Quadrant Asset Management - QAM Update - January 2013

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The QAM letter that highlights recent developments that we think either affect the markets or are important to understanding them.

"Uncertainty is an uncomfortable position. But certainty is an absurd one."
- Voltaire, French Philosopher


Tapering

In sports, a critical time for coaches and athletes is the taper phase. The primary objective of tapering is to decrease the training stress to allow the body to recover and eliminate fatigue. When the training level is decreased, fatigue decreases more rapidly than fitness, and increased performance results from the increasing difference between the two factors. Thus, in a well-designed taper, the body becomes rested (with all the associated benefits) and the athlete's fitness level is well maintained.

This is not the type of tapering we would like to discuss in this issue of the QAM Update. However the constant comparison by the investment industry - in commercials and the media - of competitive sports and high-profile athletes with the investment management process, has always intrigued us at QAM. It is interesting to note that, to the best of our knowledge, no high-profile athlete compares himself or herself with any portfolio manager.

Portfolio management is not a competitive sport; it is both an individual and team effort to achieve some predetermined financial goal, balancing one's risk-tolerance level with the desire to protect and enhance capital wealth. Many investors fail to follow simple, time-tested tenets that improve the odds of achieving success and, at the same time, reduce the anxiety naturally associated with an uncertain undertaking due to this erroneous comparison as a competition.

So what is "tapering" in the financial markets and how would it affect portfolios?

Central Banks continue to utilize the strategy of financial repression to keep interest rates low in an effort to fuel national economies. In May the Federal Reserve indicated that tapering (a reduction in the bond buying program) was possible as early as the end of 2013. Positive data on the health of the US economy was one of the reasons to support such a statement. So the message from the Fed was a good one - things are looking better.

Reacting to the news that the $85 billion monthly bond buying program would be tapered by the Fed if their benchmark targets of unemployment and inflation were being met sooner than previously anticipated (good news),investors (speculators?) rushed in and re-priced risk in a matter of weeks. Yields on the 10-year US Treasury moved from 1.6% to 2.6% before ending the quarter at 2.5%. Basically, the bond market treated good news as if it were bad news. As Charles Munger (Vice-Chairman of Berkshire Hathaway) said about the current economic problems: "if you are not confused you don't understand it very well."

What the Fed seems to be implying is that, while slowing down on its asset purchase program (injecting more money into the system) might happen sooner than expected, they are not stopping it for now nor they will do it abruptly. It is information to be aware of and taken into consideration when making investing decisions but, at QAM, we wonder: is it all that surprising? What were the markets expecting? Eternal money printing?

As Charlie Munger said in the last Annual Shareholders Meeting of Berkshire Hathaway in Omaha "economists should worry about consequences of printing a lot of money" and we, at QAM, say that investors should worry a little too.

There is some perversity in the dynamics at play as the Federal Government benefits by some inflation that is induced by quantitative easing. Debt is measured in nominal Dollars. And the Federal Government has more than just a little debt to pay. There is a strong incentive to deflate that liability and at the same time provide monetary stimulus to the economy. But the risk of overdoing it and creating excessive inflationary pressures are very serious and we understand are front of mind of the Fed and other Central Banks officials.

At QAM we think that, more than ever, Investment Management is about risk management and managing uncertainty. We estimate that the topic of rising interest rates is going to be a dominating theme in the next months. Our Investment Committee meets weekly to focus on the fixed income dilemma. We would rather shorten duration and give up yield than risk the negative impact of rising rates.

We remain firm in our belief that inflation protected growth in the long-run comes from holding high quality stocks, while liquidity requirements and stability has to be provided by a prudently selected Fixed Income position in the portfolio.

Q2/2013 in Perspective

Performance as of June 30, 2013 (CAD)
  3 month 1 year 3 years 5 years 10 years
S&P/TSX Composite Index -4.1% 7.9% 5.4% -0.5% 8.4%
S&P 500 Index 6.5% 24.6% 18.0% 7.7% 4.7%
MSCI EAFE Index 2.8% 23.1% 10.1% 0.5% 5.5%

Government of Canada Benchmark Bond Yields
  28-Jun-13 29-Mar-13 29-Jun-12
2 Year 1.22% 1.00% 1.03%
10 Year 2.44% 1.87% 1.74%
30 Year 2.90% 2.50% 2.33%

The second quarter of 2013 showed mixed results with the US Equity Market, represented by the S&P500, posting a very strong 6.5% return in CAD and the EAFE Index (Europe, Australia and Far East) posting a positive 2.8% in CAD while the MSCI Emerging Markets lost 4.8% (CAD) and the Canadian Equity Market lost 4.1% being heavily affected by the poor performing Materials sector (22.8% down for Q2). The Materials sector represents approximately 13% of the S&P/TSX index.

Medium to long term rates increased significantly in Q2 with the 10-year Government of Canada Benchmark bond yield increasing 57 bps from 1.87% to 2.44% in synch with its US counterparts. As bond prices move in the opposite direction as interest rates (when interest rates rise, bond prices fall and the longer the bond the higher the magnitude of this relation in most cases), the DEX universe Bond Index posted the worst quarterly return since the mid-1990's losing almost 2.4%.

The Bank of Canada Key interest rate (the overnight target rate at which major financial institutions borrow and lend one-day funds among themselves) has been kept at 1.00% (at that level since September 2010).

The Canadian Dollar has depreciated around 3% in Q2 falling from $0.98 USD to $0.95 USD moving up to $0.96 USD following quarter end.

 

Disclosures

This report is prepared for the use of Quadrant Asset Management personnel and clients and may not be redistributed, retransmitted or disclosed, in whole or in part, or in any form or manner, without the express written consent of Quadrant Asset Management. Any unauthorized use or disclosure is prohibited.

The information herein was obtained from various sources and Quadrant Asset Management does not guarantee its accuracy.

Neither Quadrant Asset Management nor any director, officer or employee of Quadrant Asset Management accepts any liability whatsoever for any direct, indirect or consequential damages or losses arising from any use of this report or its contents.