2003 Investment Outlook

Margaret M. Samuel, CFA, Portfolio Manager, iPerformance Fund Corporation and Director, The Empire Club of Canada; Denton Creighton, Director, Institutional Equities, Octagon Capital Corporation; Grant Kerr, Associate Minister, St. Paul's United Church, Brampton; Mark A. Kennedy, Senior Managing Director, Institutional Equities, Raymond James Ltd.; William F. White, President, IBK Capital Corp.; Joseph J. Oliver, President and CEO, Investment Dealers Association of Canada; Gerald C. Throop, Executive Vice-President and Managing Director, Equity Markets Group, Merrill Lynch Canada Inc.; Blake C. Goldring, CFA, President and CEO, AGF Management Limited and Director, The Empire Club of Canada; Randee Pavalow, Director, Capital Markets, Ontario Securities Commission; Chuck Powis, CFA, Managing Director, Institutional Bond Sales, RBC Capital Markets; Kevin D. Williams, Vice-President and Director. TD Newcrest; Rozanne E. Reszel, CFA, President and CEO, Canadian Investor Protection Fund; and David Fleck, Executive Managing Director, Institutional Equity Sales and Trading, BMO Nesbitt Burns Inc.

Introduction by Ann Curran

For the last eight years the Empire Club has hosted an Investment Forum. The wonderful aspect of being the oldest club of record is that you can actually go back through our yearbooks or more conveniently our Web site to see how accurately our financial experts were able to predict the market!

Not to make our speakers today nervous but unlike the comments and reports that appear in newspapers and magazines and vanish when the next edition comes along, we last and last. In fact, through us you can find out what happened before, during and after the stock market crash of 1929 or you could just as easily recall what companies were herald as being the next dotcom breakthrough of the '90s.

However, predicting the future is one of the riskiest ventures known to man. It can bring great rewards or great sorrow. Before I introduce our speakers today let me just remind you of one thing, advice is wonderful but as time and circumstances unfold, your decisions are ultimately up to you.

Our first speaker today is Benedict Cheng, Vice-President, Portfolio Management at the Signature Funds Group of CI Funds, who will discuss Fixed Income (Domestic and International).

Ben Cheng has more than 12 years of investment industry experience. He focuses on fixed-income securities with an emphasis on the analysis of corporate bonds and preferred equities.

Mr. Cheng managed fixed-income portfolios for BPI Mutual Funds before he joined CI in 1999 with the merger of the two companies. Prior to joining BPI in 1997, he held positions at Sceptre Investment Counsel Ltd. and Perpetuity Asset Management Inc.

Mr. Cheng has a Bachelor of Commerce degree from the University of Toronto and the Chartered Financial Analyst designation.

Our second speaker today is John Kellett, Vice-President, Portfolio Manager, Canadian Equities, RBC Global Investment Management Inc.

John has been in the investment industry since 1968 and with RBC Global Investment Management and its predecessor companies since 1978.

John specializes in the financial services industry and is a member of the Canadian Equity and Stock Selection Committee as well as the Investment Policy Committee. By augmenting the traditional dividend fund investment approach with aggressive secondary strategies, John has consistently delivered first and second quartile performances.

He graduated from McGill University with a Bachelor of Commerce degree and is a Chartered Financial Analyst.

Our third speaker today is Mark Schmeer, Vice-President and Managing Director, North American Equities, MFC Global Investment Management and Manulife Financial, who will discuss U.S. Equities.

Mark Schmeer joined MFC Global Investment Management in 1995. As Vice-President and Managing Director, North American Equities, he is responsible for MFC Global Investment's U.S. and Canadian equity desks, indexed portfolios and asset allocation products, with overall responsibility for over C$7.5 billion in assets. He is also the lead portfolio manager of MFC Global Investment Management's U.S. large cap funds. Mark has worked in the investment industry for over 23 years. Prior to joining MFC Global Investment Management, he was Vice-President, U.S. Equities at Sun Life Investment Management. Mark has a Chartered Financial Analyst designation and graduated from Boston College with an MA in Economics.

Ben Cheng

I was invited last month to speak today about the economy, interest rates and where we see income markets going in 2003.

I manage portfolios that invest in high-yield corporate bonds, income trusts, and REITs and make decisions on how to shape portfolios. Our interest-rate forecast plays a crucial part of how we manage the funds and how we manage expectations for the funds. When interest rates are heading lower or are expected to stay at a low level, interest-rate-sensitive securities should be outperforming. Indeed, over the last three years we have had double-digit gains in the income-trust market annually. However, when interest rates are headed higher, we have to concentrate on capital preservation. I believe that is the market we have to look forward to in 2003.

On the surface it would seem fairly easy to conclude that interest rates are headed higher from here. The Fed. Funds Futures Index is telling us we should expect around 50-75 basis points of tightening by the Fed. in 2003. We believe that both long- and short-term interest rates are headed higher, but any increase in rates is probably going to be more mild than the market expects.

Yields on T-Bills and 10-year bonds in Canada and the U.S. are at the lowest levels we have seen in 40 years. And, equity markets have tumbled for the last three years in a row--an event we have not seen for about 30 years. However, deflation in the American economy seems to be the hot topic of the moment. By some measures, deflation is a reality in the U.S. economy today. Consumer retail goods are currently deflating at a rate of 1.5 per cent per year in the United States. This measure obviously excludes important factors such as housing costs, energy and medical care. But, it is a disturbing measure nonetheless, because it points to a continuing lack of pricing power by retailers and manufacturers.

In the last 12 months, Alan Greenspan and other members of the Federal Reserve have spoken about the risks of deflation in the U.S. economy. However, Mr. Greenspan has also been quick to point out that the risks of deflation taking hold in the U.S. economy are remote. It is noteworthy that in June of 2002, the Fed. released a discussion paper on the lessons learned from the effects of deflation in Japan in the latter half of the 1990s. With the benefit of hindsight, one of the main conclusions from this paper was that as inflation and interest rates approach zero and

the risk of deflation is high, the monetary and fiscal authorities must go beyond what most conventional models would suggest in order to "reflate" the economy. This may be a subtle hint that the Fed. is willing to hold short interest rates at low levels for longer than the market expects. In fact, we believe that the Fed. and central banks around the world are more than willing to run the risk of reflating the economy at this point in the cycle. Central banks are fully equipped to deal with inflation. Money supply can be tightened and interest rates can increase to "wring out' inflationary pressures. But, as we have seen in Japan through the nineties, once inflation approaches zero and goes negative, the effectiveness of further interest-rate cuts becomes very much like pushing on a string.

Indeed, the $670-billion fiscal stimulus package brought forward by the White House two days ago signals to the markets that the President and the Republicans are also aware of the extraordinary means that will be necessary to bring the economy out of its doldrums.

Currently, corporate America is going through a "healing" phase that will certainly take longer than 12 months. Overcapacity in many industries has forced severe cutbacks in capital spending. Companies are restructuring with a focus on reducing costs, paying down debt, reducing excess capacity and increasing dividends. In such an environment it may be years before we see a significant rebound in capital spending.

On the consumer side, it looks like the U.S. consumer is looking very tired. Consumers are facing onerous levels of debt on their balance sheet. Even though interest rates are at historically low levels there is little doubt that consumers in the U.S. and Canada are retrenching. In 2002, we have seen the consumer savings level rise to about 4 per cent in the U.S. Yesterday the Federal Reserve announced the first decline in consumer borrowing in five years. With consumer confidence expected to remain weak, we would expect to see the consumer continue to pay down debt from here. While increased consumer savings is good for the long-run health of the economy it will probably not help economic growth in the short run.

Consumer spending would increase if we were expecting significant job growth from here. However, U.S. job growth has been negative over the last 24 months, where more than two million people have lost their jobs. We expect that, with capital spending continuing to be anemic, job growth should be fairly flat in 2003. That being said, any rebound we see in consumer spending over the next 12 months will likely to be tepid, at best.

With the economic recovery looking very moderate for 2003, we have to conclude that interest rates are probably not headed much higher in the next 12 months. U.S. short-term interest rates are probably going to be flat and longer-term bonds (10-year) are probably going to rise by about 50 basis points (bps) in anticipation of further economic recovery in 2004. In Canada, we expect that interest-rate changes will be very similar to what we expect in the U.S. Canada will probably have the best economic performance of all the G7 nations. However, our economy will probably experience marginally better economic performance than the U.S. Canada now does about 80 per cent of trade with the U.S. and about 40 per cent of our overall economy is based upon trade. Thus, we do not expect the Canadian economy to significantly outperform the U.S. economy for an extended period of time. For 2003, economic growth in the U.S. should be about 2 to 2.5 per cent and Canada's GDP growth should be about a half a per cent better.

So what are we doing with our accounts, you might ask. Within our bond accounts that are measured against the Scotia Capital Bond Universe we have shortened duration and have an overweight position in corporates. Corporate spreads should continue to tighten in 2003 as profitability improves.

We have reduced our exposure to real estate (i.e. REIN throughout 2002 and will continue to have an underweight position throughout 2003. The good fundamentals through the latter half of the 1990s no longer exist. Vacancy rates for office space in Canada have increased to 11 per cent. In the United States the problem is worse with vacancy levels now more than 15 per cent. These are levels that we have not seen in almost 10 years. According to ReisAmerica net absorption of office space has been negative for an unprecedented seven straight quarters. Also, as interest rates are expected to rise, real-estate owners no longer see the benefits of declining interest-rate costs. We expect that it may take 18-24 months before we see a solid turnaround in real-estate fundamentals.

We are currently at a slight overweight position in income trusts. As mentioned earlier, income trusts have been the hot market for the last three years and it is now a topic of much debate. However I do believe that we will have decent returns from this sector in 2003. The trust market has changed substantially in the last six years and it is no longer a market of just oil and gas producers. With more diversity in a market with a capitalization of about $50 billion it is possible to buy trusts that will be able to grow their distributable cash flow as the economy improves. This is where we are concentrating the portfolios, as obviously these trusts will have less interest-rate sensitivity. There is still a very real risk of IPCs and secondary issuance flooding the market. We had well in excess of $5 billion in new issuance for 2002 and I expect a number similar to that in 2003.

And finally, in corporate bond land, we are also slightly overweight and will be adding to this sector over the course of the year. High-yield bonds in Canada and the U.S. have been a tough place to invest over the last three years, as nominal performance has been negative. Yield spreads over government bonds have expanded to historic levels on the back of massive corporate defaults. However, we believe that default rates have probably peaked in 2002 and even in an environment of dampened economic growth, some corporations will be able to pay down debt and improve their balance sheets. This is obviously good news for corporate bondholders and we expect this asset class to be one of the top performers in income markets for 2003.

Thank you.

John Kellett

Good afternoon, members of the Empire Club, ladies and gentlemen:

I was so honoured to be asked to speak to this prestigious club that I accepted the invitation against my better instincts and long-standing practice. After all, I have survived 35 years in the investment business by generally avoiding career-damaging pitfalls such as publicly forecasting the outlook for the stock market. I adopted this practice because of hard experience. Many in this audience are familiar with the annual forecast dinner sponsored by the Toronto Society of Financial Analysts. For those of you who are not, the society invites three or four speakers every year, distinguished more by a need for publicity than by good sense, to forecast various outcomes for the capital markets, with the fiendish twist that those same speakers have to return the following year to justify what they have said.

It was my misfortune to be selected to speak in September 1981 on the outlook for stock markets just as my bullish forecast ran into the teeth of a major bear market. Because I am very interested in politics my theme was that Ronald Reagan and Margaret Thatcher--who were both quite unpopular at that time, early in their mandates--would prove very favourable for global stock markets. By the following summer, my forecast for the

TSE 300 was so far off target (on the downside) that at lunch time I would walk considerably out of my way to avoid seeing the market indicator on a sign outside the National Trust building on King St., because I didn't want to ruin my appetite. That year the return dinner happened to be unusually late in September and in August the market started a rally that was as unexpected as it was relentless (or as Time magazine wrote in September that year: "No one predicted it. No one can explain it. No one dreamed that it could keep going day after day").

In the end my forecasts on the U.S. and British markets were right almost to the day, but I missed the Canadian market (my supposed area of expertise) by several months, because politically our government had gone in the opposite direction by introducing the National Energy Program. Having had my summer entirely ruined I decided I would avoid forecasting wherever possible and it has taken 20 years for me to break that rule.

I also note that in the notice for this meeting my fellow forecasters and I are described as "industry experts." Without impugning their talents, this sort of description can be the kiss of death.

Have you ever noticed that bearish market letter writers (such as John Crudele and Richard Russell) love to mock their more bullish brethren as "so-called experts" (so called by whom they.do not say, but it is a useful straw man on whom to pour scorn). So seeing that adjective in print attached to my name has caused me some anxiety

Having confessed to an unnatural interest in politics I will set the stage for my forecast for equity markets in 2003 by noting some favourable political developments. The first is that the Republicans have controlled the White House and both Houses of Congress in only two of the 58 years since World War Two, prior to this year. The average annual return in those two years on the S&P 500 was 14 per cent, even though real GDP growth was only 1.5 per cent, substantially less than the 3.4-per-cent average since the war. This was because inflation was well contained and because markets view that party as more friendly to them. Already we are seeing suggestions from Capitol Hill that double taxation of dividends be eliminated and this would, if enacted, be very positive for stocks in an era when dividends are viewed with increasing favour by investors.

The second is that the market has advanced in the third year of every presidential term since 1939, or 16 successive occasions, as the incumbent looks to strengthen his party's reelection prospects.

I would say that the outlook for the stock market is no murkier today than usual, which is to say it is, as always, highly unpredictable. Optimists can find many economic statistics to their liking including the biggest increase in productivity since 1966, (5.6 per cent year over year in Q3 in the U.S.). Consumer spending has held up remarkably well due to lower taxes and interest rates, and higher house prices, and both the manufacturing and non-manufacturing ISM indices jumped in December to 54.7, well into territory that indicates a growing economy. Perhaps the best news, however, has been the remarkable performance of the Canadian economy, both in absolute terms and relative to its peers.

In every single month the consensus of economists was too low (no wonder they call it the dismal science). We have had the largest year-over-year increase in new home prices in 12 years and the forecast growth in our GDP of 3.2 per cent in 2003 is expected to be bettered by only Australia in the Economist Magazine poll.

However, this poll ignores, as do many prognosticators, the excellent economic performance by several countries whose contribution to global growth has hitherto been small, but is growing rapidly, and I would include in this category China, India and Russia.

If global growth is more robust than people expect, it is nevertheless still held hostage to the performance of the U.S. economy. Although, as mentioned earlier, there are encouraging signs nevertheless there are also plenty of reasons for caution. Corporations remain caught in an exceptionally severe profit contraction, with S&P operating profits down 42 per cent from their peak in 2000 and with almost no pricing power to enhance the revenue line. They are therefore obliged to keep cutting costs, hardly a route to prosperity and self-defeating if it has an adverse effect on employment and consumer confidence.

Also, margins are under great pressure as the differential between the change in cost of materials and retail sales inflation is now the largest since 1980.

Currently the market is torn between a fear of deflation and the prospect of reinflation. Clearly the Federal Reserve Board is far more afraid of the former and has done everything possible to reignite the economy, including dropping interest-rate levels to the lowest in my career and providing a steady diet of liquidity. Thus the money supply measure the Fed. considers the most conducive to economic change, MZM, was up 11.8 per cent year over year in the third quarter.

Interestingly, during the recent market rally, stocks have done best when economic statistics indicated a lesser likelihood of further Fed. ease, so the stock market seems to be hoping for somewhat higher interest rates. In each of the last three calendar years investors in bonds have enjoyed higher returns than equity investors, both an unusual occurrence (it last happened during the early years of the Depression, from 1929 to 1931) and unsustainable in a successful capitalist system. In the competition for scarce investment resources, perhaps it is time for a shift from fixed income into equities.

There are other worries to contend with. The recent decline in the U.S. dollar could cause all sorts of problems for an economy and financial markets dependent on a large daily cash infusion just to offset trade outflows.

A competitive devaluation is every central banker's worst nightmare but the relative lack of attractiveness of the yen, euro and U.S. dollar has been a boon for gold prices. The threat of war, whether in Iraq or Korea, is unquantifiable but highly unsettling to markets, as is the possibility of further terrorist attacks. Finally, U.S. insider selling jumped 125 per cent from October to November, with nearly $14 sold for every $1 bought. This does not indicate overwhelming confidence on the part of America's corporate titans, the misdemeanours of some of whom in recent years have done much to contribute to the current market malaise and loss of confidence.

All of which is a lengthy preamble to my forecast for North American equities. My normal bullishness is tempered by the realization that most strategists are also bullish, at least in part because after three consecutive down years, a fourth is historically unlikely. That has happened only once in the past century, from 1929 to 1932, but it is surely an ill omen that this past December's weak showing by the U.S. stock market was the worst since the December of the penultimate year of that period (1931).

Notwithstanding all these causes for concern, I do believe the market will rally in 2003, generating moderately good returns, perhaps of the order of 10 per cent to 12 per cent, but with more volatility than most investors care to see. Canada's market, unlike my previous forecasting episode, should perform relatively well, dependent as it is on commodities and a heavily weighted financial-services sector that has generally weathered the credit crisis better than its international counterparts. We are currently experiencing the most powerful commodity move in 22 years with 96 per cent of commodity prices rising. With gold, energy, and other commodities leading the way, this should attract global attention to our market.

It is also important to remember that market indices can be a misleading indicator of a market's health.

For instance, the dividend fund I run has returned positive 2.0 per cent annually over the past two years, compared to the -12.5 per cent annual return generated by the TSE 300 index over the same period so selection can mitigate the damage done by the overall market, and as well as the above-mentioned sectors, investors should concentrate on those companies with a record of increasing dividends and the ability to increase them in the future.

In conclusion, please remember two or three pithy comments from previous so-called industry experts. "In investing the return you want should depend on whether you want to eat well or sleep well" and Will Roger's well known dictum: "Don't gamble! Take all savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it." And just last month Morgan Stanley's well known strategist Barton Biggs advised: "Be open-minded. Anything can happen."

Thank you very much for both listening to me, and not obliging me to come back next year and justify this foolishness.

Mark Schmeer

My name is Mark Schmeer and I'm Managing Director of North American Equities for MFC Global Investment Management, the investment management arm of Manulife Financial. At MFC Global we have over 90 investment professionals in markets around the world doing fundamental and quantitative investment research. I'm going to summarize our thoughts on the outlook for the U.S. economy and stock market for 2003.

We think economic growth will be reasonably good this year, at least 2 1/2 cent, but more likely in excess of 3 per cent. This forecast is somewhat more optimistic than consensus, which is looking for growth closer to 2 per cent this year. We have several reasons for our more optimistic viewpoint.

First, we expect consumer spending to remain healthy. Real disposable income was up 6 per cent in the year ending November; both the Conference Board's and the University of Michigan's confidence indicators appear to have bottomed; payroll employment turned positive in May; and it appears we are poised for yet another mortgage-refinancing boom.

Second, it appears capital spending is turning. Business spending increased by 0.6 per cent in Q3, the first increase in two years. IT spending as a per cent of depreciation bottomed in Ql and has moved higher since. In a recent survey 44 per cent of ClOs expect to spend more on PCs in 2003 than in 2002. Finally, capital spending is closely tied to earnings and earnings have turned up. S&P 500 operating earnings were up 5 per cent in Q2, 15 per cent in Q3, and we think Q4 will be even better, and earnings will improve an additional 9 per cent in 2003 as profit margins improve due to productivity enhancements. As earnings increase, capital spending will increase.

Lastly, the Bush administration's economic stimulus plan will likely add something close to $100 billion in tax cuts and additional spending in its first year. The stimulus plan that has been proposed includes eliminating the double taxation of dividends on stocks. In fact this is the biggest part of the plan, accounting for more than half its estimated cost.

The plan is complicated and also includes a proposal to eliminate taxation of stock price increases resulting from an increase in retained earnings. Essentially, both dividend-paying stocks and non-dividend-paying growth stocks would benefit from these proposals. If passed, the plan would increase the relative attractiveness of stocks versus bonds and REITs. Also, the plan would increase

the relative attractiveness of high-dividend-yielding stocks and growth stocks versus value stocks. The plan that eventually gets passed will no doubt look different from the initial draft, but it seems certain that a meaningful stimulus plan will get passed in time to stimulate growth this year and stocks will benefit.

So we're concluding growth in the U.S. this year will be around 3 per cent, and historically when growth has been around this level the stock market has returned 15 per cent on average and has provided a positive return 85 per cent of the time.

There are clearly a number of risks, including war with Iraq, terrorism, the risk of deflation, accounting fraud, underfunded pensions, and higher oil prices. Some of these issues are easily addressed; for example, the issue of accounting fraud. There have been no significant new accounting fraud stories in months. The SEC reviewed the latest reports of every one of the largest U.S. companies last year so we believe this issue has been laid to rest.

Pensions are underfunded for the first time since 1993. Prior to 1993, pensions were last underfunded in 1982. Both times were great buying opportunities for stocks. The point is that underfunded pensions are a sign of the end of the bear market, not the start of one.

Oil: In recent days Venezuela has stated that they have been able to increase oil. production from almost zero to 600K bpd; OPEC has said they are prepared to increase production by 2M bpd; and the U.S., UK and Japan, among others, have increased their strategic reserves by two to three million bpd over the past three months. We believe the world is well prepared for a possible disruption from Iraq. In fact we think the greater likelihood is for a sharp decline in the price of oil this year.

Deflation: Services represent 2/3 of the American economy and we are not likely to see deflation there. How many expect to pay less for health care, a ticket to a baseball game or a movie? There is no global competition for services; you can't go to China for a haircut; without deflation in services, we don't think you can have deflation overall.

War: The stock market record during wars is mixed, ranging from 0.6 per cent annualized during the Vietnam War to 16 per cent annualized during WW II. But the most comparable is likely to be the Gulf War during which the market returned 10 per cent annualized.

Terrorism: We find this to be the toughest issue to lay to rest. Probably the best we can say is capitalism and democracy will survive, although that may seem small consolation on a day like 9/11.

A couple more stats you may find of interest:

In the past 40 years, when the market was down at least 30 per cent from its three-year high, as it is now, the market returned an average of 31 per cent in the following year.

Currently bond sentiment is very bullish while stock sentiment is neutral. In the past when we have had a similar disparity, stocks returned 19 per cent on average in the next year.

Interest rates have declined sharply in the past year. In the past, when 10-year interest rates fell as they have in the past year, the average return from stocks in the following year was 18 per cent.

And last but not least, a comment on valuation. The current P/E ratio for the S&P 500 is not cheap. But when you compare it to interest rates the market's valuation is nearly as cheap as it has been at any time in the past 30 years. We conclude that stocks are a pretty good buy at this time. We expect a double-digit return this year and we think if we are surprised, it is more likely to be a positive surprise.

Thank you

The appreciation of the meeting was expressed by Blake C. Goldring CFA, President and CEO, AGF Management Limited and Director, The Empire Club of Canada.