Start the Presses: Quantitative Easing

Quantitative easing is a central banking policy tool used when the rate of interest falls so close to zero that further reductions are either impossible or are having no effect on stimulating the economy or preventing deflation.

The central bank is essentially creating money out of thin air to buy government securities, although it could conceivably be used to buy anything, such as government agency debt or mortgage-backed securities.

Last week, the US Federal Reserve, demonstrating that it would, in fact, “employ all available tools to promote the resumption of sustainable economic growth,” announced its intention to buy up toUSD300 billion in longer-term US Treasury notes as well as another USD750 billion of mortgage-backed securities with money it “adds” to its balance sheet.

While last week’s announcement brought much attention to the term, quantitative easing had its “soft open” last fall: The Fed’s balance sheet has grown from USD900 billion before the Lehman Brother bankruptcy to USD1.8 trillion. These new steps will lift that amount to perhaps USD3 trillion.

The Fed’s focus has now shifted from easing the interest rate to increasing the quantity of money, and the aim of supplying funds is no longer to ease concerns about narrow liquidity but to increase the overall money supply, thereby easing concerns about the stability of the banks, while hoping to engineer an eventual upturn in lending, economic activity and, yes, inflation.

The rate on the 10-year Treasury came down faster and harder than it had since 1962, and 30-year mortgage rates have already sunk to the 4.75 area. And, yes, the US dollar dove as well. Spot crude and gold prices also jumped on the announcement, immediate reactions that reflect long-term inflation concerns.

Back in 2002, when he was still an academic noted for his Great Depression expertise, current Federal Reserve Chairman Ben Bernanke delivered remarks about the central bank’s options to fight deflation when the fed funds rate had reached zero, the now-famous Helicopter Ben Speech. At the time he suggested deflation was a remote possibility in the US, but the last 18 months have rendered that forecast moot and his, at the time, far-out forecast rather prescient. Click through the link above; it’s worth a read, if only to illustrate how rapidly things have deteriorated.

What we have now is essentially the Fed creating currency out of thin air with which to purchase assets. This is clearly a mission reserved for the worst of circumstances, and we’ll deal with the unintended consequences later. But easing access to credit and stimulating growth are the objectives right now.

The Bank of England, the Bank of Japan, and the Swiss National Bank had already launched their quantitative easing programs, and the Bank of Canada (BoC) is now likely to follow suit. The BoC must do so to prevent the loonie from rising to levels that would further devastate its manufacturers.

The BoC will officially join the quantitative easing crowd with its April Monetary Policy Report. The BoC said in early March, while announcing a 50 basis point cut in its target interest rate, that it would outline its framework on both quantitative and credit easing with its regular quarterly report.

The immediate aim of the BoC’s efforts is to narrow spreads on commercial mortgage backed (CMBS) and asset backed securities (ABS)–there are few buyers in the market right now for such securities, which have evolved to form a sort of “shadow” banking system that allows credit to flow more easily to individuals and businesses. Spreads on these securities remain very wide because there are few buyers in the current market, and that, in turn, means reduced access to credit.

BoC Governor Mark Carney, in London early this month for a meeting of G20 central bankers and finance ministers, hinted Canada too would fire up the press in the cause of growth.

“It’s important to do that in a comprehensive, holistic fashion so that people can see the range of tools that the bank continues to have,” Carney told reporters after the preparatory meeting in advance of an early April summit of G20 leaders. Many of the downside risks to the economy the BoC identified in its January Monetary Policy Report Update were materializing. “I would draw your attention to the commitment of central banks to maintain expansionary policies,” he said. “Rates will remain low for longer. In Canada … our overnight or target rate can be expected to remain at its current level of 50 basis points or lower until there are clear signs that the output gap is beginning to close.”

Officials at the G20 meeting underlined the significance of the joint central bank pledge, signaling that even traditionally conservative central banks had indicated they were prepared to take the leap into quantitative easing as they run out of room to cut interest rates. The Fed’s announcement is not likely to prompt a definite realignment in currencies, in part because other central banks are likely to follow its lead in quantitative easing. It’s not a global currency game-changer because other central banks, such as the BoC, are embracing quantitative easing.

Central banks and finance ministers are focused on short-term concerns such as easing access to credit for individuals and businesses. Whether it’s no-longer-exotic monetary policies result in inflation in the long run is a question for tomorrow.

The prospective new debt issue by the US Treasury and risky asset position of the Federal Reserve put in play some powerful forces for inflation over the longer run that may prove quite difficult to contain–and so gold would be an obvious haven. This is an important issue, but the Fed’s actions are motivated entirely by growth.

And if the global economy gets growing again, exposure to Canadian oil and gas trusts, for example, will prove profitable. There’s been an unprecedented level of supply destruction during the last several months, and that’s now overtaken demand destruction as the central concern on the fossil fuels front.

When the global economy revs up again, the same stresses that drove the run to USD150 oil–specifically, emerging Asia and its enormous middle class consumption potential–will still be in place. And, if you’re still concerned about inflation, there’s this: Investors have used crude as a hedge against the US dollar in the past. Crude hit its USD147 per barrel peak in July 2008, when the US dollar was at its weakest in years.

Grits Gain

A Nanos Research survey of Canadian political opinion conducted March 13 to March 18 put the Liberal Party at 36 percent support, up 3 percentage points from the previous poll last month and 10 points from the October election. The Grits, under new leader Michael Ignatieff, have overtaken the Conservatives, led by Prime Minister Stephen Harper, who have 33 percent support, down 1 point from February and off nearly 5 points from the election.

Mr. Harper remains the top choice for prime minister, with 33 percent support, up 1 point from February. Mr. Ignatieff was next with 27 percent, down 1 point from a month earlier.

Speaking Engagements

There are few better places to combine work and play than Sin City: Join Canadian Edge, Editor Roger Conrad and The Energy Strategist Editor Elliott Gue for The Money Show Las Vegas, May 11-14, 2009, at The Mandalay Bay Resort & Casino.

With Elliott’s and Roger’s sage advice, this is one trip to Vegas that won’t make a wreck out of you.

To attend as Roger’s guest, click here or call 800-970-4355 and refer to promotion code 012649.

And make plans to join Roger, Elliott, Gregg Early and Benjamin Shepherd at the 18th Atlanta Investment Conference. Sponsored by Friends for Autism, the conference is held in a mountain setting north of Atlanta from Thursday, April 23, to Saturday, April 25.

Roger, a steady hand through many market events such as the one we’re dealing with now, will talk about Canadian income and royalty trusts as well as his new service focused on exploiting the greatest spending boom in history, New World 3.0.

Elliott will detail the new direction for Personal Finance and provide insight into his approach to stock selection and portfolio management. What’s required now amid these difficult times are clarity and focus, qualities Elliott has demonstrated in these pages and through The Energy Strategist for years.

Gregg, a constant at PF for nearly two decades, will be there to address recent developments with the publication. He’ll also discuss the Smart Grid, an endeavor he’s exploring as part of his role with New World 3.0.

Ben, editor of Louis Rukeyser’s Mutual Funds and Louis Rukeyser’s Wall Street, the in-house mutual fund expert, will discuss efficient, cost effective ways to simplify the investing process.

Be sure to bring your questions. These guys love to talk markets and everything that impacts them.

Attendance is limited to 175 of the most enlightened, savvy individual investors. Go to http://www.aicatchota.com/ for more information. Meals are included for the Maple Leaf Memo discounted price of $459 for a single and $599 for couples. Call 770-952-7861 or e-mail altinvestconf@mindspring.com to register.

The Roundup

Conservative Holdings

Artis REIT (TSX: AX-U, OTC: ARESF) recorded a 22 percent increase in revenue, as it continued to efficiently manage its portfolio while successfully adding $116.6 million in new properties. Funds from operations (FFO) per share rose 7.7 percent, while distributable income (DI) per share ticked up 2 percent. Occupancy rates held their own portfolio-wide at 96.5 percent, and 97.4 percent including committed space. The fourth quarter payout ratio based on both FFO and DI fell to a very comfortable 64.3 percent.

Artis’ fourth quarter growth was slower than full-year rates. 2008 revenue, for example, rose 46.3 percent, while FFO and DI per share moved up 17 percent and 12.1 percent, respectively. This was largely due to a slower pace of development and acquisitions later in the year, a trend that’s continuing into 2009 as management responds conservatively to tight credit markets and Canada’s recession.

However, growth in same property net operating income–the best measure of profit margins for REITs–was basically the same for the fourth quarter and the full year, 6.9 percent versus 7.4 percent. One big reason: a 45.8 percent fourth quarter increase in rents on expiring leases. That’s also a trend that should continue, as rents portfolio wide remain more than 20 percent below current market rates.

Some 42 percent of gross leasable area is office space, 31.5 percent is retail and the rest is industrial, located in strong and less competitive areas of four western provinces. About half properties are in Alberta, where growth has slowed due to the collapse in energy prices. But nearly half of Artis’ 2009 expiring leases already have commitments, at an average rate 22 percent above current rents. Lease quality is further strengthened by the fact that over half of properties are leased to “national” tenants and 8 percent to governments.

Despite Artis’ torrid growth in recent years, management has held debt levels well in check. The ratio of total mortgages, loans and bank indebtedness to the book value of its properties stands at just 51.6 percent, versus a 70 percent limit in its charter. The REIT has a $60 million credit line that’s renewable at its option and only about half is drawn at present. Moreover, only 5.4 percent of mortgage debt expires this year, all in the second half.

The bottom line is Artis remains well positioned to continue solid growth through 2009. Yielding a whopping 16 percent, Artis REIT is a buy up to USD10.

Innergex Power Income Fund (TSX: IEF-U, OTC: INGRF) enjoyed a 38.7 percent increase in revenue, thanks to a 43.4 percent increase in output from its fleet of hydroelectric and wind power plants. Cash flow rose 35.8 percent while adjusted net income per share, the account from which dividends are paid, rose 37.5 percent.

Importantly, management was able to renegotiate the trust’s financial arrangements before last year’s crisis hit. As a result, 92 percent of debt is at low fixed rates. That stability is matched by an average 15.4 year life of its power sales contracts, all of which are to ultra-reliable payers like major utilities and governments. In addition, the current power plant fleet has an average projected life of 25 years.

The trust left 2008 with no significant debt maturities until 2013, an unused credit line of CAD10 million and CAD23.7 million cash in the bank, enough to cover three quarters of distributions. That in management words, “positions the Fund to consider any investment or acquisition opportunities that might become available on the market in 2009.” And it’s solid protection for the distribution as well, as current cash flow covers virtually all capital costs and dividends.

All in all, the picture of stability Innergex showed when we added it to the Portfolio last year looks brighter than ever. Down slightly from its initial recommendation and yielding over 11 percent, Innergex Power Income Fund is a buy up to USD12.

Conservative Holdings’ Reporting Dates

• Atlantic Power Corp (TSX: ATP-U, OTC: ATPWF) Mar. 30, 2009 (Confirmed)

Aggressive Holdings

Advantage Energy Income Fund’s (TSX: AVN-U, NYSE: AAV) fourth quarter earnings showed some ill effects from the collapse of energy prices since last summer. Overall, however, they paint the picture of a business that’s maintaining its financial integrity amid tough conditions, while positioning for what could be a very rewarding future.

At the same time, however, management heaved a very large bombshell at investors: eliminating its remaining dividends and announcing Advantage will convert early from a trust to a corporation. The plan, which the company hopes to complete by June 30, needs a two-thirds affirmative vote of unitholders, who should receive proxy materials shortly from brokers.

In one sense, Advantage’s move is logical. Despite hedging, cash flows are taking a wicked hit from the meltdown of natural gas prices (67 percent of output). At the same time, however, it has hit on an extremely rich reserve at its Montney Shale play in Glacier, Alberta.

As reported in the Mar. 13 Flash Alert, 2008 drilling at Glacier allowed Advantage to replace 290 percent of its annual output of oil and gas at a ridiculously low finding and development cost of just CAD3.48 per barrel of oil equivalent. That pushed the company’s working interest ownership at the site to the equivalent of 2.9 trillion cubic feet of proved plus probable natural gas reserves, according to independent rater Sproule. And Advantage has an inventory of 440 more drilling sites that could push those numbers higher still.

The flipside of having all of these reserves is it will take considerable capital to exploit them, with CAD2.5 billion the latest estimate. Had natural gas prices not crashed from the low teens last summer to around USD4 per million British thermal units now, CEO Andy Mah and the rest of the management team might have been able to take the path of developing Glacier while continuing to pay dividends. As it is, there’s simply not enough cash to do both, and management has chosen development.

Gutting the dividend entirely, of course, carries the cost of alienating Advantage’s current shareholder base. That’s apparently what’s happened this week, as a near double off the lows in the trust’s shares reversed on Thursday when the announcement was made.

As we’ve seen with other early converting companies, the market ultimately recognizes value. Once the initial selling wave has washed over Advantage, we’ll likely see a new group of shareholders come in to buy with different motivations, mainly as a bet on energy prices and a possible takeover.

No matter how you slice it, Advantage sells for barely a fifth the net asset value of reserves in the ground, as currently assessed by Sproule. That was a compelling incentive to own shares before the conversion announcement. And if anything the company’s new ability to plough all its cash into development makes it even more attractive as a growth/takeover play.

What that means in dollars and cents is Advantage shares are likely to rally sharply from these levels, once the conversion news plays itself out. The move will be particularly rewarding if energy prices turn up in a meaningful way, particularly natural gas. And there’s always the very real possibility of a takeover, given the large number of players in the Montney shale, including ARC Energy.

On the other hand, there are a large number of Canadian oil and gas producing trusts that are also selling dirt cheap despite owning valuable reserves–and which continue to pay very generous dividends. Consequently, while I’m not inclined to sell Advantage from the Portfolio at this price, I will likely move out of it at a future date. Hold Advantage Energy Income Fund for now.