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Market uncertainty continues.

Bank of Canada governor, Mark Carney says Canada is somewhat sheltered from the problems facing much of the developed world in the wake of the recent recession, but we can’t avoid the global shocks altogether.

Despite the fact that Canada's downturn was relatively mild, Carney said no one should underestimate the severity of the recent economic and financial crisis, or the damage it has left behind. "This was the Great Recession" he said.

We asked one of our lead portfolio managers, Bruce Campbell, to provide perspective:

Stocks corrected in May amid mounting fears that Europe's sovereign debt crisis and China's policy tightening would cause a double dip in global growth. While there is some evidence of global contagion in the widening of credit spreads, the degree is modest compared to the 2008 experience.

We judge the latest weakness to be a correction in a bull market, rather than the beginning of a new bear. Q1 earnings came in stronger than expected, and we are maintaining our forecast of a moderate but steady recovery in earnings. On our 2010 earnings forecast, the S&P/TSX and the S&P 500 are trading at relatively attractive multiples of 16.0x and 14.3x, respectively.

We are maintaining one year targets of 12,750 for the S&P/TSX and 1,275 for the S&P 500.

Based on one-year implied returns, stocks look attractive, especially the S&P 500. However, it should be noted that current correction is only 5 weeks old, compared to an average duration of corrections in the previous bull market of 7 weeks for the S&P/TSX and 10 weeks for the S&P 500. Helped by currency appreciation versus overseas counterparts, the Canadian and U.S. markets ranked second and third, respectively, in May among the 23 major markets tracked by MSCI. We maintain a modest overweight in both markets compared to the average Canadian pension fund.

After three months of positive returns, the S&P/TSX Composite Index declined by 3.5% in May. The low interest rate environment is stimulating the economy and we are seeing a pickup in the four-quarter trailing operating earnings for the S&P/TSX Composite Index. The S&P/TSX Composite Index four-quarter trailing operating earnings are up 14% from the January trough.

Some of the most recent market action, points to the possibility of some further turmoil ahead. We now assume that markets may stay unsettled throughout the summer.

We expect the Eurozone to re-accelerate to the above-trend growth after the financial crisis fades. The real effective exchange rate of the euro has fallen by around 9% on its 1H 2009 average. This is the most favorable external environment for the Eurozone in more than a decade. In addition, the financial position of households and companies looks sound, and the ECB has just reduced its estimate for bank write-offs in 2010 by €38bn. While some small countries on the Euro periphery will have to tighten fiscal policy significantly, the core countries are going only for modest austerity. This is the key point to watch for equity markets to ease their concern.

The last two weeks of data however, have sent mixed signals. The weak Philly Fed reading (8.0 vs. 20.0) and rising jobless claims suggest a weakening of business conditions. However, consumer confidence remains resilient, and spending since late May seems to have picked up. Trust data also point to improving credit quality. But it remains evident that economic visibility has weakened since April and is the basis for growth concerns. Growth scares have been common early into an expansion or following some financial crisis – logical we think as investors question the sustainability of an expansion. The common thread is that the sell-offs have been fast and deep, lasting 1.8 mos with avg. decline of 16% compared to 1.5 mos and 14% this episode . Moreover, around these equity declines, ISM, consumer confidence, and jobless claims typically worsened by 9 points, 12 points, and 27k, respectively. The subsequent bounce has tended to be sharp as well, with typical gains of 16% and 20% after 3 and 6 mos, respectively. This would imply higher markets by Labour Day if the historical trend holds, we think that this time we may well lag the typical rebound but could still get a bounce into the fall.

Markets cannot remain in a "state of crisis" forever, and we believe investors will start to focus on "relative value" as they re-enter risky markets. The persistent sell-off in markets since late April has drained investors of any appetite for risk, further demonstrated by those pondering the "lack of catalysts" for stocks during the summer. Of all things weighing on investor sentiment: Euro-area, China, Gulf oil spill, and Washington, only Europe poses "long term risk" and thus, we believe, is most heavily weighing on risk appetite. Equities are the "junior" piece of the capital structure and thus most conveniently sold during periods of risk retracement.

We know fundamental analysis is not necessarily resonating with investors, but we believe there is a strong case to be made for relative value of corporate bonds vs. equities. After all, this is the same issuer, paying out the same cash. Moreover, if bonds are cheap vs. stocks, issuers will issue debt and either buy back shares, fund capex that way, or acquire other companies. This implies that equities could rise 10-15% if interest rates stay lower for longer and the list of crisis' passes.

As long as risk aversion remains and U.S. core inflation continues to recede, Treasury yields should remain low and perhaps move even lower.

However, before year-end, yields should start rising again after the expected bottoming of inflation and in anticipation of an early-2011 Fed tightening start, led by the front end of the curve. Of course, this presumes risk appetites have been sufficiently re-whetted by then. The Bank of Canada raised its policy rate 25 bps to 0.50% on June 1, as expected. However, the policy statement's forward-looking language was more conditional than it was in April, when a potential June move was first signalled. With activity in Canada "unfolding largely as expected", the cause for increased BoC caution appears to be the potential for more "spillover" from events in Europe (beyond the recent slide in commodity prices and tighter financial conditions). Presuming there's no further significant problems, we look for the Bank to continue raising rates. Government of Canada bonds have been underperforming their U.S. counterparts. Waning risk appetites and dimming European economic growth prospects add to the list of policy considerations for the Federal Reserve that include continuing disinflation, labour market slack and a lack of credit creation.

Under this uncertain but potentially positive backdrop, we should remind ourselves that Canada has been the place to be as far as investing in equity markets over the last few years. American returns are not only worse than ours, but are highly negative in Canadian dollars for the last decade.

In Canadian dollars we have outperformed world equity markets by roughly 20% since the crash alone.

Also in this environment, we should still think about safety. Portfolios have lots of cash and lots of gold as portfolio insurance. As well, dividend-paying stocks on the equity side and corporate bonds on the fixed income side are the places to be. Our balanced portfolios will have yields in the 4-5% range and so if equity markets grow just a little, our returns will be high-single digits for the year!


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