“Debt diet” starts today

This morning’s announcement by the Finance Minister is the start of a government program to put Canadians on a “debt diet”, according to CIBC World Markets. While this may remove some liquidity from the market, it should make economic growth more sustainable in 2011.

“Canada’s economic mix has been the polar opposite of the U.S., with last year’s winners featuring debt financed booms in consumption and homebuilding,” says Avery Shenfeld, chief economist at CIBC. “But policy makers now have that credit buildup in their policy gun sights, and will use higher rates and regulatory changes to bring spending into better line with income, and cool mortgage demand.

In a new forecast report entitled, Not Yet Heaven in Twenty Eleven, Shenfeld predicts the year should start off strong, before a mid-year interest rate increase reins in growth. Full-year performance will likely come in below expectations. He expects growth will fall just short of 2.5%.

The Bank of Canada’s rate hikes will be restrained to 100 basis points, as the U.S. Federal Reserve avoids raising rates south of the border. The Fed’s policy will be aimed at sustaining the U.S. recovery, while the Bank of Canada will seek a balance between curbing inflation and keeping the loonie in check.

“Any pull back in the loonie won’t last long,” Shenfeld warns. “The market isn’t priced for the further widening in short-term rate differentials that we expect, in part because it gives some odds to a Fed rate hike that in our view would be widely premature for an economy still facing massive unemployment. A more generous yield advantage in Canada should see a return to a near-parity exchange rate by year end.”

With the government stepping in to wean consumers off of their debt habits, Ottawa will likely practice what it preaches and tighten its own belt. Economic growth will be driven by increased business investment at home and increased exports to the U.S., as the American economy recovers.

While Canadian lenders were far more prudent than their counterparts in the U.S., Shenfeld says our debt habits need to be curbed before rising interest rates cut into discretionary income.

“Maintain this diet of borrowing for five more years and debt obesity would indeed weigh down the household sector’s momentum,” he says. “It’s time to start the borrowing diet now, and that means policies aimed at slower debt-financed consumption growth and a cooler housing market.”

Debt-financed spending has helped keep the economy growing through the global recession, but a return to old fashioned household frugality will help maintain growth.

What does all this mean for investors?

“Stocks handily outperformed bonds last year, and should do so again in 2011,” Shenfeld says. “Dividend yields are still closer to bond yields than they typically are, and even with a modest rise in 10-year Canada rates to 3.6%, the future stream of dividends will still represent solid value at today’s low discount rates.”