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Disappearing Risk Premium Returns

By: Joe Hornyak

Emerging markets and Japan, those were the two big stories last year. Emerging markets had a terrific year, up 26 per cent, much more than the more mature markets. They were followed only by Japan, which finally had “the big catch-up.”

David McCaslin, senior vice-president at Greystone Managed Investments Inc., says these markets were “perhaps catching, and weʼll see if this is the case or not, the last wave of the tremendous liquidity that was generated after 2001. All those baby steps that the U.S. fed has gone through over the last two years by raising interest rates” are happening around the world. Now, central banks everywhere are increasing rates. Even the Bank of Japan has said “the party is over, no more zero rates for us,” which is a sign of greater positive economic growth.

Risk Premium

The second big issue is the risk premium which had almost vanished – even in those markets which could be deemed to have been riskier markets – is coming back, says Gerald Cooper-Key, manager of international equities at Mawer Investment Management.

“And it wasnʼt just a matter of emerging markets, you saw the risk premium vanishing on junk bonds and everything else. In fact, some of the emerging markets, in my view, are better quality than some of the other markets anyway.”

Part and parcel with this is “a general sell-off right across the board.” In fact, Cooper- Key says some world class companies which are in the emerging area have been sold off “too much” relative to elsewhere.

However, he says this is not all that surprising. “The markets have become a little overbought in my view.” In fact, he had started selling and taking profits earlier in the year. “At the time, it clearly looked as though I was being too early in doing that. Indeed, I was I guess. It looks pretty good today, but it didnʼt then. However, my feeling is that if the markets slow down to where good value comes to the fore again – as it will and as it always does – then I will start reapplying cash to it.”

Currency

Canadian investors do face one impediment to investing in EAFE and Emerging Markets. While the performance of Canadian markets has prompted many to stay in Canada, thatʼs only part of the story, says McCaslin.

“If we go back to what happened in 2005,” he says, international markets did well. For example, EAFE in local currencies had a return in the neighbourhood of 26 per cent. But “a big, big chunk” of that – in fact, the majority of it – “got washed away” in currency translation so the net return to Canadian investors was something in the neighbourhood of 10.7 per cent.

And while that is nothing to sneeze at, McCaslin says this currency translation is something that Canadian investors have to be increasingly aware of. For example, the U.S. dollar had a terrific year in 2005 as the other major currencies in the world underperformed against it. “What was different about the Canadian dollar was it appreciated somewhat against the U.S. dollar. And relative to these other key currencies – the Euro, Yen, and Pound – the Canadian dollar had huge appreciation. That was the currency impact that took that 15 per cent or more away from Canadian dollar returns.”

Changed Yet Again

This year, things have changed yet again. So far, everything is clobbering the U.S. dollar. While this does change week-toweek, on a year-to-date basis, these other currencies – the Euro, Yen, and Pound – are not only outperforming the U.S. dollar and appreciating against it, but they are also stronger versus the Canadian dollar.

“This year, weʼre getting a currency lift,” says McCaslin. So with the EAFE markets up 2.1 per cent in local currencies as of the end of May, in Canadian dollars they were up 5.3 per cent.

“When you ask the question ʻwhat are Canadian funds doing and what should they be doing,ʼ I think the answer is they should be aware of what their structure is overall in terms of what their expectations are for global investing and for currency which, whether they like it or not, is a big part of that.

“If their foreign exposure is getting up to a significant part of their portfolio, they should be thinking about currency. They may not necessarily do anything about it as, at the end of the day, they may choose to continue to go unhedged or may decide to do some hedging program. However, if Canadian funds are going to get their foreign exposure up, at some point they have to start thinking about currency.”

Joe Hornyak is executive editor of Benefits and Pensions Monitor.

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