Focus on quality in range-bound market

In economic terms, the planets seem to be lining up. First the markets rebounded from their recessionary lows. More recently, the Bank of Canada has been warning that interest rate hikes are on their way.

Today there was even more evidence that Canada’s recovery is in full swing, as Statistics Canada reported January marked the fifth consecutive gain in gross domestic product.

But so far, Canadian investors are only dipping their toes back into the risk pool

The 2010 RRSP season saw investors continue to prefer income-oriented products, with bond and balanced funds leading sales. This marks a return of capital that had been parked in short-term assets, and reflects a slight increase in risk appetite.

“Income oriented funds are perceived as being less risky, as they are less volatile — certainly they proved that in 2008 — but I think its was also a response to the very low interest rates being offered in the traditional safe havens, like money market funds and savings accounts,” says Norman Raschkowan, chief investment officer at Mackenzie Investments.

But another factor driving the income story, is that aging baby boomers are rotating into these assets, a trend which Raschkowan sees continuing as more boomers exit the workforce.

“People are more conscious now that when they retire, their savings are going to have to last 25 or 30 years,” he says. “You need to have that element of inflation protection that is provided by participating in the growth of the economy.”

The income bias could benefit the financial and utilities sectors, while the growth requirement should drive capital into more economically sensitive areas, such as resources and technology.

“One thing that was a bit of a change in February was that we started to see net flows into domestic equity funds. You really hadn’t seen that, despite the fact that the TSX has done quite well from the lows of a year ago.”

While this is yet another instance of Canadian investors chasing returns, he says it is encouraging to see this sign of confidence in the overall economy.

“If you look at the domestic market, things are improving and we’re fortunate that one of the byproducts of a stronger currency is that it keeps interest rates lower,” he says.

Larger businesses are benefiting from the currently low interest rate environment, using borrowed capital to fund expansion once more. But Raschkowan says the economy is somewhat “bipolar” in that smaller businesses are struggling to secure financing.

“Small business has more sensitivity to the Canadian dollar, and you tend to see smaller manufacturing businesses more reliant on the export market,” he says. “I think we’re still a few months away from them being able to say that the world has turned.”

The Bank of Canada has made its intention to raise interest rates around mid year abundantly clear, so even if small business is able to secure financing, it could be at a greater cost. But Raschkowan says the economy can withstand higher rates.

“I think the early stage of rising interest rates doesn’t tend to disrupt the market or economy, because it’s really in response to improving economic growth,” he says. “It’s a confirmation that the economy is in good shape and that people can anticipate rising profits from their investments.”

What’s more disconcerting, though, is the impact that soaring government debt will have on global debt markets.

With a glut of sovereign debt coming to market, corporations are facing higher costs of capital as they must compete with higher rated issuers. This drives up the cost of capital, limiting companies’ ability to expand operations and moderating growth prospects.

“Growth isn’t going to be as robust as it was in past post-recession cycles,” he says. “Our expectation is that we’re going to have a market that is range-bound — trading within an upwardly sloping band, but still providing pretty modest returns.”

Investment managers who focus on quality companies will excel, as those businesses with stronger balance sheets will outperform their peers. One strong sign of that quality is the dividend, which he says should not be seen as a drain on growth potential.

Taking a value tilt, he says investment opportunities abound in the U.S. right now, as many investors are still unenthusiastic about the world’s biggest economy. But that opinion ignores those companies that are far more exposed to the global economy than the American consumer.

“U.S. multinationals are going to be in a position where they can benefit from the fact that the U.S. dollar, over the last five years, has come down a lot,” he says. “That’s made U.S. multinationals more competitive worldwide. Those tend to be companies that are leaders in their field, but also tend to pay reasonable dividends.”

(03/31/10)