Canadian equities and bond markets have experienced a strong rally since last spring, and have priced in an economic recovery. Moreover, some managers of Canadian equity balanced funds see further upside in equities, although others are hedging their bets.

“Looking at the economy, everything continues to be positive. A lot of the underlying drivers are improving,” says Bob Swanson, lead manager of Fidelity Canadian Asset Allocation Fund, and vice president of Fidelity Management and Research Co. in Boston. “We’ve seen a stabilization of housing prices. Across the board, it’s clear that many of the components of the economy are improving.”

Yet, there are worries about some key economic factors, such as high U.S. unemployment. “One thing that concerns me is the duration of unemployment. The average [duration] is 27 months — or twice the historical average,” adds Swanson, a member of Fidelity’s Team Canada management team; he shares portfolio-management duties with Brian Miron, Daniel Dupont and Don Newman. “That has more of a long-lasting impact on the economy, and potentially consumer spending, than what we’ve seen in previous postwar recoveries.”

Another drag on the economy is weak consumer spending, which fund managers attribute to many households trying to reduce debt.

The question is: what shape will the recovery take? “Maybe it’s a Nike ‘swoosh’ shape,” jokes Swanson. “We’ve come down, and then it’s a gradual incline. We won’t see the economy screaming back, because of the deleveraging process and the duration of unemployment, which will weigh heavily on future spending. [The economy] will continue to improve, but perhaps not in a V-shape.”

But the markets have staged a V-shaped bounce in response to strong earnings growth, which has been driven by massive cuts in inventories, expenses and labour. “The majority of the benefit of the margin expansion is behind us,” says Swanson. “The big surprise is that we could get a surge in equity prices in the first and second quarter, and then move sideways the rest of the year, unless there is a tremendous improvement in top-line growth.”

From a strategic viewpoint, Swan-son has positioned the Fidelity fund for cyclical growth. Some 66% of the fund’s assets under management is in equities, including 60% in common equities and 6% in convertible bonds that are equity-like, split into three components: 50 to 60 Canadian stocks, about 100 U.S. large-cap growth stocks and about 80 global resources-oriented names.

On the fixed-income side, 25% of the fund’s AUM is in government and investment-grade corporate bonds, and 5% is in high-yield corporate bonds. For risk-control purposes, the fixed-income portion is spread across 650 securities. The duration is 6.5 years for the Canadian bond allocation, which is neutral relative to the benchmark DEX universe bond index.

“I want exposure to certain asset classes, but managed in a diversified fashion to mitigate risk,” says Swanson, who adds that 4% of the fund’s AUM is in cash.

One top energy name that reflects the Fidelity fund’s growth bias is EnCana Corp. “It’s controversial because it was split into two parts. When all is said and done, it wasn’t greater than the sum of the parts. We’ll see how that works out,” says Swanson. “But it is a big component in the Canadian economy, and the largest gas producer in North America.”

Although the stock has been a laggard because of weak natural gas prices, Swanson says, the team has added to the fund’s position in the company in the past couple of quarters. “It is still fairly attractive from a valuation perspective. That’s based on low expectations for gas prices,” says Swanson, noting that the stock has a price/earnings multiple of 13. A long-term holding, the stock is trading at $33.20 a share, compared with its March 2009 low of $23.80. Swanson has no stated target.



Are happier days here again? “We appear to be on the path again,” says Dom Grestoni, senior vice president and head of the North American equities group at Winnipeg-based I.G. Investment Management Ltd. and lead manager of Investors Canadian Balanced Fund. “Governments and regulators brought all these measures in to put an end to the decline, and bring in stability. They have brought confidence back.”

Grestoni notes that several large, commodity-based companies had responded to the downturn by laying off personnel and shutting down facilities to ensure they would survive. “You can see that in the productivity numbers,” says Grestoni. “Unfortunately that didn’t help the unemployment rolls. But even there we are starting to see stability. A lot of capital has been raised, in all sectors but led by the financials again, which have raised extraordinary amounts of capital. Commodity companies have restructured and mothballed some projects and cut back capital expenditures. This discipline is necessary to get us back to a more stable, rational economy.”

@page_break@The Canadian and U.S. economies should resume growth in the 2%-2.5% range, Grestoni argues: “There are indications that companies are hiring again. The recession ended last July-August, so we are through the worst. Commodity prices are reflecting that. I’d hate to say it’s a typical recovery cycle, but it probably will be in line with past recovery cycles.”

Like Swanson, Grestoni believes the markets are going through a “digestion” phase: “Once we see that profitability is durable and confirmed by lagging indicators, and as unemployment turns into job gains, the market will resume its next leg.”

An active money manager, Grestoni began shifting the Investors fund out of fixed-income last fall and winter and increasing the equities weighting. Today, the fund is at its maximum equities exposure — 70% of AUM, split between Canadian firms (55%) and U.S. companies (15%). There is also 20% in bonds and 10% in cash. When the cash is included, the duration of the fixed-income portion is three years. “We believe that continued improvement in the economy will result in interest rates moving higher in 2010,” says Grestoni. “Our bond portfolio is defensively positioned.”

The Investors fund did have a small-cap tilt about six months ago, but has moved into large-cap, economically-sensitive names, he adds: “We are positioned for an economic environment that will improve for the weeks and months to come.”

One of the top holdings in the 35-name fund is Teck Resources Ltd. As the market downgraded the stock severely, Grestoni adopted a contrarian view. “It has one of the leading zinc mines in the world, in Alaska,” he says, noting that Teck also has copper and coal properties in North America. “The assumption [last fall] was that commodity prices would not recover and demand would not come back. It was a massive overreaction. Teck has fairly good properties, and the high-growth emerging economies are still going to need these commodities.” Acquired last winter at around $3.50 a share, the stock is $39.50. Grestoni has no stated target.

In a similar vein, Grestoni likes Alcoa Inc. One of the world’s largest aluminum manufacturers, the firm saw its stock plummet to less than US$5 a share last December from US$44 in mid-2008 because of fears of a worldwide aluminum glut. “It’s taken many steps to restructure and refocus,” says Grestoni. “It’s a stock that will be highly leveraged to U.S. economic stabilization.” The stock now trades at US$15.75.



After last year’s strong run-up in equities, it’s time to lighten up on equities and redirect cash flow to bonds, says Doug Warwick, lead manager of TD Monthly In-come Fund and managing director of Toronto-based TD Asset Management Inc. About 63.8% of the fund’s AUM is in equities, 33.8% is in fixed-income and 2.4% is in cash. The bulk of the fixed-income is in more than 100 investment-grade corporate bonds issued by about 50 companies. The average duration is about 5.5 years. Yields range from 2.4% for bonds issued by RioCan Real Estate Investment Trust to 7.8% by Cascades Inc.

“We are still making a call that equities will outperform bonds, but we are reducing that bet a bit,” says Warwick, noting that the TD fund’s benchmark is 40% of AUM in fixed-income, 60% in stocks (split between income trusts, 30%; common equities, 20%; and preferred shares, 10%). “Our strategy is to move into the shorter bonds and get yield pickup by choosing the right corporate credits. We don’t want to get hurt with the yield curve going against us.”

Long-term bond yields have been gradually rising as U.S. Treasury bonds are yielding 4.5% and Government of Canadas are yielding 4%. “If U.S. yields rise, you can be sure that Canada will follow. You’re not getting rewarded for holding long-dated government bonds,” says Warwick, who shares duties with TDAM vice presidents Michael Lough and Greg Kocik.

On the equities side, Warwick favours about 35 blue-chip names that consistently pay dividends. “Even though they have gone up a lot in price [since March 2009], the valuations are still reasonable,” he says, adding that the TD fund is designed to generate income and has a running yield of about 3%. “They got unreasonably low in March, when there was a massive liquidation of anything with risk. It was a panic situation — or panic opportunity. A lot of that fear has been taken out of the market.”

Noting that Canadian bank stocks are trading at 11 to 12 times 2010 earnings and yielding around 4%, Warwick adds that these dividend-paying stocks “are probably a better bet than bonds in the longer term.”

About 30% of the TD fund’s AUM is in financials, followed by about 15% in energy (split between income trusts and stocks) and single-digit holdings in sectors such as telecommunications and consumer discretionary.

One top holding is Toronto-based Manulife Financial Corp. The insurance firm has upset investors by cutting dividends and twice issuing more common equity to bolster capital ratios. “There is a lot of uncertainty about what management is doing, and whether there is some problem that has not been disclosed,” says Warwick. “My thinking is it would have had to disclose that by now. At $19 a share, Manulife could be one of the better performing names over the next few months. Everyone hates it.” He points out that Manulife is an AAA-rated company and a leader in North America and Asia and has ample capital for internal growth or acquisitions. “You have to have faith that management will continue growing the company as it has in the past.” Although Warwick has no stated target, he says it’s easy to see the stock at $25 a share in about two years.

On the energy side, Warwick and his team have long favoured Canadian Oil Sands Trust. The firm, which owns part of the Syncrude consortium, has been under pressure from environmentalists. “But we need the oil and it is a large, low-cost producer,” says Warwick. The royalty trust peaked at $52 a share in mid-2008 and bottomed at $16.65 last February. It now trades at $29 and has a distribution yield of 4.8%.

“We can’t make a short-term call on the oil price. Longer term, though, oil consumption continues to rise, mainly because of demand from Asia,” says Warwick. “It’s becoming increasingly difficult to find large new sources of supply.” If the oil price rises from the current level of US$72 a barrel, COST’s distribution could grow. “We think it’s an appropriate holding for our fund.” IE