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Financial Markets in forMore Volatility by Dr. Sherry Cooper

It is a time of transition for the North American economy. The U.S. will continue to lead growth in the G7, but its econ-omy is cooling. In Canada, the economy has gone for wellover a decade without a recession but there is a Westerntilt to the overall gains. Meanwhile, Europe and Japan are

rebounding from sluggish growth.

The Bank of Canada left its policy rate unchanged on July 11,for the first time in a year, signalling a pause in its 225-basis-point

tightening campaign. Then, on August 8, the U.S. Federal Reserve pausedas well, after 17 consecutive hikes. Although North American monetarypolicies are now in a holding pattern, financial markets are unlikely to flyturbulence-free in the months ahead.

On both sides of the Canada-U.S. border, the combination of high energyprices along with high rates of resource utilization is applying upwardpressure on inflation. Meanwhile, economic momentum is ebbing, poten-tially dampening inflation pressure. The reason why these central bankshave paused is that they believe they have lifted rates enough to ensurethat economic growth slows suf-ficiently to drive out inflationwhile steering clear of recession.

Unfortunately, the data duringthe months ahead are likely toshow growth and inflation veer-ing from this planned path. Attimes, the indicators will exhibitsigns of stronger growth andfaster inflation, prodding specu-lation of more central bank tightening, which will be a drag for stock andbond markets. At other times, the data will display signs of weaker growthand slower inflation, stoking expectations of central bank easing, whichwill be a boost for stocks and bonds. Despite the monetary policy pauses,Canadian and U.S. financial markets are still likely to be at the mercy ofthe whims of economic data in the months ahead. In addition, we are in aperiod of extreme geopolitical turbulence, which will inevitably rock mar-kets from time to time. But, the silver lining is that the volatility is likely tobe less than in prior economic cycles.

continued on the back page

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Here’s good news for wine lovers and teetotallers alike:Investing in a diversified portfolio of investment gradewine, either on its own or as part of a diversified port-folio, delivers superior double-digit returns, signifi-cantly lowers volatility and provides diversificationbenefits. As a result, buying and selling bottled winefrom and onto secondary markets, such as trade, retailand auctions, has grown into amulti-billion dollar industryover the last 25 years.

The two-tier global wine mar-ket is made up of early con-sumption and investmentgrade wines. Over 90% of thewine market is early consump-tion, that is, wine consumedwithin three years fromrelease. As it is sold immedi-ately to the final consumer, ithas no resale value and neverfinds its way back to the sec-ondary market.

However, investment grade wines—the “blue chips”—possess impeccable quality, longevity and history, aprice performance track record and a highly liquid secondary market following (annual volumes $2.1 billion CDN).

The blue chips—including winesfrom Bordeaux,Burgundy, RhoneValley, Tuscany,Piedmont andChampagne—pro-duce significantresale values andare actively tradedin the global sec-ondary market.Over the 21-yearperiod from 1982

to 2003, the Fine Wine 50 Index (a portfolio of 50investment grade wines) averaged an approximately12% return per annum. The risk, measured inRiskGradeTM (RG), of a portfolio of investment gradewine held on its own (RG = 55) or held as part of adiversified portfolio of equities and bonds (RG = 70) issignificantly lower compared to a portfolio of equitiesand bonds only (RG = 80).

Interestingly, the investment grade wine market is not correlated with financial and economic markets.Rather, investment grade wine prices are supported by a global demand/supply imbalance. The globaldemand for superior wine is increasing as there is only a finite supply of wine due to non-expandableacreages. When a wine is released for consumptionglobally, the supply of wine is reduced and the demandincreases, inevitably causing prices to increase. Sinceinvestment grade wine prices are unaffected by themovement of equity and bond prices, the zero correla-

tion with thefinancial andeconomicmarkets leadsto significant-ly lowervolatility, andprovidesdiversificationto a portfolioof traditionalinvestments.

However, liketraditionalinvesting,there are

many strategies you can use to buy wine. Like equities,you can invest in “neglected value”. This simply meansbuying below an asset’s fair market value and sellingeither at or above its fair market value.

>FUELL ING UP YOURINVESTMENTBARREL by Mahesh Kumar

“...buying and selling bottledwine from and onto secondarymarkets, such as trade, retailand auctions, has grown intoa multi-billion dollar indus-try over the last 25 years.”

You can also engage in arbitrage in the wine market.For example, if a case of investment grade wine isbeing auctioned at Sotheby’s in New York for $5,000and the same case of wine is being auctioned atSotheby’s in Paris for $4,500, arbitrageurs will buy inone market and sell into another, profiting from theprice differentials.

Some investors identify sleepers both in terms of wineand vintage, buying lesser-classed wines in great yearsand great ones in lesser years. Others “talent-spot”, forinstance, buying wines that are either underrated orless known, but which are likely to win wider acclaimin the future. Alternatively, some trade down to “paleblue chip” wines, which can show significant invest-ment potential in the future once these pale blue chipwines become more popular, and the demand for thesewines increases.

“En primeur” buying involves securing allocations of wine before it is bottled and physically available

(i.e. buying “wine futures”). En primeur buying is usedselectively, only in highly sought after, fairly pricedvintages. Buying wine en primeur has the potential toproduce substantial short-term profits as the growth inwine prices in the first few years of a wine’s life can besignificant. Buying bottled wine from primary markets,for example, directly from the producers, eliminates

intermediaries’ mark-ups.

Investing in a wine fund involvesfund managers, including pensionfund managers, buying investmentgrade wine and/or shares in blue chip wine companies. Fundmanagers actively switch out ofovervalued wines and lesser vin-tages into undervalued wines andgreater vintages, so that portfolioreturns are maximized.

Buying the right wines for yourportfolio is the same as buying theright wines for your table: To maxi-mize portfolio returns, lower volatil-ity and enhance diversification,wine should only be bought fromsources with strict quality andprovenance guidelines and stored ina controlled optimum environment.

Mahesh Kumar BA (Honors), MBA, DipIC Mgmnt.,ACMA, ATT, CMC, is the Founder, President and CEO ofRoman-Boston Consulting Corporation (www.roman-bostonconsulting.com). Mahesh Kumar is the author of Wine Investment for Portfolio Diversification – HowCollecting Fine Wines Can Yield Greater Returns ThanStocks & Bonds, winner of the 2006 Gourmand GlobalMedia Award for the “Best Wine Education Book in theWorld.” He is also an associate faculty member at theFaculty of Management at Royal Roads University,Victoria, BC.

P R O T E C T I N G Y O U R S E L FO N L I N EBMO InvestorLine is committed to protecting yourconfidential information and privacy. We will not useyour email address to send or ask for any personalinformation about you.

Recent events in the online brokerage industry havemade protecting your privacy even more important.For more information visit the PRIVACY and SECURITY sections at bmoinvestorline.com.

Year-End Tax Tips From The Experts

Given the significant tax changes for 2006 andonward, your investment strategy could benefitfrom some expert tax tips on year-end tax plan-ning. The Knowledge Bureau is Canada’s leadingeducator in the tax and financial services indus-try. Here, some of The Knowledge Bureau’sexperts give you their favourite tax tips.

For more tax-saving strategies, go to bmoinvestorline.com and read Year-End Tax Planning 2006 - Full of Surprises byEvelyn Jacks.

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The recent federal budgeteliminated tax on capitalgains resulting when pub-licly traded (listed) securities

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or mutual fund units that havebuilt up gains over the years should be your donationvehicle of choice, as opposed to giving cash.

An even greater benefit comes fromdonating matured flow-throughshares, which usually become liquidthrough a tax-free rollover into aneligible mutual fund after a two-yearholding period. The fund will typi-cally have a cost base near zero afterthe flow-through entity convertsexploration tax deductions into capital gains. A sale would result in a capital gain, the tax on whichnegates some of the tax benefits

from purchase. Donating the fund to charity instead ofselling eliminates the tax liability on the gain, multiply-ing the net benefit of the tax-advantaged investment inflow-through shares.

“...stocks or mutual fund units that have built up gainsover the years should be yourdonation vehicle of choice, as opposed to giving cash.”

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F I N A N C I A LM A R K E T S I NF O R M O R EV O L AT I L I T Ycontinued from front page

Both the Bank of Canada andthe Fed have not needed toraise rates to back-breakinglevels, as in previous episodesof rising inflation, minimizingthe risk of outright recession.This risk is also reducedbecause businesses on bothsides of the border boast thehealthiest balance sheets ingenerations, and firms are nowmuch better at managing theirpayrolls and inventories.Meantime, globalization andcompetition continue to crimpthe ability of firms to pass ontheir higher costs, minimizingthe risk of an inflation out-break. There will be financialmarket turbulence ahead, butit’s going to be a bit easier tonavigate than in the past.

Dr. Sherry Cooper is GlobalEconomic Strategist, ExecutiveVice-President, BMO FinancialGroup and Chief Economist,BMO Nesbitt Burns.

®

DARYL DIAMOND is President

of Diamond Retirement Services

and author

of Buying

Time:

Trading

Your

Savings

For Income

and Lifestyle.

Consider loaning money to yourlower-earning spouse to splitincome earned on non-registeredassets and reduce taxes on thatincome. The Canada RevenueAgency (CRA) permits this type ofinter-spousal loan as long as cer-tain conditions are met:

Interest – Interest on the loan mustbe charged to the borrower by thelender. The interest rate can be set by the lender, but cannot beless than the prescribed rate estab-lished by CRA; this rate of interestis set quarterly. The rate or interestapplies for the duration of the loanregardless of future changes to theprescribed rate.

Payment of Interest – Payment of loan interest must be actuallymade by the borrower and docu-mented. It is due at the end of thecalendar year and must be paid byJanuary 30 following the calendaryear end.

For example, assume a wife loansher husband $20,000 for invest-ment purposes. He immediatelyinvests the money so any invest-ment income is now taxed in hishands. Assuming a 4% prescribedinterest rate, he will pay her $800per year in interest by January 30,which she must declare as income.This same amount serves as adeduction from income for himsince he used the money to acquireincome-producing investments. In this case, the family unit paysless combined tax by arranging thislegitimate income-splitting trans-action and taking advantage of hislower marginal tax rate.

For more tax-saving ideas, visit the Tax Corner at bmoinvestorline.com.

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