Fund Manager
Steve Duenkler
Fund Performance
Front Street Strategic Yield Fund was up 4.39% for the year ending 2011. The convertible debt market remained resilient and volatility in the second half of the year greatly benefited the Fund. During the year, the S&P/TSX Composite was down 8.7% while the S&P 500 and DOW Jones were both up 2.11% and 8.3% respectively. European markets suffered larger declines, with the French market down 13.4%, the Italian market down 22%, and the Spanish market down 8.8%. The CRB Commodities Index (ThomReuters/Jefferies) was down 8.3% on the year, with copper suffering a particularly large decline of 20%.
Commentary
Bond yields continued their move lower in 2011. The 30-year Canadian bond began the year yielding 3.5% and closed at 2.5%. The DEX Universe Bond Index (Canadian Corporate Bond Index) returned 9.4%, the best year since 2000. The convertible bond market followed suit, with bonds moving higher. In January 2012 alone, the extra yield, investors demanded to own the debt of Canadian investment-grade corporations rather than federal government debt, was 133 basis points, the lowest spread since May 2011. In 2011, Canadian corporate bonds returned 7.3%, their 11th consecutive annual gain. Canadian government bonds returned 6.2% in 2011. Canadian corporations, in general, have solid balance sheets and lots of cash flow supporting these valuations.
Economic data in the U.S. continued to be resilient, despite the market volatility in 2011. The Institute of Supply Management Survey for December was 53.9, with readings over 50 indicating an expanding economy. Consumer confidence has been strong, with the Michigan Consumer Sentiment survey reaching 69.9 in December, versus 64.1 in November. However, this gauge averaged 89 in the five years prior to the 2008 recession, so it appears that some pessimism remains. In 2012, we believe the U.S. economy will likely continue to grow in the 2%-3% range.
Commodity markets were under significant pressure in 2011. The Chinese market was down 25% while the Australian market and the S&P/TSX Composite Index were down 15% and 8.6% respectively. This was a result of continuing strength in the U.S. dollar and weakness in emerging markets, especially China and India. The Chinese Consumer Price Index reached 6.5% in July, which forced their central bank to implement hawkish monetary polices such as increases in both interest rates and banks’ reserve requirements. The Chinese housing market came under pressure, with overall property sales volume falling 12% year-over-year to a six-year low. The developers have warned that prices have begun falling, especially in major cities. The GDP rate trended lower in 2011, reaching 9.1% in Q3 versus 9.8% in the same period last year.
More recently, in response to a slowing economy, the Chinese central bank has started to reverse monetary measures by lowering the reserve ratio requirements for banks, signaling a potential end to strict monetary policies. China’s challenge in 2012 will be to sustain expansion without corresponding inflation and significant real estate speculation.
The Federal Reserve (Fed) has pledged to keep interest rates exceptionally low until at least 2013 while maintaining their elevated balance sheet of $2.3 trillion. Given that the unemployment rate is just below 9%, the Fed is unlikely to change their policies. The Fed may look for further easing in 2012 with another form of quantitative easing if economic data deteriorates. However, the effectiveness of these programs will likely come into question as the impact of QE I and II on the real economy was not as strong as the impact on the stock markets. Clearly, the effectiveness of the Fed’s monetary policies has not rendered the desired results as unemployment remains high and economic growth remains muted. Fed chairman Ben Bernanke stated the need for governments to provide a fiscal boost to the economy in some form of spending, either by helping homeowners refinancing mortgages directly, or by potentially increasing infrastructure spending. The Fed has made it clear that it will take all necessary actions to support growth and re-inflate the economy.
Sovereign debt issues in Europe rattled global markets in 2011. European sovereigns and banks need to raise 1.9 trillion Euros to re-finance maturing debt in 2012. Italy requires 300 billion Euros in 2012, 113 billion of which is needed in the first quarter. The European Central Bank (ECB) has shown an unwillingness to buy significant amounts of sovereign debt, which should keep yields elevated. Austerity measures implemented by Italy, Spain, and Greece will be monitored closely in the coming year. The long-term success of these measures will provide stability and lower interest rates. Furthermore, Germany’s unwillingness to participate in debt monetization will result in increased fiscal integration among remaining European Union members. The stance of Germany and the ECB is that the ECB will not be the “lender of last resort” to its’ members.
Most of these issues in Europe have been at the forefront for almost two years now and are widely understood by global markets. While the solution has been slow and temperamental, it is unlikely that the European debt issues will be as dominant this year, making way for the economy to take centre stage. This will likely stabilize the Euro early in the year and remove the headwinds to the commodities market.
Currently analysts expect the S&P 500 earnings to average $108 per share in 2012, meaning the index is trading at 11.6 times forward estimated earnings. In December, some large companies such as Texas Instruments, Intel and E.I. Du Pont de Nemours reduced their 4th quarter estimates, indicating weaker demand and accelerated destocking. The big question for the year will be whether the weakness in Europe and emerging markets will continue in 2012 and whether this will negatively impact the U.S. economy.
While Europe was mildly recessionary during 2011, most global economies continued to expand, albeit at a modest rate. Much of this weakness is fully reflected in both the equity and bond markets. Corporate balance sheets and profitability remain robust. The consumer has also remained resilient, despite daily headlines of “doom and gloom” from Europe. While the U.S. housing market has not strengthened, it has certainly stabilized. Given low interest rates and widespread liquidity in the system, equity markets remain cheap and corporate cash balances remain high, by historic measures. With respect to the economy, we believe the worst case scenario for 2012 will be a continuation of the stagnant growth experienced during 2011. We believe the surprise in the economy, if any, will be unexpected strength.
As economic headwinds continue to dampen growth prospects, we believe that the current low- interest environment may persist for at least one to three years. Corporate balance sheets continue to strengthen, which bodes well for the convertible debt market. Volatility should remain fairly high this year due to the uncertain conditions in Europe, which should benefit the Fund. The Fund currently has a standing gross yield of just over 8.5% and is approximately hedged at 50%. Trading volatility and adding to properly valued yield plays will be the funds priority this upcoming year. We remain optimistic for the Fund’s prospects in 2012.
Steve Duenkler
Steve Duenkler - Q4 2011
Date Published
Fund Manager
Fund Performance
Front Street Strategic Yield Fund was up 4.39% for the year ending 2011. The convertible debt market remained resilient and volatility in the second half of the year greatly benefited the Fund. During the year, the S&P/TSX Composite was down 8.7% while the S&P 500 and DOW Jones were both up 2.11% and 8.3% respectively. European markets suffered larger declines, with the French market down 13.4%, the Italian market down 22%, and the Spanish market down 8.8%. The CRB Commodities Index (ThomReuters/Jefferies) was down 8.3% on the year, with copper suffering a particularly large decline of 20%.
Commentary
Bond yields continued their move lower in 2011. The 30-year Canadian bond began the year yielding 3.5% and closed at 2.5%. The DEX Universe Bond Index (Canadian Corporate Bond Index) returned 9.4%, the best year since 2000. The convertible bond market followed suit, with bonds moving higher. In January 2012 alone, the extra yield, investors demanded to own the debt of Canadian investment-grade corporations rather than federal government debt, was 133 basis points, the lowest spread since May 2011. In 2011, Canadian corporate bonds returned 7.3%, their 11th consecutive annual gain. Canadian government bonds returned 6.2% in 2011. Canadian corporations, in general, have solid balance sheets and lots of cash flow supporting these valuations.
Economic data in the U.S. continued to be resilient, despite the market volatility in 2011. The Institute of Supply Management Survey for December was 53.9, with readings over 50 indicating an expanding economy. Consumer confidence has been strong, with the Michigan Consumer Sentiment survey reaching 69.9 in December, versus 64.1 in November. However, this gauge averaged 89 in the five years prior to the 2008 recession, so it appears that some pessimism remains. In 2012, we believe the U.S. economy will likely continue to grow in the 2%-3% range.
Commodity markets were under significant pressure in 2011. The Chinese market was down 25% while the Australian market and the S&P/TSX Composite Index were down 15% and 8.6% respectively. This was a result of continuing strength in the U.S. dollar and weakness in emerging markets, especially China and India. The Chinese Consumer Price Index reached 6.5% in July, which forced their central bank to implement hawkish monetary polices such as increases in both interest rates and banks’ reserve requirements. The Chinese housing market came under pressure, with overall property sales volume falling 12% year-over-year to a six-year low. The developers have warned that prices have begun falling, especially in major cities. The GDP rate trended lower in 2011, reaching 9.1% in Q3 versus 9.8% in the same period last year.
More recently, in response to a slowing economy, the Chinese central bank has started to reverse monetary measures by lowering the reserve ratio requirements for banks, signaling a potential end to strict monetary policies. China’s challenge in 2012 will be to sustain expansion without corresponding inflation and significant real estate speculation.
The Federal Reserve (Fed) has pledged to keep interest rates exceptionally low until at least 2013 while maintaining their elevated balance sheet of $2.3 trillion. Given that the unemployment rate is just below 9%, the Fed is unlikely to change their policies. The Fed may look for further easing in 2012 with another form of quantitative easing if economic data deteriorates. However, the effectiveness of these programs will likely come into question as the impact of QE I and II on the real economy was not as strong as the impact on the stock markets. Clearly, the effectiveness of the Fed’s monetary policies has not rendered the desired results as unemployment remains high and economic growth remains muted. Fed chairman Ben Bernanke stated the need for governments to provide a fiscal boost to the economy in some form of spending, either by helping homeowners refinancing mortgages directly, or by potentially increasing infrastructure spending. The Fed has made it clear that it will take all necessary actions to support growth and re-inflate the economy.
Sovereign debt issues in Europe rattled global markets in 2011. European sovereigns and banks need to raise 1.9 trillion Euros to re-finance maturing debt in 2012. Italy requires 300 billion Euros in 2012, 113 billion of which is needed in the first quarter. The European Central Bank (ECB) has shown an unwillingness to buy significant amounts of sovereign debt, which should keep yields elevated. Austerity measures implemented by Italy, Spain, and Greece will be monitored closely in the coming year. The long-term success of these measures will provide stability and lower interest rates. Furthermore, Germany’s unwillingness to participate in debt monetization will result in increased fiscal integration among remaining European Union members. The stance of Germany and the ECB is that the ECB will not be the “lender of last resort” to its’ members.
Most of these issues in Europe have been at the forefront for almost two years now and are widely understood by global markets. While the solution has been slow and temperamental, it is unlikely that the European debt issues will be as dominant this year, making way for the economy to take centre stage. This will likely stabilize the Euro early in the year and remove the headwinds to the commodities market.
Currently analysts expect the S&P 500 earnings to average $108 per share in 2012, meaning the index is trading at 11.6 times forward estimated earnings. In December, some large companies such as Texas Instruments, Intel and E.I. Du Pont de Nemours reduced their 4th quarter estimates, indicating weaker demand and accelerated destocking. The big question for the year will be whether the weakness in Europe and emerging markets will continue in 2012 and whether this will negatively impact the U.S. economy.
While Europe was mildly recessionary during 2011, most global economies continued to expand, albeit at a modest rate. Much of this weakness is fully reflected in both the equity and bond markets. Corporate balance sheets and profitability remain robust. The consumer has also remained resilient, despite daily headlines of “doom and gloom” from Europe. While the U.S. housing market has not strengthened, it has certainly stabilized. Given low interest rates and widespread liquidity in the system, equity markets remain cheap and corporate cash balances remain high, by historic measures. With respect to the economy, we believe the worst case scenario for 2012 will be a continuation of the stagnant growth experienced during 2011. We believe the surprise in the economy, if any, will be unexpected strength.
As economic headwinds continue to dampen growth prospects, we believe that the current low- interest environment may persist for at least one to three years. Corporate balance sheets continue to strengthen, which bodes well for the convertible debt market. Volatility should remain fairly high this year due to the uncertain conditions in Europe, which should benefit the Fund. The Fund currently has a standing gross yield of just over 8.5% and is approximately hedged at 50%. Trading volatility and adding to properly valued yield plays will be the funds priority this upcoming year. We remain optimistic for the Fund’s prospects in 2012.
Steve Duenkler