WHAT’S AHEAD FOR 2005

Looking back on the year ended, the most surprising economic development in my mind was the decline in long-term interest rates. While growth rebounded in both Canada and the US, as I expected, and central banks in both countries began to reduce monetary accommodation, bond markets actually rallied this year, with 10 year yields declining by roughly 50 basis points.

The Canadian dollar also rallied, but inflation remained much lower than the rise in oil and other commodity prices would have suggested. Stock market returns were more muted, although TSX gains did manage to squeak into double-digit territory, and certainly outpaced the US stock market, especially in US dollar terms.

does not surprise me that the US dollar has found a bid in recent weeks. After all, the whole world was bearish as indicated by the recent cover of The Economist magazine. For the short-run, anyone who would be selling the dollar had already done so. While it does appear that the US dollar will trend downward again next year, there is a limit to how far the American dollar will fall. There is no other credible alternative as far as potential reserve currencies are concerned. Gold might be a store of value, but it is hardly a medium of exchange. Further, the US equity market represents half of the world’s stocks and thus will continue to be in demand. If the US companies being invested in are expected to outpace stocks in other parts of the world, the currency decline does not pose great concern even on an absolute return basis.

No other country or region is a superpower or rivals the US in economic strength, political cohesiveness, or deep liquid capital markets. The lion’s share of all financial assets are denominated in US dollars, rates of return on investment are still relatively high and the Federal Reserve continues to hike interest rates, even though many other central banks around the world have stopped, the Bank of Canada included. It is hard to believe that with the strongest economy in the G7 last year, the US trade deficit will diminish dramatically. If it does, it would be highly contractionary for Canada, China, Japan, Europe and any other country with a large trades surplus with the US, which is just about everyone. This will negatively affect the stock markets of the preceding countries.

I am not among those that believe we are on the precipice of a destabilizing plunge in the US dollar which would likely involve a commensurate rise in the loonie. The Canadian dollar is already up 25% from its lows, and given that Canada and the US have the world’s largest trading relationship by far, a significant and rapid rise in the loonie over the next 12 to 18 months would seriously derail our economic expansion and thus our equity market. Our trade surplus has already declined 42% from its recent peak, and the Bank of Canada, has, for now, suspended additional rate hikes. Low value-added manufacturing is feeling the pinch of the stronger Canadian dollar, layoffs at troubled companies are mounting and the federal and provincial governments are already pulling out their chequebooks to bail out declining industries. Clearly a major injection of productivity–enhancing technology is needed to increase competitiveness, but even that won’t work for commoditized manufactured goods given our rising cost of labour.

In all, however, I believe that 2005 will be a good year for Canada. Growth will again be close to 3%, inflation will remain low and interest rates, while higher, will increase only modestly. The spreads between Canadian and US rates will likely continue to narrow. Stock markets will be burdened by reduced corporate earnings growth, especially in comparison to the past two years, which were supported by the sharp rise in oil and other commodity prices. Nevertheless, I expect stock investors in Canada to enjoy positive, but single-digit returns. Stocks will outperform bonds again next year, and federal budget surpluses will lead to increased expenditures rather than meaningful tax cuts. Unlike the US, Canada seems to have little appetite at present to further reduce tax rates. Too bad, because I think it would be a major positive for the economy in the long run, but even the Opposition parties seem to have stilled the call for significant tax reductions.

With all of this being said, when evaluating your individual portfolios you need to look at all markets: bonds, equities, hedge and real estate, in all geographic locations to ensure that you are properly diversified. Should the higher loonie cause a slowdown in the sales of our goods, this could cause a halt to our economy and our equity markets. If you feel you need a review on your current portfolio, call me at (604) 535-4306