Investor update

Dec 12, 2012

Good morning, ladies and gentlemen. Welcome to the U.S. Fiscal Cliff BMO Media Panel Conference Call. I would now like to turn the meeting over to Peter Scott. Please go ahead. Thank you very much, operator, and good morning, everyone. Time is running out for a resolution to the so-called fiscal cliff in the United States. This morning, BMO has brought together three experts to discuss the potential market implications related to the fiscal cliff for both the United States and Canada. Joining us are, from Chicago, Jack Ablin, Executive Vice President and Chief Investment Officer with BMO Private Bank. From New York, Scott Graham, Head of Government Bond Trading with BMO Capital Markets. From Toronto, Paul Taylor, the Chief Investment Officer for Fundamental Equities with BMO Asset Management. Each panelist will give a short presentation, after which we will open the call to questions. The operator will provide instructions on how to ask a question at that time. Leading off our discussion today is BMO Private Bank's Chief Investment Officer, Jack Ablin. Jack, please go ahead. Great. Thanks, Peter, and thank you everyone for joining the call this morning. What I thought I'd do is just give a brief synopsis of where we are on the economy and the public policy, then try to jump over the fiscal cliff issue here. With respect to policy, needless to say, we're pretty much running pedal-to-the-metal monetary policy between QE1, QE2, QE3. We expect that Operation Twist, perhaps as early as later today, its replacement will be announced. We expect that while Operation Twist was a sterilized policy, meaning that the Federal Reserve was not printing money to buy bonds, it will likely be replaced, but with an unsterilized policy, meaning more money printing to purchase government bonds, mortgage-backed securities, even potentially some sort of private mortgage pass-through or even corporate bonds, potentially. Then, of course, at least leading up to today, we have unprecedented fiscal stimulus, given that we are running a $1.3 trillion annual budget deficit. We combine the two, and unfortunately, all we have to show for it is an economic growth rate of about 2.2%. That's the running start that we have going into the fiscal cliff year, which is essentially our first year of austerity. What it ultimately means, first of all, while I think it was Chairman Bernanke that coined the term fiscal cliff, I wouldn't necessarily characterize it that way, in that while certainly December 31st detonates certain provisions to the tax code and spending cuts, it isn't like we fall off right away. It's possible, in fact, that we could continue to negotiate past December 31st, and the economy isn't necessarily destined to fall into recession. So in other words, yes, we could start to see things start to contract a little bit in terms of spending initiatives and potentially some payroll. But I think ultimately the payroll tax increase would likely be negotiated or at least put on hold. Potentially, the unemployment benefits could potentially be extended while they continue to negotiate. But even still, if they, for example, resolve the issue in the first couple of weeks of January, my sense is we can continue forward with an economy that still will move in a positive direction. So the way I would characterize it is we've got this pot of water, and our economy is this little frog sitting in the water, and right now everything's fine. But start January 1st, the heat is turned on, and depending on how long it takes to negotiate a grand bargain or some sort of a longer-term resolution, really determines how much heat there is on the economy. It's possible the stock market could get upset come January 1st. It's possible we could see a downgrade by Fitch, who is kind of watching these negotiations pretty closely. But my sense is we'll certainly have a downtrend in stocks and downtrend in economic data, but it's not necessarily the cliff the way it is characterized generally. So let me leave it there. I'll give you my outlook. So ultimately, outlook for next year is negotiated. Ultimately, we do get some form of a grand bargain by, say, mid-year. Our economy grows between 0% and 1.5% for the year. And earnings for the S&P are flat, which means we end up with about $100 a share. But even still, if it looks like we're making progress, I think we could see the S&P close at around 1,500, which would give us roughly a 6% to potentially 7% return for the year. So let me stop there. Turn it back over to Peter. Thanks so much, Jack. And now we will hear from the Head of Government Bond Trading with BMO Capital Markets, Scott Graham. Scott, please go ahead. Yeah. Good morning, everybody. Thank you very much for joining the call. I guess I'm coming from the markets from a trading perspective and kind of how the investors are really looking at what we're facing here. On December 31, roughly we're going to have $708 billion worth of spending cuts and tax measures start to roll off if all those things, and there's no further negotiation. That, combined with some of the spending cuts that will be necessary implemented as a result of getting the debt ceiling passed, could potentially lead to a drag of 4.5% on the economy. I think most participants are expecting that there will be some form of a bargain that is reached. I think that at the end of the day, if we look at what happens down in Washington, D.C., these negotiations always go to the very last minute. I think that part of that is causing some of the anxiety in the marketplace. I think that with the potential drag of somewhere between 1.5% and 4.5% on the economy next year, investors are really kind of frozen in what they're doing within the bond market. The timing of today's call is very interesting because the FOMC is meeting today, and we should have an announcement out at 12:30 P.M. Most market participants, and here at Bank of Montreal, are expecting additional quantitative easing to be announced. I think that if you listen to what the Fed has stated, and they've been very clear about this, is that the Fed can't do this all by themselves. But at a time when unemployment is elevated, the U.S. economy is fragile, we have financial concerns with the whereabouts and the what's abouts that are happening in Europe. That all leads to the conclusion that the Fed will have to step in here. Completely agree with the concept that they will probably no longer do sterilization, but they will just do outright purchases. Maybe they might reduce the magnitude of those purchases slightly below the $45 billion, but at the end of the day, we do expect the Fed is going to have to step in here and try to offset some form of the fiscal cliff, or some form, excuse me, of the fiscal drag that is expected. I think that at the end of the day, if we look at the projections and if the Fed has a 70% cap on what they can buy, actually in the third quarter of 2013, there's very few securities left in the 10-year sector of the marketplace for the Fed to continue to buy. While the economy, and I think corporate America, is actually in very healthy shape, I do think that we do need some kind of resolution on the fiscal situation. I think it's twofold, because if we have a watered-down version here, I suspect that the back end of the U.S. Treasury market will suffer as lack of credibility and a continued Fed accommodation, which at some point may, down the road, lead to inflationary pressures. I think the real concern is, though, we've seen debt-to-GDP go from 40% at the beginning of the financial crisis, kind of to 73%. While that's not something that we're not capable of handling, I think at some point, we have to look at the situation in Europe, and the similarities become very striking. I think that the focus on the U.S. fiscal deficit, et cetera, would have more focus if we did not have so many concerns and so many fires to put out in Europe. So at the end of the day, the market will remain extremely well bid. My expectations are that we will eventually punch 10-year notes through to probably record low yields, potentially even touching 125 basis points. At the end of the day, we also have one other potential boost to the interest rate market here. The FDIC insurance currently is slated to roll back to a $250,000 cap from unlimited, and the expectations are that that will cause a grab for high-quality assets and collateral in the front end of the massive marketplace. The timing of that also dovetails with the Fed potentially stopping selling further securities inside of three years, leading to basically a lack of, or scarcity value of front-end high-quality assets, and potentially even pushing bills into negative territory. Our personal view is that we probably don't get to negative territory, but if you look at the global basket of available fixed rate of securities available, the United States continues to look very cheap, and therefore, we're expecting the front end to be held in by hoarding of assets. We expect that the back end of the marketplace will remain very firm as people are searching for any kind of yield, and yield-enhancing products, and moving out the curve on the duration perspective will help that. But I'll summarize here by saying that at the end of the day, I think corporate America and actually U.S. investors are really, at this point, paralyzed by what's going on in Washington. The potential impact of somewhere between 1% and 5% is a lot to handicap, and there's a lot at stake here as we move forward. I do think that once we have some kind of resolution on this, that the economic forces at play are actually in a position to bounce back quite nicely. And actually, while I'm predicting potentially punching through to record low yields here, I think the back half of the year is going to be potentially surprisingly positive for the marketplace. Thanks very much. And now we will hear from the Chief Investment Officer for Fundamental Equities with BMO Asset Management, Paul Taylor. Paul, please go ahead. Great. Thanks, Peter. With respect to the effects on the Canadian economy and Canadian markets, I would start out and say, the U.S. fiscal cliff is important to Canada for two very fundamental reasons. The first of which is that we are an open economy. We are dependent on trade, and of course, we know that 70% of Canadian exports head from north to south. So we need to be concerned as to what kind of resolution we get to the U.S. fiscal cliff debates and what it means for the trajectory of the U.S. economy in both first half, second half of 2013, and ultimately what the tone and the psyche of the U.S. business community is as we transition into 2013. The second reason why it is important to Canada relates to the very tenuous nature of the current Canadian economic recovery. Q3, we barely grew. The sense is that Q4 2012 will run at about a 1.5% pace here north of the border. That is still positive, but it certainly runs the risk of hitting stall speed, and with the Canadian consumer certainly somewhat extended. We do have concern that, in fact, if we do get some weakness south of the border with our most southern important major trading partner, that this could be the straw that breaks the camel's back and sends the Canadian economy into a recession. So, for that reason, it is important from a Canadian economic perspective. In terms of what would be most affected from a Canadian market perspective, certainly the cyclical sectors would be most affected. We are very much dependent on energy materials, which represent, of course, nearly 50% of the Canadian equity market by market cap. With the slower U.S., and read from that, slower global economic activity, you would have to expect that the price of base metals and energy, on which we depend so heavily, would be affected negatively, and they would certainly lose a bit. Beyond that, the typical cyclicals, the consumer discretionary information technology, would be other areas that would be affected in the Canadian market. In terms of sectors that would be less affected, it would be those that are more domestically biased. One that comes to mind would be telecom, where we are less subject to the vagaries of what is happening in the global economy. The other would be consumer staples, the Jean Coutu's and Shoppers Drug Mart's and Metro's and Loblaws of the world. Certainly people will continue to buy at their local grocery or drug retailer regardless of economic conditions. Most importantly, the business community and consumer sentiment here in Canada. Obviously the Minister of Finance and the Bank of Canada Governor have, for the last 18 months, been cautioning Canadian consumers that these are generationally low interest rates that they would expect to see higher in the not so distant future, maybe not imminently, but in the intermediate term. It appears that Canadians are taking that to heart, and we are seeing some slowing of housing activity here in Toronto, certainly in Vancouver. So certainly that would suggest that the Canadian consumer is being affected by policymakers' cautions. But as well, I think they are of the view that we do have some meaningful noise on the macro front. Most notably, of course, the U.S. fiscal debate, but still the issues that we have to deal with in the Eurozone. But on the business side, certainly the psyche is one of caution. Bank of Canada Governor Carney has certainly been swift to warn the business community that them sitting on what he references as dead money is part of the problem, and we do need to turn both consumer and business sentiment if we want to have some strong sense that there will be a sustainable recovery here in Canada as we go forward. A lot of the issues that Jack and Scott reference that overhang the U.S. economy certainly overhang the Canadian economy and equity market. Our own view is that 1.5%-2% economic growth for Canada, as was mentioned for the U.S., and largely because of the potential sluggishness in the first half of the coming year, that economic growth will be sluggish for the first couple of quarters. Then hopefully we get by things and have stronger growth from there. In terms of the Canadian equity market, very similar to Jack's outlook for equities, and that is a mid to maybe high single digit returns for Canadian equities. No change to the view that cash yield on securities is king, and that will continue for the foreseeable future. So load up on yield, it will come in handy as we go forward. Peter, I will leave it there. Thanks very much, Paul. Now we will open the conference line to questions from the media. The operator will now provide you with instructions on how to ask your question. Operator, please go ahead. Thank you, Mr. Scott. We will now take questions from the telephone lines. If you are using a speakerphone, please lift your handset before making your selection. To ask a question, press star one on your telephone keypad, and should you wish to cancel your question, press the pound sign. Please press star one at this time if you have a question. There will be a brief pause while the participants register for questions. Thank you for your patience. Once again, please press star one on your telephone keypad if you have a question. The first question is from Jennifer Quan of Yahoo Finance Canada. Please go ahead. Hi, good morning. This question is for Paul. Just on your commentary on the tenuous nature of the Canadian economy and the straw that breaks the camel's back with regard to the fiscal cliff. Could you put this in the context of the average Canadian? What does this mean for the average Canadian, and what should we be bracing for? Well, Jennifer, the average Canadian will be affected by this crisis of confidence that exists in the marketplace. The one thing I'd say, and I suppose none of us really commented on it, is the elusive factor is how big an impact the whooshing sound could have across the economy and across capital markets if in fact a coherent deal is in fact agreed to in a timely fashion. Because it could lift the business sentiment indicators that are so severely depressed in terms of CapEx and hiring and all that. But here, this affects the average Canadian because we have a very weak recovery. We had strong employment gains in the month of November, but prior to that we had a couple of fairly weak prints. Specifically I'd say the most tangible is corporate Canada just not adding workers given their concern with respect to the sort of intermediate term outlook for the Canadian economy. When they're concerned about that intermediate outlook, they're just not hiring workers. I think that's the most tangible aspect of it. We're seeing that across the board. We're seeing it here in Ontario, of course. We're seeing that at the provincial level where we're dealing with a meaningful deficit and as a result, the McGuinty government, of course, the skirmish that's taking place with the teachers here in Ontario. With better visibility on revenues, perhaps the negotiations with teachers would go better. But specifically, I would point to jobs as being where it is directly affecting the average Canadian consumer. That's great. Just to follow up on your comments around housing. Obviously, on whether there be a slowdown, crash, given the moves by the federal government. Could you give your views on that and also your views on some recent concerns about the oversupply in the Toronto condo market? Yeah, I think BMO has done a couple of studies of the overall Canadian housing landscape and more specifically the condo market here in Toronto. We certainly do point out, and I think it is an important point that the nature of the Canadian housing market structurally is very different than the U.S. housing market and the issues that may have led to the bursting of the U.S. housing bubble, very different. We do not have the deductibility of mortgage interest for income tax purposes here. Our lending standards are much tighter. Ours are recourse loans, which is a very different situation. Canadians cannot simply walk away from a debt related to their home. They are personally liable for that. So yes, I think Finance Minister Flaherty and Bank of Canada Governor Carney are right to point out that there has been some excessive behavior, principally in Vancouver and the Toronto condo market. But overall, if you look at markets like Regina, Saskatchewan or Calgary or Edmonton or other centers outside of the big two sort of problem markets in Canada, still a relatively well-balanced market. So that means that we may see what we have seen over the last little while, which is a moderation in price gains or some setbacks. But I do not think there is a bubble to be burst. Let us leave it at that. Okay. Thanks, Paul. Thank you. Once again, please press star one on your telephone keypad if you have a question. The next question is from Patish Sarana Jan of Dow Jones Newswires. Please go ahead. Hi. This is to all the gentlemen on the panel. Sorry I joined in late and missed the earlier part of the conversation. But I caught some comments that there's a possibility about U.S. picking up steam in probably the second quarter. But as regards investors in North America regarding stocks, we've seen that they've tended to go with yield and that's probably lured a lot of people onto really thin ice, companies that are way past their prime, that are way focused on a dividend, not seeing growth. Do you see a catalyst in the near future that could probably get them going back into more cyclical, aggressive risk-taking? Thank you. Sure. I can take that. This is Jack Ablin from BMO Private Bank in Chicago. I think that, as Paul alluded, that business sentiment is pretty low. In fact, I just tracked CEO sentiment, and it's the lowest level of the year and probably matching among the lowest levels of last year. The NFIB just released a study of small business sentiment, and not surprisingly, we got the same results. I should also add that I do speak to many of our small business clients, and occasionally I'll speak to some of our CEO clients. Now I will say the last time I asked them was closer to the election and not really around this fiscal cliff, but I did ask, and I have asked, "Are you holding off on major expenditures, expansion, or hiring as a result of the uncertainty surrounding the election and potentially the fiscal cliff?" Among small business owners, I'd say two-thirds of them said yes. The CEOs of larger companies, probably that was closer to a quarter to a third. I guess the point is that CEOs and business executives are waiting. Now, if we do get more clarity on the fiscal cliff, if we do ultimately get a grand bargain by mid-year, which is sort of the consensus here, would some of these dollars possibly get redeployed? I think that's probably the thesis that could perhaps create the catalyst for investors to move back into more of a growth mode. I think on the other hand, if we get a nice surprise and the corporate tax rates in the U.S. become a little flatter, meaning that the rate actually comes down, and that the incentive of stashing profits, retained earnings, and cash overseas diminishes, we could see perhaps this repatriation of cash. That could also lead to maybe a little more incremental growth. I think that's probably the catalyst. But I will say I agree with your observation. In fact, we've been on this growth, I would say, growth style kick now since early 2009, and it's done a great job of outpacing value. But now growth stocks have gotten relatively expensive, and value is starting to outperform. Ultimately, I think the tailwind for value stocks, which are typically dividend-oriented stocks, will likely lead the way in 2013 and 2014. For that, I guess I tend to agree with Paul, too. Maybe just an interesting observation that we've seen over the last couple of months is a different angle on things, and that is-- Sorry, this is Paul Taylor speaking here. Is that some companies, just given some of the dynamics in the commodity price environment that we're in, and understanding the appetite that investors have for yield, are making a fundamental change in their business models. Specifically, I'm referring to the energy patch. Of course, a few years ago, we had the income trust, but that legislation went by the wayside. But most recently, even over the last couple of months, we've seen a number of oil and gas firms with oil trading in the mid-80s, and given some of their cost structures at that commodity price, not willing to commit to huge CapEx without some strong assurance of a stronger commodity price, and instead turning their whole business model towards an income orientation. So that's been a real change in the Canadian energy patch that's started to emerge very recently. Again, it's partly related to where the commodity price is at this particular point in time, and the lack of visibility on higher, specifically oil prices as we go forward with, of course, all the huge technological advances that have taken place over the last year or two across North America. But the other part of it, knowing that there's this voracious appetite for investors for yield, it's very short-term, but it's a notable change. So when you see a firm like, and I'll just pull a name sort of randomly, but Crescent Point with a yield of 6.5%-7%, they're a good example of one that's sort of making their mind up as to whether they want to be a growth story as we go forward, or do they simply want to be a cash cow and provide the yield that investors want. It's just an interesting trend to see if, in fact, this will continue into the future. Thank you. There are no further questions registered at this time. I'd like to turn the meeting back to Mr. Scott. Thank you. I have one question I'd like to throw out to all three of you. Jack, you just alluded to the notion that markets probably expect some sort of bargain to be made, possibly further on into 2013. To what degree has some sort of agreement on the fiscal cliff been priced in by the market? And what are the potential risks if, say, President Obama gets more of his way with respect to higher taxes for higher income earners, or conversely, what happens if the Republican Congress gets more of their way on the same question? This is Scott Graham. I guess I can tackle this from the bond market. At this point, I kind of see three scenarios. I see a scenario where we have a credible but measured move towards resolution of the deficit in the fiscal situation. I think in that situation, you should expect the bond market to actually have a bull flattening because I think the long end of the marketplace is very leery of a can-kicking exercise here in the U.S. We seem to have that time and time again. We can also look to the European markets on what can-kicking exercises do. I think the falling off the cliff, which would be kind of the worst of all situations in a lot of these tax cuts and spending cuts instantly implemented would be a significant event for the bond market. I don't think that scenario is at all priced into the marketplace. I think you would see a very significant flattening and rally in the marketplace, and that would be the catalyst to potentially punch you through to new record lows in yields. I think that most market participants, and I think that the BMO view here is that we're going to have somewhere between a 1%-2%, probably 1.5% drag on the economy. I'm fearful that the back end of the marketplace here in the States will take that as a watered-down version, and at some point, the credibility of the U.S. to deal with its deficit will be a factor in long-term investors. I will say, though, that for the most part, the Fed activity and the Fed action that's expected today is baked into the cake. I think most participants are expecting some kind of compromise and some kind of watered-down version of both sides of the extreme of passing every potential tax cut and kind of pushing that forward and also letting us fall off the cliff. I think kind of a reasonable approach, knowing that it will be last minute, is what's baked into the cake from the bond market investor's perspective. I think again, though, the less the U.S. or the politicians decide to tackle the long-term implementation of deficit reduction will ultimately hurt the very back end of the marketplace. Yeah. This is Jack Ablin. I would tend to agree. As both sides of Congress negotiate the level at which we want to ultimately balance the budget. Right now, taxes are about 15% of GDP. Median tax collections has been around 18% of GDP, and the Simpson-Bowles bipartisan commission projects or suggested around 20.5% of GDP. Right now, I think the consensus view is that both sides will kind of coalesce around some level. If it is 20% of GDP or somewhere thereabouts, then you should expect roughly half the gap being closed by spending cuts and half the gap being closed by tax increases. Right now, neither side has proposed anything that would be equally balanced on both parts. That's only one small part of the story, unfortunately, because looming out in the distance is another cliff. It's a cliff we're flying toward called Medicare and Social Security, and that cliff actually rises, given a certain amount of time, to 30% of GDP. No matter where we ultimately negotiate a balanced budget, if we don't tackle the difficult choices of particularly Medicare, we're going to fly right into that cliff, whether it's 15,000 feet, 18,000 feet, or 20,000 feet. Really, it's just a matter of time. If at 15,000 feet, we'll crash into it at around 2030. At 18,000 feet, it's probably 2040, and then at 20,000 feet, we crash into it about 2047. I'm hopeful, and I don't know if this is consensus or not, that both sides ultimately do try to start tackling whacking away at Medicare. Unfortunately, you've got a President who's trying to create a legacy, and I don't know if he wants to be the President that reduces entitlements on his watch. We'll have to see. A wonderful legacy, Jack, would be fiscal prudence. As a Canadian, we recently, by the way, certain retirement benefits were rolled back from age 65 to 67. At the end of the day, I think the answer everyone agrees with is some cut back to entitlement programs as a way of ensuring fiscal responsibility. As a very much affected observer, we do hope that they get to where I think everyone expects them to get, which is some entitlement reform, some cocktail of current spending restraint, and increased tax revenue. But let's get it done sooner rather than later. Right. The irony is that in the early 90s, when Canada did reform their benefits program, it was pretty much an entirely democratically controlled parliament, right? I mean, it was pretty much set. Yeah. We had strong economic growth, that is the big backdrop to this, is that somehow they need to increase revenue, they need to cut spending while not compromising that they need to have a decent economic backdrop. So there is a lot of stuff to get right on this. And the question is really, does the U.S. political system work, and can it help orchestrate that? And therein lies the, I think, some concern about whether this gets done in the short term or not. Great. Thank you very much. Operator, are there any further questions? There are no further questions at this time. Thank you very much, operator. And that concludes our conference call for this morning. I would like to thank each of our participants for providing us with their thoughts. And I also like to thank everyone who called in to join us today. If you would like to set up a follow-up interview with any of our presenters, please contact the BMO Corporate Communications main phone line at 416-867-3996. Thank you and have a good day. Thank you. The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.