December 2011
Europe's debt crisis will play out in the market
for months to come

As Europe and the US deal with their debt crises, there's more market volatility to come. Canadians' high debt levels are also a concern, particularly if there's a recession here. With interest rates likely to stay low, Steve Locke explains how he is positioning his Sentinel funds for a better income stream.

The full scale of Europe's sovereign debt crisis became clearer in November when the focus shifted from Greece to Italy and its $1.2 trillion debt. The bond market is questioning whether the EU's third-largest economy can support it. And yields on Italian debt broke through the key 7% level, which triggered bailouts in other European countries. The potential insolvency of a major economy also added to the uncertainty over whether the EU's $1 trillion bailout plan that was cobbled together over the past two years would be sufficient to rescue Italy and prevent Europe from sliding into recession.

The events in Europe only added to the uncertainty that followed the debt-ceiling debate in Washington over the summer, which pushed the US to the edge of default. So it's not surprising that economic events of this magnitude have crept into the psyche of both investors and consumers alike. They are not going to go away as quickly as we might have seen in other slowdowns or recessions, and will likely play out in the asset markets and economy over time.

The debt crisis in Europe and the US built on a macro theme that I've been talking about for a couple of years now. And that is the need for individual countries and banking systems to start shedding massive amounts of debt after what has been a longterm, multi-decade borrowing binge. We've just started, and it will ultimately be a lengthy process.

There is more market volatility on the horizon When you put that together with all the political uncertainty and lack of clear direction on dealing with the structural imbalances in the US and European economy, I believe the result will be volatility and a lower trajectory for investment returns. Ultimately, income solutions that can offer lower volatility with a total return focus are probably a good place to invest in the coming months. We don't believe that interest rates will be going higher any time soon, with both the Bank of Canada and the Federal Reserve indicating that any increase is unlikely in the foreseeable future. That has flattened the yield curve, and if you look back at the short end, earlier it was forecasting three rate hikes from the Bank of Canada in 2011. Of course now we have a much different environment, both from an economic growth and outlook perspective. And there doesn't appear to be a need to cut rates in Canada at this point. That's not the case in Europe, where the European Central Bank cut interest rates in early November, the latest sign that policymakers fear the Euro zone crisis could tip economies back into recession. And the Federal Reserve has kept rates at near-zero, where they've been for the last couple of years.		Sentinel Short-Term Income withstood impact of BoC rate hikes

However, we do see risks to the Canadian economy, particularly in the level of household debt, which now compares to the high-water mark we saw in US households leading into 2008. So we have almost 150% debt-to-income ratios in aggregate for Canada today. Those debt levels have been supported by low interest rates. But there could be an economic event that upsets the balance, making it hard for Canadians to support such a high level of debt.

It would have obvious implications for the Canadian banking sector – although the banks have improved in terms of their capital ratios over the past two years. As well, regulators have tweaked the mortgage rules a couple of times, and you've heard Bank of Canada Governor Mark Carney talk about the need to restrain mortgage lending and qualify mortgage borrowers with a little bit more rigour. Some of those things have managed to slow down the growth in debt, but I think if we see a domestic correction those debt levels could be a concern.

Building a better income stream in a low rate environment

With rates staying low or falling, we want a better yield than what the government curve is offering. Yields may stay down for some time and the Federal Reserve has indicated that they'd like to keep the short rate basically at zero over the next two years. So the yield curve is likely to be in a low range for some time. What we hope to do is create "yield carry" within the Sentinel portfolios that we manage by buying short-term corporate debt and other high-yielding instruments where we have confidence that we're going to receive a better income stream.

High-yield spreads are wider than historical averages with low defaults		Recent economic and political events have also caused us to take a more defensive stance in the funds. We made sure that the type of bank debt that we put into the portfolios is rock solid. And we think we're actually better positioned today than a few years ago if we were to enter into a protracted credit crisis in Europe. For example, when we're adding product on the high-yield side we're focused on the highest-quality area, the BB and even the BBB area of corporate debt. In fact, over the past few months the average credit quality of the high-yield holdings in Mackenzie Sentinel Strategic Income Class has actually moved up a notch from the BB low area to the BB mid area. In terms of government debt, we noticed a distinct flattening of the spread curve for provincial bonds during the early part of the summer. We sold a lot of long-term 30-year provincial debt and moved into the 8- to 10-year part of the provincial curve. We did this because we felt that, with the risk environment we're in, there was a likelihood that the curve would steepen, which in fact it did this fall. In addition, yield spreads widened. We therefore reduced risk in the portfolios on the provincial curve by about 4% to 5% of assets. A fairly significant chunk of the portfolios has moved in that trade and this has proved helpful over the last couple of months.

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