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October 17, 2007

Prudential Outlooks
by Wilfred Hahn

An experienced market technician once gave us this portfolio advice several decades ago: "Put half your money into a strip coupon, the other half into gold bullion. That way, no matter what happens -- an inflationary spiral or a deflation -- at least one half of your portfolio will prosper to allow you to retire without worries."

This advice warrants reflection at this time as more than a few investors are beginning to wonder about the future given recent events. Looking ahead, it does seem true that there are more scenarios to consider today -- meaning outcomes with not inconsequential probabilities -- than before. That does not mean that any of these potential outcomes are likely. Yet, in the present-day environment of advanced globalization, trends and conditions seem either bigger, smaller, better or worse than investors have witnessed before. To us, that simply means that the range of economic and financial outcomes is wider. Therefore, more than ever, it requires a balanced and welldiversified portfolio ... one that that is not prone to any one risk or extreme.

Investment Market Overview. Comparing equity market levels at quarter-end with those of only 3 months earlier, a seemingly steady environment seemed apparent. In Canadian dollar terms, Canadian and US equities moved up 2.5% and down -0.53%, respectively (MSCI indices). The MSCI World stock market index rose 3.86% in local currency terms. Yet, in between the two quarter ends, there occurred quite a maelstrom of change ... and, on many fronts.

Consider that during the past quarter, Canadian equity markets at one point fell as much as 14.9% from their prior high. South of the border, the US S&P 500 equity index dropped as much as 12% at one point. Even greater volatility was experienced in parts of the credit markets. Remarkably, 10-year interest rates fell from a yield of as high as 5.20% to lows near 4.30% during this intervening crisis phase. Even short-term interest rate levels wobbled under the duress of a credit crunch that apparently swept the world.

In view of financial conditions that appeared to be unraveling, the US Federal Reserve Board quickly stepped in with a discount rate cut -- a largely symbolic measure. However, three weeks later, as credit conditions remained locked and more deteriorating economic statistics emerged, the Federal Reserve cut the Fed funds rate by 0.50 b.p. At this point, however, a "fork in the road" became apparent. While, on the one hand, previously-stressed financial markets reacted positively, at the same time investors began to fear a new era of inflationary policies. Resul tantly, the USD dol lar plummeted against international currencies and commodity prices soared. Reflecting this concern, gold prices rose to new multi-decade highs.

The apparent catalyst for these serious gyrations was the impact of worsening real estate developments in the US. To date, well over 100 mortgage companies have been shuttered in US. These longer-running developments finally cascaded into high-profile troubles in late July when Bear Stearns, a major Wall Street firm, announced that two investment funds which were heavily invested in mortgage-backed investments suffered large losses. These stresses quickly fanned out internationally as two European banks failed, requiring a rescue by central banks.

Currently, financial market fears have subsided and there are some signs that credit market conditions are improving. However, the root cause of earlier problems -- a slowing US economy, a severe depression in the U.S. housing sector, continuing over- indebtedness and high financial leverage in the financial system -- remain largely undiminished.

Covering Many Scenarios. Given the seemingly panicked interest rate moves in the US of the past quarter and the all-time new lows of the US dollar, a broad range of outcomes is being contemplated by investors. We therefore remember the advice of our old-time technician friend.

Will a slowing US economy enter into recession? Could this impact the rest of the world, particularly Europe which is now struggling with an overvalued currency (the euro)? Is it therefore likely that soon more central banks will slash interest rates as their economies slow, real estate bubbles begin to deflate, and overvalued currencies hinder exports? Already, stresses such as these are emerging in the UK, not to mention some parts of Continental Europe. On the other hand, perhaps things will work out happily.

It reminds of the "beggar thy neighbour" conditions that emerged during other worldwide economic slowdowns in the past. At such times, countries compete to lower their currencies and interest rates, so as to remain competitive in export markets. In turn, such conditions would trigger a defensive response on the part of investors who fear that rising monetary inflation around the world will debase the value of their wealth.

Actually, a glimpse of this type of response has already been witnessed in recent weeks, as commodity and precious metals prices have soared. Given the record-extreme stratification of wealth in North America as well as globally, were such a movement to occur, its impact could be sizable. It would represent a flight from depreciating money. While this is an extreme scenario that may not have a very high probability, it is not an unfamiliar phenomenon nor should it be ignored in assessing portfolio risks and returns. Economists call this type of environment a "velocity inflation." As more people flee one asset type to another that they believe is best suited to preserving the relative value of their wealth, the price of latter item booms whether a monetary inflation occurs or not.

Currency Markets Dynamics. This past quarter, most Canadians will likely have gaped in awe as the Canadian dollar soared to parity with the US dollar (USD). We certainly did. We are disappointed for at least three reasons. Firstly, currency theory and valuations have been turned on their ear. Financial bubbles are everywhere it seems, including currencies. Canadian currency traders were heard to say such things as having achieved a "proud currency." On the other hand, Canadian producers -- who create real wealth, and compete in the global economy -- were despondent.

Apparently, the predominant reason for the international financial love affair with the Canadian dollar (CAD) is because Canada is perceived as a "commodity" country that is also rich in petroleum reserves. That brings us to the second reason for our disappointment. It seems that Canadians are uninformed that most commodities are priced in US dollars. Therefore, if the CAD is made to soar against the USD, Canadians are uniquely deprived of some of the windfall on their commodity exports. Such an occurrence promotes resource development while hollowing out Canada's higher-value-added industries.

The third reason for our disappointment is the effect that a rising CAD has upon international investment returns. However, on this score, things are not as bad as they may seem. While the US/ CAD exchange rate draws the highest profile for Canadians, the world is much bigger than the US. The soaring CAD of this past quarter (up 6.7% against USD) is actually the result of a collapsing USD. This is an important distinction as is shown in Figure #2 above. Also illustrated there is the CAD trend against the euro. Today, the Canadian dollar is virtually unchanged against the euro from a year ago (actually slightly lower by 0.4%) In fact, this past quarter, while the CAD soared, so did the euro. That means that the CAD/euro relationship has been stable, and therefore also its impact upon international investments in Europe.

Summary Conclusions & Outlook. There are a wide range of scenarios ahead that must be considered and balanced. As such, it is much too early to suggest that any one outcome has a high probability ... much less, certainty. Even a simple cash investment may not provide the reliable harbour during the current world financial environment. The appropriate response is to remain committed to broadly diversified portfolios. For example, we have maintained a high weighting in gold-related investments even as we have retained above average cash balances and exposures to assets that are non-correlated to a slumping US dollar.

It is also best not to be reactive to recent or short-term trends. To do so often leads to mistakes and unnecessary transaction costs. While portfolios with international holdings will have now suffered the drag of a rising CAD for a number or years (at least against US dollar holdings) this is not the time to abandon such diversification. Global portfolios will have experienced the brunt of this effect especially so this year. Yet, currency theory and proven valuation methods continue to strongly underscore the fact that the Canadian dollar is extremely over-valued and will not remain so for ever.

Wilfred Hahn
Hahn Investment Stewards & Company Inc.

The Global Spin is published and distributed by Hahn Investment Stewards & Company Inc., serving to provide comment and analysis on important economic and investment issues of relevance to general investors not otherwise widely available in the public domain.

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