Legacy Group Economic Update June 2015

After close to 30 years in the Financial and Insurance Field, I have witnessed (and survived) many different economic events. Over this time period, I could summarize a few observations that I feel are quite consistent and, hopefully, relevant. In a nutshell, it comes down to:

A: Economic and world changes are inevitable; get used to them!

Human emotion with regards to markets and investments is a major factor to consider in overall planning.

As one would assume, the two above factors are not mutually cohesive. They push and pull against each other and in some circumstances with great force. The following is a brief, concise history of what I have witnessed in my 30 years in the financial field.

I started as a money trader in 1984, offering term deposits and wholesale money products at rates over 10%. At that point in time, I was working with people that continued to reference the 18% rates that were offered in 1981. It is again very strange how many people refer back to that time when rates went to the moon!! Many of my current retired clients still talk about that very strange economic event. Unfortunately, most refer to what they had to pay on their mortgages at that time. Some say they were very fortunate to lock in rates the year or so before at 10% and 11% so they missed the massive jump to 18% and, in some cases, 21% mortgage rates.

  • Lesson: I recall it was very difficult to convince people to buy GIC’s for more than 3 years, even though rates were higher. The reason for this was typical: the 1981 interest rate event “imprinted” the interest rate shock into people’s hearts and most felt that rates would rise again and did not want to miss the opportunity. As a result, people bought 30-90 day term deposits hoping rates would rise past the 11% rates that were being offered on 3-5 year terms.

Interest rates stayed relatively flat after 1981 and then “peaked” once again in 1990. I recall selling 15 year GIC terms with Standard Life at a rate of 12.40%. (Sorry, can’t give anyone that today!)  Since that time, interest rates of steadily declined to where a 10 year Government of Canada bond rate is at an unbelievable 1.25%. 5 year mortgages are below 3%, a far cry from the 10%-12% and 18% days of the 80’s.

If interest rate changes aren’t enough to cause a pause in one’s thinking, then what about oil prices. This is a commodity that everyone talks about because it is so essential to our way of living (yes, we need to change that for sure.) As a result, price changes effect us in so many ways (although doesn’t seem to in Canada, at least not at the pumps.) Let’s review a bit of oil price history just to put our economics into perspective.

In 1946, oil per barrel was $1.63 in inflation adjusted terms. Today it would equal $19.41/bbl. In 1973, it was $4.75/bbl.  In 1980, just before the run up in interest rates (please note inflation caused somewhat by oil prices rising), oil was costing $37.42/bbl. That is close to a 700% increase in 7 years or 100% per year. OPEC’s supply cartel involvement contributed to much of the fluctuation in the oil prices.  Oddly, an oil supply glut in 1986 caused the price to drop back to $14.44/bbl, which rose again to $23.19bbl in 1990, and fell back to $11.91/bbl (lowest point in years). It hit its highest price of $136/bbl in June 2008. Within 9 months from this point, it fell to $36/bbl during the economic crash of 2008. In 2011, it was back over $100/bbl, and today it is trading around $60/bbl.

  • Lesson #2: Whether we like it or not, oil prices affect our economic lives in severe ways, especially for us in Canada. The run up in prices from the early 70’s to the 80’s caused massive inflation pressures which in turn drove interest rates. Oil prices almost doubled in relative terms from the mid 80’s to 1990, causing again a rise in interest rates. Even during the 2007 run-up in oil prices, interest rates doubled. They just did it at a much lower level but still increased in a significant way. One could conclude that oil prices increase with increased economic activity as that is somewhat true; oil prices are also very politically and worldly influenced. There are many other factors that we don’t control that can influence the price of oil. As we have all witnessed in this past year with prices dropping from the $90’s to the $40’s, now back into the $60/bbl range, oil continues to be volatile. (And, yes, I wonder why I’m still paying the same price at the pump when oil was trading at $90/bbl. Don’t get me started!!)

Human Emotions:

One of the most interesting observations I have seen in my 30yr career has to do mostly with human reaction to economic markets. As mentioned above, people had the idea of rates going back to 18% or at least higher than the 10% they were currently making. Recently the idea of $200/bbl oil price was discussed and believed as Peak Oil theory went through people’s minds. The stock market downturn of 2008/2009 shook people’s confidence to the core about markets and even the world money system, even though every 10 years or so we see a major correction in markets and then eventually a recovery. So emotion, especially fear, plays a major role in how people invest and perceive investments, unfortunately usually in a negative manner.

Our experience has shown and history has proven that people who did not bow into their fears and bought companies that provided needed services or products in society, benefited greatly. Not only are many of our clients collecting dividends from these purchases, but those dividends are much higher than when the stocks were first purchased, and the prices of these stocks have also risen considerably. Even today Bank stocks in Canada are paying dividend rates at 4% and above while still maintaining only a 40% to 50% payout ratio. What this means is that they could easily double the dividend to 8%- 9% if they choose to payout all profits, instead they keep some and reinvest back in their businesses. With bond yields trading below 3%, it is very difficult to ignore the yields on some well established blue chip companies. What we do still hear is the fear, which sounds like, “the stock market has risen so much since 2008, we are due for a correction!!” “The Canadian economy is slowing and that will affect the stock market!” “The government has printed too much money and inflation is coming again!” Albeit some of this can be true and there is a need at times to readjust portfolios, the bottom line is what are you listening to vs what is the reality. Do we listen to that fear, or go back in history and track what has happened during the ups and downs. During the downturn of 2008, our core blue chip portfolio fell 35% at the same time the dividend cash flow increased by 17%, and only one company reduced their dividend payout. Over the next year, the portfolio returned to pre-2008 values and dividends remained being collected. As I have always said, treat the dividend like you would a rent cheque on a piece of real estate you may own. Real estate owners don’t look at the value of their real estate every day or every quarter, they look at the rent cheques and what they are collecting from their asset. We need to do the same with stocks.

So what about economics and risk? What are investors to do at this point in time of history? As I have already discussed, emotion plays a role at any place in time. The reason I have gone back in history and discussed all the changes for interest rates, markets and oil prices is to drive home the point that change is inevitable. It will always be with us. I do not know where oil prices will be in a year!! I don’t think anyone does. Interest rates look like they may rise in the USA at least…maybe, maybe not. What I do know is that we will be putting gas in our cars, buying food at the store, needing medical assistance, and using a bank in some way. So the businesses that provide essential good and services will probably be in business this time next year. What price we will have to pay for those businesses may change, but the dividends that they send us should be consistent. That is what we should be concerning ourselves with.

Is there a place for low interest bonds? Yes, there is! For people whose fears and emotions about markets cause too much grief in their lives, they should buy more bonds. For people who require consistent cash flow for retirement or family needs over the next 5 years, they should purchase bonds to provide these monies. Everyone is different and has their own comfort level regarding investing. Our job is to help you determine what that is and arrange your portfolio to fit your personality, so that your human side connects with the market in the right balance.

I hope this was helpful and put investing into perspective. I will follow this up with a specific report about the new Budget changes to the RRIF minimum payment rules and TFSA limits. Please look for it shortly.

If this newsletter causes some thought in your mind about your current portfolio and you wish to either discuss some details or make changes, please contact our office for a review.

Have a great investing day.

Robert L. Pesti CLU EPC CIM
President The Legacy Group

 

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