Investment Forum—1996

Head Table Guests

Liviya Mendelsohn, OAC student, Northern Secondary School; The Rev. Dr. Thomas Eng, Minister, Chinese Presbyterian Church of Toronto; Joseph Oliver, President and CEO, Investment Dealers Association; Mark Kassirer, President and CEO, Deutsche Morgan Grenfell Canada Ltd.; Rob Grundleger, Vice-President and Director, First Marathon Securities Ltd.; Jeffrey Green, President and Managing Director, Gordon Capital Corporation; Blake C. Goldring, President, AGF Mutual Funds and a Director, The Empire Club of Canada; Reay Mackay, President, RBC Dominion Securities; Tom Hockin, President and CEO, The Investment Funds Institute of Canada; Jim MacDonald, Vice Chairman, ScotiaMcLeod Inc.; Keith Gray, Executive Vice-President, Toronto Dominion Bank; and John MacNaughton, President, Nesbitt Burns and a distinguished Past President, The Empire Club of Canada.

Introduction by David Edmison

Samuel Clemens, also known as Mark Twain, said that "January is a very bad month for speculating, just like February, March, April, May, etc."

Twain, of course, was right; speculating can be dangerous and history tells us there are few winners. In fact there used to be a theory that the "odd lotter," the small investor who purchased less than a board lot of 100 shares, usually bought at the peak of a market cycle and sold at the bottom of a cycle. Well the small investor today, has, more often than not, used mutual funds as the favoured vehicle for investing. They offer diversification, a multitude of different products to choose from, and the professional expertise that investors now realise they require.

The mutual fund industry has grown dramatically over the years and along with other institutional investors, such as pension funds, completely dominate the financial markets. The largest U.S-based mutual fund company recently advertised that they had $320 billion in assets. To put this sum in perspective, this represents three-quarters of Canada's national debt.

With us today to offer their views on the outlook for the markets for 1996 are three of Canada's leading fund managers. They will present to us, at this important time as we contemplate where to invest our RRSP funds, their views on the outlook for interest rates and bond prices and foreign and Canadian equities. For those of you who attended the forum presented by The Empire Club last year and listened to the views offered by Michael Landry, John Zechner and Warren Goldring you would have been struck by the positive tone of each of their forecasts. You also would have done well by acting on their advice.

So, let us hope this year's forecasters are as helpful in making our investment decision.

Our first guest is Veronica Hirsch. She is Vice-President and Portfolio Manager for AGF Canadian Equity and the equity portion of the AGF Growth and Income Fund. AGF, after the recent acquisition of the 20:20 Funds is the fifth-largest mutual fund in Canada with $7.6 billion in assets under administration. AGF was founded in 1957 and has enjoyed a long tradition of steady returns through both up and down cycles. Ms. Hirsch has had over 16 years of investment experience and recently joined AGF from a large insurance company where she managed a variety of top quartile Canadian funds. Ladies and gentlemen, I ask you to please welcome our first guest Veronica Hirsch, who will discuss the outlook for Canadian equities.

Veronika Hirsch

If you've been watching TV or reading the press, you might have noticed my face peering at you and my voice proclaiming that "Timing is everything." Admittedly, not a particularly original statement. As a Canadian portfolio manager, if I were ever to turn bullish on our beleaguered Canadian stock market, now is the only time I have. The 1995 Quebec referendum and the possibility of another one by late 1997 doesn't leave me with much choice in timing. Thus I am compelled to make the bold prediction that the TSE 300 Index will reach 6000 sometime this year-a 28-per-cent return from the present level. This is predicated on the hope that gold will break out of its narrow reading range and reach $492.50 before the summer is over. I must warn you that I base this prediction entirely on hope rather than any depth of knowledge, but having managed a precious metals fund in my previous life, I have taken the liberty of impersonating a bullion expert. The Canadian market, with its strong correlation with the price of gold, should thus have a good run on the back of the gold move.

Having been attracted to the Canadian gold stocks, I envision the global investor broadening his horizons by buying many other resource stocks in Canada--preferably ones I own myself. His interest in the Canadian market would indeed be warranted, as our market does have a very high exposure to industries that flourish late in the business cycle, which is precisely the stage we are now entering. Let me tell you why I think the global investor will return to Canada, having been absent from our market since after the crash of 1987. Canadian membership in NAFTA has not only resulted in a restructured, focussed, globally competitive and well-financed corporate sector, but in a substantially increased growth of the export sectors of our economy. With NAF TA, we have gained access to foreign markets.

Last, but perhaps most important, governments on both the provincial and the federal levels have finally started demonstrating fiscal responsibility by either balancing their budgets or making significant strides toward deficit reductions. These were essential moves in regaining foreign investors' confidence in Canada.

If you would indulge me for a while longer, I would like to touch on some reasons why I feel bullish on the prospects of the equity markets generally, over the longer term.

Because the excesses of the 70s and 80s have necessitated government downsizing, economic growth in OECD countries will be meagre for the balance of this century, and most likely some years beyond. This will result in a lack of opportunities for people to improve their standard of living. I can substantiate this by quoting surveys that suggest, for the first time since the Great Depression, less confidence that future generations will be as well off as the current one.

Despite this lack of confidence, there is plenty of desire for the baby-boom generation to maintain its upscale lifestyle, while at the same time facing the prospects of the longest retirement period ever. But as Maurice Chevalier said: "Old age isn't too bad when you consider the alternatives." One obvious way out of this dilemma is to substantially increase the return on one's capital. This can be accomplished by replacing the traditional investments in interest-bearing instruments for the more recently popular equity investments.

This trend is, in fact, well advanced in North America, where there has been more inflow into the stock funds in the past three years than the total inflow into this industry in the previous 60 years. According to J. Kenfield Morley, "In investing, the return you want should depend on whether you want to eat well--or sleep well." Because of the busy lifestyle we all have, we have given up sleep anyway, and we can now only hope to eat well. Thus, I foresee an unprecedented flow of savings, inheritances, and pensions into equity markets. This marked increase in stock market participation should be positive for the direction of markets over time.

In conclusion, I have to quote fellow Canadian Edgar Bronfman: "To turn $100 into $110 is work. To turn $100 million into $110 million is inevitable." My interpretation: Everyone can become wealthy provided he has enough capital invested in the stock markets. Happy investing!

Introduction by David Edmison

Our next guest is Donald F Reed. He is President and CEO of Templeton Management Limited Toronto, President and Director of Templeton Investment Counsel of Fort Lauderdale, Florida, and Chairman, Portfolio Management Committee of Templeton Worldwide Inc. Templeton was founded in 1954 by legendary investor John Templeton. The firm was acquired in 1992 by Franklin Resources, a well-established U.S.-based mutual funds company. The Franklin/Templeton Group are the largest independent publicly traded mutual fund company in the world, with assets under administration of $135 billion.

Mr. Reed is responsible for managing both global and international portfolios on behalf of Templeton Management Ltd. Prior to joining Templeton he was President and Director of Reed Monahan Nicolishen Investment Counsel. He is active in the Financial Analysts Federation and was co-founder of the International Society of Financial Analysts serving as a Director since it was founded.

Ladies and gentlemen, please welcome Donald Reed who will cover the outlook for foreign equities.

Donald Reed

Thank you for inviting me to speak today to The Empire Club regarding our thoughts on international markets. We've all heard the old adages about forecasting. First of all, forecasting is difficult especially about the future.

Secondly, a forecaster should never give a market level and a date that this will be achieved in the same sentence. Today I intend to honour this second tradition. I should further add that any of the comments that you hear today are based on the combined wisdom of the global and international research team that I have the privilege to work with at Templeton.

We have already heard a forecast on the Canadian equity market. I can see looking at the audience that our Templeton analysts have been taking copious notes based on these comments. But what about the rest of the world? Ninety seven and a half per cent of all opportunities available to an investor are outside the Canadian borders. Furthermore, many of the largest companies in the world are located outside North America--seven out of 10 of the largest automobile companies, eight out of 10 of the largest chemical companies, and 10 out of 10 of the largest banking companies.

Templeton has earned its reputation by having the ability to invest on a bottom-up basis. In other words, we're stock pickers. In 1981, a global investor could invest in only eight countries around the world. All the other markets were closed. Today, as an organisation, we are investing in over 50 countries through our various mandates in global investing, including emerging markets and global fixed income.

We do not believe that we are clever enough to invest from a top-down perspective. As a top-down investor, we would be required to correctly forecast and rank economic growth in the 50 countries in which we invest. Second, we would be required to determine the lead-lag relationship between the economy and the securities market. Third, we would then have to rank, in terms of performance, these markets so that we could correctly allocate our portfolio in percentage terms to take advantage of this performance. We do not think we are clever enough to do this nor have we ever met anyone who possesses these skills. But if you ever run into anyone, please have them give us a call because we would love to hire them.

Recognising that we are bottom-up investors, it is probably most appropriate to give you a feel for where we stood at year-end in our global portfolios to give you an idea of how we positioned ourselves.

In 1995, we reduced our exposure to the U.S. market. At year-end a typical global portfolio would have held approximately 30 per cent in the U.S. which is somewhat below the exposure contained in the MSCI World Index. In the U.S. market we have good representation in capital goods, finance and other selected equities. At the same time we began to increase our exposure to the emerging markets. The emerging markets gained their most popularity in 1993. Returns of 70, 80, and 90 per cent in mutual fund portfolios exposed solely to these markets were not unusual. But the peak did come in 1993. Since that time we have seen markets like India, Brazil, and Columbia down 30 per cent. Argentina, Indonesia, Pakistan, Portugal, and Venezuela all down 40 per cent, while Greece, Sri Lanka, and Taiwan experienced market declines of 50 per cent. At the bottom of the list are Turkey and Poland whose markets were down about 60 per cent. These markets are not for the faint of heart. With this decrease in price came an increase in interest from our portfolio managers. As an organisation, we have been adding to Mexico, Brazil, Argentina and Hong Kong to name a few.

It is not unusual for a global portfolio to contain individual securities in 30 or more countries. We believe very strongly, as stated earlier, in the diversification principle which is, as Warren Buffet said, "Diversification protects against ignorance." Furthermore, we also believe in the principle of owning a basket of currencies. We've achieved this in some of our portfolios where we own as many as three dozen different currencies through investments in individual securities in various markets around the world. As it is an impossible task to forecast currency levels, this provides good protection against currency fluctuations as one currency offsets the other. In other words, what you may lose on the Deutsche Mark you'll pick up on the Peseta, maybe lose on the Pound Sterling, pick up on the Swiss Franc and lose on the French Franc.

Last year our research team visited over 50 countries and 1,000 companies. To do our job right we think this travel is a necessity so that we can better understand local customs, accounting differences, and trading differences between countries. We have adopted several principles of investing that were first espoused by our founder Sir John Templeton. The overriding factor that an investor should take to heart is that of common sense. And common sense tells us that if we look in many markets we are likely to surface more bargains than by just looking in one market. This basic principle has held true through the last 50 years.

So, where are we finding value? Small cap investments, generally speaking, on a worldwide basis have not performed well over the last several years. In 1995, we did see a pick-up in this area and we believe that going forward, small cap stocks do present interesting opportunities for capital appreciation. We have already talked about emerging markets and the fact that we have been positioning ourselves in several of the emerging markets where prices have moved lower through the last couple of years. With these lower prices has come lower risk in emerging markets. The emerging markets economies are growing at roughly twice the rate of those of the developed markets. Even if you question the economic growth in China over the last 10 years or so (it is reported to be at an 8-1/2 per cent compounded level over this period) it is still easy to realise that there is tremendous potential in that country. For example, oil consumption per capita in China is less than one barrel

per year. Just across from mainland China in Taiwan that number is 11 barrels per capita, and in Korea it is 13 barrels. Now I'm not saying that Chinese consumption will reach 11 barrels per capita per year in the foreseeable future but let's assume the consumption of oil in China were to rise to two or even three barrels per capita. Try to visualise what an additional 1.2 billion barrels per year or 2.4 billion barrels per year of consumption would do to OPEC and to oil prices on a worldwide basis. It's mind boggling.

When we look at the consumption of chicken in China, the average consumption is about one chicken per year. Contrast that with over 20 chickens per year in Hong Kong, 30 chickens per year in Singapore, and 39 chickens per year in the U.S. and think of the possibilities of growth in that industry. As a matter of fact there is stock that we've owned in the past, a Hong Kong company called CP Poxphand that we've been a great participant in at Templeton through the years. The products for this company were three--chickens, chicken feed and motorcycles. I don't know where the motorcycles came in but that was the actual product mix of the company.

Television is going through a growth phase in China right now. There are more televisions in China than there are in the U.S. There are fewer telephones, so there's growth potential there. But think about the television side of it for a minute and how that should be promoting the consumer products that we enjoy here in North America.

My colleague Mark Mobius in our emerging markets areas likes to tell the story about a family he met in China who was watching the television show, "Dynasty." The lady said to her husband "Why can I not have a Frigidaire like the one shown on 'Dynasty,' or why can I not have some of the other consumer products?" We think that China represents an outstanding opportunity for us, and not only China itself but also the regions that surround China. Needless to say we are bullish on the potential for China, Hong Kong and all of the outlying countries in the Far East.

While we are bottom-up investors at Templeton, common sense will dictate that you are likely to find more bargains in cheaper markets than in expensive markets. One look at our portfolios will show you that our exposure in countries such as Spain, Sweden, the Netherlands, and New Zealand is far above the level that is dictated by the index. The reason? All of these markets are trading below 13 times earnings while the World markets carry a hefty multiple in excess of 21 times earnings and the EAFE Index above 26 times earnings. The other fundamental valuations used by analysts such as P/B and P/CE are, for the most part, less than those of the index while the yield in some cases is well in excess of the index. So there's an indication of where we, as an organisation, are finding value but you should realise that we are long-term investors and are looking out five years in our analysis.

Some of the markets where we are finding it difficult to find value include the heavyweights such as the U.S. and Japan. I have already spoken about the U.S. and the fact that a value investor often will not show heavy exposure to the high-tech area. Our exposure is currently 30 per cent. Japan presents an additional difficulty. As probably the first investor in the Japanese market several decades ago, Templeton was able to buy securities at three times earnings in an environment where the market was trading at four times earnings. At year-end, the Morgan Stanley Japanese Index was trading at 105 times earnings. Indeed. A multiple of 105 indicates that it will take 105 years of earnings at current levels to realise the price of the index. Now let's be fair. That assumes no growth in earnings over this period. But even if we should determine that earnings will grow twice as fast it still indicates recapturing the price of the index in about 50 years. Contrast that with the Netherlands trading at under 13 times earnings then you soon realise that the earnings will recapture the price of the index in just 13 years. As value investors we have a lot of difficulty finding individual situations in Japan but we have been able to find a modest number of situations that represent value and should a correction occur on that market, more value will emerge.

In the final analysis, as a firm looking forward, we are bullish on the international markets. As analysts and portfolio managers we travel a lot visiting companies in many exotic locations around the world. I recall mentioning to Sir John that the international markets are so exciting that I'd almost be willing to do this job for free. As his eyes opened wider, and for those of you who know the thriftiness of Sir John, I had to repeat the most meaningful word in that statement, "Almost."

Thank you for taking the time to listen to me today.

Introduction by David Edmison

Our final guest speaker is Alan Brownridge. Mr. Brownridge is Senior Vice-President of I. G. Management Ltd. l. G. Management is the wholly owned subsidiary of Investors Group, Canada's largest mutual fund company, with assets under administration of $18 billion. Mr. Brownridge is responsible for overall development and co-ordination of strategies and policies pertaining to the management of over $3 billion of fixed-income assets managed by I. G. Investment Management. Our guest has a C.G.A. in addition to his C.F.A. and has authored several articles on investment management. Ladies and gentlemen, I ask you to please welcome our final speaker, Allan Brownridge, who will discuss interest rates and the prospects for the bond market.

Allan Brownridge

Bond investments, after selling off dramatically in 1994, posted one of the best years on record in 1995. In local currency terms, government bond returns within the G-7 countries varied from 17 to 32 per cent. If one factored in the currency gains and losses, the returns varied between 12-43 per cent. The Canadian bond market held its own, putting in its third-best year ever--despite concerns earlier in the year by foreign investors over Canada's large accumulation of public sector debt and later in the year the referendum in Quebec.

Well, that was 1995. What happens in 1996?

After such spectacular bond returns last year, it would be very easy to suggest that 1996 will turn out to be a replay of 1994. After all, interest rates declined sharply in 1993, only to reverse direction in 1994 after the American central bank, the Federal Reserve, began to raise interest rates in February of that year. From a bond investor's perspective, the biggest difference between the start of 1994 and 1996 is that the Federal Reserve is not about to raise interest rates. We think the opposite will occur. We expect a continued easing of monetary policy in the U.S. that will result in short-term rates moving lower by one-half of one per cent to one per cent. If you are a bond investor that is not bad news. Bond investments rarely do badly when monetary policy is easing. Conversely, when policy turns restrictive and short-term rates are rising, it usually is not too late to reduce one's exposure to bonds. Because of the high correlation of Canadian interest rates to those in the U.S., Canadian investors are required to pay as much attention to what the Federal Reserve is up to as to what the Bank of Canada is doing.

In our view, we think there is a strong case for both central banks to continue lowering administered rates. While Canada's weak domestic economy badly needs lower interest rates, we also think that economic growth in the United States this year will prove to be disappointing. Let me propose a number of points to illustrate our concerns about the risk of slower growth this year.

1. The U.S. economic expansion is moving into its sixth year this spring. The post-war average has been just over four years. The odds favour a slowing of economic activity in 1996 if for no other reason than the age of the current expansion.

2. While levels of consumer debt are at record levels in Canada, they are also dangerously high in the United States. Consumer instalment debt has increased by over 30 per cent during the past two years. Delinquency rates on bank credit are at recession levels and the percentage of disposable income American households are devoting to debt service payments is now roughly 17 per cent--a level which, although below the peaks of the last recession, is still historically very high.

Some economists have argued that today's high debt levels are manageable because the net worth off individual Americans has increased due to the rise in financial asset prices in recent years. Last year alone, financial asset prices in the U.S. increased by $2 trillion. This more optimistic outlook may be correct, but in our view a disproportionate amount of these gains have accrued to the very wealthy and largely older Americans, both groups typically not highly indebted. As far as being able to spend some of the income from these gains, most of the interest and dividend payments are not in spendable form but locked in tax-sheltered investments--only 20 per cent of U.S. households actually receive spendable dividends.

3. Fiscal policy will continue to act as a minor drag on economic growth in 1996.

4. Monetary policy in the U.S. cannot be described as easy. Today's Federal Funds rate of 5.5 per cent relative to an inflation rate of under three per cent is by historical measures still slightly restrictive. Relative to an inflation rate below three per cent, the prime lending rate at 8.5 per cent strikes us as being quite expensive.

It is interesting to note that 1996 is also a presidential election year. Business downturns haven't normally occurred during election years perhaps because the central bank has erred on the side of not hesitating to cut rates. Perhaps we should be more concerned about 1997 because six of the nine post-war recessions have occurred the year following the presidential election.

What are the implications of this scenario for bond investments? As I suggested to you earlier, as long as monetary policy is easing, a significant rise in bond yields is unlikely. If there is a minor problem for bonds, particularly U.S. bonds, it is that the market has already discounted additional easing measures by the Federal Reserve. Based on current yield levels, another one percentage point cut in short-term rates has already been anticipated. Our guess is that bond yields this year will neither rise nor fall dramatically. The benchmark 30-year government bond in the U.S. could fall as low as 5.75 per cent but not exceed 6.50 per cent.

We are a little more optimistic about the Canadian bond market. Government of Canada bonds, in our view, represent better value than their U.S. counterparts. Nominal yields on 10-year and longer government of Canada bonds yield an extra percentage point and a half over their U.S. counterparts while inflation in Canada this year is set to drop below the U.S. inflation rate for the seventh straight year. Fiscal restraint continues to be the order of the day for government across Canada, and were it not for the political uncertainty surrounding Quebec's future in Canada long-term yields would be much lower.

There is a possibility that the issue of Quebec's independence will take a respite this year but reappear in 1997 when the Canadian Constitution is scheduled for review. If this is the case, we think the Canadian bond market will outperform the U.S. We are forecasting Canadian bond returns this year of between six and eight per cent which compared to an inflation rate below three per cent and money-market yields below six per cent is still a competitive return.

Outside North America, there is more latitude for bond yields to fall in Europe. Compared to the U.S. market, yield curves are steeper, real returns generally higher and the fiscal tightening measures required by most European countries to meet the fiscal requirements of monetary union in 1999 suggest that monetary policy can ease further. The possibility of lower interest rates in Europe is also enhanced by the likelihood the German economy, Europe's largest, still requires lower interest rates. There's a good chance the German economy contracted slightly in the final quarter of 1995, and will be hard pressed in 1996 to exceed the last year's growth rate of 1.9 per cent. We expect 10-year German government bonds presently yielding a bit more than U.S. treasuries will drop in yield below their U.S. counterparts before the year is out.

While we think Europe's markets will be the best-performing markets among the industrialised countries, Japan's bond market likely will be the worst. Nominal yields on 10-year Japanese government bonds are only three per cent, monetary policy is extremely easy and fiscal policy is loose. This accommodative policy mix has become an absolute necessity in order to both devalue the overpriced yen and provide the necessary liquidity to a stressed banking system. While this is a sensible policy response to the deflationary problems Japan's economy is now experiencing, it is not a response that ultimately results in lower bond yields.

Let me summarise our interest rate view:

1. Short-term rates are heading lower throughout the industrialised countries during the first half of 1996.

2. The outlook for North American bond investments is still generally positive. We still see a continuation of the strong deflationary pressures that have hampered the global economy in the 1990s extending into 1996.

3. If politics take a breather, we expect Canadian bonds to outperform their U.S. counterparts.

4. The best-performing bond markets this year are likely in Europe, the worst, Japan.

For those investors who do venture into European markets this year, we think that while you may gain on your choice of market, you may lose on the currency. We are part of a chorus of forecasters who expect the U.S. dollar to appreciate moderately this year. We think the tide is slowly turning for the American dollar. While the current account deficit remains large and the savings rate too low, other comparisons such as competitive labour costs, labour flexibility, strong corporate balance sheets and a contractionary fiscal policy support a slow and irregular appreciation of the dollar.

In the case of the Canadian/U.S. dollar relationship, it would be very easy to embrace the bullish case for the Canadian dollar. The fundamentals look pretty good: inflation remains low, labour costs are competitive, the trade surplus has more than doubled over the past three years, the current account deficit is at a 10-year low and all levels of government are reducing spending. Our enthusiasm for the dollar is tempered by two factors: the first is that the Bank of Canada has used every opportunity to push short-term interest rates lower because of the weakness of our domestic economy. The interest rate differential between Canadian and U.S. rates is now quite narrow. We think the Bank will continue to pursue this policy--effectively trading dollar strength for lower rates. Second, Canada's political uncertainty also puts a ceiling on how high our dollar can move. We think the dollar will trade between 71 cents U.S. and 74 cents U.S. during 1996.

That concludes our forecast of where we see the major interest rate and currency markets heading in 1996. It has been a pleasure sharing it with you.

Thank you.

The appreciation of the meeting was expressed by Blake C. Goldring, President, AGF Mutual Funds and a Director, The Empire Club of Canada.