Stick with stocks, BMO advises

“Our favourite sectors are still pro-cyclical though, financials, consumer discretionary, basic materials and technology,” said Jack Ablin, the chief investment officer, Harris Private Bank, in a recent BMO conference call. “With respect to the emerging markets, while we are certainly optimistic about their economies, we just feel that their markets are still overpriced.”

Ablin and Paul Taylor, chief investment officer, BMO Harris Private Banking, cautiously gave their take on the state of the U.S. and Canadian economies as they emerge from the Great Recession.

“While we are neutral in emerging [markets] right now, we would encourage any investor interested in the emerging [markets] to buy commodities, rather than emerging market equities,” Ablin continued.

“Well, that means just buy Canadian equity, which is music to our ears because not only do we manage the asset mixed profile of our client accounts, we manage Canadian equities internally,” Taylor chimed in.

“Our broad view is that we are relatively constructive on equities, but only because the alternative is so meager in terms of a return potential with returns on cash being basically nil and with returns on bonds, 10-year at 3.4%,” he continued. “Inflation eventually will be an issue that the Bank of Canada will have to start being concerned about, probably in 2011, 2012. We don’t see value in government of Canada bonds in the current environment.”

The BMO team is not alone. The latest results of a Russell Active Manager Report, support their view. In the study, active managers stated they believe 2010 will offer an opportunity to add value above the S&P/TSX benchmark.

“The expectation is that stock selection rather than sector positioning will have a larger impact on active manager performance in 2010, compared to 2009,” said Kathleen Wylie, the senior research analyst at Russell Investments Canada Limited. “The improvement in sector breadth that started in the fourth quarter of 2009 appears to be extending into 2010, which will certainly benefit the benchmark-relative performance of active managers. If correlations of stock returns are lower, this development will make it a better market for picking stocks. As a result, investment managers with skill in selecting stocks will be rewarded.”

In fact, January was a good month for large-cap Canadian equity investment managers. Eight out of 10 S&P/TSX Composite Index sectors outperformed the overall benchmark. Only the energy and materials sectors lagged.

According to Wylie, if the trend continues, active managers could beat the S&P/TSX benchmark as large-cap managers have their largest underweights in energy and materials.

Approximately 36% of large-cap managers outperformed the S&P/TSX benchmark in the first quarter of 2009, 38% in the second and 41% in the third. By the fourth quarter of 2009, sector breadth improved with seven out of 10 sectors beating the benchmark and 57% of managers outperforming the benchmark.

“Over the past 10 years, large-cap Canadian equity investment managers have outperformed the benchmark on average by roughly 190 basis points per year,” said Wylie. “This level of outperformance highlights the benefits of active management and expert stock selection over the long run.”

Economic outlook
On the state of the U.S. and Canadian economies, Ablin and Taylor say GDP growth will benefit from the tailwind provided by stimulative policies.

“I would argue that tailwind is unfortunately artificial. It is an electric fan powered by batteries and those batteries are set to run out mid to late this year,” said Ablin of the U.S. government stimulus. “The good news though is that the most recent report on GDP and manufacturing suggests that we are moving into 2010 with a running start and we will have enough momentum during the middle of the year so that when we do take this patient off life support, they will have a pulse.”

Ablin predicts an eventual slowdown as Americans see their tax rates starting to increase in June when most state and local governments have to make up the pullback in income tax receipts they had collected for 2010.

“At some point we are going to be facing higher taxes, facing an economy that will not be propped up by as much stimulus,” Ablin predicted. “We are going to see momentum slow down, potentially a breakdown, which case we would starting raising defensive cash positions, sometime mid-year and expect that half of that gain that we enjoyed in the first half will be given back in the latter half of the year.”

Looking at the direction the Canadian economy, Taylor’s comments mirrored Ablin’s.

“We see an improving trend in leading economic indicators. We may have seen a little bit of a speed bump in some indicators of late but still believe the underlying trend is still fairly strong,” he said. Inflationary threats appear weak, as one of the primary drivers — higher wages — are unlikely in a high unemployment environment.

Ablin doesn’t believe inflation will be much of a threat this year in the United States either, based on his interpretation of bank lending and the velocity of money. Once those factors tick up, he will take that as an indication that inflation is imminent.

“We look at two offsetting factors. One, money supply growth reached a peak of 9% about six months ago and now has come down to 5%. Where is all this money going? It is going into the banking system. It is absorbing it like a black hole,” he said. “I watch velocity very carefully. Velocity is the number of times a dollar that goes into the banking system gets lent during the course of a year. It has reached a peak of between 3-and-a-half and 4 times. It is absorbing all of the money supply Washington has been creating.”

(02/03/10)