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The Cresting Economic WaveWednesday, January 25, 2006
The Cresting Economic Wave
The economic wave is cresting as the global economy has successfully transitioned from the unsustainably high 5% growth rate in 2004, to lower more sustainable growth rates around 4%. Ditto for the U.S. economy. A sustainable global and North American economic expansion amidst low inflation remains the most likely outcome in 2006. The ability to withstand the energy price shock following from Hurricanes Katrina and Rita stands as a testament to the durability of the expansion. At the same time the limited inflation impact underscores how well anchored expectations are, limiting the risk of an expansion-killing inflation break out. Nonetheless, ongoing economic growth does create some longer-term cyclical inflation risks as economies bump up against capacity. Over time central bankers are likely to continue nudging their key interest rates up toward their neutral, or what we like to call their Goldilocks level. Higher rates will reinforce the trend toward a waning in economic momentum. The cresting growth wave implies the same for earnings.
Higher short-term interest rates imply flagging economic and earnings momentum
The U.S. Federal Reserve (Fed) has raised the Fed funds rate 325 basis points from 1.00% to 4.25%, pointing to a slowdown in the U.S. economy this year as well as a further drop in earnings growth. However, with the Fed signalling that the rate hiking cycle is coming to an end, the risk of a U.S. recession has fallen. Global growth rates are dropping slightly from the 5% rate recorded in 2004 as global short-term interest rates rise. Lower U.S. growth is expected to be partly offset by a pick up in the European Union, a sign that the world economy is becoming better balanced, a development that is a plus for commodity prices and the Canadian dollar. Persisting momentum in Canada’s economy is likely to push the Bank of Canada (BoC) to push its key rate up to 4% and keep earnings growth in a 10-15% range.
Global imbalances still pointing to a weaker U.S. dollar
There are signs that the tug of war between cyclical forces and current account imbalances are tipping back toward a weaker U.S. dollar in 2006. During 2005 solid U.S. economic growth and the Fed’s interest rate actions more than offset the impact of the large current account deficit, lifting the greenback. A slowing U.S. economy and the end of the Fed’s rate hike cycle points to a less favourable cyclical backdrop for the dollar, leaving it vulnerable to the current account situation. Another 15-20% drop in the U.S. dollar is likely over the next two to three years, a decline that should remain orderly as the Asian central banks continue to accumulate surplus dollars. Strong commodity prices and a weaker U.S. dollar point toward additional Canadian dollar gains in 2006 to 90 U.S. cents.
Short-term, high quality bonds favoured
With the U.S. economy poised to slow, U.S. Treasuries look fairly valued at current yields. However, the flat yield curve generates a preference for 2-5 year maturities. With the Canadian economy entering 2006 on a strong note, Government of Canada bonds look expensive. Additional BoC rate hikes should lift 2-5 year Canada yields to a more attractive 4% level. In the meantime, we are inclined to focus on an even shorter maturity: one year, where yields are just below 4%. Slowing earnings points to corporate bond underperformance and argues for a focus on high quality credits.
Equity valuations favourable; emphasis on large caps and non-cyclicals
Most equity markets face favourable valuations despite the solid gains posted since 2002. Alongside a favourable economic backdrop this suggests a further advance in 2006, though falling economic and earnings growth suggests a shift in sector performance away from the cyclical sectors toward the non-cyclical ones, as well as a shift from small cap stocks to large caps. In the U.S., the falling U.S. dollar supports a focus on the large multinational corporations. Canadian valuations are stretched even if we remove the effect of the energy sector, and the Canadian market is likely to lag foreign markets this year. The emphasis on non-cyclical sectors and large caps also holds true for Canada. Also, with oil prices expected to trend toward the upper end of our expected $50-80 range, another year of good gains in the energy sector are likely. Beyond 2006 we see the balance of risks on oil prices tipping downward, a development that suggests using periods of strength this year to move portfolio weightings on energy from a TSX market weight of roughly 24% toward a global weight just below 10%.
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