The S&P TSX stock index made a valiant recovery in October, only to see most of it wiped out in November. December exhibited a zig-zag pattern, ending down modestly. The expression “zig-zag” may become an apt descriptor of 2012 as well. Since European and American debt woes remain the focal point of the markets, and are expected to persist for some time, uncomfortable volatility is the name of the game in equity markets.

We can only pine for the time when the word Europe conjured up fantasies of romantic travel destinations. The Eurozone represented the number of countries one could try to cram into an all-too-short vacation. Today, we know far too much about Europe, and none of it is romantic. Our favourite pastime of assessing the US political scene has been supplanted by an attempt to keep up with a series of new European acronyms, each one purporting to succinctly define a solution to the debt crisis.

In the end, the most likely way out of Europe’s mess may be to issue more debt, giving countries like Spain time to restructure their fiscal situations, and imposing the drudgery of living within one’s means on the whole continent. As a “way out” (solution seems too strong a word) becomes more apparent, equity markets may rally further, as the potential for recession is replaced by a slow growth scenario.

To a degree, this may be underway. As this is being written, the European Central Bank has recently floated liquidity into the private banking sector by effectively lending banks money at very low rates which they then are expected to loan to those countries experiencing borrowing difficulties. On the surface, this looks good as the banks could certainly use some easy earnings to shore up their weakened balance sheets. But look deeper and one quickly realizes that this is another way of printing money, and doing so is often the path to inflation. The inestimable Tony Boeckh wrote The Great Reflation, published in 2010, in which he said “logic says that if the last crisis was caused by excessive money and credit inflation, even more of the same should cause an even bigger crisis.”

Last quarter we emphasized the merits of dividends in a slow growth economy. This strategy remains apropos today. However, many investors misunderstand this approach. With bond yields at remarkably low levels, these investors are piling into utilities, telephone companies and other supposedly safe stocks. While the businesses of these companies may be safe, overpaying to get dividend yield is not safe. Many may be disappointed by this “chasing yield” effort. In our view, the best course is still to buy leading companies which will deliver solid financial results in all types of economic conditions. When we do it right, we identify companies which will increase their dividends on a sustainable basis.   These continue to be available at reasonable prices in today’s market.

But what about fixed income opportunities? After all, interest rates fell even further in 2011, enabling bonds to be the best category among conventional investment classes.

2011 Investment Performance (in Canadian dollars):

Certainly there is little evidence that markets will calm themselves in the near future. In fact, volatility may be here to stay. Three of the four most volatile periods in the last 50 years have occurred in the last decade: 2002, 2008, and 2011. And recall the flash crash of 2010. Nothing has been done to curtail the high frequency trading phenomenon.

Furthermore, we live in a world now recognized to be awash in debt with its attendant risks. Finally, the world’s economies are more integrated than at any point in our lifetimes. Free trade deals, and just-in-time inventory sourcing from around the world, connect us like never before. The Japanese tsunami and floods in Thailand served notice to international manufacturing companies, and consumers, just how intertwined we have become. Overlay a new set of tensions in the Middle East, whose oil lubricates the world’s economies, and negative shocks are likely. The Arab Spring has emboldened the citizens of a number of nations that were previously ruled by strong men. ‘Long tail’ events anywhere in the world can destabilize all of the world’s economies and markets. For an investor, the diversification benefits that one might seek from investing abroad just aren’t there anymore. Not that this approach was ever effective during financial crises. In times of trouble, all markets decline in unison.

The problem with bonds however, is that with interest yields at historic lows, new investments will result in low ‘locked in’ rates of income. With today’s yields at distressed low levels, bond durations are extended, creating the likelihood of much greater volatility in bond prices in the future. So fixed income investments that have traditionally been purchased for yield and safety, are less likely to fulfill these objectives compared to the past.