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A Time for Caution

During the past year investors have seen an almost uninterrupted rise in North American equity markets. Even better, Canadian equity markets, after being left behind by US equity markets in the first half of 2013, have for the last year out performed the US. This out performance was somewhat diluted by a decline in the Canadian dollar versus the US dollar. However that decline has been positive for Canadian exporters, particularly Canadian energy companies. The Canadian economy was also able to handle one of the worst winters on record and posted positive growth in the first quarter of 2014, compared to the US that experienced a decline in GDP in Q1.

World equity markets have changed dramatically over the last year and a half, from markets driven by emotion with little interest in fundamentals, to markets focused on fundamentals with little or no fear or emotion. For example, remember in the recent past the impact of emotion and the market declines caused by the Greek debt default. Financial problems in a country that constituted perhaps 3% of the GDP of the European Union were seen as having the potential to cause the collapse of the EU itself. North American equity markets declined and returns for investors in the two years ending Dec 31st 2012 were dismal. The memory of the market crash in 2008 was still fresh in the minds of too many investors and no one wanted to be caught off guard again.

How times have changed! The ongoing problems in the Ukraine escalated. The pro Russian President of the Ukraine fled to Russia and Russia took over the Ukrainian Crimean province. Western countries objected – armed conflict broke out in pro Russian Ukrainian provinces. Suddenly a full blown East – West crisis was in place complete with threats and sanctions. Financial markets ignored it all and continued to be buoyant in North America and Europe. Why not?

The fundamental economic and corporate news continued to be positive. Unemployment in the US and Canad declined steadily. The US housing market continued to recover. Interest rates in Canada and the US stayed low with promises to keep them low. Equity markets in North America posted positive returns despite the beginning of the reduction of Federal Reserve stimulus. In Europe financial markets also moved ahead, with equity markets rising, and interest rates declining,with Spanish government debt interest rates falling to match US Treasury levels.

Financial markets have moved from being totally paranoid to being totally complacent. Measures of volatility have fallen to extreme lows with bad news having little or no impact. History has shown that this type of market attitude rarely lasts for too long. Eventually reality sets in and a truly damaging political or economic event will occur and the fear (not greed) returns to financial markets.

Such an event may be on our doorstep. The success of the rebels in Iraq is disturbing as so far they have been able to defeat the regular Iraqi army at will. While the Iraqi government has continued to assure the world that the oil production in southern Iraq is secure, they have yet to stop the rebel advance. Should the rebels close down Iraqi oil production, two million barrels of oil a day would be taken out of world markets. Oil prices could rise dramatically - which would have an immediate negative economic impact.

What is of particular concern in Iraq is the nature of the conflict. To a degree this is a religious war pitting Muslim Sunnis (the rebels) against the Muslim Shiites. These two branches of the Muslim religion have been in conflict for centuries. Europe in the 17th century experienced the Thirty Years War, a religious war with Catholic states and Protestant states in conflict. That war has been termed one of the most destructive conflicts in European history, as entire regions of central Europe were devastated. The larger players in the Iraqi situation are Shiite Iran and Sunni Saudi Arabia, with the US caught in the middle. If this situation continues to deteriorate financial markets will have to take notice and react negatively.

Despite a relatively positive economic outlook, the Iraq situation is definitely a black cloud on the economic horizon. The Canadian energy sector would benefit, but higher energy costs would be a drag on all areas of the economy. The real question would be will higher energy costs cause another world recession? Unlikely as that possibility is, even a hint of such a development would bring some fear and volatility back into financial markets.

Our investment strategy at this current time emphasizes dividend paying stocks and/or exchange traded funds (with a moderate increase in exposure to the energy sector) combined with institutional quality alternative investments which employ strategies such as unconstrained credit/fixed income, direct lending (through professionally managed mortgage pools) and equity ownership in real estate with the objective of providing equity like returns with lower levels of volatility. We believe our clients’ portfolios are well positioned for a period of equity market weakness.

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