Mid-year surprises

We’re now more than half-way through the year and, as so often happens, the financial universe is not unfolding as expected. In fact, many of the fearless forecasts made last New Year’s have turned out to be way off the mark. Here are my nominations for the top five surprises so far in 2007.

Income trusts. After Finance Minister Jim Flaherty dropped his Halloween bomb, the trust market went into freefall, at one point losing more than $30 billion on paper. The sector rallied a little in December but by early January it was back in the doldrums, with the S&P/TSX Capped Income Trust Index bouncing along at about the 140 level. (The lowest point was 134.95 in early November.)

No one expected much from trusts in 2007. After all, the sector had received a death sentence from the Conservatives and Mr. Flaherty gave no indication that he would budge on the issue (which he didn’t).

As it turns out, although trusts are doomed they aren’t just folding their tents and slipping silently away. Nor are investors ready to let go of them, even though we all know what’s coming in 2011. In the first six months of this year, the Capped Income Trust Index defied predictions and gained 5.4 per cent. That’s a far cry from the heady days of 2003 to 2006 but it’s a lot better than most people expected.

Even more surprising was the speed at which takeover mania took hold. Within three months of the Flaherty decision, we began seeing announcements that one trust after another was being snapped up at a premium price, often by foreign private equity firms. The buy-out binge is still going on; within the past few weeks we’ve seen two major transactions. First, the E.D. Smith Income Fund (TSX: JAM.UN) was purchased by TreeHouse Foods of Illinois for a net $8.55 per unit, a 16.5 per cent premium over the previous day’s closing price. Then came the news that Calgary’s CCS Income Trust (TSX: CCR.UN) is being taken private by a group headed by company founder David Werklund at a price of $46 a share, a 21.4 per cent premium to the last trade before the news was made public. There are undoubtedly many more such deals in the works.

All surprises aren’t necessarily bad. The trust sector’s performance in the first half of 2007 is a prime example.

Canadian stocks. The TSX started the year on a dismal note. During the first week of trading in 2007, the Composite Index lost 430 points, or 3.3 per centof its value. It was indeed an unhappy New Year and did not augur well for the next 12 months. Expert opinion was mixed on where the market was heading but the prevailing view (which I shared) was that caution was in order. After all, the bull market had been going for more than four years.

The good times never roll forever, they say, but they’re rolling for a lot longer than many of us expected. The S&P/TSX Composite Index cracked touched an all-time high of 14,646.82 in mid-July and was ahead 13 per cent year-to-date at that point. Recently, Jeff Rubin of CIBC World Markets predicted the TSX will hit 15,000 by the end of the year and provide investors with a total return of 18.1 per cent for 2007.

Tech stocks. Wall Street’s performance was somewhat more predictable than that of the TSX in the first half, although the 11.1 per centadvance in the Dow to July 20 was a little better than was generally expected in the light of the problems in the U.S. housing market. The big surprise, and a development that many investors still aren’t fully aware of, has been the resurgence of the high-tech sector. After the dot-com debacle, tech stocks were moribund for several years. Investors wanted nothing to do with the sector and the Nasdaq Composite limped along at around the 2,000 level until the late summer of 2006. It then began a strong rally which continued through the first half of this year, taking the index to over 2,700. The year-to-date gain to July 20 was 11.3 per cent, beating the Dow by two-tenths of a percentage point. Tech could well be the hot story of the second half of the year.

Interest rates. In January, the feeling was that interest rates were likely to turn down. The country was coming off a weak fourth quarter and the forecasts for 2007 were for modest growth. In its January statement, the Bank of Canada projected that the annualized GDP rate would pick up to about 2.5 per cent in the first half of the year and that total CPI inflation would average just over 1 per cent during 2007. That outlook strengthened the view that rates would either hold steady or fall.

A lot has changed in six months. Now we’re looking at the likelihood of a quarter-point increase this week, with more to come later in the summer. Bond prices have been pummelled as a result and there are concerns that the rate of bankruptcies in the country will worsen as consumers are stretched beyond their limits. About the only people who are happy are fixed-income investors who keep their money in T-bills and GICs.

The loonie. As we began the year, the Canadian dollar was still drifting down from its high point of US91c, reached in mid-June 2006. It ended last year at US85.81c and got as low as US84.37c on Feb. 8 at which point some economists were predicting it would finish 2007 in the US80c – US82c range.

But in July, our dollar surged through US95c and the prospect of parity by year-end no longer seems far-fetched. There are several reasons for the loonie’s turnaround, including a rebound in oil prices, a stronger than expected showing from the Canadian economy, the prospect of rising interest rates, takeover deals that have brought in foreign capital, and the on-going weakness of the U.S. greenback. All of these factors remain in place, so further advances in the loonie appear likely.

From an investing point of view, that makes owning U.S. stocks less attractive. The Dow may be up 11.1 per cent on the year but the loonie is ahead by just about the same amount. If you’re investing in the U.S. indexes, you’re treading water unless you’re hedging the currency.

Those are a lot of surprises in just six months. It would be nice if second half of the year was a little more tranquil, but that’s probably wishful thinking.

This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder member, go to http://www.buildingwealth.ca/promotion/50plusproducts.htm