Canadian commodities look golden in 2006

(January 2006) The last time the S&P/TSX Composite broke through 11,000 investors foolishly believed the good times wouldn’t end. But end they did. Markets around the world fell hard, led by a raucous sell off in the U.S. tech sector.

The markets have recovered, but the U.S. is shaky and could be a catalyst to bring them back down again. The difference this time, according to several leading economists, is that if the U.S. succumbs to its fiscal and economic challenges, it won’t necessarily drag Canada down with it.

David Rosenberg, chief North American economist for Merrill Lynch in New York, says the high demand for commodities puts Canada in a good position. Demand for resources is expected to grow with countries like Japan turning a corner and an anticipated spending boom in Germany ahead of a planned value-added tax in 2007.

Another observer adds that we’re seeing the first phase of a 15-year upward cycle in commodity prices — although there will be bumps along the way. Supplies on a global basis are finite and dwindling, and reserve replacement has become a major issue after two decades of reduced exploration, says RBC Capital Markets chair Anthony Fell. Any new resource find could take up to 10 years to come online.

All of this bodes well for Canada, which is overweight in resources.

Canada’s rich gold sector is also well positioned. Fell sees gold prices, which are currently fluctuating around US$540, going even higher, since demand from governments around the world already outstrips the current rate at which reserves are increasing, about 1% a year.

Moreover, with the current U.S. account deficit off the charts, central banks around the globe are looking at gold as an effective hedge against the softening U.S. dollar. “My view is the Asian central banks are becoming uncomfortable and will be looking to diversify their reserve assets and gold will be on their shopping lists,” he says.

The common thread of the economists’ outlook for 2006 is their concern about the U.S. housing market. But that concern varies. From Canada, economists describe the weakness in the U.S. housing market as being a regional problem. There is evidence of the market slowing down, but these cases are isolated and, at the risk of saying it’s different this time, BMO Financial Group’s chief economist, Rick Egelton, says he doesn’t expect to see the housing market burst like it did in the 1980s.

Even though the U.S. is showing cracks, with consumer spending slowing and people taking on higher mortgages, its economy has been quite resilient as witnessed in the months after Hurricane Katrina.

The view for Canadian-born economist Rosenberg from his New York office is quite different. In his opinion the single biggest risk to the outlook for the U.S. is what happens to home prices. “Even if we see a flattening of U.S. home prices the negative effect that that’s going to have … will drain more than a percentage point out of consumer spending in the next year,” he warns.

The U.S. is entering a time when growth rates are similar to those seen in 2003, 1995 and 1986 — years when the U.S. Federal Reserve Board was forced to ultimately cut rates, he says. “If we’re right on our forecasts, the only ones who will be disappointed at the end of the year ahead are the growth bulls, the inflation monitors and the bond dealers.”

In other words, this is a dangerous time to put too much stock in the continued resilience of the U.S. consumer. The same warning applies to ability of the Federal Reserve to steer the U.S. economy clear of trouble. “Financial markets are in a euphoric state with the overview that central banks are in control and that we will never again have a serious recession or a global financial crisis like a major run on the U.S. dollar,” Fell snorts. “I don’t believe it.”

The central banks in Canada and the U.S. are entering their most challenging period, Egelton says. “It’s at this point in the cycle where mistakes are made.” Until now the course for the banks has been fairly clear with both countries coming out of a recession, and with low interest rates.

The largest impact he sees for Canada going forward stems from the U.S. dollar, with the biggest impact coming to Canada’s manufacturing heartland — Ontario and Quebec — where some expect growth will slow to about 2%.

Economists expect the loonie will continue its flight in 2006, most likely pushing towards 90 cents U.S. Rosenberg, one of the most bearish economists on Wall St., is bullish on the Canadian dollar, saying it could be at par with the U.S. greenback in two years.

All told, 2006 isn’t expected to be a eventful year; 2007 could be another story.

This article was originally published in Advisor’s Edge Report. Filed by Mark Brown, Advisor.ca, mark.brown@advisor.rogers.com

(01/23/06)

Mark Brown