Telecommunications companies were particularly strong performers among HYD issuers. The sector was hard hit by the high tech downturn. Large debt loads that had been incurred became difficult to service for many telecom companies, and their bonds fell to distressed levels. Eventually the carriers were able to cut back expenditures enough that HYD investors became more comfortable with their ability to generate the cash flow necessary to service their debts.

Global equity markets rebounded in 2003, registering gains for the first time in four years. A short campaign in Iraq, improving investor and consumer confidence and low interest rates were credited with fuelling optimism for a U.S.-led global economic recovery. The following sections discuss equity market performance, initial public offering (IPO) activity and income trusts.

During the first quarter of 2003 North American equity markets fell amid global geopolitical uncertainties (Figures 8 and 9). Investor confidence waned as the focus shifted from improving corporate earnings to geopolitical news, and as a result, markets approached October 2002 lows. On March 13 stock markets in North America and Europe rose after reports indicated that U.S. officials were in surrender negotiations with key members of the Iraqi regime. The Dow Jones Industrial Average (DJIA) rose 3.57%, its largest daily gain year-to-date. Markets also bounced back strongly in Europe. The Toronto Stock Exchange (S&P/TSX) Composite Index rose 1.1% that day. Britain’s leading shares soared to their best one-day gain since October 1987, surging 6.1%, recovering from the eight-year low hit on March 12, 2003.

There were moderate retracements when the rumoured surrender talks were followed by the invasion of Iraq on March 20. Overall, however, markets were firm, retaining much of the advance achieved in the preceding weeks. As the war progressed and the outcome became clear, markets pushed forward. North American equity markets rocketed higher during the second quarter; the S&P 500 rallied 15%, the benchmark’s largest gain since a 21% jump in the fourth quarter of 1998. Similarly, the DJIA climbed 12% and the NASDAQ Composite Index rose 21%, their strongest performances in more than four years. The S&P/TSX Composite Index did not fare as well, but still managed to post a quarterly gain of 10%.

Global equity markets continued to rally through the second half of the year. The blackout that affected large parts of Ontario and the northeastern U.S. had limited economic impact. In the U.S., strong economic data fuelled optimism that an economic recovery was underway. Investor confidence strengthened after taking a beating in 2002 following corporate scandals such as Enron and WorldCom.

However, the rise of equity markets was tempered briefly in late September, when OPEC surprised the markets by agreeing to cut output, fuelling concerns that rising energy costs could slow the pace of a U.S. economic recovery. In the U.S. the DJIA gave up 2%, and the NASDAQ Composite Index was hardest hit, losing more than 3%, with weak sales forecasts coming out of the tech sector adding to the decline. The S&P/TSX Composite Index took a light hit, losing less than 1%. European and Asian markets also gave up some ground.

Global equity markets ended 2003 on a positive note, closing near multi-year highs and posting positive returns for the first time since 1999 (Table 5). Canada’s benchmark index ended the year posting a 24.3% gain, while the blue-chip DJIA gained 25.3%.

Major European and Asian markets also achieved positive returns. In terms of sectoral performance, all of the TSX’s 13 sub-groups were higher by year-end (Figure 10). The strongest performers were stocks in the TSX’s Metals and Mining sub-index, gaining 76.3% after leading the S&P/TSX Composite Index decline in 2002.

Another notable development was that Canadian investors showed renewed enthusiasm for high tech shares by pouring funds back into the sector. After suffering a 60% loss in 2002, the TSX’s Information Technology sub-index rebounded, posting a 59.3% gain, surpassing even the NASDAQ Composite Index’s 50% recovery in 2003. Telecommunications suppliers Nortel Networks and Research In Motion were among the big winners. Despite the run-up in tech shares, traditional valuation measures for the S&P/TSX Composite Index, such as the price/earnings ratio, remained relatively flat at around 28 times, which would suggest that earnings recovered on stronger demand as the global economy began to turn.

Table 5
Global Equity Index Returns (%)

After leading all sub-indexes higher in 2002, the gold index was the worst performer of the year, posting a 13.6% gain, despite the fact the price of the precious metal gained 20%.

B) Primary Market

Canada’s IPO market was down approximately 20% in 2003 from 2002, but still well above the poor performance of 2001. There were 56 new offerings in 2003 worth C$4.6 billion, compared to C$5.8 billion in 2002. However, the great majority of IPO activity in Canada for the year was not in traditional IPOs but in the income trust sector (Table 6).

Table 6
IPO Dollars Raised by Domestic Companies on Domestic Exchanges (C$ billions)

Despite the rebound in equity markets, the year 2003 will go down in U.S. history as one of the slowest periods for IPOs. Though deal flow was relatively unchanged, the amount of capital raised was down by more than 40%. However, market commentators anticipate a turnaround in IPO activity in 2004, building on the momentum of a strong December, when around 30% of total IPO capital raised was in the final month of the year. Market watchers are also encouraged by the rather large flow of quality deals in registration with the U.S. Securities and Exchange Commission.

C) Income Trusts

In Canada the income trust market continued to grow dramatically in 2003, albeit at a slower pace than in 2002, in an environment of continued low interest rates, but no longer of low equity market returns. In the past two years income trusts accounted for most Canadian IPO activity: 83.6% in 2003 and 86.6% in 2002 of total capital raised (Figure 11). The gross value of income trust IPOs fell to C$3.8 billion in 2003 from C$5.0 billion in 2002. In terms of total issuance, income trusts had their strongest showing ever in the third quarter with just over C$5.3 billion, eclipsing total common equity issuance for the quarter and representing a substantial increase in secondary offerings by income trusts. Helping the sector to record levels in the third quarter was the Yellow Pages Income Fund, offering the second-largest income trust IPO ever at $935 million.

To date interest in the asset class has been limited mostly to retail investors and to mutual funds serving the retail market. These investors are seeking high and relatively stable income streams in a context of low interest rates and dividend payouts. Pension funds have generally stayed out of the asset class, reflecting concerns about the risk of unlimited unitholder liability, which has also kept income trusts off Canada’s benchmark S&P/TSX Composite Index.

Derivatives

Overview

The remarkable growth in the global derivatives market continued throughout the first half of 2003, fuelled by an increasing demand across a variety of enterprises for a more quantitative approach to risk management. The currency derivative market was especially active in 2003 as volatile currency movements encouraged non-financial players to enter the market and hedge their exchange rate risk. Trading in derivatives listed on global exchanges was strong early in the year but waned during the third quarter as the players who provide liquidity to the market by facilitating trading ("market makers") backed away after suffering some losses related to a steep, unexpected rise in bond yields during the summer.

A) Over-the-Counter Derivatives

Financial derivatives are either listed on a financial exchange or are over-the-counter (OTC—i.e., arranged between two parties). The global OTC derivative market, which is considerably larger than the exchange-traded market, has been growing rapidly for the past 20 years, a trend that continued during 2003 (Figure 12) according to the semi-annual data collected by the Bank for International Settlements (BIS). The International Swaps and Derivatives Association (ISDA) and the U.S. Office of the Comptroller of the Currency (OCC) have confirmed the rapid expansion of the OTC market. The ISDA reported a 22% increase in the global stock of OTC contracts in the first half of 2003, while the OCC reported a 17% rise in commercial bank holdings of derivatives contracts (most of which are OTC). Currency options were the most dynamic sub-segment, expanding by 42%. Some of the smaller currency markets expanded even more rapidly, with options involving the pound sterling, the Swiss franc and the Canadian dollar growing by 74%, 92% and 152% respectively. The accelerating downward trend in the U.S. dollar apparently prompted non-financial customers to seek protection, as holdings of currency options by such users rose by 91% in the BIS’ most recent review period.

B) Exchange-Traded Derivatives

During the first half of 2003 global exchange-traded activity grew even more than OTC business (Figure 13). But during the third quarter the aggregate turnover of exchange-traded financial derivatives contracts monitored by the BIS fell by 9% to U.S.$223 trillion, as turnover in interest rate contracts fell following a pronounced drop in money market contracts on U.S. exchanges. This was generally attributed to the upward pressure on the yields of U.S. fixed income assets in July and August and a slackening in the pace of mortgage refinancing in the U.S. 

C) Canada

In Canada the market for exchange-traded derivatives is smaller than the OTC market and takes place on the Bourse de Montréal. Since the Bourse de Montréal became fully automated two years ago, it has seen an 40% increase in average daily volume such that at the present time about 70,000 contracts and $30 billion in value are traded daily on the exchange. Trading volumes were fairly steady in 2003 as average daily trading volumes in 3-month bankers’ acceptances (BAX) and 10-year Government of Canada bond futures remained rangebound (Figure 14). The Bourse de Montréal has become a player in the U.S. equity options market by joining with the Boston Stock Exchange and Interactive Brokers to form the Boston Option Exchange, the launch of which was approved by the U.S. Securities and Exchange Commission on January 14, 2004.

Foreign Exchange

Overview

The Canadian dollar appreciated strongly throughout 2003, reaching decade highs in December. General U.S. dollar weakness in 2003 allowed the Canadian dollar to equal or better the performance of other major currencies, although the Canadian dollar did not keep pace with the Australian dollar. Despite the Canadian dollar’s relative strength, data suggest that it continued to trade below purchasing power parity in 2003.

A) Canadian Dollar Performance

From January 1 to December 31, 2003, the Canadian dollar increased 21%, attaining levels last seen in August 1993. After experiencing rangebound trading between 62 and 64 cents U.S. during the second half of 2002, the Canadian dollar joined most other major currencies in making strong gains against the U.S. dollar from January through to mid-May 2003 (Figure 15) as concerns related to the war in Iraq weighed on the U.S. currency. The Canadian dollar relinquished some of its gains from mid-May to July, dipping back toward 70 cents U.S. However, by August the Canadian dollar resumed its strengthening path above 74 cents U.S. before settling into rangebound trading between 74.5 and 77 cents U.S. for most of the fourth quarter of 2003. The highest close of the year came on December 30 when a fresh 10-year high of 77.26 cents U.S. was set.

Most analysts explain the appreciation of the Canadian dollar largely in terms of general U.S. dollar weakness, which may represent a concrete response to large U.S. current account deficits that have averaged over 4% of gross domestic product (GDP) since 2000. Other likely sources of upward momentum in the Canadian dollar include the increase in commodity prices, the positive differential in Canada-U.S. short-term interest rates (Table 7), Canada’s record of low and stable inflation, fiscal and current account surpluses, and declining federal government debt and net foreign debt as a share of GDP.

Table 7
Five-Year Bond Yields in 2003 (%)

B) Canadian Dollar Performance Compared to Other Major Currencies

In 2002 the Canadian dollar did not appreciate against the U.S. dollar at the same pace as other major currencies such as the yen and euro. However, in 2003 the Canadian dollar performed on par with the euro and outperformed the British pound and Japanese yen, although it advanced somewhat less than the Australian dollar, to which it is often compared (Figure 16). The Australian dollar’s ascent in 2003, like that of the Canada dollar, was partially linked to the increase in commodity prices, as both economies are to some extent resource-based (Figure 17). Of note is the yen’s strengthening, despite being held back during 2003 by the Japanese government’s massive intervention in the market.

C) Outlook for 2004

In mid-December the major Canadian banks issued differing forecasts for the Canadian dollar over 2004. Three of the five major banks forecast a gradual rise in the value of the loonie, but at the time of writing this article almost every forecasted figure had already been exceeded (Table 8). CIBC, however, issued a bearish forecast for the Canadian dollar.

Table 8
Forecast Canada-U.S. Exchange Rate in 2004

D) Purchasing Power Parity

Based on the Organisation for Economic Co-operation and Development’s (OECD’s) 2002/2003 data on purchasing power parity (Table 9), which compares the price of a representative basket of consumer goods and services among OECD countries, one could make the case that while the Canadian dollar is undervalued, it is less undervalued against the U.S. dollar than it was in 2002. A basket of goods and services that cost U.S.$100 in the U.S. could have been purchased for U.S.$81 in Canada during August 2002, when the monthly average for the Canadian dollar was U.S.$0.6380. The same data from November 2003 shows that a basket of goods and services that cost U.S.$100 in the U.S. could have been purchased for U.S.$97 in Canada.

Table 9
Comparative Price Levels (Canada = 100)

Mutual Funds

Overview

After a difficult start, the Canadian mutual fund industry ended 2003 on a high note as stock markets regained lost ground and investor optimism returned. The stock market recovery of 2003 had a particularly beneficial impact on equity funds, which had fared badly in 2002. On a less positive note, 2003 may be remembered as a year of mutual fund scandals in the U.S., where trading abuses have tarnished the reputation of the mutual fund industry.

A) Fund Growth

In many respects, the first three quarters of 2003 were difficult for the mutual fund industry in Canada, as net sales (excluding reinvested distributions) were negative for the year as a whole. The industry recorded a net withdrawal of approximately $650 million in 2003, the first since 1991. However, the industry closed out 2003 on a strong note as net sales were $513 million in November and $1.1 billion in December (Figure 18).

When including reinvested distributions, gross sales were actually positive for 2003, so that assets under management increased to $439 billion, the second highest figure ever for the industry (Figure 19). Total assets under management increased 3.6% in December and are 12.1% higher compared to a year earlier.

B) Fund Assets

With the exception of money market funds, all categories of mutual funds recorded increases in assets in 2003. With the resurgence of the stock market in the last three quarters of 2003, equity funds became more appealing to investors as valuations improved. The result was an increase in equity and dividend fund assets in the last nine months of 2003 (Figure 20), after remaining relatively flat in the previous six months. Despite soaring equity markets, bond funds still managed to increase their assets, benefiting from the safe haven appeal of government bonds. On the other hand, money markets were clearly negatively affected by the performance of equities. The best performers of the year were "dividend and income" funds and "bond and income" funds, which increased by 43.3% and 28.2% respectively (Table 10).

Table 10
Assets by Fund Type  

C) Fund Companies

All of the top 10 fund companies in Canada (Table 11) saw increases in assets in 2003. RBC Asset Management Inc. displaced Investors Group in the number one spot with a 20.3% increase in assets over the previous year. C.I. Mutual Funds Inc., which acquired Synergy Mutual Funds and Skylon Capital Corp. in 2003, saw its assets increase by 16.1%. However, CIBC Asset Management recorded a 50.1% increase in assets, the largest among the top 10 fund companies, earning the company a place in the top five. Mutual fund dealers and the banks continue to be the primary players in the industry, managing over 80% of assets (Figure 21). Many of the large dealers continue to snap up smaller fund companies.

Table 11
Top 10 Fund Companies by Assets

¹ Canadian VC data lags by one quarter.  [Return]

² Investments by VC firms in portfolio companies.  [Return]

³ Capital raised by VC firms from outside investors such as pension funds or high net worth individuals, or earmarked for VC investments in portfolio companies.  [Return]