China Growth

2011 was the year the Chinese economy slowed to under 10% for the first time in a decade. The Chinese government is attempting to address this by instituting steps to stimulate the economy. The size of the Chinese economy precludes a sustainable return to 10% plus GDP growth. Structural growth of 7-9% makes more sense to us when looking at the next 5 years.

We also see a change in the composition of the growth rate for the economy. Chinese growth has been driven by infrastructure spending that was focussed on real estate and exports. The government’s latest 5 year plan has emphasized domestic consumption growth over export led infrastructure growth.

This has implications in the type of companies that will benefit from Chinese economic growth. While the capital equipment and commodity companies were the big beneficiaries of this investment led boom over the last few years, going forward it will be the consumer products companies that benefit most from this growth in consumption. Companies with strong brands that have been investing in China will benefit from this growth trend.

The Continuing European Debt Crisis and its impact on North American Stocks

The ongoing saga of the European debt crisis was the big story of 2011 . This prolonged uncertainty resulted in higher than usual stock market volatility. The US market emerged as a relatively safe haven, finishing roughly flat for the year.

The Canadian Stock market declined by 11.3%, doing better than most European and Asian markets. Investors are waiting for a clear buy signal before they fully commit to investing in the equity markets. Unfortunately, the market never gives a clear signal as to when or what direction its next move will be. As we have previously discussed, stock markets are most likely to do what will cause the maximum pain for the majority of investors. As investors hesitate, in fear of a repeat of the 2008 market decline (which we do not think is a likely occurrence), investors may be caught chasing a rising market.

The worldwide media has been focusing on the negative impact of the European debt crisis; they have not focused on reasons to be optimistic on the North American stock markets. American corporate profits remain strong and are demonstrating growth. Valuations are definitely on the cheap side when compared to historical levels. Interest rates remain low and the Federal Reserve board has signalled that rates will remain low for the foreseeable future. Companies are sitting on a pile of cash; these strong balance sheets will provide flexibility in tough times.

Concerns remain that European negatives may overwhelm all the positives and bring down the global economy. We think that Europe will continue to make the tough choices necessary for long term financial stability. Both Italy and Greece have new governments, which are already implementing austerity programs.

The US economy remains plagued by a lack of a strong fiscal direction. The debt is growing at a frightening rate as Washington remains in political gridlock. Economic growth is tepid (2-3%) with little real movement in unemployment rates or real estate prices. Real estate, typically a driver of economic recoveries, is not adding to American GDP growth. The upside is that a combination of cheap American currency, labour and land is contributing to American competitiveness on a global scale.

In my 25 years of investing, this is the first time I have seen the US stock markets so dependent on events that are external to the US. The merging of the European economies means that one country's woes could potentially bring down the European system. Both individual stocks and markets are demonstrating a greater tendency to move up and down as a group than observed in previous cycles.

A deep European recession has the potential to impact growth worldwide. It is this uncertainty that has placed US stocks in a historically cheap position (see chart on previous page). Although the US would not experience anything as severe as the 2008 and 2009 declines, it would not escape unscathed. From an investor perspective, these low valuations provide selective buying opportunities. Alternatively, if Europe gets their act together and formulates a credible plan, stocks are a screaming buy.

The Canadian equity markets have been further hurt by concerns about a Chinese economic slowdown (see China on Page 2) and its impact on commodity stocks. With household debt levels in Canada above US household debt levels and with the potential for a cooling in housing activity, the Canadian equity Market is not for the faint of heart.

Bonds were again the best performing asset class for 2011, as they benefited from their relative safety as investors fled risky assets. While it is impressive that bonds have continued to exhibit such strong performance, we do not believe that this performance is sustainable from a longer term perspective. 10 year government bonds are currently yielding less than 2%. As the European crisis uncertainty diminishes, for good or bad, investors will be more willing to move assets away from the safety of bonds into the relatively cheaper and high growth potential of stocks.

The beginning of 2012 is a world where Europe is in recession and emerging markets have slowed. The resiliency of US economic growth at 2-3% is one of the fastest growth rates in the developed world. Despite the relative safety of bonds, we remain unenthusiastic as yields are at historical low levels. We prefer companies that will be able to grow through these challenging times and are exposed to the growth markets of the developing world. Companies with growing dividends which are higher than their own bond yields provide an attractive place to invest.