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< page 27 of 44 > |
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Investment performance | Market overview | Consolidated returns | Equities |
Inflation-sensitive investments | Fixed income and absolute return strategies | Investment costs |
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Market overview
North American stock markets got off to a good start in early 2007, but underwent a sea change during the summer when the U.S. subprime mortgage market collapsed. In short order, the resulting U.S. credit crunch froze Canada’s market for non-bank asset-backed commercial paper (ABCP) as investors refused to roll over these short-term notes due to uncertainty over the extent, if any, to which they were backed by subprime loans in the U.S. The subprime shock wave rippled through world financial markets, prompting central banks to offer relief by injecting liquidity into the system.
Canadian and U.S. stock markets recovered smartly in September and October, but suffered sharp downturns in November as a number of major financial institutions announced substantial write downs as they approached fiscal year ends. Share prices rebounded in December as central banks injected still more liquidity into the system. Major foreign markets followed a similar pattern, except for Japan’s Tokyo Exchange, which ended the year down 11.2%. Emerging markets showed very strong performance, with some posting gains of 30% or more.
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Turbulence from international credit markets spilled over into North American equity indexes, creating significant volatility throughout the year. |
The Canadian dollar’s rising value in 2007 further complicated the fund’s annual returns. Because we report our foreign investment returns in Canadian dollars, its strength against most foreign currencies diminished our infrastructure and non-Canadian equities returns.
Overall volatility increased, validating our underlying policy of maintaining equity exposure below the level of less mature pension plans, and our decision to invest in assets with low correlation to the broad public markets. Along with short-term pain, the summer downturn did create a buying opportunity and we substantially increased our exposure to credit, including emerging markets debt. We also seized the opportunity to acquire shares of several high-quality companies, whose performance we had been tracking for up to two years.
Rising oil prices and concerns about the health of the U.S. economy fuelled a strong run up in the value of the Canadian dollar, which gained 18.1% against the U.S. dollar. The Canadian dollar also rose in relation to other major currencies, but to a lesser extent.
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We hedged 50% of our U.S. dollar exposure for much of the year.
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The Canadian dollar’s rise meant that Canadian investors realized markedly lower returns on foreign assets when home country performance was expressed in Canadian dollars. For example, the S&P 500 – which reflects major U.S. companies – returned 5.5% for 2007, but -10.7% when expressed in Canadian dollars. Hedging against the U.S. dollar and other major currencies allowed us to benefit from the relative devaluation of other currencies. Approximately 50% of our U.S. dollar exposure was hedged for much of the year.
Through the year, interest rates remained low, but were consistent with economic growth as measured by gross domestic product, and with inflation growth. Low interest rates globally continued to moderate fixed income returns, but these interest rates fell more than we expected, producing returns that were slightly higher than anticipated when the year began. The Canadian bond market, as measured by the Scotia Capital Markets Universe Index, returned 4.6%. Globally, the JPMorgan Global Bond Index returned 6.0%.
In Canada, both the economy and the stock market benefited as oil neared US$100 a barrel and other resource commodities rose too. While the current bull market in commodities began in 2002, current lofty prices have good support from rapidly industrializing economies in Asia and other emerging markets. Coupled with the need for industrialized countries to renew their own long-neglected infrastructure, demand for Canadian resources should remain strong and benefit our holdings in this sector.
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We hedge our exposure to foreign currencies to reduce the impact of currency fluctuations on the value of our foreign investments. |
The summer’s credit crunch was the defining issue for Teachers’ in terms of total portfolio return for 2007. Our public equities and bonds did well during the first half of the year, but reversed course in late June and July. We had heeded warning signals and made portfolio adjustments, but – like other market participants – were surprised by the speed and impact of the ensuing correction.
The fund was affected by a marketwide repricing, which impacted several structured investment vehicles we held. As subprime trading became difficult and even impossible and non-bank ABCP trading was frozen, investors with sizeable positions began selling other, higher-quality investments to generate the liquidity required to meet their obligations. This selling created downward pressure on all asset categories.
As we look ahead, we expect to see continuing impacts from the credit crisis in the near term. Although it started in the U.S., liquidity has become a global problem. It will take time for the financial system to recover; as this occurs, we expect to see further volatility develop in other markets.
Looking forward to the next 10 years, we are confident that major central banks will remain faithful to their inflation target of 2.0%, plus or minus one percentage point, and that actual inflation will follow suit. As inflation is a key component of estimating the plan’s liabilities, the real returns of stocks and bonds must be compared to determine the impact on the plan’s liabilities. The accompanying table shows Canadian equities and bond real returns – after inflation – for the past five decades.
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| Canadian equities real return |
7.1% |
15.9 |
7.1 |
7.8 |
6.3 |
| Canadian long bond real return |
0.9% |
5.8 |
5.3 |
6.5 |
4.2 |
| Canadian inflation rate |
2.5% |
2.1 |
2.2 |
4.0 |
4.1 |
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| Based on Standard & Poor’s S&P/TSX Total Return Index, Scotia Capital Long-term Overall Bond Index (DEX Long-term Bond Index) and the CPI
all-items index. |
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| Over the last 50 years, Canadian equities after inflation have outperformed bonds by an average of 2.1%. This supports our view that real returns for stocks will outperform those of bonds by 2.0% to 2.5% in the future, which is less than recent experience. |
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