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Benefits and Pensions MonitorReflation Refloats U.S. EconomyBy: Joe Hornyak
However, economic growth in the U.S. accelerated during the first quarter in 2003, peaking at 8.2 per cent in the third quarter, he says. Craig Gaskin, vice-president and director, portfolio management, for TD Quantitative Capital, says the revival of the U.S. economy can be traced to a very aggressive ‘reflation’ policy. Reflation is the general rise in prices in various aspects of the economy. The environment of low interest rates “where people are willing to borrow and businesses are willing to borrow to expand,” freed up cash which consumers are using to purchase non-durables and durable goods. “That purchase activity supports pricing and, in fact, might result in upward pricing pressure,” he says. However, this has not come without a cost. Bill Onslow, vice-president, U.S. equities, for Natcan Investment Management, points to “the twin deficits” which will probably surface in 2005. The level of household debt has created a current account deficit of about $500 billion. The fiscal deficit is approaching that amount and “neither one of those trends are really sustainable. I think the worry is that pressure will come to bear on the U.S. bond market and force interest rates up, perhaps higher than they otherwise would if they were just focusing on domestic considerations.” Acceptable Condition Yet, the current administration views this “as being an acceptable condition of reviving the current U.S. economy,” says Gaskin. That may be in part due the fact 2004 is an election year. Gladys Boehler, senior vice-president responsible for U.S. equities for Greystone Managed Investments, says election years are always fairly strong both from a stock market point of view and an economic point of view. Another key element for the U.S. economy is the decline of the dollar. A policy appears to be in place to let the U.S. dollar decline in value in the hopes that it helps to generate export activity and translates into domestic economic strength. And the consensus appears to be that the U.S. dollar will continue to decline. Schmeer notes that when the Fed tightens, the dollar typically moves higher. Because the Fed has not yet begun to tighten, this suggests that the dollar will not strengthen any time soon. Still, the feeling is that the U.S. is in good shape. Substantial Increases Boehler sees several significant things that have already been built into the economic picture which will play out this year. These include the final impact of the consumer tax cuts that “should hit pretty heavily in the second quarter” and the termination of the 50 per cent depreciation allowance at the end of December 2004. These will cause “pretty substantial increases in capital spending throughout the year.” The short-term market outlook for Onslow is that double-digits returns, closer to the historic norm of 10 to 12 per cent, are possible. Strong growth in productivity means corporate profits will run, on a yearto- year basis, in the neighbourhood of 25 per cent after 2004. And the profit estimate for 2004 of 15 per cent “isn’t bad,” he says. Schmeer, however, says while the macro environment for stocks is positive, valuation levels are stretched. As a result, it is reasonable to expect positive returns from the stock market in 2004, “but strong double-digit returns are less likely.” Area that have the potential to impact investor confidence, says Gaskin, are issues relating to governance, in particular those relating to practices at mutual fund and investment companies. “The attention is certainly on the mutual fund industry and these things have a way of negatively impacting investor confidence.” Gaskin doesn’t believe we’ve seen the last of these investigations and fears “the ripple effect will flow through to Canada. Ongoing risk factors include geopolitical ones. Gaskin doesn’t think “we’re out of the woods.” U.S. investors and the general population are looking to the progress of the rebuilding in Iraq and are looking for more positive signals as to when, and if, the U.S. might extract itself from that environment. “Terrorism is still very much on the minds of U.S. investors,” he says. “If there was a terrorist event, I think that would shake investor confidence.” Job Creation Job creation is a controversial issue. Some have raised concerns about recent reports that very few jobs are being created. But Boehler says the controversy stems from the fact there are two sets of numbers. One looks at the payroll number and is a survey largely of big corporations. This one reports disappointing job creation numbers. The other survey is smaller and looks at households. It is more representative of the small business. Here, the job creation numbers are quite strong. Job creation would be a problem “if there was no indication of job pick-up. But it does appear that it’s happening more in small businesses than in large businesses,” says Boehler. For Canadian investors in U.S. equities, says Gaskin, as the U.S. dollar loses value relative to the Canadian dollar, returns will be compressed which poses a secondary risk. “Those that were invested last year in the U.S. experienced a local return close to 28 per cent,” he says. “When translated to Canadian dollar returns, that drops to something close to six per cent.” However, for Canadian investors putting long-term money into the U.S., Boehler says the current Canadian dollar offers them “the best buying opportunity in a decade.” Onslow believes Canadian investors have other reasons to be very cautious. Over the last year alone, costs for Canada companies dependent upon exports to the U.S. – and 85 per cent of our exports do go to the U.S. – have risen 21 per cent. “That’s very hard to overcome on a shortterm basis and we’re starting to see some of the fallout from the strength in the Canadian dollar.” Recover Leadership In terms of investment opportunities, Gaskin thinks the large cap segment of the market (specifically S&P 500 companies) is poised to recover leadership. Having lagged in performance terms over the recent years, “I think that they’re probably poised to recover.” He cites a number of factors. These include the improving economic conditions around the world. For example, as the economies of Europe and Asia start to pick up, global multi-national companies will benefit as export and foreign market activity hits higher levels. Since a lot more of the large caps have global revenue generation capabilities, these firms will benefit, despite the weakness in the U.S. dollar, from currency-related gains on their foreign revenues which will prove beneficial from an accounting perspective. Onslow also likes the prospects for large cap stocks. Last year, as a recovery year from a very severe market, saw a lot of low quality, small cap, stocks – which were hit particularly hard in the fallout from the bursting of the tech bubble – do very well. Indeed, the Russell 2000 significantly outperformed the S&P 500. He suspects this has “probably run its course and investors should probably focus more on higher quality companies.” Some of the larger companies are in a better position to benefit from their improved international position. They also generally pay higher dividends which means that dividend tax relief, which wasn’t really a factor in the market last year, will become one. “Going forward, more of the total return on U.S. stocks will come from dividends as opposed to capital appreciation." Joe Hornyak is executive editor of Benefits and Pensions Monitor. ----------------------------------------------------------------------------------- History Predicts Market Performance If research by Mark Schmeer, vice-president and managing director of North American Equities for MFC Global Investment Management, is correct, U.S. markets will go up this year. Schmeer points to several historic indicators of stock market performance starting with economic growth. Economic growth in the U.S. is expected to average four per cent for the year as consumer spending slows to a more sustainable level while business spending strengthens. Historically when the economy has grown at around four per cent, the stock market has returned 14 per cent. Earnings growth is another indicator. For 2004, earnings should grow at something greater than 10 per cent. When earnings growth is between 10 per cent and 15 per cent, the stock market has returned 11 per cent. Interest rates are another indicator and an important one for the stock market. The average annualized return when the Fed is tightening is slightly negative. When the Fed is easing, the return is more than 30 per cent. How fast the economy grows, together with the trend in inflation, will influence the timing of the Fed’s policy towards interest rates. Schmeer expects the Fed to increase rates once in May but to hold off on any further increases until 2005. And he suggests the market will probably not respond negatively to this increase. However, one negative indicator is long interest rates. The 10-year treasury rate bottomed in June at around 3.2 per cent and has increased about 100 basis points since. Historically, when interest rates have increased in a similar way, stocks have generated below average returns in the following year. |
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What a difference a year makes. At this time last year, says Mark Schmeer, vice-president and managing director of North American Equities for MFC Global Investment Management, “we had already passed the bear market low, but investors were still pessimistic. Concerns included weak economic growth and earnings, accounting fraud, underfunded pensions, high oil prices, the risk of deflation, war with Iraq, and terrorism.” 