Markets ignoring solid economic performance, report says

(September 16, 2004) The stock market’s tepid performance this year is something of a puzzle, considering the relatively strong performance of both the Canadian and U.S. economies, says TD Bank Financial Group in its latest quarterly forecast.

Since 2001, the Canadian economy has averaged annual real GDP growth of 2.9%, while the U.S. has fared even better, at 3.4%, the report says. Inflation is under control, unemployment is falling and corporate profits are on the rise.

“Not too long ago, markets would have viewed this as nirvana,” says TD chief economist Don Drummond. So why the lukewarm response from investors?

Drummond believes that expectations of a sustained and strong market recovery may have been unrealistic. And he speculates that investors are comparing today’s economic picture to that of the late 1990s. However, that period was characterized by a business investment bubble and consumption fuelled by unsustainable equity gains, he notes, adding the era cannot be replicated without huge economic imbalances being created once again.

“The ideal should be moderate growth, subdued inflation and low unemployment,” says Drummond. “And looking ahead, that is precisely what we expect the Canadian and U.S. economies to deliver.”

TD predicts real GDP growth of around 3.5% for the remainder of the year and through 2005, moderating slightly to around 3% by 2006. Drummond also expects corporate growth to rise in line with nominal GDP growth, which translates to an average annual increase of around 5%.

“Equities will likely be hard pressed to deliver returns significantly better than the pace of underlying growth in the coming months, particularly in an environment where investors may fret over the impact of central bank rate hikes,” he says.

The Bank of Canada recently raised its key overnight lending rate 25 basis points to 2.25%. TD expects the bank rate to hit 2.75% by the end of the year and to climb as high as 4%, perhaps as soon as next summer.

Given the backdrop of rising interest rates, Canadian bond yields are poised to rise significantly in the months ahead, the report predicts. “Three factors are likely to see Canadian bonds outperform: slightly narrower short-term rate spreads, supply pressures on treasuries and a further appreciation in the Canadian dollar that will provide capital gains to foreign holders of Canadian fixed income instruments.”

Filed by Doug Watt, Advisor.ca, doug.watt@advisor.rogers.com