Financial Forum 2008

January 3, 2008



DONALD G. M. COXE

Global Portfolio Strategist, BMO Financial Group



NICK BARISHEFF

Bullion Management Group Inc



DON DRUMMOND

Senior Vice-President and Chief Economist, TD Bank Financial Group Annual Financial



Forum Chairman: Catherine S. Swift

President, The Empire Club of Canada



Head Table Guests:



William F. White: President, IBK Capital Corp., and Director, The Empire Club of Canada

Thomas S. Caldwell: Chairman and Portfolio Manager, Caldwell Investment Management Ltd.

Edward Paul Badovinac: CET, KH, MMLJ, Retired Professor, Telecommunications, George Brown College, and Director, The Empire Club of Canada

Albert Contardi: Vice-President Compliance and Corporate Finance, PowerOne Capital Markets Limited

Robert J. B. Orviss: Becher McMahon Capital Markets

Susan Wolburgh Jenah: President and CEO, Investment Dealers Association of Canada

Robert Cook: President, CNQ

Jay Smith: Vice-President and Director, CIBC World Markets Inc.

Margaret M. Samuel: CFA, Chief Investment Officer and Portfolio Manager, Quadrexx Asset Management Inc., and Director, The Empire Club of Canada

James E. A. Turner: QC, Vice-Chair, Ontario Securities Commission

Reverend Bruce Smith: King-Bay Chaplain, King-Bay Chaplaincy

Christina A. Cavanagh: Executive Director, Toronto CFA Society

Morley W. Salmon: Chairman, Limited Market Dealers Association of Canada

Keith McMeekin: President, Brant Securities Limited

Richard W. Nesbitt: CEO, TSX Group

Peter Dymott: Managing Director, Fixed Income and Currencies, RBC Capital Markets.



Introduction by Catherine Swift:



I don’t envy our panel today in attempting to provide an investment outlook for 2008 at such a volatile time. With such factors as oil having hit US$100 a barrel for the first time over the last few days, ongoing turmoil in financial markets stemming from the sub-prime lending fiasco in the U.S., a strong Canadian dollar threatening many industries here at home and more than the usual amount of geopolitical instability following such events as the assassination of Benazir Bhutto, predicting the events of the coming year will be even more challenging than usual. I commend our panelists today on their courage in taking on this task.



Our first brave soul is Donald Coxe, Global Portfolio Strategist with BMO Financial Group. His work is available to corporate and institutional clients in BMO Capital Markets and individual investors for Nesbitt Burns Private Client Group. He was ranked number one last year by Canadian institutional investors in the Brendan Woods survey, and has been top-ranked for many years. This week, BMO Nesbitt Burns launched a new commodity investment product following Don’s investment thesis giving individuals the ability to invest in a strategically selected commodity index exposure—the Basic Points Weighted Commodity Linked Deposit Notes. He is the author of the book, “The New Reality of Wall Street,” and is interviewed regularly on television and in the business press. Before he got into institutional investing, he was an Associate Editor of National Review magazine in New York, and a lawyer in Toronto.



Please join me in welcoming Donald Coxe.



DONALD COXE:



For those of you who are still overinvested in banking and financial stocks and underweighted in commodity stocks what comes to mind is Leon Trotsky’s statement made in the early thirties that the man who wanted to live a serene and happy life had chosen the wrong century to be born into. His dictum was justified three years later when Stalin’s agent drove a pick axe into his brain.



The century that has begun is a century that has redefined the capital markets and is continuing to do so. It is the century in which billions of people joined the global middle class and much to the shock of the latte liberals and others they want what we’ve had. Shirley MacLaine said the Chinese will never make the mistake that we did with automobiles. They love their bicycles too much. That belief has been torn to shreds.



So from a capital market standpoint, the fact that we are entering our eighth year of the great commodity bull market should be no surprise. But the financial stocks are a disaster area of the market. What we have seen on Wall Street is the second worst display of unproductive investing that we’ve ever had. The worst of course was the tech mania which was the greatest collection of financial idiocy ever seen. We have seen a few geniuses in mathematics and physics and so forth creating products which have got out of control and are inflicting misery, not just among U.S. homeowners but on the global economy and on the stockholders of the organization that have egregiously overpaid them for years. One of the interesting things about this is that they have nothing to fear because even when their sins are exposed they’re given going-away presents which are roughly equivalent to David Beckham’s income for three years.



That kind of misleading, deceptive, misbehaviour has tremendous financial consequences and it takes a long time to work them out. So therefore, just as last year, the worst group to be in was the financial stocks and the best was commodities because commodities are real things.



Our formula for investing is that you invest in unhedged reserves in the ground in politically secure areas of the world. Last year we added a new asset class to this group. It started with the mines and oils which were the agriculturals led by the fertilizer stocks and the farm equipment stocks, because the people who gave you $100 oil and gave you $3 copper by their middle-class moves have added meat and dairy products to their diets. I saw this when I took a month’s leave of absence in India a year ago. What they are doing is repricing food. The greatest challenge in the world is not $100 oil. It is getting enough food so that the new middle class can eat the way our middle class does. That means we have got to expand food output dramatically, despite the fact that we have had a 17-year winning streak in the U.S. Midwest for growing weather which is where 54 per cent of the world’s corn is produced. At some point that winning streak will end and then we will have a food crisis which in economic terms will be the greatest ever seen. That’s the downside.



The upside is that you have the opportunity as investors to participate in the solution to this problem because although we can’t create new oil, and the attempt to do it through ethanol is a misguided venture, what we can do is increase yields in crops around the world something close to what they are in my adopted home state of Illinois, which is over 200 bushels to the acre. The rest of the world does about 30 bushels of corn per acre. That will be done with more fertilizer, with genetically modified seeds, and with advanced machinery and technology. There are about two dozen stocks in the world that are going to redefine the world’s food supplies and those stocks will have a precious value as we move forward.



So the investment strategy for the coming year is that the cornerstone of any investment strategy must be to recognize that food price inflation is coming. It’s going to hit this year hard. We have got a year-over-year growth in U.S. raw food costs at 22 per cent, and six and a half per cent at the consumer level, but this bulge in the pipe is gradually going to work its way through the system. So what you have seen now in terms of fuel inflation is going to come with much more pain and food inflation. You should be therefore fully hedged by having access to those stocks that benefit from rising food prices. That’s a good start.



Secondly, interest rates have been depressed to ridiculously low levels for a variety of things—foreign exchange funds, sovereign wealth funds. That will gradually give way so you are going to look to, over the next couple of years, rising interest rates, rising inflation, and we will come out of any economic downturn caused by Wall Street, just as Wall Street gave us the recession of 2001 which was unnecessary. The boom that will come thereafter will make the commodity boom that we have seen up until now a rather trivial event.



I get to speak to the Empire Club once every 10 years. If I get invited back nine years from now, I will talk back to the time when food prices seemed so low and the stocks of food companies seemed so cheap. Thank you and for those of you who are invested my way I promise you a very happy new year.



Introduction by Catherine Swift:



Our second panelist is Nick Barisheff, founder and President of Bullion Management Group, which is a full service bullion boutique dedicated to providing investors with a cost-effective, convenient way to purchase and hold physical bullion. Widely recognized as a Canadian bullion expert, he has written numerous articles on bullion and other current market trends that are published on various news and business Web sites. He has been interviewed for many national publications, and appears monthly on Financial Sense Newshour. He has been actively involved in the finance and investment business for over 30 years. His career began in the 1970s at the Investment Division of A. E. LePage in Toronto. He created the concept of Bullion Fund, which is Canada’s first and only RRSP-eligible, open-end mutual fund with a fixed investment policy of purchasing equal dollar amounts of gold, silver and platinum bullion.



Please join me in welcoming Nick Barisheff.



NICK BARISHEFF:



I am honoured to be invited to present the investment outlook for precious metals in 2008, as well as provide some insights into the longer-term trends. Since commodities are priced in U.S. dollars, price references will be in U.S. dollars.



Yesterday, gold surpassed its 1980 intraday high, closing at $857/ounce. Platinum surpassed its 1980 high of $1,070 in 2006, and yesterday closed at $1,539. This makes future price predictions difficult, since we are now in unchartered waters.



In contrast to the 1980 price spike, the current rise in precious metals is sustainable and, most importantly, is occurring in all major currencies since August 2005. It will come as a surprise to most that in 1980, gold only surpassed $800 per ounce on two trading days. In 2007, however, gold was above $800 on 22 days. The peak monthly average price of $675 was surpassed five times in 2007.



In my January 2005 address to the Empire Club, I stated that it didn’t really matter whether gold was $400 or $500 per ounce that year, because the price was destined to go much higher. Since then, in U.S. dollars, gold has increased by 95 per cent, silver by 131 per cent, and platinum by 81 per cent.



For 2008, the gold price forecast ranges between $725 and $1,100 per ounce, and I still say that whether the price is $700 per ounce or $1,100 per ounce, it will not matter in the long term. Unless the underlying factors causing the recent price increases reverse, precious metals prices will continue to rise in all currencies in 2008 and beyond.



Since the Canadian dollar is expected to stabilize at or below current levels this year, price increases in Canadian dollars should match those of U.S. dollar increases.



The implications of this price rise have been largely misinterpreted and misunderstood. Consequently, precious metals are still absent from most portfolios. Many investors believe that gold is merely a commodity like copper or lead, with limited industrial uses. One investment manager typified this commonly held view when he said, “I have no use for gold. You can’t eat it and you can’t put it in your gas tank.”



Often, precious metals price increases are attributed to jewellery demand. While jewellery is an important demand factor, particularly in South East Asia, it is not viewed there as a mere adornment, as in western countries. Gold and silver are considered to be monetary assets that can be used to preserve real wealth from generation to generation.



Precious metals’ price increases are not due to simple commodity fundamentals, but rather to precious metals’ monetary role as a store of value. Gold and silver have been used as money for over 3,000 years, and platinum for several hundred years. Today, they are still used as stores of wealth and as inflation hedges by the world’s richest families. They are held as currency reserves by central banks the world over. Although there is considerable controversy over central banks’ leasing of gold, their current gold holdings are still reported as approximately 928 million ounces. And while western central banks have reduced their holdings, Asian and Russian central banks have increased theirs.



The fact that most banks and brokerages trade gold at their currency desks rather than their commodities desks further attests to gold’s monetary role. The net turnover of about $15 billion a day in physical gold bullion by the members of the London Bullion Marketing Association also confirms gold’s current monetary role. Although the daily volume is unpublished, estimates are that volume is between $100 and $150 billion per day.



Clearly, this is not jewellery demand but gold trading as a currency.



If we acknowledge that gold has a monetary role in today’s world, what does its rising price indicate?



Analysis of the economic statistics can lead to a variety of conclusions, but a rise in the price of gold is essentially a vote of non-confidence in paper currencies, and a leading indicator of future inflation.



Many global investors may now be concerned about counter-party risk and what may turn out to be the worst financial crisis the credit markets have ever seen. In addition, the explosive growth in derivatives, new highs in the oil price, unsustainable U.S. consumer debt, and a possible unwinding of the yen carry trade provide plenty to be concerned about.



However, the major cause of gold’s rising price is the unprecedented global increases in money supply, and the resulting inflationary implications. While popular belief holds that inflation is an increase in the Consumer Price Index, the classic definition of inflation is an increase in the money supply, which results in price increases.



Over the past year, the money supply has increased by:



8 per cent in Canada;

12 per cent in the U.K.;

12 per cent in Euros;

14 per cent in Mexico;

16 per cent in Brazil;

18 per cent in China;

21 per cent in India;

and 42 per cent in Russia.



Although the U.S. Federal Reserve discontinued reporting of M3 in March 2006, several sources have reconstructed the data and have determined that the money supply of the world’s reserve currency is now growing at an unprecedented annualized rate of 16 per cent. Since 2005, the U.S. money supply has increased from $10 trillion to a staggering $13 trillion.



Increases in money supply will likely accelerate, since central banks have announced they are prepared to provide unlimited amounts of liquidity in an attempt to maintain solvency and avoid a systemic financial crisis. The inflationary implications of this policy should be obvious.



Gold’s role in predicting inflation, as well as hedging against it, has been documented by several sources. Various studies have concluded that gold, silver and platinum are the best leading indicators of inflation. Of the three metals, platinum is the best. Given that platinum increased by 37 per cent in 2007, and has surpassed its 1980 all-time high by nearly 43 per cent, the future outlook for real inflation indicates dramatic increases.



Financial media generally use the Core Consumer Price Index as a measure of inflation. It, however, is only useful for people that don’t eat or use energy.



Even the full Consumer Price Index has been relatively dormant, rising from an annualized rate of 2.5 per cent earlier in the year to an annualized rate of 4.3 per cent in November.



Even with this recent increase, the CPI understates and lags real inflation.



It is important to understand that the methodology used to calculate the CPI was changed in the early 1990s, and new concepts such as substitution and hedonic adjustments were introduced. If the pre-1990s methodology was used today, the CPI would now be in excess of 8 per cent.



And it’s not just precious metals that are pointing to much higher inflation rates. The Producer Price Index has increased by 7 per cent, commodities prices by 17 per cent, and oil by 57 per cent.



In establishing asset allocations for the coming years, a realistic view of inflation is crucial. Real wealth management must take into account real inflation. If real inflation is already at 8 per cent, then long-term bonds are not really a safe investment, but rather a guaranteed loss of purchasing power. And while the equity indexes may make new highs in nominal terms, they will likely experience losses in real terms.



As we begin 2008, one thing is undeniable: the gold price has been steadily rising in all currencies since the summer of 2005, and that rise is now accelerating. Since climbing precious metals prices are an accurate indicator of future inflation and other economic vulnerabilities, investors would be prudent to structure their portfolios to minimize the effects of rising real inflation, and protect their wealth from systemic financial risks.



According to studies by Ibbotson & Associates, precious metals are the most positively correlated asset class to inflation. From a strategic viewpoint they concluded that an allocation between 7 and 15 per cent to gold, silver and platinum bullion can reduce risks and improve returns over the long term. To hedge against inflation, or for a tactical allocation, much higher percentages would be required.



While we can debate appropriate percentage allocations, the fact remains that most portfolios have no allocation to precious metals whatsoever. As a result, they are not protected from inflation or other systemic risks, and are neither balanced nor diversified.



While mining stocks, precious metals proxies and derivatives may provide some exposure and speculative trading opportunities, real long-term wealth preservation requires fully allocated, segregated and insured bullion as the foundation of every portfolio. As we have recently experienced, the counterparties to Corporate Debt Obligations and mortgages, may default. The counterparty risk in many derivatives, which Warren Buffet calls “Financial Weapons of Mass Destruction,” is unknown. Since bullion is neither anyone else’s liability nor promise of performance, only it can provide protection against both systemic financial risks and monetary inflation.



As the price of gold, silver and platinum continues to rise there will eventually be a reallocation from financial assets, which now exceed $187 trillion, to precious metals by mainstream investors. Since aboveground supplies of precious metals total less than $4 trillion and there is only $600 billion in privately held gold bullion, substantially higher prices are inevitable.



When that reallocation begins, gold at $1,100 per ounce will look like a bargain.

Thank you.



Introduction by Catherine Swift:



The last panelist is Don Drummond, Senior VP and Chief Economist for TD Bank Financial Group. Don joined the federal Department of Finance upon completing his studies in Economics at Queen’s. During almost 23 years at Finance, he held a series of progressively more senior positions in the areas of economic analysis and forecasting, fiscal policy and tax policy. His last three positions were, respectively, Assistant Deputy Minister of Fiscal Policy and Economic Analysis, Assistant Deputy Minister of Tax Policy and Legislation and most recently, Associate Deputy Minister. He joined TD Bank in June 2000 as Senior Vice-President and Chief Economist. He leads TD Economics’ work in analyzing and forecasting economic performance in Canada and abroad. He travels widely across Canada and abroad, speaking to TD clients and various groups about the Canadian economy and its prospects, and he is frequently quoted by media on economic and policy issues.



Please join me in welcoming Don Drummond.



DON DRUMMOND:



I’m very fortunate to be here because after I agreed to speak to you today I was summoned to jury duty and told that if selected I would be in the jury process all week. I can give you a tip. In case the same thing happens to you, it does not count as a legitimate excuse, that you can’t do it because you are speaking to the Empire Club. I don’t know if that says anything about the status of the Empire Club. What did do the trick is I went on Monday for the interview process and they asked me whether I’d forecast that the dollar would be at parity and I said, “Not even close.” So they told me to go and speak to the Empire Club. So here I am. I will try out my forecast on you.



The section was billed as equity fixed income and commodities and you have heard quite a bit about commodities, so I will try to deal with the equity and the fixed income. This is no surprise. As an economist I will give you a bit of an economic context for that.



The world economy has been motoring along at over 5-per-cent growth for many years now. Five years in a row. We do think it will slow down to about 4 1/4-per-cent growth in 2008, so about a percentage point off the growth, certainly taking some of the steam out of that, but still not a bad outcome. If you look at the average world growth in the last 30 years it’s been 3 3/4 per cent so it is still above that average. We expect most of the major economies to slow down to the 1 3/4 to 2-per-cent range, so that would include the United States, Canada, and Europe as a block. An exception within that would be Japan, which will be quite a bit slower than that, probably only about 3/4-per-cent growth.



I find myself in an odd place talking about the U.S. because for a couple of years, partly by design, I was at the bottom end of forecast talking about some untoward things that were happening in the U.S. Most other forecasters kept ploughing ahead and now a lot of people have leaked over, so I try to convince people that things are going to be a little bit ugly in the U.S. Now I’ve almost kind of convinced people that it is not going to be quite as bad as some were expecting so why do I not expect that?



Well we are all focusing on the sub-prime and what that is doing to the residential housing sector. That is only one-twentieth of the economy. That is itself not a big deal and there are some off-sets. Government spending has been going at a fair clip. Business investment and corporate balance sheets are in great shape. Exchange rate depreciation is performing its magic. Exports are growing much faster than imports. Ultimately it comes down to the consumer and I do think that the key catalyst that is slowing the growth in the U.S. will be slower consumption but I don’t think it will collapse.



There is one scenario out there. It is an interesting time to be an investor and an economist because there is a great deal of uncertainty and it is coming from that financial side. If you look at a lot of those big investment houses, if you look at some of their type 3 assets, that risky category, they are triple and quadruple the amount of capital and they could face write-offs in the one-third range. So they might not be worth an awful lot. What would that do to the economy? We really haven’t been in that kind of situation. I think it will do some damage but I’m presuming that there will not be a major financial system collapse and the economy will get through that, albeit with somewhat slower growth.



So what would you expect then in that kind of environment for equity markets?



My starting point is the equity markets and the major markets seem to be appropriately priced if you look at P/E ratios and other indicators. Corporate profits are going to grow and in an environment of only 2-per-cent growth and another 2-per-cent inflation you wouldn’t think corporate profits would grow much faster than 4 or 5 per cent. Get some risk premium and there’s dividend payouts so I would expect in most of the economies you would see 7 to 8-per-cent gains on equity markets, probably a little bit better than you might think in a consensus forecast looking at the doom and gloom from the economy. But remember a lot of that’s already factored in.



There will be a lot of volatility, which I think could be favourable for people who are fairly active traders: the volatility that largely comes as company after company reveal their actual exposure to some of these risky markets. We haven’t even begun to scratch the surface of where all this sub-prime debt is located around the world. We will get a much bigger picture when there are revelations as we have seen since the summer. There will be some setbacks in the markets but I think that they’ll ultimately recover from that. I look for the U.S. market to do a little better than the Canadian but I suspect that the previous two speakers will probably say something a bit different from that. My thesis would be a little bit slower world growth will keep the cap on commodity prices. I agree that they will be strong in the future. I don’t think particularly strong in 2008 and I think that will hold the Canadian market back a little bit vis-à-vis the U.S. market, but the U.S. and the European markets will do quite well on the equity front.



An interesting situation in Canada is that many people have their investments outside Canada particularly in the United States. I don’t know if that is appropriate, with the head of the TSX right beside me. In part it is because of the TSX being overweighted in commodities, which again would be a great thing if you followed the forecast of the two previous speakers.



Finally on the fixed-income markets, in this economic context I do expect some more central bank rate cuts but not an awful lot and not anything like we saw in 2001 and 2002. Only one more cut of 25 basis points from the Bank of Canada. Two more from the Federal Reserve at 50 basis points. That’s not going to give a big lift to either the fixed-income markets or to the equity markets.



We think that the bond markets will be fairly forward looking as there does seem to be some stabilization in U.S. housing and the downside seems to be somewhat limited. In these major economies we look for fixed-income markets to be fairly stable. Look for a 10-year treasury to creep up towards the 5-per-cent mark as we move into 2009. The 10-year Canadian bonds creeping up to about 4.5 per cent so limited returns and I think I’ll end it there.



I wonder why the sub-prime happened, why did some of these other markets get out of equilibrium? I think the root cause was that people were dissatisfied with their portfolios of getting 3 1/2 to 4 1/2-per-cent rates of return when they were largely invested in fixed income. I think that is the kind of norm and I would expect that over time people will become more comfortable with those types of rates of return and will not be racing so far out the risk curve and taking these unknown and fairly high degrees of risk.



So in capsule look for equity markets in that mid-to-high single-digit rates, fixed income in the 4 to 4 1/2-per-cent rate, some further weakness in the Canadian dollar and that will generally cap the declines we have seen in the last couple of years in the U.S. dollar.

Thank you.



The appreciation of the meeting was expressed by Margaret M. Samuel, CFA, Chief Investment Officer and Portfolio Manager, Quadrexx Asset Management Inc., and Director, The Empire Club of Canada.