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The Basics of Canadian Residency
A basic understanding of PPNs
30 Big Ideas: Energy
30 Big Ideas: Financials
this issue
Tax Issues P.4 PPNs P.7
Energy P.12 Financials P.19
Canadians Resident Abroad
ISSUE 6: Nov/Dec 2012
Featured Articles
The Basics of Canadian
Determining the tax consequences of
moving to another country, whether
permanently or temporarily, requires
some foresight. Since Canadian resi-
dents are taxed on worldwide income,
maintaining residency in Canada
Read more: page 4
Understanding PPNs
As the name implies, in a Principal
Protected Note, the principal amount
invested is generally protected if held
until maturity.
Read more: page 7
2
Canadians Resident Abroad Nov/Dec 2012
Contents
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Publisher: Dax Sukhraj Editor: Dax Sukhraj
Editorial Board: Pervez Patel Arun Nagratha
Dax Sukhraj
CRA Magazine is Canada’s first e-magazine designed specifically for Canadians who are presently
living abroad, who have done so in the past or who are contemplating an out-of-country sojourn in
the future.
Our magazine is distributed electronically free of charge to subscribers in 142 countries around the
world. In addition to sound and timely advice in the investment and tax arenas, CRA e-magazine
covers everything from offshore employment, vacation/travel and international real estate informa-
tion to country profiles, medical/insurance and education options for your children.
3
Canadians Resident Abroad Nov/Dec 2012
First Word
Welcome to the Nov/Dec 2012 edition of CRA Magazine.
In this issue, our residency experts Arun and Wayne write an important article about the basics of Canadian residency for
tax purposes. This article has been revised from its original release in 2004. As we receive lots of inquires about these
issues, our readers should find this article very useful.
Abu Nizam writes about Principal Protected Notes (commonly known as PPNs) in a simplistic way to give a general in-
troduction about this sophisticated financial product. This is the first of a two part series as he writes about how the prod-
uct works from a technical point of view.
Fidelity Investments Canada has published 30 big ideas for 2012 and beyond for all 10 sectors. We think readers will
benefit from these themes when making investment decisions. We would like to publish all 30 ideas but it will become so
enormous that it would take three editions of our magazine to cover it. We have decided to publish only 6 ideas from 2
sectors instead.
We sincerely hope that you enjoy this issue. Should you wish to contact us please send an e-mail to
[email protected]. As always, your questions and comments are welcomed.
Dax Sukhraj
Publisher
4
The Basics of Canadian Residency for
Tax Purposes
Arun (Ernie) Nagratha, CA, CPA
Wayne Bewick, CA, CFP, CPA
This article has been revised from its original release in 2004.
Residency and worldwide income
Determining the tax consequences of moving to another
country, whether permanently or temporarily, requires
some foresight. Since Canadian residents are taxed on
worldwide income, maintaining residency in Canada will
require you to file a Canadian tax return on an annual
basis, including in your return income from all sources,
both Canadian and foreign. You may also be required to
file a tax return in the country you are going to live in. If
you sever your Canadian residency for tax purposes, a
final “departure tax return” should be filed in Canada.
Since many other countries around the world have lower
individual income tax rates than Canada, you may want
to sever your residency in order to be in a situation
where you will no longer be taxed on your worldwide in-
come in Canada. It is important that before you make
that decision, you first determine if you are even in a po-
sition to be able to sever residency and whether it makes
sense in your situation. Tax residency does not affect
your citizenship or legal residency status. It is specific to
tax.
Determining if you are a resident of Canada for tax pur-
poses depends on your intention at the time you leave
Canada. You must ask yourself if you plan to return to
Canada in the “foreseeable” future. If your plans are not
to return to Canada, you may be in a position to sever
your residency with Canada if you support your intention
to remain abroad by severing your residential ties with
Canada. There is no specific time period after which you
will be seen to be a non-resident of Canada, so it is im-
portant that the steps you take to prove your intention to
be a non-resident are followed carefully.
Residential ties with Canada
Residential ties with Canada are typically seen as pri-
mary or secondary. It is important that you sever all pri-
mary residential ties when ceasing residency. Maintain-
ing any significant primary ties could be looked at by the
Canada Revenue Agency (CRA) as causing your resi-
dency to be maintained in Canada. Secondary residen-
tial ties are looked at collectively by the CRA.
Page 4
5
The Basics of Canadian Residency for
Tax Purposes
No one secondary tie would likely be cause you to be
viewed as maintaining Canadian residency, however,
efforts should be made to sever all ties with Canada.
Some common examples of primary ties are maintaining
a residence(s) in Canada that is available for your use,
leaving a spouse or common-law partner in Canada and
supporting dependants in Canada. Some common sec-
ondary ties are personal property left behind in Canada,
maintaining Canadian bank accounts, Canadian credit
cards, and professional and/or club memberships in Ca-
nadian organizations.
It is important that you inform any Canadian residents
making payments to you, such as financial institutions
that you have investments with, that you intend to be a
non-resident of Canada. Not only does this show the
CRA your intention to be a non-resident, but it also en-
sures that payments made to you after your departure
are subject to the appropriate non-resident withholding
taxes. If these non-resident withholding taxes are not
withheld by the Canadian payer, you will be required to
voluntarily remit the withholding tax after you have left
Canada.
If your residency status is questioned by the CRA, they
may ask you to submit a form NR73 - Determination of
Residency Status (Leaving Canada). It is advisable that
you fill in this form at the time of your departure and
keep a copy for your records, in case it is requested. It is
not advisable that you submit this form to the CRA
unless you and your tax advisor have difficulty determin-
ing your residency status.
Departure tax
If you become a non-resident of Canada for tax pur-
poses, you must file a final departure tax return in Can-
ada, due April 30th after the year in which you sever
your residential ties with Canada. There are various tax
implications that could arise in this final return.
Page 5
6
The Basics of Canadian Residency for
Tax Purposes
By: Arun Nagratha & Wayne Bewick. Contact: 60 Columbia Way Suite 900, Markham, ON, Canada, L3R 0C9. Tel: 905.709.7911. Fax: 905.946.2207.
E-mail: [email protected]. Web: www.cramagazine.com. Page: 6
The most common example is the deemed disposition of
certain assets you own, based on fair market value. An-
other example is the pro-ration of personal tax credits for
your period of residency. Apart from the departure tax
return itself, rental properties owned by non-residents
have specific filing requirements in Canada as do sales
of property.
This is just a sample of some of the issues that should
be considered on your departure from Canada. It is im-
portant that you seek professional advice to ensure that
all of your departure tax issues are taken into considera-
tion in your final tax return.
Treaty Resident If you are seen as a tax resident of Canada and another
country, that Canada has a tax treaty with, you could be
deemed a non-resident of Canada under the treaty.
Most treaties with Canada have a “tie-breaker” Article 4.
This Article goes through various steps to determine
which of the two countries an individual more a resident
of under the treaty is. The individual would then be a
resident of one of the two countries and deemed a non-
resident of the other. In this sense, one could have ties
to Canada and still be considered a non-resident of Can-
ada depending on how significant these ties are as com-
pared to the other treaty country.
Maintaining Canadian residency
If significant ties to Canada cause you to be seen as a
resident, and you are not deemed a resident of another
country under a treaty, keep in mind that you will still
have to file a Canadian tax return on an annual basis
reporting your worldwide income, even if this income
was earned in another country. In most cases, you will
be allowed a foreign tax credit for foreign taxes already
paid on this income but you must still meet your tax filing
requirements in Canada. If you do not file your tax re-
turn, you may receive a request at some point from the
CRA requesting you to file.
Ernie and Wayne are Tax Advisors with Trowbridge Profes-
sional Corporation, Chartered Accountants | Tax Advisors.
Their firm focuses on international tax services for Canadians
around the world. For further information on their firm and the
services they provide, you can contact them using the contact
details below.
7
A Basic Understanding of Principal
Protected Notes (PPNs): part 1
Abu Nizam, CIM
In my last few articles, I wrote about technical analy-
sis and stock options. In the technical analysis arti-
cle, I wrote about some important and well known
technical analysis and how to use them along with
fundamentals.
In the stock options article, I wrote about call options and
put options and various option strategies. At a minimum,
investors should use some technical analysis because of
the increasing amount of volatility which makes the tim-
ing of an investment more important. Investors should
explore the area of stock options as well. Today, I will
write about Principal Protected Notes, more commonly
known as PPNs. As the name implies, in a Principal Pro-
tected Note, the principal amount invested is generally
protected if held until maturity.
A principal-protected note (“PPN”) is a
debt instrument issued by a creditwor-
thy issuer, the return on which is linked
to the performance of another invest-
ment called the underlying asset.
The main appeal of PPNs as an invest-
ment lies in the fact that they protect
investors’ principal while at the same
time providing them with an opportu-
nity to participate in a possible increase
in the value of the underlying asset.
- “Due Diligence Guidelines on Principal-protected
Notes” by Andre Fok Kam, Investment Dealers Associa-
tion of Canada (Now IIROC), Mar 28, 2007
Readers should know that even though it says the princi-
pal is protected, the protection comes only if it is held
until maturity, which is generally 5 to 7 years after the
investment has been made. That means that in an infla-
tion adjusted basis, investors who only recover their prin-
cipal are exposed to an erosion of the purchasing power
of their investment over the term of the PPN.
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A Basic Understanding of Principal
Protected Notes (PPNs): part 1
Types of PPNs:
Besides the protection, PPNs typically are linked to a
mutual fund or hedge fund (or other financial instrument)
and fall into the four broad categories listed below:
1. Mutual Fund-Linked Notes
The return is linked to a particular mutual fund or portfo-
lio of mutual funds.
2. Hedge Fund-Linked Notes
The return is linked to the performance of an underlying
hedge fund, or more commonly, a portfolio of hedge
funds.
3. Index-Linked Notes
The return is linked to the performance of an equity in-
dex, such as the S&P/TSX Composite Index or S&P
500.
4. Alternative Investment-Linked Notes
The return may be linked to different commodities, man-
aged futures or income-producing notes. This is a new
version of PPN, designed to satisfy investors’ income
need.
Who should consider purchasing PPNs?
The following points are taken from the RBC Structured
Notes website FAQ and are generally applicable to all
investors:
RBC Principal Protected Notes are created for investors
who want any of the following:
The potential to earn a return that is greater than
what is available from traditional fixed income invest-
ments with similar risks.
Exposure to equity or commodity markets with the
potential for a principal guarantee.
Exposure to foreign equity and commodity markets
without the foreign currency risk.
Exposure to equity and commodity markets that are
otherwise difficult to access.
To protect previous investment gains but remain ex-
posed to equity or commodity markets.
How it works:
To understand how it works one has to understand a
zero-coupon bond first. This debt instrument is the heart
of any PPN. A zero-coupon bond is a debt security that
doesn't pay interest (a coupon) but is traded at a dis-
count. At maturity, when the bond is redeemed for its full
face value, the holder earns a return which is the differ-
ence between the purchase price and the face value. So
let’s say for a simplistic example, a $1000 dollar face
value bond is purchased at $900 and the investor re-
deems it one year later. The return would be $100.
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A Basic Understanding of Principal
Protected Notes (PPNs): part 1
With this understanding, let’s talk about the two struc-
tures used by PPNs:
1. Zero-coupon bond plus call option
2. Constant Proportion Portfolio Insurance (CPPI)
Zero-coupon bond plus call option:
In the zero-coupon bond plus call option, the PPN issuer
invests most of the proceeds in a zero-coupon bond that
has the same maturity as the PPN notes issued. When
the bond matures the issuer redeems the bond which
guarantees the return of principal on maturity.
The remainder of the proceeds from the PPN note issu-
ance is invested in a call option package on the underly-
ing asset, which may provide the upside for the note. As
a call option is the right to the holder and not an obliga-
tion, on a maturity date, if the option is in money, the is-
suer will exercise it or simply let it expire.
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A Basic Understanding of Principal
Protected Notes (PPNs): part 1
Depending upon the performance of the call option, the
investor may or may not make a return. However, be-
cause of the investment in a zero-coupon bond, the in-
vestor can get his/her principal amount back.
For example, let’s say a manager of a PPN invests $800
in zero-coupon bonds for every $1,000 raised, in order to
guarantee the $1,000 principal will be available in five
years to be returned when the PPN matures.
Therefore, for each $1,000 raised, there is $200 left to
invest in a riskier asset in order to provide for interim in-
terest payments and to boost returns.
The manger will buy a call option on the underlying asset
with the $200. On the maturity date, if the option is in-the
-money, the manager will exercise it making a profit. If
the option is out-of-money the manager will simply let it
expire.
I need to stop here for today. In our next edition, I will
talk about the Constant Proportion Portfolio Insurance
(CPPI) structure, various risks associated with PPNs, the
cost of PPNs, and briefly about Principal at risk notes.
Wish you happy holidays and a happy New Year.
Page 10
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30 Big Ideas for 2012 and Beyond
Fidelity Investments, Canada
Fidelity Investments Canada has published 30 big
ideas for 2012 and beyond for all 10 sectors
(consumer discretionary, consumer staples, energy,
health care, financials, industrials, materials, infor-
mation technology, utilities and telecommunica-
tions).
We think readers will benefit from these themes when
making investment decisions. We would like to publish
all 30 ideas but it will get so enormous that it would take
three editions of our magazine to cover it. We have de-
cided to publish only 6 ideas from 2 sectors instead.
Now to choose which two sectors, we looked at how
these sectors have performed year to date and have
picked up the best performing and the worst performing
sectors. Readers can see how the sectors have per-
formed in 2012 year-to-date and the rest of the article
has been taken from Fidelity Investments Canada’s web-
site
Page 11
12
30 Big Ideas for 2012 and Beyond
Intro
What trends will shape the investment landscape in
the years ahead?
A special report from Fidelity Investments, our U.S. part-
ner, highlights the top 30 investment themes the firm’s
equity sector specialists believe are likely to have the
greatest influence on the performance of each sector in
2012 and beyond.
Energy:
The performance of energy stocks historically has been
cyclical in nature, meaning they tend to outperform the
broader market during periods of economic expansion
and lag during economic deceleration. More specifically,
energy stocks historically have outperformed at the mid
and late stages of an economic cycle, when an expan-
sion is firmly entrenched and demand for energy com-
modities and energy services is at or near peak levels.
During the past couple of years, the energy sector has
become increasingly more complex. Geopolitical ten-
sions in the Middle East and North Africa have raised the
risk of crude oil supply disruptions.
The major crude oil spill in the Gulf of Mexico in the
spring of 2010 raised the probability of increased indus-
try regulation for U.S. oil producers – a source of uncer-
tainty with regard to future earnings. Elsewhere, the
earthquake and tsunami in Japan during the spring of
2011 also posed new challenges to global supply and
demand. Despite this more complex backdrop, we be-
lieve there are a few compelling dynamics underway in
the energy sector that have the potential to significantly
alter the landscape and provide attractive opportunities
for long-term investment.
Three themes for energy: Theme 1: The emergence of more productive new drill-
ing techniques
Theme 2: The growth of the liquid natural gas market
Theme 3: The renaissance in deepwater exploration
Investment theme: The emergence
of new, more productive drilling
techniques
Key takeaways
New techniques for extracting natural gas and crude oil from the earth have helped ease concerns about the inability of U.S.-based
energy producers to grow domestic supply and offset the country’s heavy dependence on foreign sources for these commodities.
These unconventional new drilling techniques have lowered the overall cost structure for companies engaged in the exploration of
traditional energy sources, such as crude oil and natural gas.
More productive drilling techniques have led to an overall increase in mid-continent U.S. oil production, which has led to lower pric-
ing for refiners.
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30 Big Ideas for 2012 and Beyond
New drilling technologies
Advances in horizontal drilling and hydraulic fracturing
techniques (commonly referred to as “fracking”) are al-
lowing U.S. exploration companies to tap natural gas
and crude oil reserves embedded in previously impene-
trable rock and trapped thousands of feet underground.
Hydraulic fracturing involves blasting huge volumes of
water, sand and chemicals deep underground, which
creates fissures or fractures that allow the natural gas
trapped inside shale rock to flow out. This new drilling
technology was initially adopted and applied to improve
the extraction of natural gas in shale rock formations. Its
success led to an increase in the supply of – and lower
prices for – natural gas. More recently, exploration com-
panies have begun to apply the same fracking tech-
niques in old conventional crude oil basins that had been
viewed as unproductive based on traditional drilling
methods. The results have been favourable, leading to
what many in the industry are referring to as a
“renaissance” in domestic oil and natural gas drilling.
During the past decade, the long-term bull case for the
stocks of U.S. companies involved in the exploration and
discovery of crude oil has been largely premised on ris-
ing global demand, the inability to grow domestic supply
and rising prices. There has been little production growth
outside of the Organization of the Petroleum Exporting
Countries (OPEC) during this period. As a result, we’ve
seen rising crude oil prices, followed by an increase in
drilling to stave off rising global demand growth. More
recently, energy exploration and production companies
have been adding new unconventional wells to existing
crude oil reservoirs, resulting in extensions of proved
reserves (Exhibit 1, below).
The productivity of fracking for both commodities has
been beneficial for integrated energy producers, but also
for companies focused primarily on drilling. The number
of drilling rigs has increased substantially during the past
couple of years (see Exhibit 2, below). Elsewhere, en-
ergy services companies are benefiting from increased
service demand and higher service intensity associated
with these new techniques.
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30 Big Ideas for 2012 and Beyond
The impact of productive drilling
Overall, these new drilling technologies have led to an
increase in onshore U.S. crude oil production of about
400,000 barrels per day, which represents the first in-
crease in 30 years.1 This increase in mid-continent U.S.
oil production has led to lower, more attractive prices
compared with imported crude oil (Brent North Sea) and
improved profit margins for domestic refiners, chemical
makers and other purchasers of locally produced crude
(see Exhibit 3, below). Historically, the U.S. crude oil in-
frastructure has been built for the country to be a net
consumer/importer of oil from a global standpoint, so
these new drilling techniques and the increase in U.S.
production is potentially game-changing for many partici-
pants. At some point in the future, could the U.S. grow
enough onshore crude production to pressure global
crude oil prices? Could a further increase in production
necessitate the construction of additional domestic pipe-
lines to transport crude oil from the mid-continent states
to the Gulf coast? These are some of the dynamics we
are monitoring.
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30 Big Ideas for 2012 and Beyond
Investment implications
Unconventional drilling is likely to have a major impact
on supply growth and future energy consumption around
the world over the next decade. With respect to natural
gas, the U.S. Energy Information Administration esti-
mates there are 2,552 trillion cubic feet of natural gas in
the United States, or 110 years of use at 2009 consump-
tion levels, due largely to the application of new drilling
practices.² With U.S. politicians and entrepreneurs alike
looking to leverage such an abundant resource, the ef-
fects of more productive unconventional drilling could
spread throughout the entire global energy paradigm.
This trend is already being seen in the retirement of
older coal-generating power plants in places such as
China, and the adoption of natural gas vehicles in Asia,
Latin America and the Middle East.
Meanwhile, unconventional drilling techniques also could
have a significant impact on crude oil markets. Today,
this drilling technology is being adopted in oil fields in
Canada, Argentina and Eastern Europe, and may lead to
a significant global increase in non-OPEC production in
the years ahead. We recognize that new unconventional
drilling technologies have the potential to put downward
pressure on energy commodity prices around the world
over the long term, which may be helpful at various
times for some industry participants and detrimental to
others. We are also mindful that falling energy prices
would have a significant destabilizing effect and geopo-
litical ramifications for major energy-producing countries.
Overall, the energy sector is potentially on the cusp of
making the transition from a resource-constrained world
to one that has a much better production profile due to
improvements in drilling techniques.
Investment theme: The growth of
the liquid natural gas market
Key takeaways
Global demand for natural gas has increased in recent years due to greater interest in its more environmentally friendly properties,
compared with coal and crude oil, and the increased adoption of natural gas-fired power generation plants.
Improvements in the technology that harnesses and liquefies natural gas from reserves has led to increased production, transporta-
tion and usage of liquefied natural gas (LNG) throughout the world.
Page 15
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30 Big Ideas for 2012 and Beyond
A bounty of natural gas
For many decades, the primary focus of exploration for
energy sources had been the search for crude oil depos-
its. More recently, large integrated energy producers are
putting a greater emphasis on the exploration and pro-
duction of natural gas, for the following reasons:
New technology has allowed companies to more efficiently
harness, liquefy and transport natural gas to new and ex-
isting markets.
Stricter environmental regulations and a greater aware-
ness of the cleaner properties of natural gas, compared
with other energy commodities such as coal and crude oil,
have led to rising global demand for natural gas.
New hydraulic fracturing drilling techniques have led to an
abundant global supply of natural gas. Companies can
more effectively extract natural gas from shale rock forma-
tions in the earth, both in new locations and stranded loca-
tions and in older wells that had been drilled and viewed
as less productive using traditional drilling techniques.
Increasing demand for natural gas-generated electricity in
emerging market countries has increased amid escalating
economic growth.
Regions with large reserves of natural gas, such as Aus-
tralia, Qatar, the U.S. and Russia, have been at the fore-
front of the development of liquefied natural gas. In
2009, the U.S. became the largest natural gas producer
in the world, with shale accounting for about 20% of do-
mestic production.
Increased capital investment
The untapped abundance of natural gas deposits around
the world has motivated many large energy exploration
and production companies to invest and reinvest capital
in new LNG technology. Specifically, natural gas can be
more easily liquefied, frozen and transported around the
world (see Exhibit 4, below). For example, there are in-
dustrial boats that now have more sophisticated liquefac-
tion facilities on board, allowing them to mobilize more
quickly from one drilling location to another over the
ocean.
Page 16
17
30 Big Ideas for 2012 and Beyond
Many of these large integrated energy producers have
shifted a greater percentage of their infrastructure portfo-
lios to focus more on LNG production, because the
plants and facilities are projected to have longer produc-
tion cycles and slower rates of decline than those for
conventional oil. For example, a state-of-the-art crude oil
facility may run its course and deplete a reserve’s oil ca-
pacity in five to six years, which is a rough average.
Some modern LNG operations are expected to be in use
for as long as 30 years, with significantly slower annual
rates of declining productivity. In addition, many large
energy producers have legacy assets (e.g., onshore or
offshore fields) that are maturing and fading in productiv-
ity, and have thus repositioned their portfolios in newer,
untapped natural gas assets. As a result, growth in the
production and servicing of liquefied natural gas has in-
creased significantly during the past couple of years.
Rising global demand for LNG
There are a couple of sources for rising global demand
for LNG. First, demand for LNG has increased in emerg-
ing market countries, which have generally experienced
stronger economic growth rates. For example, imports of
LNG have surged in China during the past year.
Second, since the earthquake and tsunami that hit Ja-
pan in the spring of 2011 shut down a portion of its nu-
clear power generation capacity, the country has made
LNG a greater focus of its current and future plans for
power generation.
Investment implications
The abundance of global natural gas and the advent of
new technology to harness the commodity support engi-
neering and construction companies that can produce
the LNG capabilities needed by large integrated energy
companies. Energy producers’ greater emphasis on in-
vesting in the technology needed to develop and trans-
port LNG is a theme that we expect to be relevant for
some time.
Investment theme: The renaissance
in deepwater exploration
Key takeaways
The combination of more sophisticated drilling techniques, deepwater rigs, and seismic wave and imaging technology has provided en-
ergy producers with greater opportunity to explore for energy commodities in previously inaccessible deepwater regions.
Many energy producers view deepwater drilling as a relatively untapped frontier that could provide a source of production growth over
the next several years.
Page 17
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30 Big Ideas for 2012 and Beyond
New technology drives exploration
Improvements in seismic wave technology, which allows
companies to measure the makeup of the earth below
the ocean floor, have allowed more companies to effec-
tively search for and discover new oil reserves. In addi-
tion, the imaging technology that allows companies to
view the makeup of the earth has also improved.
New drilling and deepwater technologies are being
adopted for exploration in ultra-deepwater basins around
the world that had previously been viewed as inaccessi-
ble, such as in the Arctic Ocean, and off the coasts of
Africa and Eastern Russia. Many large energy producers
have invested in the development of new deepwater
platforms, seismic and imaging technology, and drilling
rigs to search for new sources of crude oil and natural
gas (see Exhibit 5, on your left).
Investment implications
We believe many companies are viewing deepwater ex-
ploration as a major source of growth in the coming
years, and are investing in resources that will allow them
to tap into this new frontier. A variety of companies could
benefit from this trend, including deepwater rig manufac-
turers, energy and construction companies and energy
transportation companies.
By John Dowd, Portfolio Manager
1 Bloomberg and Fidelity Asset Management as at October 31, 2011.
² “What is shale gas and why is it important?”, www.eia.doe.gov.
Before investing, consider the funds' investment objectives, risks, charges, and
expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus
containing this information. Read it carefully.
Views and opinions expressed are as of Oct. 31, 2011, and may change based on
market and other conditions.
Investment decisions should be based on an individual’s own goals, time horizon
and tolerance for risk.
Past performance is no guarantee of future results.
Investing involves risk, including risk of loss.
Because of their narrow focus, investments in one sector tend to be more volatile
than investments that diversify across many sectors and companies.
ETFs may trade at a discount to their NAV and are subject to the market fluctua-
tions of their underlying investments.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem St., Smithfield, RI 02917.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem St., Smith-
field, RI 02917.
Page 18
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30 Big Ideas for 2012 and Beyond
Financials
The financials sector continues to face several chal-
lenges. Continued economic improvement is critical to
ongoing repair of the U.S. financial system, but the
global economy’s deceleration in the third quarter of
2011 has raised concerns about a double-dip recession
in the U.S. This decelerating global growth outlook has
led to increased financial distress in the eurozone, mak-
ing it more difficult for fiscal austerity measures to re-
duce debt burdens relative to underlying economic out-
put. The aftermath of the 2008–2009 financial crisis left a
different environment than most post-war economic re-
coveries, with de-leveraging in the financial, consumer
and housing sectors creating deflationary pressures. As
a result, unlike in most mid-cycle expansions, monetary
policy has yet to tighten, and credit has recovered
slowly. Elsewhere, the U.S. housing market remains
challenged and consumer debt levels remain elevated.
Several financial regulatory reform proposals also
threaten to reduce profitability in the sector. In addition,
core inflation is accelerating across the globe, which his-
torically has been a negative for financial assets.
On the positive side of the ledger, credit conditions have
improved during the past year; historically, this has been
a favourable driver for financial stocks, especially banks.
On average, loan growth has turned positive, the ratio of
non-performing loans has declined, and delinquency
rates have fallen – even for the most toxic loan books.
From a valuation perspective, stocks on average have
been trading roughly in line with the market on a forward
-earnings basis, but are significantly discounted on a
cash-flow and book-value basis. This is particularly true
for large U.S. banks, which generally are very well capi-
talized but have been universally punished by the macro
market dynamics influencing investor behaviour.
Despite this mixed backdrop, our financials equity re-
search team believes there are a few interesting invest-
ment themes that bear monitoring over the course of
2012 and beyond.
Three themes for financials: Theme 1: The growth of Chinese banks
Theme 2: The age of austerity
Theme 3: Potential restructuring of the GSEs
Investment theme: The growth of
Chinese banks
Key takeaways
During the past decade, the largest banks in China have grown to be among the largest in the world in terms of market capitalization,
total loans outstanding and earnings.
The percentage of non-performing loans in the Chinese banking sector has fallen to an all-time low.
If the current growth trajectory for the largest Chinese banks continues, it may shift the competitive landscape in the industry and lead to
greater appreciation for the Chinese currency.
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30 Big Ideas for 2012 and Beyond
The rise of China’s banks
During the past five years, while other large global banks
were forced to write down loan and securities losses,
recapitalize themselves and de-leverage their balance
sheets, China quietly became the home of three of the
world’s largest banks, based on market capitalization. A
decade ago, none of these banks were publicly traded
entities.
The growth of the Chinese banks is astonishing in terms
of other metrics as well. The Chinese banking system
had about $3 trillion in total loans outstanding in 2006.
Since then, loans in the Chinese bank system have dou-
bled, in part due to a government stimulus boost in 2009.
Earnings have followed as well. In 2010, one major Chi-
nese bank generated net income of $24 billion, up from
$6 billion in 2006, and above the $17 billion in net in-
come generated by a major U.S. bank in 2010.1
Projected growth at current run-rate
The largest Chinese banks have estimated that their re-
spective annual loan growth will continue in the 10%–
20% range over the next few years.1 Given that the big-
gest U.S. and European banks are likely to be shrinking
their balance sheets in the coming years, the largest
Chinese banks could potentially be twice the size of the
largest U.S. and European banks by the middle of the
current decade.
Historical loan crises and Chinese government re-
sponse
Chinese banks have not been without their challenges in
dealing with severe non-performing loan (NPL) crises.
Until 1999, China’s banking sector had been dominated
by four large state-owned banks that accounted for more
than 70% of credits to both enterprises and household
deposits. By 1999, an acceleration of defaults and delin-
quent loans turned into a major crisis for these banks,
and three of them would have been viewed as insolvent
had their assets been marked to market. Thereafter, the
Chinese government set up four asset management
companies to carve out NPLs from these banks (similar
to the Resolution Trust Corp. set up by the U.S. govern-
ment after the savings and loan crisis in the 1980s).
Nearly $170 billion in bad loans was transferred to the
Chinese asset management companies in 1999–2000,
and another $50 billion was absorbed in 2004.
During the past several years, the Chinese government
has taken a series of measures designed to build a
stronger banking system, including the recapitalization of
the state-owned banks, the adoption of the international
standard accounting system and the introduction of debt-
equity swaps as an instrument for dealing with bad debt.
The government also raised tens of billions of dollars to
help write off bad debt via IPOs of stock for Chinese
banks. During the first half of the 2000s, before the Chi-
nese banks were recapitalized by the government, non-
performing loans represented 10%–20% of total out-
standing loans in the banking sector. Currently, non-
performing loans at Chinese banks represent only about
1.5% of outstanding loans, which is near an all-time low
(see Exhibit 1, next page).
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30 Big Ideas for 2012 and Beyond
Signs of caution
However, there are increasing concerns about lending
quality in China’s local government segment. During the
past year, Chinese authorities have tightened monetary
policy, which has slowed the pace of bank credit ex-
tended to mortgage applicants, small and medium enter-
prises, and other entities. Nevertheless, China’s building
boom has largely continued, and residential construction
starts have far outpaced sales.
With supply outstripping demand, extreme property
valuations in major cities and initial signs of financial dis-
tress among property developers, China may be at the
front end of a decelerating real estate market. Whether
these property sector imbalances lead to a large-scale
real estate slump and widespread loan losses for banks
in China remains to be seen, but it’s something we’re
monitoring closely.
Investment implications
A world dominated by Chinese banks could have several
important investment implications. First, large Chinese
banks could become aggressive acquirers of foreign
banks, a potentially beneficial event for shareholders of
acquired institutions. Second, with vastly larger balance
sheets, the Chinese banks could force competitive
downward pressure on pricing across the spectrum of
products and services in an attempt to gain market
share, which would be a positive for customers but a
negative for the earnings and stock prices for some U.S.
and European banks. Third, the sheer projected size of
Chinese banks in a few years' time (relative to global
peers and the Chinese economy) might encourage regu-
lators to facilitate the development of China’s capital
markets. This maturation could drive the appreciation
and convertibility of the Chinese currency, as well as its
rise as an alternative to the U.S. dollar – a dynamic that
would significantly influence the global financial and geo-
political spectrum.
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30 Big Ideas for 2012 and Beyond
Investment theme: The age of aus-
terity
Understanding the need for fiscal austerity
The escalating fiscal government deficits and high sover-
eign debt levels of many developed countries during the
past few years have been a driving source of increased
volatility in the financial markets. While the size of a
country’s fiscal deficit and debt level is critical to its cred-
itworthiness, a country’s ability to grow its economy fast
enough to service its debt is also important. Accordingly,
highly indebted countries with bleak outlooks for eco-
nomic growth have watched the yields on their out-
standing debt rise as market participants begin to ques-
tion their growth prospects and their ability to pay. In a
self-fulfilling feedback loop, higher interest rates make a
country’s fiscal challenges even greater, leading to even
greater concerns about these countries’ ability to service
their outstanding debt.
Peripheral eurozone countries have been facing these
challenges most acutely during the past couple of years,
while other countries with large deficits and high debt
levels, such as the U.S. and Germany, are seen as less
challenged, due to their relatively more favourable
growth prospects. Generally speaking, countries facing
these fiscal challenges have three main options: 1) un-
dertake fiscal austerity policy measures, which include
spending cuts, tax increases and benefit reductions; 2)
pursue monetary policy measures, such as currency de-
valuation to spur export growth, or inflationary money
policy to make domestic debt easier to pay; or 3) debt
restructuring (de facto default, through altering the terms
of repayment to bondholders).
The implementation of fiscal austerity
When the U.K. became the first major country to imple-
ment widespread austerity initiatives in the spring of
2010, Prime Minister David Cameron coined this era
“The Age of Austerity.” According to the European Un-
ion’s Treaty of Maastricht criteria, European Union (EU)
member states may not have a budget deficit that ex-
ceeds 3.0% of their gross domestic product (GDP). Sev-
eral countries exceeded that threshold in 2010, and have
since been implementing austerity measures (see Ex-
hibit 2, next page).
Key takeaways
Elevated fiscal budget deficits and debt levels, rising borrowing costs and sluggish economic growth have caused some European sov-
ereigns to implement austerity measures during the past couple of years to improve their creditworthiness and meet debt service pay-
ments.
If successful, fiscal austerity can provide a more favourable backdrop for financial assets over the long term, but it typically has led to
slower economic growth in the short term – an environment that historically has not been favourable for bank stock performance.
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30 Big Ideas for 2012 and Beyond
Investment implications
Austerity creates a challenging environment for banks.
Austerity is unequivocally negative for banks in the short
term because it generally results in weaker economic
growth. For example, when governments reduce spend-
ing on development projects, welfare and other pro-
grams, it can hinder employment and GDP growth. At
the same time, an increase in taxes and fees on port and
road transportation, licensing and permits can put pres-
sure on consumer spending. A lower-spending, slower-
growth environment typically means reduced revenue for
banks, as well as higher credit costs.
If austerity is successful over the long term, history
shows that the result will be more sustainable economic
growth – which is positive for banks. In the early 1990s,
both Canada and Sweden made large fiscal adjustments
to reduce their deficits and stabilize their government
debt-to-GDP ratios over multi-year periods.
If austerity is unsuccessful at containing deficits, sover-
eign defaults are then priced into the market. In recent
months, the yields on outstanding Greek debt have risen
sharply, at times indicating the likelihood of a default. If
additional policy measures to contain the Greek debt cri-
sis aren’t successful, the banking sector in Greece will
need to be recapitalized, potentially through nationaliza-
tion. This negative market perception of Greece’s near-
term outlook for austerity measures and economic
growth has led to significant volatility and poor perform-
ance for bank stocks in the country, and in other coun-
tries on the periphery of Europe that have also imple-
mented austerity programs (see Exhibit 3, below). Our
view is that the backdrop will continue to be challenging
for European bank stocks over the next few years, as
well as U.S. bank stocks as the country embarks on its
own austerity path.
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30 Big Ideas for 2012 and Beyond
Investment theme: Potential restruc-
turing of the GSEs
The role of the GSEs
The Federal National Mortgage Association (Fannie
Mae) and the Federal Home Loan Mortgage Corporation
(Freddie Mac) were originally established by the U.S.
government to enable the growth of affordable home-
ownership. They accomplish this objective by buying
mortgage loans (from originators, such as banks), pack-
aging mortgages into mortgage-backed securities (MBS)
and guaranteeing the payments of “conforming” mort-
gages (those meeting certain guidelines, such as debt-to
-income ratio). Through these activities, the GSEs help
to increase the availability of mortgages, provide liquidity
to the mortgage security markets and ultimately lower
the cost of financing for mortgage borrowers.
Since Fannie Mae was privatized in 1968 (and Freddie
created in 1970), the GSEs have operated as quasi-
private entities with implicit government backing. They
possessed the dual objectives of trying to generate prof-
its for stockholders while still fulfilling their initial public
objective of boosting U.S. homeownership. Both sides
benefited from the quasi-government status of the two
GSEs, with Fannie and Freddie being able to borrow
more cheaply, while passing along the cost savings in
the form of cheaper mortgage financing to American
homeowners. However, the delicate balance they main-
tained as both profit-seeking companies and public ser-
vice agencies has been the source of recent troubles.
Today, the U.S. government plays a much larger role in
the U.S. housing market than in any other developed
nation, with ownership of more than half of all out-
standing home loans (see Exhibit 4, next page).
Key takeaways
Government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac together play an enormous role in the functioning of the U.S.
housing and fixed-income markets, as they own or guarantee more than half of all outstanding U.S. mortgages and are directly or indi-
rectly tied to more than 40% of the investment-grade bond market.
During the past year, the U.S. Treasury expressed views on how it might reduce its significant involvement in the mortgage market
over time, an involvement that escalated in 2008 when the U.S. government placed the GSEs into conservatorship in the midst of fi-
nancial crisis.
Although it is unlikely that the future state of the GSEs and the government’s large role in the mortgage market will be resolved in the
near term, the possibility of a future private market solution may provide banks with a tailwind of loan growth that would support prof-
its and stocks.
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30 Big Ideas for 2012 and Beyond
2008 financial crisis brought change
In September 2008, at the peak of an escalating finan-
cial crisis driven by a slumping housing market and a
weak economy, the U.S. government put government-
sponsored mortgage giants Fannie Mae and Freddie
Mac into conservatorship, officially ending their status as
quasi-private sector companies. At the time, Fannie and
Freddie faced rising borrowing costs, falling share prices
and a corporate structure with an uncertain future. These
conditions made raising capital from private investors
nearly impossible, and placed their razor-thin capital po-
sitions in an increasingly perilous position after rising
home foreclosures continued to result in markdowns of
their mortgage security holdings.
Given the GSEs’ large roles in both the mortgage market
and the investment-grade bond market, and their inabil-
ity to raise capital and regain investor confidence on
their own, the government’s unusual action was deemed
necessary to calm global markets and attempt to hold
down mortgage borrowing costs. Further instability in the
GSEs represented the risk of an even larger bout of tur-
moil. The U.S. government effectively took managerial
control of the GSEs, operating them solely for the public
objectives of providing affordable mortgages to home-
owners and liquidity to the housing market. At the same
time, the U.S. Treasury also announced the beginning of
a series of purchases of new mortgage-backed securi-
ties guaranteed by Fannie and Freddie, representing the
first time the Treasury directly bought mortgages in an
attempt to prop up the housing market using taxpayer
money.
Page 26
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30 Big Ideas for 2012 and Beyond
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E-mail: [email protected]. Web: www.cramagazine.com. Page: 27
These developments represented an ambitious expan-
sion of the U.S. government, which agreed to play a
more direct and active role in the housing financing mar-
ket than at any point since the GSEs were privatized in
the late 1960s and early 1970s (see Exhibit 5, below).
Moreover, the GSE conservatorship significantly ex-
panded the balance sheet of the federal government,
which assumed trillions of dollars of debt onto its books.
Investment implications
The future of the GSEs is likely to be a source of consid-
erable debate in the coming years, as the current state is
unsustainable. Realistically, any change in the current
state of government conservatorship may not occur until
after the 2012 elections, but the debate is already under-
way. This past year, the U.S. Treasury presented its
views on how to reduce government involvement in the
mortgage market over time.
While a consensus is unlikely to be reached in the near
term, one likely outcome could be the replacement of
Fannie and Freddie with some form of private market
solution – and one that involves the GSEs being re-
placed by banks. If the U.S. government eventually
moves in this direction – a major policy shift – it would
provide a multi-decade, multi-trillion loan growth opportu-
nity for large U.S. regional banks.
By Ben Hesse, Portfolio Manager
1 FactSet, Bloomberg and Fidelity Asset Management as at September 30, 2011.
Greece equity market index: Athens Stock Exchange General Index, a capitalization-weighted
index of Greek stocks listed on the Athens Stock Exchange. The index was developed with a base
value of 100 as of December 31, 1980. Greece bank stock index: AFTSE/Athex Bank Index, a
capitalization-weighted index of all the stocks designed to measure the performance of the bank
sector of the Greek Stock Exchange. U.K. equity index: FTSE 350 Index, a capitalization-
weighted index comprising all the components of the FTSE 100 and the FTSE 250. The Index
represents approximately 90% of the U.K. equity market by capitalization. The starting base value
was set at the FTSE ALL Share closing value of 682.94 as of December 31, 1985. U.K. bank stock
index: FTSE 350 Banks Index, a capitalization-weighted index of all stocks designed to measure
the performance of the banking sector of the FTSE 350 Index. The Index was developed with a
base value of 1,000 as of December 31, 1985. The parent index is NMX. The Index adopted the
ICB classification effective January 2, 2006. Spain equity market index: Madrid Stock Exchange
General Index (MADX), a capitalization-weighted index that measures the performance of a
selected number of continuous market stocks. The Index was developed with a base value of 100
as of December 31, 1985. Spain bank stock index: Madrid Stock Exchange Bank Index, a capitali-
zation-weighted index of all stocks designed to measure the performance of the banking sector of
the MADX Bank Index. Ireland equity market index: Irish Stock Exchange Overall Index, a capi-
talization-weighted index of all official list equities in the Irish Stock Exchange, excluding U.K.
registered companies. The Index has a base value of 1,000 as of January 4, 1988. Ireland bank
stock index: Irish Stock Exchange Financial Index, a subgroup of the ISEQ Overall Index of the
Irish Stock Exchange. It is a capitalization-weighted index with a base value of 1,000 as of Janu-
ary 4, 1988.
28
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