U.S. losing economic clout to Asia

Fears that a U.S. economic slowdown will cripple the global economy may be a little overblown, according to economists at one of the major banks. While the U.S. remains the world’s largest single economy, the rapidly developing economies of Asia are playing a greater role in propelling global growth than ever before.

“Emerging and newly industrialized Asian nations now account for 30% of world GDP, while G7 countries represent just 41%, a reduction of six percentage points from a decade ago,” says Warren Jestin, chief economist, Scotiabank. “China and India combined are now slightly bigger than the U.S. economy.”

In Scotia Economics’ Global Outlook report, Jestin points out that these calculations are based on purchasing power parity to reflect differences in cost of living and currency valuations.

While Asia is largely seen as a source of cheap labour and an exporter of goods to more developed economies, trade within the region is booming as well. With China serving as a hub, Asian trade is already 50% greater than within NAFTA, and is growing twice as quickly.

China is also planning a massive spending program on infrastructure topping US$300 billion a year through 2010 rather than simply absorbing capital from abroad.

“Emerging and newly industrialized Asian countries produce 23% of global exports,” Jestin says. “China has become the largest exporter of non-energy products to the United States, although energy sales give Canada bragging rights as top overall supplier.”

The Scotia outlook predicts Canadian growth of about 3% over the next two years, with resource rich provinces compensating for weakness in the manufacturing-based provinces. Ontario, Quebec and the Maritimes, all reliant on factory production and U.S. tourism, will continue to struggle under the weight of a 90-cent dollar.

Meanwhile, south of the border, the U.S. is expected to finally shift into a slower growth pattern, as consumer spending weakens and business investment takes over as the primary driver.

So what does all this mean for your clients’ portfolios?

A report by Richardson Partners Financial agrees the global expansion will continue at least through the second half of 2006, surviving a predicted slowdown in U.S. growth. The report also says growth in Asia will power the global economy, along with continued growth in Europe and Japan.

The Scotia report agrees that there is currently a synchronized recovery underway in Germany, France and Italy, but points out that higher taxes and a strong euro may limit that growth. Meanwhile, the UK is witnessing rising unemployment and a cooling housing market which could douse domestic consumption.

The RFP report says strong global performance continues to favour equities over fixed income, even within the Canadian market, although the report points out investors will need to be more selective than in the recent past.

“Investors have grown used to double-digit returns given that six out of the last ten years have delivered these results,” says Clancy Ethans, senior vice president and chief investment officer. “They need to be more discriminating about the stocks they choose in this market environment.

Ethans points out that the TSX Index has only earned 3% year to date, while its long-term performance has averaged 6%, since 1919.

RPF is recommending its clients allocate 65% of their portfolio to equities, rather than the 55% benchmark weighting, and 25% to fixed income, compared to the 45% benchmark. With investor sentiment increasingly pessimistic though, the firm suggests a 10% allocation to cash, which would allow clients to take advantage of opportunities created by softness in the market.

“Volatility is higher than it has been for some time, and that makes the overall market a difficult place to invest in,” says Ethans. “Current geopolitical concerns have exacerbated this. However, when investor sentiment is at its worst, investment opportunities are created.”

Within the equity portfolio, RPF is maintaining an overweight recommendation in materials stocks, which should benefit from continued demand from Asia. Energy stocks received an underweight ranking, however, as the sector has ballooned to 30% of the index on high oil prices.

“This is more of a risk management motivated weighting rather than a negative call on oil, as we believe that oil prices will stay high despite the fact that there is about a $20 ‘fear premium’ in the current price,” says Ethans.

The Scotia report also predicts strength in the Canadian commodity sector, as the U.S. seeks more secure energy sources. The price of West Texas Intermediate is expected to remain close to $70 throughout the next 2 years. The mining sector should also fare well, as Asian demand for minerals remains strong.

Rising interest rates remain a concern, however, prompting Ethans to suggest investors lighten up on rate sensitive sectors such as financial services, utilities and telecoms. Jestin’s report adds that despite the recent pause in the credit tightening cycle, the Bank of Canada may find it has little choice but to raise rates as the U.S. Federal Reserve hikes its own rate to shore up the U.S. dollar.

“Investors would be well-advised to run an interest rate sensitivity check on their portfolios, since many are heavily overweight in these sectors due to the extremely low rate levels prior to 2006,” says Ethans. “A focus on holdings less sensitive to interest rates may still be prudent for the coming quarters.”

It should be pointed out, that a slowdown in the U.S. economy has been predicted by various market watchers since the current economic resurgence began. Cited risks to growth have included the trade gap, the fiscal deficit, consumer fatigue and rising interest rates. Yet despite rising interest rates and slow wage growth, the U.S. consumer has managed to consistently propel the economy to this point.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(07/18/06)