent of all economic growth in the world since 1995.

Domestic demand in the United States has grown at an amazing 3.7 per cent per year since 1995, twice the pace of the rest of the world. Despite a little hiccup with the technology bubble, American stock exchanges are still world beating, with the Nasdaq returning 50 per cent in 2003.

Yet why might a couple of words of caution be appropriate at this juncture? If one looks around for cracks in the armour of the North American economy (and I believe it is one North American economy and not a Canadian and an American economy) they are not too hard to find.

The first significant crack is the apparent dependence of the U.S. economy on consumers who are spending more than they earn. From a positive savings rate in the late 1980s, the average U.S. consumer is running larger and larger personal deficits, to the tune of 12 per cent of disposable income in 2002. Despite the large declines in interest rates over the past 15 years mortgage, interest and charges have been growing faster than wages since 1988 (4.6 per cent compound annual growth rate vs. 4.4 per cent), meaning that the coverage ratios on mortgages are deteriorating.

While personal liabilities in the United States have risen, at the same time average consumer income from investments has shrunk, even in nominal terms. The average U.S. consumer has become more dependent on employment income in the last 15 years.

At an aggregate level, the United States appears to behave in the same way. America runs a massive current account deficit of 5 per cent of GDP, which is driven by a combination of trade deficit and the fact that the U.S. has become a net debtor to the rest of the world. In fact in just 20 years, the U.S. has gone from being the world’s biggest creditor to its biggest debtor.

The relative uncompetitiveness of labour in North America is another concern. Software developers who earn $60 in the U.S. are competing against Indians of similar skills who earn $6 per hour. We recently looked at a shoe manufacturer in China whose employees are paid one-nineteenth of the wage of similarly skilled American factory workers.

When these jobs move offshore, what happens to the American workers? A study from 1979-99 conducted by the Institute for International Economics found that of American employees who lost their jobs to cheap imports, half had to take a pay cut and one-quarter of them took a pay cut of 30 per cent or more. It seems ironic that while America’s founding fathers considered the following truth to be self-evident–that all men are created equal–American consumers are engaging in consumptive behaviour that suggests their abnormally high incomes are some kind of permanent right of citizenship. The scene out of the front windscreen gives cause for concern, and certainly would suggest that this is no time for complacency. Underpinning a stock market that is trading between 20 and 30 times earnings, depending on what you count as earnings, looms some massive imbalances that pose daunting challenges for the future.

As I look at my options of where to deploy capital on a global basis, international markets deserve a hard look. Where are the best places to go–some say to hide? Just perhaps those countries that have been enmeshed in recession and deflation, where more money comes in than goes out, and where personal and government balance sheets are strong.

So how does one guard against falling into the rear-view mirror trap? As we look at common stocks and the people who run these businesses, we must keep our eyes firmly on those items that are visible through the front windscreen. Our research should be directed towards answering the following fundamental questions.

Does the company sell a valuable product? Is the market likely to grow or to contract? Is the product or service it provides an inevitable necessity or a nice to have? Is the business the strongest competitor in its industry? Can we identify a sustainable competitive advantage? Is it the low-cost producer? Is the business in a strong financial position? Is there a strong mechanism that exists to transfer value created by the business to the shareholder? Is management honest? Is the business being offered for sale at a price, which is less than its discounted future cash generation?

We believe there is no substitute for analyzing the relevant forward-looking fact base. The view out in front of us suggests that this is no time for complacency. That potential rewards should be carefully assessed against the risks they entail. And with this in mind, the prospects for overseas investments, from a North American point of view, are brighter than they have been for some time.

Thanks for your time.

Introduction by John Koopman

I neglected to mention that Ms. de Place Filippini is with ALC Investment Services. Folks came from afar just to see two economists who agreed to agree. When the event did take place it proved a disgrace. They agreed one plus one adds to three. Our final speaker today is a bond man, Mr. Mike Quinn, the Chief Investment Officer at Bissett Investment Management. Mr. Quinn.

Mike Quinn

I have been asked to speak on the outlook for the fixed income markets in 2004. I would like to start by reviewing the performance of the fixed income markets then talk about some of the factors we believe will have an impact on returns in 2004. Finally I will share our strategy for investing in bonds in 2004.

Being asked to talk about the fixed income markets, at functions such as this, sometimes leaves one feeling like the poor cousin of the family. The equity managers usually are able to get most of the attention as the return potential is so much higher, and even in a bad year there are stories to tell. Bonds on the other hand are overwhelmingly driven by one factor–interest rates–and so any discussion of the market inevitably turns to interest rates, not always the most exciting of luncheon topics. But bonds have tended to provide some surprises over the last few years, and I think they have the potential to surprise again in 2004. Indeed–in a capital market over the past three or four years that can charitably be called uncertain and challenging, bonds have been a tower of strength and stability. Bond returns in the last four years as measured by the Scotia Capital Universe Bond Index starting in 2000 have been 10.25 per cent, 8.06 per cent, 8.75 per cent and last year 6.7 per cent for a four-year compound rate of return of 8.43 per cent. This compares to 1 per cent for the S&P/TSX over the same period. Maybe it isn’t fair making this comparison. Returns, as the physicists say, are "sensitive dependent on initial conditions" and this was the worst bear market in years. But we bond managers have to take advantage of these opportunities. As I recall, the consensus forecast for the bond market had been for bonds to earn their coupon less a bit as rates were expected to rise. Each year the bond market outperformed, providing returns of the coupon of around 5 to 6 per cent plus capital appreciation as interest rates declined. Obviously the combination of the economic slow-down, low inflation, weak stock prices and geo-political uncertainty all contributed to the strong results in the bond market.

So what to expect in 2004? Consensus is very familiar at coupon less a bit to negative returns. A recent Ried Thurberg survey in the U.S. showed that there were only 6 bulls and 43 bears in a pool of bond managers. Eight-five per cent of global portfolio managers see yields rising. Those of you who are uncomfortable being on the consensus now know which way to turn. Is the consensus going to be fooled again?

Here is where we have to turn to interest rate forecasts. When I was doing some research in preparing for today, I came across a statistic that said that economic forecasts are right only 44 per cent of the time. My first thought was that I had better make sure I have a coin in my pocket so that I can improve on those odds. Then I was comforted by the fact that I am not an economist and maybe portfolio managers fare better. Forecasting can be a humbling experience though. Even the central banks, which have buildings full of economists, have had a hard time being consistently right. Less than a year ago, the federal government in their budget forecasted 10-year bond yields at 5.4 per cent in 2003 (they ended the year at 4.7 per cent) and 5.9 per cent for 2004. Thankfully rates have remained below those levels (so far anyway). In the U.S., the Federal Reserve has spoken of both deflation risks and inflation pressures in the past year. So with this backdrop I guess I can add my two cents’ worth.

What drives interest rates? The economy, inflation rates, supply and demand for money, and monetary and fiscal policy. Without getting into a lot of detail let’s look at each of these factors.

While there still seems to be some argument regarding the economy, we think there is little doubt that the growth revival we have seen is real and will extend into 2004. The U.S. economy grew at over 8 per cent in the third quarter; it is unlikely to falter any time soon. We expect the economy to continue to grow at a reasonable pace in 2004 as the strength expands beyond the consumer and government. Corporate spending will improve as businesses reinvest growing cash flows. People point to the lack of employment growth as a sign the economy is not improving, but this is a lagging indicator and a popular measure over the past few years has been jobless claims in the U.S. The weekly average has dropped from 400,000 to about 350,000 recently. Canada and the rest of the world will benefit from the strength in the U.S. and for the first time in years we could see a synchronized global recovery. Japan finally looks like it is emerging from a 10-year recession as the government continues to make the necessary reforms. Even in Europe, growth is steady despite a strong euro as they benefit from increased global demand.

Will this growth inevitably lead to inflation problems? We are unconvinced, and the reasons are globalization, excess capacity and continued productivity improvements. As the year progresses inflation rates are likely to climb but not significantly. The Federal Reserve is trying to reflate and has made it clear that it would like to see a higher inflation rate. Why fight the Fed on this point? One surprising statistic is that U.S. inflation rates remain below 2 per cent even with the U.S. dollar dropping steadily in 2003. Core rates are as low as they have been in five years. As global growth recovers, the likelihood of the U.S. avoiding price hikes diminishes. In Canada our stronger currency will mean that inflation here remains relatively benign. Commodity prices may continue to strengthen but their impact on overall inflation rates is less each year. For most of the world commodity price inflation has been minimal or non-existent. With commodities denominated in U.S. dollars, items like oil and gold are little changed in local currency terms, even though they remain strong in U.S. dollar terms.

What about monetary and fiscal policy? There has been little change in U.S. monetary policy which has been very accommodative. The Federal Reserve has been committed to keeping rates low for a "considerable period" and it does not appear to be much closer to raising rates despite the improved performance of the economy. In Canada the story is a bit different. Our bank rate is significantly higher than that of the United States and our dollar is strong; both equate to a restrictive policy. The bank is probably reluctant to reduce rates in the face of a recovery in the U.S. but there is room to move and we may see diverging monetary policies in 2004, as the U.S increases rates by mid-year and the Bank of Canada keeps rates here steady or reduces them early in 2004.

Fiscal policies are also diverging. An accommodative fiscal policy, in the form of tax cuts and increased spending, has spurred growth in the U.S. while also moving the U.S. federal government from a comfortable budget surplus to a $500-billion deficit. Canada meanwhile is struggling to balance its books, as politicians do not appear to be willing to surrender the gains made on this front in the 1990s. And this leads to supply and demand. Clearly with deficits growing in the U.S. the supply of bonds will be on the rise. In Canada demand seems to be stronger in the face of limited new supply. Corporate spreads have narrowed significantly over the past 15 months as investors reach for yields. A stronger economy should alleviate some of this tightness as corporations come back to the market.

Now, here comes the hard part. What does all this mean to the fixed income markets? Usually forecasters with the best results are those that make the more extreme calls. I spoke at a forecast dinner last year with two other speakers, and all of us called for the Canadian dollar to appreciate but nobody expected it to rise above $0.70 U.S. from about the $0.63 level. Similarly, our forecasts for the TSX were pretty timid. I was the most bullish expecting returns of around 10 per cent and the market gained over 25 per cent. So th