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The Markets: Update & Outlook

Canadian investors and financial markets spent the last quarter focused on the events unfolding south of the border. The struggle of the U.S. Congress to deal with the self-inflicted "fiscal cliff" legislation dominated the news and stalled financial decision making. The eleventh hour compromise was reached by eliminating the immediate tax increases for the average tax payer and it avoided the strong possibility of recession in 2013 if the tax increases had occurred. Unfortunately the compromise was far from complete and effectively postponed many significant issues for resolution down the road. This ensures that 2013 will see more crisis points as the U.S. Congress and the President deal with further cuts to entitlements, subsidies, and perhaps further tax increases, if the basic excess debt problem is to be solved. The debt ceiling, which has been a point of conflict in the past, will have to be raised in the next several months - so stay tuned for more political battles. On a more positive note a number of new representatives have joined the U.S. Congress. The recent increase in the discontent of American voters with their elected representatives should have some calming effect on some of the more disruptive political elements. The fact that compromise was reached to avoid the “fiscal cliff,” hopefully will set a pattern for future decision making.

Looking beyond the distraction of recent U.S. political battles, how has the U.S. economy been progressing? Recently overall growth has been in the 2 1/2% to 3% range which is not bad but not the 4% plus growth needed to soak up the existing levels of unemployed workers. Despite the "fiscal cliff" threat December job numbers showed the U.S. added 155,000 plus jobs.Auto sales were also buoyant and positive retail sales numbers showed consumers were still willing to spend.The U.S. housing sector is also showing signs of recovery as inventories of existing housing continue to decline. The U.S. corporate sector remains in excellent shape with significant cash reserves. The Federal Reserve continues to pump $40 billion a month into the U.S. economy through its purchases of mortgage backed securities and new security issues. This is helping the U.S. banking system to continue to repair the damage caused by the sub-prime mortgage fiasco and the housing bubble. Interest rates are low and will likely stay low in 2013 which will provide further support for economic growth.

Against this background 2013 looks to be a year of slow growth in Canada and the U.S. similar to that experienced in 2012. The process of controlling and reducing debt will occupy the attention of individuals and governments. A general sales tax in the U.S., similar to the one in Canada, is a solution gaining some attention. No quick solutions are likely and the debt problem in the U.S. will still exist next year end but progress will be made. In Canada our move towards a balanced Federal budget will continue but it is not likely to happen until 2016.

While growth in the U.S. is good for Canada, we face some specific problems here. A major engine for growth in Canada has been our energy industry. The billions of dollars being spent on the Alberta oil sands development and our exports of oil and gas to the U.S. provide jobs and corporate income for many Canadians. Delays in pipeline construction plus increases in U.S. oil and gas production have reduced oil and gas prices in Canada significantly. Slower growth in this important sector will impact overall Canadian economic growth. Solutions such as shipping by rail and reversing pipeline flows will provide some near term relief. However Canada must expand its ability to export outside of North America as North America moves towards self-sufficiency and perhaps a surplus in fossil fuels.This is an issue that should be monitored closely in 2013.

Canadian housing markets appear vulnerable. More restrictive requirements on mortgage loans have slowed sales and are likely to cause some decline in residential real estate prices. A continuation of low interest rates plus some economic growth should help prevent a real estate crash like the one that occurred in the U.S.

Another potential Canadian problem in 2013 may be our currency. With the U.S. pumping billions in new cash into the U.S. system there is the potential for a weaker U.S. dollar vs. the Canadian dollar. A Canadian dollar at $1.10 U.S., a level reached in 2007, would obviously be a significant problem for Canadian trade.

What kind of financial markets can we expect in 2013? As in 2012 equity markets will be driven more by psychology than fact. Remember the reaction of markets to the problems in Europe in 2012. The Eurozone was going to collapse and bring down the financial systems in North America. Our equity markets sold off. What happened? Nothing. The Eurozone is still struggling but still there. The unfortunate fact is that in this kind of environment the average investor has lost faith in our unpredictable equity markets. This situation compounded by computer driven trading has put the average investor at an immediate disadvantage. Large investors such as pension funds or university endowment funds are investing in non-market traded investments such as real estate, mortgages, and commodities. At Northland Wealth we are using some of these instruments in our client accounts where appropriate. Fixed income markets have attracted many investors but returns remain low.

In past years, fixed income portfolios offered capital gains but with interest rates going sideways or potentially rising, the price appreciation potential has either moderated or been eliminated. Given this backdrop, we have employed an actively managed credit strategy (where suitable) to further reduce portfolio volatility while offering increased return potential from the fixed income sector.

In 2013 we believe that while emphasis should continue to be placed on high quality dividend and interest paying securities, allocations to alternative assets such as private real estate, infrastructure, gold bullion, and absolute return credit strategies should be utilized (when and where appropriate). This will be done with the intent of providing greater portfolio diversification along with improved performance.

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