At the outset of the year, I told you about an old saying among investors: “As goes the month of January, so goes the rest of the year “. It seems that the January effect, as it is called, played itself out this year entirely as the saying would have it.
In the markets
Stock markets around the world posted strong gains in January. The trend continued throughout February and March, but in April worries over rising interest rates and a slowing global economy had begun to dampen investors’ optimism. By mid-summer the stock markets were in a total funk having taken back just about all the gains of the first few months. (Remember those disappointing June 30 statements?)
Now, as the year draws to a close, the mood has completely turned around – as it did in January – lifting stock markets significantly higher all around the world. With just eight trading days left in the year, most international markets have posted year-to-date gains in the high teens or more, sometimes significantly more. In the US, even with continued fears of a looming recession, the S&P 500 is now up year-to-date by 12%. Here in Canada, despite the income trust blowout, our TSX/S&P composite index is up by 15%, setting a new record high. Suffice it to say, a lot can happen in just a few months!
Global Outlook
This marks the fourth straight year of stellar gains for the Canadian market, mostly due to the high concentration of Canadian companies in the energy and commodities sectors. While there may still be some wind in those sails, it is the international stock markets with greater depth and breadth that are expected to outperform in future, as was the case this year. What’s more, if the value of the Canadian dollar, now around 0,86$, continues to wane as it is expected to, Canadian investors will no longer lose so much of the growth in their international investments to the currency exchange. A few money managers, like the Cundill team, have hedged their international holdings to correct that problem and will continue to do so as long as it is worthwhile.
On the economic front, although some are still predicting a recession in the US, which could eventually spill over the border, the general consensus is for a “soft-landing”, i.e. a slow-down in economic growth, but nothing more. Certainly, there is plenty of evidence to corroborate that assessment.
The world is awash in liquidity right now and excess cash usually acts as an important stimulus to economic growth. Despite the higher cost of oil and materials, corporate profitability is up, indeed way up, and most companies are in better financial shape than they have been in decades. What’s more, there is no sign of inflation on the horizon, which means interest rates are expected to remain at current levels or even go lower.
By all accounts, it looks as though we can expect another strong year in 2007. Of course, things can change again in the blink of an eye, particularly given the current geopolitical situation. That means prudence is still the order of the day. So don’t sell those bonds, yet!
Income trusts
Certainly the biggest story for Canadian investors in 2006 was the Finance Minister’s Halloween “trick”, the decision to renege on an important election promise and tax income trusts. The announcement has sparked considerable debate and I think it is worth taking the time to look at the tax and economic issues being discussed.
Taxation In Canada, we tend to believe, rightly or wrongly, that big business will do anything to get out of paying its fair share of taxes. Playing into this popular prejudice is the notion that income trusts constitute a kind of legal tax evasion for big business and the government was right to put an end to it. Of course, nothing is ever that simple.
A trust is a “flow-through” entity that does not pay tax on income when it is distributed to the unit-holders, i.e. the investor. A corporation, on the other hand, must pay tax on any net income before it can be distributed to investors in the form of a dividend. This largely explains why dividends do not yield nearly as much as the pre-tax distributions paid by income trusts, hence the overall attraction of income trusts for investors. Either way, all income is taxed whether it is at the corporate level or in the hands of the investor. Problem is not all investors are created equal and therein lies the rub.
Since the changes enacted by the last Liberal government, both dividends and income trust distributions are taxed equally for Canadian residents. The Liberal legislation did not deal with the unique situation of foreign investors, however, who pay only a 15% statutory tax rate. (Apparently as much as 40% of Canadian income trusts are owned by foreigners.) Nor did the new measures deal with pension plans and RRSPs, what the new government calls tax- exempts. Since income trusts pay out pre-tax distributions, there is a perceived tax leakage to these two groups of investors.
Of course RRSPs are only tax-deferred and not tax-exempt. This is one point, among many, which the more vociferous critics use to question the government’s calculations of tax losses to the income sector. They suggest the Finance Minister’s advisors merely need to sharpen their pencils to see there is no real tax leakage whatsoever.
Other critics argue that Flaherty’s proposed legislation simply misses the mark. They say the new law should have specifically targeted the tax leakage to non-residents and the so-called tax-exempts, instead of shutting down the entire trust sector altogether. The fact that the government did not choose to do this suggests that its objective went beyond the question of tax fairness. Which brings us to the next point of contention.
Economic impact
The long term economic impact of income trusts has long been debated largely because the corporate tax system is a disincentive to pay out income whereas the trust structure works in quite the opposite manner.
A disincentive to pay out income is a good thing, or so logic would dictate, because it encourages reinvestment of excess cash flow keeping the wheels of prosperity turning. Income trusts, on the other hand, encourage the distribution of as much income as possible. This creates a disincentive to reinvestment, which in turn, as the argument goes, disables the future capacity of business to grow and compete in the market place.
Defenders of the income trust structure point out that some mature businesses generate cash flow in excess of their needs, (ex. oil and gas, pipelines, infrastructure etc.) That income, they say, is often better allocated in the hands of investors. In those situations, the corporate structure actually “subverts” productivity, as John Brussa puts it. Brussa is the Dr. Frankenstein who engineered the first royalty trust in Canada back in 1986. He argues that to impose the corporate structure on these kinds of mature businesses is not in our economic best interests.
To date, the Finance Minister has proven quite impervious to all the criticism. But, this is a minority government and anything could happen. The Bloc has already taken the position that the transition period for existing trusts should be extended to 10 yrs. from the current proposal of four. So chances are we have not heard the last of this debate. Whether or not this yields some consensus as to what is in fact in the economic best interests of the nation remains to be seen. With so little objective analysis on either side, it is really hard to say.
As always
At this time of the year, I like to take the opportunity to express my sincere gratitude to all of you for your continued trust and appreciation. It is a real pleasure working with you. I consider myself very fortunate for that. Thank you!
