Tighter monetary policy to reduce asset returns: Economists

(December 16, 2004) Thanks to a global economic expansion of 5%, 2004 has been the strongest in the past 30 years. While growth is expected to decelerate in 2005, it will likely still be above trend, says Clément Gignac, chief economist at the National Bank of Canada. Gignac’s was one of a sheaf of reports issued today by Canada’s major banks.

In a webcast this morning, Gignac predicted global growth next year of 4%, even as central banks take some liquidity out of the financial system. While the Bank of Canada is likely to pause in the course of assessing the impact of a higher dollar on Canadian jobs, China’s central bank and the U.S. Federal Reserve both have to act to tamp down inflation expectations.

That will have an impact on asset returns. U.S. stocks look favourable in the current interest-rate environment, but growth in earnings will slow. Coupled with a 75- to 100 -basis-point increase in 10-year treasury yields, the stock outlook is modest. Says Gignac: “2005 should be a transition year and most investment vehicles will likely provide investors with modest returns.”

Gignac is forecasting a rise in the U.S. overnight rate to 3.75%. He admits that this is higher than the consensus view, but bases his projection on greater strength in the U.S. economy as well as the U.S. Federal Reserve’s overly accommodative stance. “The short rate is at the same rate as inflation,” he argues, saying that it is normally 200 to 300 basis points above the rate of inflation, before it is neutral.

Canadian outlook

Gignac adds that Canada is well positioned to take advantage of a slower-growing but still expanding Chinese economy. China is industrializing, and Canada remains a net exporter of commodities. In addition, Canadian businesses are sitting on a mountain of cash. The cash to investment ratio, he says, is the lowest in four decades. Many economists expect a surge in capital spending to boost productivity in the face of pressures on profits induced by a higher dollar.

As a result, Gignac expects the Canadian economy to grow 3%, with much of the gains concentrated in the resource-heavy sectors in western Canada.

Warren Jestin, chief economist at Scotiabank, is less sanguine. “The appreciation of our currency has major implications for growth, inflation and policy settings. The move into the 80-to-85-cent range has dampened exports, production and job creation in the manufacturing sector.” But he, too, expects economic momentum to move to the western provinces and foresees a 2.5% GDP growth rate.

Gignac sees an 85-cent dollar by the end of 2005, but unlike the situation in the early 1990s, he thinks that Canadian manufacturers are now better equipped to handle the higher currency. Don Drummond, chief economist at TD Bank, agrees, but he worries about the “lagged effect” of a higher dollar.

“Exporters are the most vulnerable to the strength in the Canadian dollar. And, while rising commodity prices and firming foreign demand helped many exporters to cope with the rise in the exchange rate over the past two years,” Drummond says, “those offsets are unlikely to be present in 2005 and 2006.”

At RBC, chief economist Craig Wright noted that “Canada’s economy weathered the rapid appreciation of the Canadian dollar in 2004 and the recent slowing in world economic growth with surprising resilience,” he said in a statement released today. Still, his forecast is for an 80-cent dollar by year-end.

Like Gignac, he expects the growth trend to continue to continue as booming labour markets bolster consumer spending, companies invest capital and the federal government maintains a sold balance sheet. He pegs next year’s growth at 3%, and expects the Bank of Canada to hold off on rate hikes until the fourth quarter.

Both Wright and Gignac expressed concern over U.S. fiscal policy. “If Mr. Bush does not turned around 180 degrees on fiscal policy to increase savings in the U.S., we have some concerns,” Gignac comments. In any case, Wright says, the U.S. fiscal deficit will be a drag on growth.

Over at Scotiabank, Jestin’s report suggests that “financial market development in 2005 will be shaped by the expectations of slower growth, low inflation and further U.S. dollar depreciation.”

Filed by Scot Blythe, Advisor.ca, scot.blythe@advisor.rogers.com.

(12/16/04)