Industry News

WHAT'S HAPPENING?
The temperature is rising across the country, but the heat is being felt most on Capitol Hill where government officials continue to negotiate a plan to address the U.S. deficit, and the more immediate August 2nd deadline (ironically also the 102nd anniversary of the first Lincoln penny being issued) when the U.S. will potentially run out of money to meet all its obligations, refrred to as the debt ceiling.

While politicians continue to debate, negotiate and posture, the mere contemplation that the U.S. would default on its debt and suffer a downgrade in their credit rating has shaken investor confidence and created near-term market volatility.  We've also experienced a rise in gold prices (the other flight-to-safety destination), and a fall in the U.S. dollar's value coinciding with uncertainty around the U.S. economic health.  In spite of the looming deadline, U.S. government debt yields have not risen dramatically in recent weeks.  Call it optimism, habit or that strange phenomenon that causes someone to look directly at a solar eclipse; investors have continued to buy U.S. government debt amidst the increased attention on the upcoming debt-ceiling deadline.

WHAT'S NEXT?
While no one can accurately predict the short and long-term outcomes that will result from the U.S. debt ceiling deadline and overall deficit concerns, we outline three potential near-term scenarios:

Scenario A:  U.S. government officials strike a deficit reduction deal and avoid a default and U.S. avoids a credit rating downgrade.
A large deficit-reduction deal coupled with a debt ceiling increase should relieve much of investors' uncertainty around the issue and therefore, be well received by markets.  In this scenario we expect riskier assets, such as cyclical commoditites and equities that are more levered to economic conditions, to perform better than less risky assets like bonds, gold and defensive equity sectors.  Bond yields may decrease further as investors become more comfortable with the U.S. fiscal picture.  The U.S. dollar would likely remain depressed or continue to gradually decline in value, creating longer term upward pressure on commodities and inflation.

Scenario B:  U.S. government officials strike a deal and avoid a default, but U.S. debt credit rating is still downgraded because reduction plans are not seen as comprehensive enough by the rating agencies.
This scenario poses the largest grey area in terms of likely outcomes because capital markets have already begun to factor in some of this risk; therefore it becomes a matter of degrees to which the makets will respond.  We've already experienced a rise in gold prices, considered the other traditional safe-haven investment, and volatile equity markets with a modest downward trend.  As well, the U.S. dollar has taken a significant haircut against a basket of world currencies, including the Canadian loonie.  Overall we expect markets to respond negatively to the news of a credit rating downgrade (gold up, equities down, U.S. dollar down, bond yields up), but the degree to which each of these outcomes is realized will depend in part on how much the market has already anticipated this scenario.

Scenario C:  U.S. government officials fail to strike a deal.  The U.S. defaults and the U.S. debt credit rating is downgraded.
This is the one scenario everyone is supposedly working to avoid, and we believe it will be.  That said, it is a possibility and we would expect capital markets to react quite negatively in the near term, creating an increase in market volatility.  Risk assets would likely decline in value (equities and commodities), while defensive assets and bonds would attract more investment dollars.  We would expect yields to rise to account for the higher risk rating.  A U.S. recession would be a major risk under this scenario if a deal was not struck quickly to reverse the default.

KEEPING A LONGER-TERM PERSPECTIVE
The longer-term scenario is much harder to predict as at any time any number of unrelated events, both in the U.S. and abroad, also influence market trends.  Having said that, there are many positive signs the broader outlook for the global economy remains positive, which provides support for a positive longer-term outlook for equity markets.

• Global economic expansion continues, led by emerging markets, China's GDP grew by 9.5 per cent in Q2 year-over-year.  This slowed from Q1, but still is strong in the face of higher interest rates and reserve requirements.
• Corporate balance sheets are strong and holding lots of cash; while at the same time corporate earnings growth continues to exceed expectations in the current earnings season.  Eighty percent of S&P500 companies have beaten earnings expections to date.
• The Canadian economy has produced more jobs this year, with current unemployment rate at a two and a half year low.
• U.S. consumers are slowly improving their personal balance sheets with a ratio of personal debt to disposable income trending lower.
• Interest rates remain at low levels on a historical basis which provides additional support to help mitigate macroeconomic risks.

GOING FORWARD
GLC's portfolio managers and analysts are always monitoring factors that affect the investment mandates they manage.  This includes economic and market conditions to identify opportunities that provide long-term investors with attractive risk-adjusted opportunities.  Over the past two years and leading into the second quarter of 2011, world markets including the S&P/TSX Composite and the S&P500, experienced a significant market run, so a consolidation of gains in the markets and a general re-pricing of risk is normal.  While the U.S. debt concerns may be taking top headlines now, in the longer-term investors will benefit from renewed confidence as market fundamentals and corporate balance sheets take precedent over headlines and top-of-the-hour news reports. 

Taken from GLC Asset Management Group
www.glc-amgroup.com - July28, 2011