Energy prices to weigh on equity returns, managers say

Investment managers across the country are predicting significantly lower equity returns in 2007, mainly due to falling energy prices.

According to the Fearless Forecast, an annual survey conducted by Mercer Investment Consulting, investment managers at 51 institutional firms predict equity returns will come in between 7% and 9%; returns in 2006 were 17.3%.

“There’s been a big push in energy prices over the past few years,” says Yvan Breton, national partner at Mercer. “Now the price of oil is going down — we’ve seen that since the beginning of the year. So what the managers predict is that the sectors that were good over the past few years, such as materials and energy, will be the worst sectors in 2007.”

Then what sector should investors look at? Financials, says Breton, adding that stable interest rates will help the sector improve further in 2007.

The Fearless Forecast also expects equity markets to outperform bonds, which managers predict will deliver returns of 3.3% to 4.8%, and, with lower interest rates on the horizon, Mercer says long bonds should outpace the broad bond index.

“Interest rates are historically low,” says Breton. “So for bonds to perform well, it would mean that interest rates would have to go even lower. And that’s not what they think will happen.”

The report points out that with stabilized interest rates and a higher performing equity market, pension plans will continue to look at the stock market as a place to invest, despite its high-risk nature. “The majority of managers are calling for long bonds to deliver near current yields in 2007, and over the next five years,” said Peter Muldowney, business leader for Mercer, in a news release. “[This] suggests that pension plan sponsors may have to continue to make substantial pension contributions. This could entice pension plan sponsors to consider taking more investment risk.”

The report also reveals that Japan and the U.K. will be top-performing countries, while international and American markets will have the highest returns. This is good news for the U.S., which, despite delivering returns of 15.5% in 2006, has been underperforming for the past few years.

“The predictions from managers are that growth and profits are coming back for U.S. multinationals,” Breton says.

Of course, a lot depends on oil prices and the global demand for natural resources, which, the report says, is “expected to be the top issues influencing Canadian capital markets in 2007.” These issues are more important to managers than some core economic indicators such as inflation, the dollar and interest rates.

Another prediction made in the Fearless Forecast is that mergers and acquisitions will remain alive and well in the coming year. The report says 70% of managers surveyed expect that M&A activity in Canada will increase or stay the same as last year.

“All companies try to grow their revenues,” says Breton. “Money seems to be available, so they think by merging companies, they can achieve better profitability. You’ve seen a lot of consolidation, and you’ll see more of that. The trends will continue.”

While the report won’t officially be released until late January, Mercer has revealed a few other important investment forecasts for the coming year: Investment managers predict a drop of 0.5% in the Bank of Canada overnight rate to 3.75%, and a decrease of 0.75% in the U.S. Federal Funds rate to 4.5% by the end of 2007. Annual inflation could fall to 2%, while the Canadian dollar’s year-end close is expected to be around 86 cents US.

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@rci.rogers.com