The global credit crisis has abated, and most countries are on the road to recovery. That road, however, may be long and bumpy for some. Canada now has a golden opportunity to outshine other industrialized countries, as manufacturing is rebounding, especially in the auto sector, and demand for commodities such as oil and base metals will continue to escalate. The TSX has outperformed the other G7 stock markets this year, especially on an exchange rate–adjusted basis.

Understanding how changes in the yield curve can affect your portfolio

Self-directed investors need to use all of the market predictive information at their disposal to make wise choices. The yield curve is one such tool, but it’s often poorly understood. Depicting the relationship between short- and long-term interest rates, it has become a preferred market and economic indicator for many analysts and investors. For those who take the time to understand it properly, the yield curve offers a valuable reference point for forecasting future interest rates and economic activity.

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Answering that question might help you avoid going broke in retirement, says York business school professor and pension economics researcher Moshe Milevsky, in a recent interview with BMO InvestorLine.

Each of us has an asset called human capital: skills and knowledge that enable us to do work that produces economic value. An entrepreneur running a small business has human capital that resembles a stock, so his or her portfolio should contain fewer risky investments, Milevsky says. A baby boomer government employee with a guaranteed defined pension is like a bond, so his or her portfolio can skew toward riskier assets.

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* All rewards offered are subject to the Terms and Conditions of the AIR MILES Reward Program.
** See Terms & Conditions for details.

The global credit crisis has abated, and most countries are on the road to recovery. That road, however, may be long and bumpy for some. Canada now has a golden opportunity to outshine other industrialized countries, as manufacturing is rebounding, especially in the auto sector, and demand for commodities such as oil and base metals will continue to escalate. The TSX has outperformed the other G7 stock markets this year, especially on an exchange rate–adjusted basis.

While the TSX in Canadian dollar terms is up 20 percent year to date, compared with a more modest 15 percent for the S&P 500, in U.S. dollar terms our stock market has appreciated a whopping 35 percent. The attractiveness of investments in Canadian assets has not been lost on global market participants. Our currency’s strength is reflecting the positive outlook, and the loonie is likely to hit parity with the U.S. dollar over the next 18 months, a headwind for investments in U.S. dollar assets.

To be sure, the strong loonie makes it more difficult for our exporters to compete, but as the U.S. economy recovers we will undoubtedly benefit. We have seen this in spades with the success of the U.S. Cash for Clunkers program, which encouraged car buyers to trade in their old gas guzzlers for newer, more fuel-efficient models. The program was so successful over its short life that the U.S. Transportation Department had to hire additional workers to process dealer refunds, and some sales were lost owing to extraordinary inventory depletion. This triggered a jump in auto production in the third and fourth quarters, and workers are finally enjoying the effects of an upturn in the industry.

In addition, the U.S. housing market is bottoming out, in no small measure due to markedly improved affordability. First-time homebuyers are the big winners, boosted by the first-time homebuyer tax credit. Canada’s housing market has been red hot since the spring, more than making up for plummeting sales in January and February. The revival in U.S. housing will stimulate Canadian exports of lumber, copper and other building materials. As well, strong domestic home sales go hand in hand with stepped-up expenditures for furniture, electronics, appliances and the like.

Canadian consumers are among the most confident in the G7, as our banking system did not suffer the enormous losses experienced elsewhere, and household net worth has held up quite well in comparison to that of our neighbours to the south, where homeowner equity was obliterated and stocks have underperformed.

Central bankers will no doubt keep interest rates low over the coming months, despite concern in some circles of an ultimate inflationary impact. Inflation in Canada has been exceptionally low, below the Bank of Canada’s target level, so rest assured that we won’t see any aggressive tightening of monetary policy through the first half of next year. Central bankers in much of the industrialized world will remain cautious, as economic recovery continues to rely on government support - less so in Canada, but certainly in the U.S.

This recovery is unlikely to mimic the robust growth rates of earlier ones. In many countries, worries linger that the banking system is still under pressure, with mounting losses on loans, especially on commercial real estate, and that U.S. banks and households still have a long way to go in reducing debt. European and American policy-makers are concerned that, for example, incentives for car buying merely pulled spending forward, and that high unemployment will keep a lid on consumer spending. Policy-makers fear that the replenishment of inventories, which is helping to support growth now, might run its course by year end.

While momentum may lag and setbacks will occur, the combined forces of a sharp revival in emerging market economies, low interest rates and dissipation in the financial credit crisis should provide a moderate but sustainable recovery through 2010 and 2011. With the U.S. dollar still vulnerable, the TSX will continue to stand out among G7 stock markets.

Sherry Cooper is a global economic strategist and executive vice-president with BMO Financial Group and chief economist for BMO Capital Markets.

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Understanding how changes in the yield curve can affect your portfolio

Self-directed investors need to use all of the market predictive information at their disposal to make wise choices. The yield curve is one such tool, but it’s often poorly understood. Depicting the relationship between short- and long-term interest rates, it has become a preferred market and economic indicator for many analysts and investors. For those who take the time to understand it properly, the yield curve offers a valuable reference point for forecasting future interest rates and economic activity.

So what exactly is the yield curve? What determines its shape? And how can you use it to analyze current market conditions and help project future market conditions?

Understanding the basics
Also known as the term structure of interest rates, the yield curve is simply a graph that plots the yield of bonds of the same class with differing maturities. Time to maturity is plotted horizontally along the x-axis of the graph, typically from three months to 30 years, whereas the corresponding yield to maturity is plotted vertically along the Y axis. At a glance, investors can see the relationship between bond yields and their maturities.

Although a yield curve can be created for almost any type of debt instrument, the most common is that of federal government bonds. The government bond market is generally considered risk free, and includes securities of nearly every maturity, from three months to 30 years. This comparison ensures that differences in yield, commonly referred to as the yield spread, are due solely to differences in maturity, and not to other factors such as credit or liquidity risk. The slope of the yield curve has long since been regarded as a good leading indicator of economic activity. It provides investors with a market consensus on the direction of interest rates, and of the economy in general. Properly interpreting the shape of the yield curve is critical for making meaningful forecasts.

Types of yield curves
The yield curve can take one of a few basic shapes: normal, steep, flat or inverted.

Normal: A normal yield curve is created when short-term yields are lower than long-term yields for the same type of debt instrument. Also known as a positive yield curve, this shape is the most common. The curve is considered normal because investors are compensated with higher yields for holding longer-term bonds, which are more susceptible to such risks as inflation and default. For investors, a normal yield curve is typically an indicator of a healthy, growing economy.

Steep: A steep upward sloping curve is formed when long-term yields are significantly higher than short-term, thereby creating a steeper sloping curve. This situation usually reflects an easy monetary policy and indicates an expectation that interest rates will rise dramatically in the future. Therefore a higher yield is demanded for longer maturities. Historically, a sharply positive sloping yield curve has often preceded an economic upturn. Investors generally interpret a steep yield curve as an indicator of strong economic growth. Such growth is sometimes accompanied by higher inflation, and usually by tighter monetary policy and higher interest rates, both of which can hurt bond returns.

Flat: In a flat yield curve, the yields on short- and long-term bonds are roughly the same. This can happen when the central bank raises interest rates to cool off a rapidly growing economy. The short-term yields rise to reflect interest rate hikes, while long-term rates either remain unchanged, or fall as inflation concerns subside. A flat yield curve is irregular, and usually occurs during a transition to an upward or downward slope. Many investors consider a flat yield curve to signify an upcoming economic slowdown.

Inverted: When short-term yields are higher than long-term yields, the yield curve slopes downward, and is referred to as an inverted or negative yield curve. Inverted yield curves are uncommon, and typically indicate tight credit conditions and a lack of confidence in short-term prospects for the economy. For investors, an inverted yield curve usually signals a slowing economy and the possibility of an approaching recession. A sharply inverted yield curve often means that investors expect very sluggish economic conditions, lower inflation, and thus lower interest rates.

Current environment: The current shape of the yield curve in Canada is steeply positive. In fact, it has just recently dropped back from its steepest level ever. It’s tempting to take this as conclusive evidence that the recession in Canada has ended, as the Bank of Canada has recently announced. But there are many other factors to consider in anticipation of an economic recovery, such as the cause of the current turmoil. Historically, recoveries from recessions caused by financial crises tend to be much slower than normal. Investors should consider more than one economic indicator when making investment decisions.

Bottom line: Forecasting what the market and the economy are going to do next is no easy task. As with weather forecasting, economic forecasting is not an exact science. For example, does an inverted yield curve signal a recession? Usually, but not always. While not exactly a crystal ball, the yield curve is definitely a valuable tool for predicting future market and economic direction. It’s one more instrument to help you create strategies for boosting total returns and building wealth.

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Answering that question might help you avoid going broke in retirement, says York business school professor and pension economics researcher Moshe Milevsky, in a recent interview with BMO InvestorLine.

Each of us has an asset called human capital: skills and knowledge that enable us to do work that produces economic value. An entrepreneur running a small business has human capital that resembles a stock, so his or her portfolio should contain fewer risky investments, Milevsky says. A baby boomer government employee with a guaranteed defined pension is like a bond, so his or her portfolio can skew toward riskier assets.

Figure out now whether you’re a stock or a bond, he advises. Then you can analyze risks – like inflation, your expected longevity and the sequence of market returns as you approach retirement – and create a strategy so your retirement planning doesn’t become a ticking time bomb.

BMO InvestorLine: Are You A Stock or a Bond? is the title of your latest book. What does that mean?

Moshe Milevsky: You are your biggest investment. Once you know whether you’re a stock or a bond you can make choices that decrease your vulnerability to risk.

BIL: As a self-directed investor, how do I decide whether I’m a stock or a bond?

MM: An investment banker with an income correlated with market performance has human capital that is definitely a stock. Therefore, a significant portion of his retirement account should be allocated to bonds and safer fixed-income instruments. If your human capital resembles a stock, meaning your income –earning ability is more high risk, then you should have fewer equities in your investment portfolio.

A tenured university professor like I am, with a secure job, a predictable income and a pension, is more like a bond. My human capital is almost guaranteed. Therefore, I should hedge by investing in the stock market.

Some people are stocks, some people are bonds and everyone else is a combination of the two.

It’s all about ensuring that your personal financial balance sheet is diversified.

BIL: What do you mean by “personal balance sheet”?

MM: Your career is like a gold mine or an oil well. Every year you extract gold from the mine or oil from the ground. You have an investment in that asset for the next 30 or 40 years. How does that fit with the rest of your investments?

Think about people who worked for Nortel in Ottawa. Everything was linked to Nortel - their real estate, their pensions, their jobs, their stock options, their portfolios - and look what happened. Their human capital, financial capital and even their social capital (the networks they developed with their friends, colleagues and coworkers) was invested in Nortel. Those disappeared. That was poor holistic diversification, a lack of awareness of the personal balance sheet. In five years, it could be Apple or Nokia. As well as all your money. don’t put all your balance sheet eggs in one basket.

BIL: So the balance sheet includes all the other types of capital that you just mentioned?

MM: All the capital you have. My exercise number one is to sit down and analyze what your personal balance sheet looks like. Add up the value of your pension, your employment labour, your financial capital, and your house, then put them into categories, and make sure you’ve diversified across the board.

If you’re a government employee in your 50s with a guaranteed defined pension, you’re a bond. If your human capital is a bond, then you make sure your financial capital is somewhere else. If you’re an entrepreneur running a small business and all your eggs are in that basket, and you’re not drawing a salary because you want to grow the business, then your human capital is one big stock.

The point is to make sure that whatever you are, your assets are not. The concept of diversifying human capital and financial capital is a lot more important than it was a year or two ago.

BIL: Is there a test you can take to determine what percentage you should invest in stocks or bonds?

MM: There isn’t a check-the-box method yet. We’re going to develop human capital classification boxes. The first step is to recognize whether you’re more stock or bond.

BIL: The book says it’s a financial myth that bonds are the best choice for retirees. Why?

MM: If you’re in your 40s and you’re looking at retirement income planning and you decide you don’t want to take any risks, you may want to put it all in bonds because you’re getting older and you can’t tolerate financial risk. That’s a problem because of longevity. You have to find some way to expose your portfolio to the stock market, especially if you’re a bond.

There’s nothing magical about retirement that automatically means you should have a more conservative portfolio allocation.

BIL: Why does asset allocation become less important than product allocation as we near retirement?

MM: In the early years of our financial life, we try to spread our investments across diverse and uncorrelated asset classes. When we get closer to retirement, product allocation should take on a larger role. You must decide how much of your retirement income will come from financial instruments like exchange traded funds and mutual funds, and how much should come from pension-like products: life annuities, variable annuities and other guaranteed insurance products. The focus shifts from wealth accumulation to income generation.

BIL: Why is it useful for each of us to think of ourselves as a small company called You Inc. and manage our lives as if we were a small corporation?

MM: Once you say “You Inc.,” it certainly gets people thinking. Who is the board of directors at your company? My mother-in-law and my kids are on my board of directors, and are very vocal directors at our company meetings. Who directs the corporation’s long-term investments and long-term policy? I think we can learn a lot from corporate financial management in terms of our personal finances. With all the risks being transferred to our balance sheets, it’s about time more people do this.

BIL: Is a written financial plan key to success, even if you make your own plan?

MM: Absolutely. I do almost all of it myself. I obviously talk to a lot of people and gather information, but I have a family budget and I put together a balance sheet every year. Long-term planning is incredibly important, more so for people who are independent and do it themselves. It just seems like an odd, annoying exercise, but it’s critical.

It makes me feel better just doing the plan, so I have more knowledge about my financial circumstances. I have a written tolerance and budget for how much I can lose in every asset class. The plan is extremely helpful in managing in a world of uncertainty - more so now than a few years ago. I don’t want to wake up in the morning and see the TSX is down 5,000 points and then panic. I want a strategic plan and an envelope that says “TSX Down 5,000.” I open the envelope and follow the instructions I wrote when I was calm three weeks ago. That’s financial planning.

BIL: Any reassuring comments about the markets?

MM: It’s not the RSP or the house or the portfolio that is your most valuable asset. My mission right now is to make people understand that they are their biggest asset.

To decide what type of investor you are, and whether taking on more or less risk will help you meet your financial goals for retirement, sign in to your account and complete the Investor Profile questionnaire.

The articles in this newsletter are prepared as a general source of information. They are not intended to provide legal, investment, accounting or tax advice, and should not be relied upon in that regard. If legal or investment advice or other professional assistance is needed, the services of a competent professional should be obtained. The information contained in this newsletter is based on sources believed to be reliable, but its accuracy cannot be guaranteed. The views expressed and information provided in the articles are attributable solely to the authors.

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It’s like getting a free* flight to New York or Seattle.**

Open an account with $100,000 in new assets or transfer or deposit $100,000 in new assets to your existing account by October 31, 2009, and you’ll receive 1,300 AIR MILES^®† reward miles.

* All rewards offered are subject to the Terms and Conditions of the AIR MILES Reward Program.
** See Terms & Conditions for details.

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Looking for investments that are easy to understand and offer trading flexibility at a low cost? Consider BMO ETFs. BMO Financial Group has launched a series of 4 BMO ETFs that cover most of the major North American asset classes. These include:

• BMO Canadian Government Bond Index ETF
• BMO Dow Jones Canada Titans 60 Index ETF
• BMO U.S. Equity Index ETF
• BMO Dow Jones Diamonds Index ETF

Learn more

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In December 2008, BMO Financial Group became the first and only major Canadian bank to offer registered disability savings plans. This plan helps parents and others save for the long-term financial security of a person with severe or prolonged disabilities.

• Anyone can contribute to an RDSP
• The lifetime contribution limit is $200,000 per beneficiary, with no annual limit
• Contributions may qualify for payments from the Canada Disability Savings Grant (CDSG)* program, up to a lifetime maximum of $70,000 per beneficiary
• Lower-income beneficiaries and families may qualify for payments from the Canada Disability Savings Bond (CDSB)* program, up to a lifetime maximum of $20,000, without having to contribute to an RDSP
• Growth on investments within the plan is tax deferred
• When funds are withdrawn, the CDSG, CDSB and any investment income are taxed to the beneficiary, who likely has a much lower tax rate than parents or other contributors

* Eligibility ends December 31st in the year the beneficiary turns 49. Both the CDSG and the CDSB are contributed by the Government of Canada and paid directly to the plan on behalf of the beneficiary.

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A survey of Canadian households shows that investors have only 13% of their total wealth in non-Canadian holdings.* Conversely, many large pension plans are allocating more to their portfolios’ global content. For example, the Canada Pension Plan’s global equity portion has grown to 35%, according to the The Globe and Mail (Feb. 26, 2007). You decide how much global content may be right for you, to help you capitalize on opportunities and reach your investment objectives.

*Source: Investor Economics, Household Balance Sheet Report, 2007 edition

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