Investment Thesis Intact

Our primary investment thesis since 2002 has been that whether by design or by default, central banks globally have adopted a posture that would on balance tend to encourage higher rates of inflation in coming years. With this in mind, we have recommended that investors try to emphasize the real economy over the financial economy in structuring their portfolios.

In the 3 months ended February 29, 2008, we have seen further evidence of the dominance of real economy assets over financial economy assets. In the commodities markets, the Reuters/CRB Futures Index made a new record high, as have most of its constituents, including gold, crude oil, copper and numerous agricultural commodities.

Credit Crisis Continues

Market news continues to be dominated by the credit crisis in the United States, and mounting evidence that the economic slowdown is gathering force there. Recently, the only economic news has been bad news. Leading and coincident indicators of economic activity continue to fall. Of particular concern, housing prices show no sign of having bottomed, and the months supply of unsold homes has climbed to its highest level since the early 1990s.

BMO Capital Markets Economics believes that the U.S economy has entered a recession, but that economic growth is likely to resume in the second half of 2008. Whether the U.S Economy experiences a mid-cycle slowdown or a recession, with housing prices falling and jobless claims rising it likely will be difficult for many to believe the economy is not contracting in 2008.

Attack of the Acronyms

It would seem as though markets are under attack from acronyms. As we have noted the credit crisis got underway in the market for Residential Mortgage-Backed Securities (RMBS), and the collateralized Debt Obligations (CDOs) comprised of them. The much higher than expected default rate on CDOs, combined with their maddening complexity have wreaked havoc on bank balance sheets, and in off balance sheets structures such as SIVs (Structures Investment Vehicles) and VIEs (Variable Interest Entities), which in turn issued ABCP (Asset-Backed Commercial Paper.)

As the Financial Times Lex column pointed out, it as though in trying to get a handle on the credit crisis, the markets are battling a hydra, the mythological monster with nine heads, which grows two new heads to replace each head lost in battle.

Thus far, by our reckoning, banking systems write downs relating to the financial structures write downs relating to the financial structures discusses above now total more that US$170 billion.

Anti-Recession Playbook is Open Again

The response of the U.S Federal Reserve (the Fed) and the Bush administration to the crisis is broadly similar to the approach taken in the wake of the telecommunications/media/technology meltdown in the U.S stock market in 2000-2002. At that time the Fed eased monetary policy aggressively, taking the Fed Funds rate from 6.50 percent down to 1.0 percent over the course of 2 ½ years. Importantly, in doing so, the Fed brough the Fed Funds rate sufficiently low that is was negative in real terms. For its part, the Bush administration enacted a total of three tax cuts in the period, providing fiscal stimulus on top of the monetary stimulus. Finally, the U.S Treasury tacitly approved of the weakening of the U.S dollar against global currencies.

The easing by the Fed, the fiscal stimulus from the Bush administration, and the subtle encouragement of a weaker dollar by the treasury were sufficient to stop and reverse the prior 20-plus year trend of disinflation/deflation in the United States.

Bush Administration, Congress Authorize Fiscal Stimulus

By May of this year, rebate cheques totaling nearly US$170 billion will be arriving in the mailboxes of 130 million American households. The agreement between the administration and the Congress on the stimulus package was reached extremely quickly far more quickly than was the case in the early 2000s.

We believe that even though the Fed initially was slow to move on reducing the cost of credit, it is now taking the problem seriously, and combined with the economic stimulus package will be sufficient to keep the U.S. out of recession. However, we do expect very sluggish growth in the first half of 2008. As was the case in the early part of this decade, we believe that the combined stimulus on monetary and fiscal side will get the job done.

Inflationary Pressures Building and it is Global

We should not be surprised that by repeating the action taken (in a more aggressive fashion, it

should be noted) beginning in 2001, the result is that the inflationary forces we have been

warning about since 2002 are gathering strength.

The inflation we are talking about is increasingly becoming a global phenomenon. For example, in the Euro zone, inflation is at a 14-year high of 3.2 per cent annualized. In Australia, the most recent reading on the CPI was 3.8 per cent a 16year high. In the Gulf region, inflation readings above 6 per cent are projected for 2008, with some Middle East countries expected to experience double-digit rates this year. In China, inflation is running at an 11-year high of 7.1 percent. In Singapore, the annual inflation rate is at a 20-year high of 6.6 per cent.

Canada is an Exception For Now

Commodity-driven inflation pressures in Canada have been offset by the strength of the Canadian dollar, lowering import prices. Since the loonie breached parity with the U.S. dollar in 2007, consumers have put continuing pricing pressure on retailers to match prices in the U.S.

This pressure on retail prices and the disinflationary effect it has on the CPI, gives the Bank of Canada scope to lower the overnight rate at the same pace as in the U.S. Given that inflationary pressures are building around the globe, eventually the disinflationary impact of the Canadian dollar will dissipate.

Outlook for the Balance of 2008

Research now has a year-end target of 14,500 for the S&P/TSX and 1500 for the S&P 500. These targets reflect the current earnings outlook, which Research believes has firmed in recent weeks, and is significantly better than the typical cyclical decline in earnings associated with showing economic growth. For the S&P/TSX Composite, this implies high single-digit returns for the rest of 2008, while for the S&P 500, the target implies double-digit total returns to the end of the year.

Equity market sectors rated Outperform include: Insurance, Capital Goods (ex-Aerospace), Chemicals and Fertilizers, Consumer Durables and Apparel, Golds, Integrated Oils and Refiners, Oil and Gas Producers, Media and Transports.