NORTH AMERICAN & INTERNATIONAL ECONOMIC HIGHLIGHTS
The US stock market is officially in a bear market and the TSX lost more than 6% since the beginning of July. A year from now we will refer to the current period as the “bad times”. but between now and then, what will define the next six to twelve months? The following is a brief list of the main themes that we think will dominate the economy and markets in the near term.
Economic Activity
We are probably at the bottom of the cycle. In the US, the economy is probably shrinking and in Canada, we are starting to see growing consistent signs that the labour market is slowing. We probably will stay at thisbottom for a few more months with some early signs of a sustained recovery becoming visible in the fourth quarter of 2008.
Inflation
The trend is up. The main reason for higher inflation down the road is surging energy and food prices. Note that until recently the Fed and the Bank of Canada were focusing only on core inflation (which excludes food and energy prices). But realizing that the current rise in food and energy prices is more structural in nature, both central banks are now focusing more and more on “all-items” inflation that includes the food and energy components. Accordingly, look for US inflation to reach 4.2% by year-end. In Canada, we have not yet felt the impact of higher food prices due to the appreciation of the dollar. But in economics almost everything is determined at the margin. And with the Canadian dollar remaining more or less at current level, food inflation will no longer be protected by a rising currency, and therefore it will take overall inflation in Canada to 3% by year-end. Interest Rates
With inflation rising and the economy slowing, we are in stagflation. The Fed and the Bank of Canada are in a difficult position since raising rates now to fight inflation will further damage an already fragile economy. So what to do? The best guess is that both central banks will wait until the end of the year, when the signs of a sustained recovery are extremely clear before starting to raise rates. Accordingly, we expect the Fed to raise rates by 150-200 basis points and long-term rates in the US to rise by roughly 60-70 basis points. In Canada, with inflation a bit lower and economic growth stronger than in the US, the Bank will probably raise the bank rate by only 100 basis points with long-term rates rising by only 30-40 basis points.
The Stock Market
The US market is officially in bear territory and probably will stay there for a while. Given current sentiment, it is hard to see a recovery in the near term. In fact, we expect additional sell-offs in the very near term. In terms of the duration of the market decline, we are still 2-3 months short of the average duration of all previous bear markets as the magnitude of the decline is still 5%-10% short than the average. Having said that, we believe that the market is cheap (and probably will get cheaper in the coming months or two). This means that currently there are many opportunities from a 2-year investment horizon perspective.
In Canada, the recent decline in the stock market reflects the ongoing impact of the credit crunch on the financial as well as general fears that the stagflationary conditions will further damage the Canadian economy. The energy sector will remain relatively robust due to our belief that energy prices will remain elevated. Overall, it is difficult to see a sustained recovery in the TSX before there are convincing signs that the US market has reached a bottom. As is the case in the US, at current valuations, the non-commodity segment of the market is very cheap.
