Canadian economy to remain robust in 2008: Scotiabank

(December 2007) Despite the loonie moving “too far, too fast,” one Scotiabank economist expects both the Canadian economy and the dollar to remain strong through next year.

Warren Jestin, senior vice-president and chief economist with Scotiabank, says “underlying economic fundamentals remain broadly supportive for the loonie and negative for the greenback. Against this background, we expect the Canada–U.S. exchange rate to average close to $1.05 over the next year.”

However, market volatility due to the credit crunch and sub-prime mortgage mess will keep things tumultuous until at least the spring, and negative fallout from soft U.S. economic activity will last well into 2009. This, along with weakened profit margins, business investment growth and a “Fed [that] moves further out of sync with other central banks,” will keep the American buck in a precarious position.

The greenback’s decline can also be attributed to the huge merchandise trade shortfall of about $800 billion. Import receipts are about 70% higher than exports, so a “rapid adjustment requires a big downdraft in commodity prices and reining in U.S. consumers’ proclivity to buy low-cost imports — both unlikely in the near future,” says Jestin.

But it’s not just the faltering economy that’s keeping the American dollar down; the world finally sees Canada as a resource-rich country. “[That’s] a positive for the currency that will be sustained by longer-term strength in commodity markets,” says Jestin.

He adds that while oil prices might drop and industrial metals may soften, “prices will remain historically high and act as a magnet for further large-scale investment.”

The Canadian economy is buoyed further by twin trade and fiscal surpluses, and a more cautious monetary policy. Jestin says that all these positive factors will keep the dollar “flying high” even as the economy slows down and lower inflation forces the Bank of Canada to cut interest rates in 2008.

One sector benefiting from Canada’s strong economic performance is services. Jestin says that with 80% of the Canadian economy devoted to service, “[this] is where the growth is now; that’s where the growth will be over the next 10 years.”

Manufacturing, however, is another story. That sector will continue to face “considerable challenges” when the industry adjusts to currency appreciation and more competition from affordable, offshore imports comes into play.

So far, though, the growth in services and construction has offset job losses in the manufacturing sector. “At the national level, new jobs in construction over the past year have roughly matched those lost in manufacturing,” Jestin notes.

The economy also needs to tip its hat to the Canadian government, adds Jestin, who says provincial and federal surpluses of $30 billion last year have allowed governments to offer tax relief measures, which have helped spur the economy.

All of this good news means only one thing: the U.S. dollar will keep falling against the loonie. Jestin says that the market volatility in the global currency markets could last until 2010. For the short term, the Canadian dollar will jump around based on commodity markets and the timing of rate cuts, but longer term, it’s likely the dollar will stay above parity.

So what does this mean for investors? Vincent Delisle, Scotia’s director, portfolio strategy, expects large-cap stocks to outperform over the next couple of years. He says people should look at sectors that are less cyclical, such as gold, staples and utilities or early cyclicals such as financials and telecom.

Overweighting financials might sound odd, considering many banks have presented conservative outlooks for the next year, but Delisle says investors need to focus on Canadian banks, not American ones. “It’s more comfortable when we look at Canadian banks than U.S. financials. [And] I don’t think all banks are created equal. You’re seeing some dispersion and valuation premiums grow for the banks that are doing okay and others being penalized. Having said that, I’m very optimistic that 2009 will look better in terms of profit growth and some type of rebound in the U.S.”

As for next year, Delisle thinks that the TSX will fluctuate wildly, as it has the past few months. He says it could move from 13,000 to 14,500 points at the start of 2008. That means investors could have a lot of opportunity to buy cheap equities.

“The first quarter of 2008 will be a copy of what we’ve seen for the past five or six months — a lot of volatility, but a lot of opportunities for fear and for joy,” he says. “By December 2008 we expect that stocks will have doubled the performance of bonds, and we’d maintain an overweighting in the stock market.”

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

(12/13/07)

Bryan Borzykowski