Experts cautiously optimistic for 2007

A little choppy, but no shipwreck seems to be the general sentiment for the year ahead in the economy and the markets. While there are clouds on the horizon in the form of the ongoing correction in the U.S. housing markets, experts are expressing guarded optimism about 2007.

Peter Hodson, senior portfolio manager with Sprott Asset Management, said that much of what takes place in both the American and Canadian economies next year may depend on housing prices in the U.S. He concedes there is still some possibility of a worst case outcome, in which a housing market meltdown leads to a collapse in consumer spending followed by a potentially ugly recession. However, his best guess is a moderately upbeat “goldilocks” scenario, where housing prices remain relatively stable, or at least don’t decline precipitously.

In that case, he says: “We’re pretty much at full employment, the consumer keeps spending, the companies employing those consumers keep expanding, etc, but you don’t get into inflation, so you still get expected interest rate cuts next year.” All that, he points out, would be good for the economy and for the markets.

Scott Baker, President of SD Baker & Associates Portfolio Management echoes Hodson’s sentiment on the state of the housing market in North America. He notes that “higher interest rates have had a pretty profound impact on housing in the U.S. Prices had risen over the last four years, pretty much across the board, to pretty extraordinary levels, so we’re not surprised that prices have flattened. That said, there’s still a lot of demand for housing driven by immigration and echo baby boomers. So we’re not exactly bullish on housing, but we do think that housing prices will go up at the rate of inflation for say, the next decade.”

Baker notes that the decelerating growth in both the U.S. and Canadian economies over the last year is a result of monetary tightening over the last two years, and agrees with Hodson and other observers that the trend will probably reverse itself in 2007. “We suspect that the economy continues to slow down in North America into next year to the point where we think that sometime next year the Fed will start lowering interest rates again. We’re starting to see inflation moderate, so it’s really not an issue. Even when the economy was peaking around the world, you still had pretty modest inflation, even though energy prices were going through the roof.”

Kim Shannon, president of Sionna Investment Management, doesn’t believe inflation is a concern either. “I don’t expect runaway inflation to come back anytime soon, so I don’t have to worry about interest rates going dramatically higher and having an impact on high yielding products or [interest rate sensitive] financial services companies,” she says.

George Vasic, strategist for UBS Investment Research, notes that corporate earnings are still relatively healthy, and he expects that 2007 will offer opportunities for good returns even after gains in 2006. He predicts a 10% decline in the U.S. housing market for next year, but believes that the slowdown in growth already evident in North America represents a soft landing and not a recession. Vasic also observes that even though slow growth in the U.S. will have an impact on the Canadian economy, particularly in the export sector, Canada is currently in a fiscal position to implement of growth-boosting tax cuts if necessary.

Sprott’s Hodson also takes the view that the North American economy is in better shape than some housing-oriented pundits believe. “A lot of the negativity around the markets is priced in, and I don’t see a collapse in corporate earnings. I see high employment, high productivity, and high profit margins. I don’t see huge negativity in the companies that I’m looking at, and yet I see and hear giant negativity every single day from all sorts of investors, and so I think there’s a lot of bad news already priced in.” In other words, any economic news that’s not dire will probably be good for the markets.

Baker says that in the short term his sense is that “sentiment is fairly exuberant right now with respect to the U.S. and Canadian stock markets, and I would expect a pullback in the markets sometime in the first quarter.” However, Baker, who emphasizes a long-term view towards investing, feels that rapid and ongoing growth in Asia will continue to fuel a long commodity cycle, regardless of what happens in North America. “Everybody still thinks that China’s growth is export led and dependent on U.S. consumers, but that’s not true — the real growth is coming more and more from internal consumption driven by their emerging middle class. That has important implications for the world because we’re no longer as dependent on the U.S. consumer. Another part of the story is migration in China from a rural to an urban environment, which is requiring a lot of infrastructure build-out. That plays into what we think will be a very long commodity cycle, from which Canada is well-positioned to benefit.”

Vasic is also positive on energy and materials, based on their “stronger for longer” commodity price call. They are predicting resurgent oil prices and greater demand for materials in 2007, and are recommending overweighting those sectors.

Patrick Metzger is a freelance writer based in Toronto

(12/28/06)