Economists ready to write off 2009

If the bleeding stops before 2010, then 2009 will have been a success according to revised forecasts from economists. Even Jeff Rubin of CIBC World Markets, arguably the most bullish commentator in Canada, is underweighting stocks and moving to defensive positions as the economic crisis deepens.

The “real” economy and the stock market do not run in tandem. However, it’s difficult to have a sustained rally in stock markets without an improved outlook for the economy. Most forecasters are now looking at 2010 for certainty that things are turning around, essentially giving 2009 up for dead.

“Even with a second-half economic recovery, it is hard to see the TSX beyond 9,000 at year-end,” says Jeff Rubin, CIBC World Markets chief economist and chief strategist. “Assuming a sustained recovery in 2010, we could see the index rise to 11,000 by the end of next year. But even so, that will still leave Canadian equity valuations almost 30% below their mid-2008 peak — a bleak testament to how much the world has changed.”

Rubin says he’s shedding equity exposure for medium-term. In line with these lower targets, and the near-term prospects for a further pullback in valuations, CIBC is shifting two percentage points of its portfolio from equities to cash. Rubin believes there is too much downward momentum on today’s stock valuations to serve as an attractive buying opportunity.

“While we expect a rally by year-end, getting through the next few months of weak economic and earnings reports will reward a more cautious portfolio allocation,” Rubin says. “Not only are we going to a modest 2-point underweight in equities in favour of adding further to our overweight in cash, but our sector selections are tilted to staying out of the way of high beta, cyclical sectors. Defensive stocks started out this year as underperformers, but downbeat economic reports have turned the tide, allowing such sectors to again outpace the market.”

It’s atypical for Rubin to take such a muted tone, but his sentiments seem to be shared by other banks.

Richard Kelly, senior economist at TD Financial, points out that it’s highly unlikely that the economy will turn around before 2010.

“The economy is going to continue to trend down for most of this year. Canada already contracted about 3.5% in the fourth quarter, and we expect it to be substantially worse in the first quarter of this year. We’re probably going to see contractions for the first three quarters of 2009. Maybe when you get to that fourth quarter, you’ll just start to see a bit of daylight on the positive side,” he says. “You’re really talking about 2010 where you have the economic conditions to put the life back into commodity prices. That probably puts the Canadian recovery somewhere into next year.”

From an investment perspective, however, there is merit to staying invested in 2009. Typically, as a forward looking indicator, stock markets can and often do surge ahead, even in the midst of an economic downturn.

“Investors can clearly see with examples like yesterday that the snapbacks can be just as violent as the downturns,” says Patricia Croft, chief economist at RBC Global Asset Management. “The stock market is a forward looking indicator, so stock prices have well indeed bottomed before the economy bottoms. Stock markets can rally even as earnings are falling — again based on the expectation that a year from now we’ll be looking at a very different environment.”

In Croft’s view there could be opportunity for when economic indicators start to stabilize.

“What has to happen on the economic front is we have to see the numbers improve; things can be bad, but not as bad. Some people refer to that as the second derivative — the rate of change. Maybe unemployment numbers will be down to 400,000 instead of 650,000. Stocks will actually take that as a positive sign that the healing process has begun,” she says. “I believe it does have to be financials that will need to improve in order for us to see a sustainable rally to get us out. We have to see signs that the global financial system has stabilized before equity markets can rally.”

The prevailing belief is that the massive stimulus package should begin working sometime later this year.

Rubin expects brighter earning prospects for 2010, noting that valuations will continue to look cheap to investors looking at 12-month forward price-to-earnings ratios that extend into that year for earnings.

Rubin emphasizes that economic recoveries typically generate sharp earnings rebounds, in part because sectors seeing severe setbacks have a low base for comparison. His latest report calls for increased earnings for both financials and resource sector companies in 2010. CIBC expects TSX earnings will see a 12% rebound in 2010.

Where Rubin’s view starts to deviate from some of his contemporaries is when it comes to inflation. Rubin believes the fiscal stimulus package will create a large inflationary cycle once the economy recovers, making gold and other inflation hedges attractive investments.

Kelly doesn’t agree.

“Inflation is a very minor concern. You’re talking about a massive alpha-gap, to use economist terms. We have very large unemployment rates that put downward pressure on prices and keep them there. It takes a lot of stimulus to get you out of that. If the economy was going full steam ahead, $1 trillion in stimulus that would be extremely inflationary. With unemployment rates expected to reach double digits, that stimulus just fills the holes created by that,” he says. “If we go through an inflationary cycle in the latter part of 2010, that would almost be a good sign, because it means we’ve gotten through this crisis.”

(03/11/09)