Go Global: The compelling case continues for a significant level of non-Canadian equities

The North American economic picture is unfolding largely as expected. The U.S. economy is slowing as evidenced by the dip in GDP. Declines in new home sales and construction as well as the auto sector continue to take their toll on the manufacturing sector. The unexciting read on the holiday shopping season further reinforces the outlook for slower growth. At the same time inflation remains a concern, with the core Price index up 2.4% y/y, above the U.S. Federal Reserve’s “comfort zone” of 1-2%. Without clear sings of an easing in inflation the Fed is expected to remain vigilant and leave the Fed Funds rate at 5.25% for some time. It is our belief that as we move through 2007 the slow down in the U.S will ultimately dampen inflation which will open the door for the Fed to cut rates. We anticipate the Fed will reduce the Fed Funds rate by 50 basis point by mid-2007.

The Canadian economic backdrop is very similar to that of our southern neighbour’s. GDP growth has been disappointing while inflation has exceeded expectations. Domestic demand in Canada remains solid however net exports which have struggled due to our strong currency are likely to face further headwinds from the slowing U.S economy. At the same time core inflation is at 2.3% y/y compared to the Bank of Canada’s target of 2%. We expect the Bank of Canada will reduce short term rates by 25 basis points in the first half of 2007 in the face of slower GDP growth.

Although U.S.GDP is expected to average 2.60% in 2007 and dampen global growth, the global economy overall remains on solid ground. The ongoing robust expansion in China and India as well as the emerging markets is expected to help deliver 4.6% global GDP in 2007.

From a regional perspective the outlook for Europe continues to improve. The expansion in Europe is broad based and likely sustainable. In Japan, the economy is on definite firmer footing.

Little has changed my outlook for the bond market. In general, I expect bond yields to be range-bound and remain low relative to historical experience. While yields are likely to trend lower from current levels over the near term, we expect to see them rise during the latter half of 2007 to current levels as economic growth re-accelerates, thus my return outlook for bonds currently remains mediocre.

Despite the sell-off in the income trust sector, the S&P/TSX Composite has managed to reach new highs. The bullish tone within the equity market has not been limited to domestic equities with the MSCI World Index advancing significantly in the last quarter of 2006. I remain of the view that the global economic slowdown will not deteriorate into a recession. Although the slower pace of growth will cause earnings growth to slow I do not foresee it turning negative. It is against a backdrop of anticipated continued healthy global economic growth, low bond yields and reasonable valuations that I maintain my bias toward equities within portfolios. I continue to find the case for a significant level of non-Canadian equities compelling due to the diversification benefits and more attractive valuations offered by foreign markets as well as anticipated further weakness in the Canadian Dollar.

Recently, the loonie has underperformed the U.S dollar and experienced significant declines against a number of other currencies, in particular the euro (Chart1). The underlying trend for our dollar suggests further weakness lies ahead, depending on the performance of commodity prices.