International trade is expected to be the key driver of Canadian economic growth in 2015, as exports continue to receive a boost from a weak Canadian dollar, an accelerating U.S. economy and, to a lesser degree, an improving European economy, according to Russell Investments’ 2015 Global Annual Outlook.
“While critical risks remain – primarily the direction of commodity prices, oil in particular, we believe a strengthening domestic economy coupled with stabilizing oil prices over a 12-month horizon should translate into modest returns for domestic equities in 2015,” said Shailesh Kshatriya, associate director, client investment strategies at Russell Investments Canada Limited.
The report notes the key risks to growth in 2015 in Canada will be housing and commodity prices – with the price of oil being the wildcard. “There is no way to sugarcoat the fact that household debt levels are stretched and home prices elevated. However, we believe the Bank of Canada will be sidelined for much of 2015. In the absence of rate increases, the risk of a sharp decline in home prices may well be contained yet another year; nonetheless, it’s a risk which cannot be ignored,” adds Kshatriya.
Canadian economic growth is expected to be 2.2%-2.5%. While respectable, the downside risks emanating from an overpriced housing market and lower oil prices in particular, cannot be overlooked.
The Bank of Canada is expected to hold its target rate of 1.0% for most of 2015, with the potential for one rate hike towards the end of the year – preferring to wait for the Fed to commence increasing rates to assess how the U.S. economy responds to higher interest rates prior to initiating its own.
Mid- to longer-term bond yields are expected to head higher in 2015 with Government of Canada 10-year bond yields expected to be in the 2.50%-2.75% range by year-end.
A dovish central bank, coupled with contracting short-term yield spreads between Canada and the U.S., means the Canadian dollar has more downside than upside risks. The currency is therefore expected to hover in a range of $0.84 – $0.92 USD in 2015.
Russell’s year-end target for the S&P/TSX Composite Index is 15,000. With the caveat that oil price declines are not egregious, the combination of reasonable GDP growth and a favourable profit margin cycle should equate to modest returns from domestic equities in 2015.
Global Forecast Overview
From a global perspective, Russell’s strategists explain how anticipated tightening from the U.S. Federal Reserve and Bank of England, contrasted with expectations for easing from the European Central Bank (ECB) and Bank of Japan, will play a leading role in shaping the global capital markets through 2015.
“After shaping global economic and market realities the past five years, the major central banks appear headed in divergent directions in 2015,” said Russell’s global head of Investment Strategy, Andrew Pease. “The key question for investors to watch in 2015 is the amount of spare capacity in the U.S. economy. This will determine the amount of inflation pressure, the extent of Fed tightening, profit margins and long-term interest rates.”
The report also lays out two main scenarios for the U.S. economy. The favored outlook is a continuation of single-digit profit growth, further gradual declines in unemployment, and a Fed that commences gradual tightening in mid-2015 with clear communication. In this scenario, U.S. 10-year Treasury yields rise beyond 3% and credit performs well – relative to Treasuries – with a backdrop of low default rates and subdued volatility.
For 2015, Russell remains optimistic, with expectations for stronger growth in all the developed economies, such as real GDP growth of 3.0% in the U.S. and 1% to 1.5% in the Eurozone.
“The U.S. market sets the tone for the global outlook, and a key indicator to watch will be hourly earnings in monthly employment reports,” added Pease. “This will provide the first evidence that labour market conditions are tightening enough to hurt margins, push up inflation, and make the Fed more hawkish. Conversely, subdued wage growth will be evidence that our favoured scenario is on track.”
Business Cycle: Cautious optimism in developed markets
U.S. economic growth is robust, with expectations in 2015 for average monthly payroll gains of 200,000 and U.S. inflation of 2.0%.
Japan is already showing tentative signs of economic recovery and will further benefit from quantitative easing as well as the delay of next year’s consumption tax increase. Growth indicators in the Eurozone are mixed, but recovering corporate profits and additional ECB stimulus contribute to an optimistic growth outlook.
Emerging Markets, however, are challenged by falling commodity prices, financing pressure on countries with a current-account deficit – such as Brazil and Turkey – from the rising U.S. dollar (USD), and expectations of Chinese GDP growing by only 7.0%.
Valuation: U.S. is stretched while Japanese and European equities are neutral
U.S. equities are still the most expensive with a price-to-book value around 2.8 times and a cyclically adjusted price-to-earnings ratio of more than 21 times, per the U.S. large-cap Russell 1000 Index as of Dec. 12, 2014. Both Japanese and European equities are scored as neutral value. Equity valuations in the Emerging Markets are attractive, with the biggest price-to-book value discount relative to developed markets in 10 years.
Sentiment: Developed markets maintain positive momentum, despite some contrarian signals
A large number of signals are in overbought territory, yet momentum still acts as a positive driver for equity markets. The U.S. in particular looks overbought on a range of short- and medium- term indicators, including measures of investor sentiment, some technical indicators, and positioning indicators. The Eurozone maintains positive price momentum even though short-term sentiment has increased. Sentiment in the major Asia-Pacific regional markets, perhaps with the exception of Australia, is upbeat, but prone to disappointment in the short term.