What’s on your mind?
The fallout from the sub-prime crisis and the growth of the Canadian dollar are just two of the topics clients are asking about. T.E. Wealth explored these issues and what it means for investors with T.E. Investment Counsel.
Strategies: The sub-prime mortgage crisis continues to be in the headlines.
What’s going on?
Steven Belchetz, President and Chief Investment Officer: The problem has its origins in the United States when sub-prime mortgages were issued to poor-credit risk consumers at above-market rates. Consumers (and their lenders) were banking on a continued rise in housing prices to make the transaction profitable. As the housing market in the U.S. started to weaken, the opportunity for profit diminished and borrowers faced the potential of owing more than their property was worth. More and more consumers are defaulting on the loans and lenders are facing mounting loan losses. While this has generally been the cycle of credit for years, in this case the loan losses aren’t limited to the original lenders. This problem has had growing implications for the entire financial system and not just in the U.S. Not surprisingly, as banks and other intermediaries face losses they are less willing to lend.
Strategies: How did this happen?
Robert Broad, Vice President and Investment Counsellor: Pools of these mortgages were sold to investment banks. They in turn securitized the debt into sub-prime mortgage-backed securities with ratings from AAA to BBB. The highest rated debt was often sold to financial institutions, pension funds and investment managers. The remaining lower-rated debt was repackaged as collateralized debt obligations and, through financial engineering, much of the sub-prime debt received investment grade rates. As investors became aware of the problem with sub-prime mortgages, demand for the securitized investments diminished, leaving institutions and investment managers with substantial downgraded debt. Fear spread to other debt, drying up demand for collateralized loan obligations and asset-backed commercial paper, ultimately resulting in a tightening of liquidity and credit.
Strategies: How big of a problem is it?
Steven: The extent of the problem isn’t completely known as financial institutions around the world are still coming to terms with their exposure. Some estimate that global banks still have to write down between US$100-billion and $400-billion in losses. Fortunately, central banks have stepped in to mitigate stresses on the banking system, consortiums of financial institutions have banded together to purchase back some of the debt instruments and the U.S. government has stepped in to provide support for borrowers and lenders. Also on the plus side, fundamentals in the corporate sector in the U.S. are strong and both the global and emerging market economies are expected to grow. More disconcerting is the continued deterioration in U.S. housing prices, slowing consumer spending and creating tighter lending conditions. The latter has the potential to affect other areas of the financial markets by making it harder for consumers to spend and more expensive for companies to invest.
Strategies: What impact can investors expect to see?
Jeff House, Associate Investment Counsellor: We have already seen the effect of the sub-prime crisis on financial services stocks in the U.S. and in Canada. The real concern is how much of an effect the sub-prime crisis will have on the overall performance of the economy. There is already an expectation of slower economic growth and some fears that the U.S. will go into a recession.
At present there is no need for panic. To date nothing major has gone wrong – the U.S. economy is forecast to continue to grow, albeit more slowly, employment in the U.S. remains strong and corporate balance sheets are in good shape. Many U.S. companies operate internationally and the U.S. market is well diversified, so it is well equipped to ride out an economic slowdown.
Strategies: What about here in Canada?
Steven: Canada’s fortunes have been tied to a strong commodity market in recent years. That’s what has been driving our stock market and contributing to the rise in our dollar. Higher commodity prices are a product of increased demand resulting from healthy economic growth. So any threat of a recession in the U.S. and a slowing global economy is also a threat to commodity prices. Investors in Canada, where the market is dominated by three sectors – financial services (down 5.34% in the fourth quarter of 2007), energy and materials (both commodity-related) would do well to be diversified both in Canada and around the world.
Strategies: The Canadian dollar has been riding high – will this continue?
Robert: The high value of the Canadian dollar is a factor of two developments – the strength of our commodity-based economy and depreciation of the U.S. dollar. On the strength of our economy, the currency has appreciated against other currencies – the euro and pound, for example. The weakness in the U.S. dollar has also had a significant effect on boosting our dollar’s value. I’m not going to make any currency predictions but the fate of our dollar over the short-term really depends on what happens with our economy and whether the U. S. dollar continues to depreciate. A large current account deficit and foreign trade deficit combined with a high level of foreign ownership make the U.S. dollar vulnerable to further depreciation but predictions of the U.S. dollar’s demise as reserve currency are premature.
Strategies: Is this an opportunity for investors?
Jeff: While the dollar is high, I would encourage investors to take advantage of it. The same principal that applies to cross-border shopping also applies to your investment portfolio. U.S. and international stocks are a good deal for Canadians right now as our dollar buys more. It has been frustrating for investor to see the returns from their international holdings eliminated as our dollar appreciated. Keep in mind that the reporting of these returns in Canadian dollars assumes that you are liquidating your portfolio and converting to Canadian dollars on that day, which is not what is happening. And remember, currency isn’t like a stock; it doesn’t appreciate forever, nor can it depreciate to zero. A good indicator of a currency’s long-term value is its purchasing parity value. At current levels, the dollar is trading above its purchasing parity by about 10% to 15%.
Strategies: Optimistic or pessimistic?
Steven: Investing is all about managing risks, anticipating what can go wrong, and building a portfolio that protects against these events. I don’t think that makes me a pessimist but it does make me a better investor.
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