February, 2010 | Straight answers

In this issue of Straight Answers, we return to our focus on investor education and best practices for achieving financial security. As we enter the new year, and are immersed in the marketing hype that is the RRSP season, we think it important to review some fundamentals. I have compiled a short list of five financial resolutions that I encourage all investors to consider. They may not be new concepts, but the tried and true axioms invariably yield the best long-term results.

We begin with Weigh House Chief Investment Strategist Ken Hawkins, who offers his predictions for the year ahead. While not all of us align completely with Ken’s outlook for 2010, we do give him the opportunity to ‘hold court’ in this issue. My colleague Mike Macdonald provides some valuable tips to consider when developing your financial plan in an article entitled ‘Financial Planning for Today ... and Tomorrow’ that first appeared in the Hamilton Spectator.

Carlo Palazzo

Investment Outlook for 2010

By Ken Hawkins

Highlights:

  • Moderate economic growth as the economy will remain sluggish through H1 2010.
  • Emerging markets set to post better results - in the order of 6.5% growth in GDP.
  • Subdued inflation will keep near-term interest rates low.
  • Expect the Federal Reserve and the Bank of Canada to raise interest rates this summer, as the economy continues to show signs of recovery.
  • Rising interest rates suggest a poor year for bonds.
  • Stock market returns will be moderate - but equities should outperform bonds.

Back from the Brink, Moderate Growth in Store

The world’s economies began their recovery in late last spring. Although economic conditions have improved somewhat, there remains significant excess industrial capacity, unemployment, mounting fiscal deficits and increased government intervention. Consumers are cautious as well, choosing to pay down debt rather than increase spending.

In today’s sluggish economic environment, growth is expected to be quite modest. Only when the broader global recovery leads to a sustained improvement in exports should we expect more substantive growth. Emerging markets are the lone exception with China leading the way. China’s GDP is growing at 8.9%, with industrial production and retail sales each increasing at about 16%. (For emerging marketing as a whole, economists are forecasting a 6.5% growth in GDP.) In contrast, the U.S. is expected to grow at 2.8%, Europe at 1.2%, and Japan at only 0.4%.

More Stimulus Required

Fiscal and monetary stimulus will have to continue before the U.S. economy is able to stand on its own legs. Officials estimate that less than one-fifth of the Government’s $787 billion stimulus package has been paid out so far. That leaves over $600 billion to work its way into the system.

With inflation at historical lows, monetary authorities can and should keep interest rates low to provide additional monetary stimulus. Indeed, central banks in North America, Europe and Japan are expected to hold short-term interest rates at rock-bottom levels for the next six months. Given the fragility of the economic recovery, these authorities will want to be confident that the threat to the financial system has dissipated - and growth restored - before allowing rates to rise again.

Inflation will Remain in Check

In the U.S. and Canada, the headline CPI number sits in deflationary territory on a year-on-year basis, while the core reading resides near multi-decade lows. A strong Canadian dollar also contributes to the deflationary environment, as prices for imported goods and services are lower in aggregate. Excessive capacity built-up during the recession suggests inflation will remain subdued in the near term.

As the credit crisis continues to abate however, we expect developed economies will once again experience inflationary pressures rather than deflationary ones. As a result, we expect headline inflation to remain well behaved but gradually creep higher as the impact of declining commodity prices reverses.

Interest Rates Should Rise Later this Year

Once the recovery is durable enough to improve unemployment, we expect the Federal Reserve and the Bank of Canada to begin the long process of returning monetary policy to a neutral stance and start to raise interest rates. Economists are forecasting interest rate increases across all maturities beginning this summer. In the U.S., rates are predicted to climb about 1% this year, with slightly lower increases anticipated for Canada.

The central banks must move cautiously. Raising interest rates too quickly could stifle growth, and bring about a ‘double dip’ in the economy. If monetary policy were to remain too loose for too long however, the counter risk of higher inflation and asset bubbles[1] increases significantly.

Higher Interest Rates Mean Lower Bond Prices

Rising interest rates will put downward pressure on bond prices. We believed that corporate bonds will hold their value better than Government bonds this year. Corporate bonds are buoyed by the fact that credit spreads, although dramatically narrower, are still above their long-term historical averages. Concurrently, the probability of corporate defaults is decreasing as economic conditions improve. We encourage investors to prepare for higher interest rates by transferring bond holdings into shorter-term durations. The conventional wisdom suggests short-term bonds hold up better than long-term bonds as interest rates rise.

Stock Markets in Equilibrium

Equity valuations in developed countries remain slightly below long-term averages and look cheap in comparison to other asset classes such as cash and bonds. Support for equities is expected to continue, with short-term valuations broadly neutral and fundamentals improving. The increasingly remote chance of a double dip recession, low inflation and interest rates, and simulative fiscal policy all contribute to a positive environment for equities in the year ahead.

On the basis of normalized earnings and longer-term fair value gauges, the TSX is reasonably priced but nonetheless remains one of the developed world’s more expensive markets. With its resource-heavy composition, the TSX is expected to respond very favourably to the global economic recovery, particularly amongst Asian countries.

The scale of cost cutting, combined with low interest rates and rehabilitation in the financial markets suggest that U.S. corporations could achieve earnings growth in the order of 20% in ach of the next two years. Commentators are calling for single digit market returns in 2010. Going forward, performance will be based more on sector and earnings growth, and less on macro economic recovery. In short, 2009 was a macro growth story, 2010 will be a micro one.

As pessimism surrounding the economy disappears, stocks have rebounded. We maintain that improved earnings are required to drive stock prices higher however. That is, we do not expect price increases from higher P/E multiples, as multiples are not likely to rise during a period of escalating interest rates. Our outlook is somewhat more positive for Asian equities, where markets are benefiting from an attractive combination of excess liquidity, consistently low inflation and strong demand from China, which continues to vacuum up imports from neighbouring countries.

It is a delicate balance to sustain the continuing higher market without a hiccup or minor correction. Strong growth could hasten the onset of higher interest rates, perhaps causing them to rise quicker than most people expect. If growth is too slow, earnings will disappoint, which could result in poorer market returns. But the combination of rising long-end yields and tepid growth would be unambiguously negative for stock returns.

Many observers expect markets to peak early in the year, sag sometime in 2Q or 3Q, and stage a comeback towards year-end.

Ken Hawkins is Chief Investment Strategist at Weigh House Investor Services. Ken can be reached at ken.hawkins@weighhouse.com

[1] An asset bubble is formed when the prices of assets are over-inflated due to excess demand.

Your Investment ‘To-Do’ List - Top Five Financial Tips for 2010

By Carlo Palazzo

If you’re anything like me, your New Year’s resolutions have already gone by the wayside. Apparently, the atmosphere of the holidays, along with hefty helpings of food and wine, make many of us think we’ll become healthier, wealthier and wiser by year-end.

Don’t be deterred by January’s sobering return to work-a-day reality. It is a good time to set realistic goals - hopefully ones that you’ll keep. Here is a short list of financial resolutions you should consider for the coming year.

1. Get a Financial Plan

There are many reasons for sound financial planning. Perhaps the most compelling is that it will tell you how much money you need to save - and what rate of return you need to earn on your savings - in order to retire comfortably. Unfortunately these questions remain unresolved for many investors. Those willing to seek out answers are rewarded with peace-of-mind both now and in retirement.

Other topics addressed in a comprehensive financial plan include tax planning, saving for children’s education, and insurance coverage.

2. Compare your Investment Results to a Benchmark

At Weigh House, we believe that every investment portfolio should be managed with the same care and prudence as a large pension fund. And pension fund managers invariably measure their performance results against appropriate benchmarks! If you’re not measuring your returns against a benchmark, now is the time to start.

The first step is determining the right benchmark based on your portfolio’s composition. (Weigh House Investor Consultants can certainly help you with this determination.) Step two is asking your investment advisor to agree to that benchmark as the basis for measuring his or her performance. Step three is requesting a quarterly report that shows the rate of return you earned, and compares that rate with the agreed-to benchmark. If your advisor is unwilling to work with you on these requests, then red flags should be popping up everywhere - it may be time to get a new advisor.

3. Pay Yourself First

January and February are known in the investment industry as ‘RRSP Season’, a time of year when many Canadians make their once-yearly deposit to their RRSP. But is a once-yearly deposit really the best way to save for retirement? We don’t think so.

According to The Financial Advisors Association of Canada, people who wait until the last minute typically save less than those who save smaller amounts each month. Also, last-minute contributions often result in last-minute investment decisions - not the sort of decision-making process you should rely on.

In contrast, we implore you to ‘pay yourself first’. Paying yourself first is a financial planning concept that treats your savings plan as if it was just another monthly obligation. Implementing this strategy involves setting a monthly savings target, and having your bank automatically transfer the target amount from your chequing account to your investment account each month. Too often people pay themselves - save their money - only after they’ve paid everyone else. The problem is that people buy both needs and wants - and since our wants will always exceed our income, there is never any money left over at the end of the month to save. An automatic savings program sets money aside before it can be squandered on non-essentials.

4. Open a Tax Free Savings Account

This is a no-brainer. If you are currently paying tax on your investments, why not move them to a Tax Free Savings Account and eliminate the Government’s take?

Even if all of your investments are in an RRSP, you still need an emergency fund. The Tax Free Savings Account is perfect for liquid savings, as the interest is tax-free and, unlike an RRSP, money can be withdrawn at any time without losing your contribution room.

5. Buy a Home

Don’t look now, but the posted interest rate on variable mortgages is about 2.25%. Quite often, borrowers can get loans below the posted rates - so a variable rate mortgage in the range of 1.5% is not unrealistic right now. Such rates represent a once-in-a-lifetime opportunity for home buyers.

Caution is necessary however. If mortgage interest rates rise - which they are almost certain to do - then your monthly mortgage payments will rise with them. Furthermore, you are not the only person thinking about buying property and the influx of demand has many suggesting that the real estate market is due for a correction.

So if you have been considering buying a home, now is a good time. Just keep in mind that you should carefully gauge your capacity for debt. You should ensure your mortgage is low enough that if rates rise you can still comfortably make your monthly payments. Secondly, arrange a comprehensive appraisal of any property you choose to bid on. You want to ensure that it represents good value.

Carlo Palazzo is a Financial Analyst at Weigh House Investor Services. Carlo can be reached at carlo.palazzo@weighhouse.com.

Financial Planning for Today ... and Tomorrow

By Mike Macdonald

One of the toughest challenges for anyone under age 40 is fitting important, but not urgent, retirement planning into their hectic schedules. Everybody is well aware that retirement planning will eventually be important, but when does it make sense to begin? Unfortunately, most retirement information is presented by companies who sell investments. It is no wonder their message always seems to suggest you need to save every penny and scrimp today to enjoy a great life in some distant future. For most of us however, it becomes a matter of making choices for our immediate needs, and a far-off retirement is not likely to be a top priority. Financial planning, as opposed to retirement planning, is designed to help you make the right choices today between spending, investing and reducing debt. Not all these activities are of equal importance at every stage of your life.

Most people would benefit by creating a simple financial plan. It will assist you in setting priorities and provide better understanding of the choices you control. Update your plan every few years and you will find yourself making the right choices for you and your family for both short term and long term decisions. Along the way, a good plan will guide you to take the steps necessary to build a solid retirement when the time and priority are right for you.

The majority of people would be better served by developing a sound financial plan and a conservative investment strategy, rather than by engaging a salesperson to construct an expensive mutual fund portfolio that has little or no regard for personal financial circumstances or lifestyle objectives!

Tips for Developing Your Financial Plan:

  • Your financial success will very likely be based upon saving continuously over a long period. The best saving vehicle for most people is a company pension plan and you benefit from joining a plan regardless of how long you think you might work at your current firm.
  • Saving a small amount (5-10%) of your paycheque via automatic withdrawal from your bank on payday allows you to ‘pay yourself first’ and makes saving money a little less stressful.
  • Early in life, you need flexibility more than tax benefits so you might decide to build an emergency fund in the new Tax Free Savings Account before you worry about RRSPs.
  • Fees (particularly mutual fund fees) will siphon off a large portion of your investment returns. Keep fees low and you will generally have better results. As an example, you might look at ETF index funds as a great alternative to conventional mutual funds.
  • During the early years of our working lives, we will likely use debt to help us fund our lifestyle. Keeping total monthly obligations under 40% of your income will help you avoid a debt crunch. Focus on eliminating credit card, consumer and student debts as quickly as possible.
  • Have a plan for your money and update it every year to ensure you are comfortable with where your money is going.

Once you start growing your savings, you will begin to focus on how your money is invested. The biggest challenge in investing money is getting unbiased investment advice. Regardless of whether you hire an advisor or do-it-yourself, the best person to monitor your investments is you! Having a simple easy-to-execute plan and investment strategy allows you to maintain control of your finances at all times.

In short, what you do today will have a significant impact on the quality of your retirement years, but we have different priorities at each stage of life. Financial planning puts these priorities into perspective, providing useful guidance over a long life, to ensure the last one third is as great as the first two thirds.

Mike Macdonald is a Weigh House Investor Consultant in Burllington, Ontario. He can be reached at mike.macdonald@weighhouse.com.