Gloomy months ahead for economy: RBC

Most advisors know long-term investing is the way to go, but if you’ve got a trigger-happy client, then be prepared to buy (or sell) over the next few months.

That’s because RBC Economics says the next few months will be filled with rate cuts and uncertainty, something short-term-focused investors might be able to use to their advantage.

“These reports help advisors and clients form a view in terms of what the U.S. economy might be doing near-term,” says Paul Ferley, assistant chief economist with RBC. “If our forecast plays out, interest rates in the very near term will be cut further, and once growth recovers, the Feds will start reversing the rate. These patterns of interest rates create various trading opportunities.”

While some investors will welcome the volatility, others will likely be concerned about the U.S. economy’s potential slide into a recession. Most banks, including RBC, say a recession is unlikely, but it could happen.

“Clearly the U.S. housing market is in a recession,” says Ferley. “But residential investment is a small component of the GDP, about 5%. To get a more serious weakening of the GDP, you need weakness in the housing sector overlaid with weakness in the economy, like a higher cost of capital for a long period of time.”

Ferley points to the U.S. economy’s 4.9% growth in the third quarter and healthy consumer spending at 3% as indicators that the economy will bounce back “as long as financial volatility is short-lived.”

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With that in mind, economists do expect things — except for the housing sector — to return to relative normalcy in the latter half of 2008. The renewed strength is partly due to the rate cuts that should happen over the next couple of months.

RBC’s economists expect that the Federal Reserve will cut rates by another 100 basis points by the middle of this year, while the Bank of Canada will likely reduce rates by 75 basis points.

“We have to see more aggressive action by the central banks in both Canada and the U.S. to try and contain the credit tightening that’s playing out in the States. To try and make sure it remains short-lived,” says Ferley.

But an aggressive Fed could spark inflation, which is why Federal Reserve chairman Ben Bernanke hasn’t taken more action than he has. “Inflation risk has been a factor that’s been holding Bernanke from more forthrightly addressing the problems,” explains Ferley. “The Fed wants to make it clear that it’s not taking its eye off inflation.”

Until the Fed cuts rates again, growth in the first part of ’08 is expected to slow in North America. In the U.S., GDP growth will likely be at 1.5%, while Canada can expect 2% growth. However, if the economy picks up like RBC expects, growth in the second half of the year will be 2.5% in both Canada and the U.S. That should put the Great White North’s yearly GDP growth at 2.1%, which is down from 2.6% in 2007.

“The improvement in Canada’s terms of trade has been an important factor in supporting the domestic economy,” says Craig Wright, senior vice-president and chief economist at RBC. “Due to the stronger performance of export prices relative to import prices, Canadians have enjoyed greater spending capacity from these export revenues. However, import volumes have been growing at a faster rate than exports, resulting in the overall trade sector weighing down real GDP growth.”

As for the U.S. housing market, which sparked a lot of turmoil over the summer, things aren’t looking up. RBC says the sector “remains the Achilles’ heel for the economy,” and that there are “limited signs that the correction is abating.”

The bank projects another double-digit decline in residential investment in the fourth quarter and big losses in early 2008, though things should improve later this year.

Besides GDP growth and an American recession, something investors and advisors like to watch is currency fluctuation. On Friday the dollar dropped more than a cent on weak job growth — 18,700 jobs disappeared; analysts expected 15,000 to be created — which means a rate cut is even more likely come January 22.

But, putting aside Friday’s drop, there’s a good chance the Canadian dollar will stay strong for the first half of ’08, as volatile markets put downward pressure on the greenback. When the economy bounces back, though, the loonie could fall to about 91 cents.

Clearly, the economy’s future is a mixed bag — volatile at the beginning and strong at the end — so it’s probably not a good idea for investors to panic during the first few uncertain months. While it’s important to know what the near term holds, it’s best to heed Wright’s predictions on 2008. “Our view is that much of the gloom in the near term uncertainly will lift as we move through the year and longer run,” he says. “This isn’t the big one.”

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

(01/11/08)

Bryan Borzykowski