A bumpy ride

It has been a record-breaking year for the markets in 2006. The S&P/TSX Composite Index and the Dow Jones both topped 12,000 for the first time ever; oil’s gone from $60 a barrel to a record $78 and back down again; gold hit a 26-year high of $732 an ounce; and income trusts fell out of favour after the federal government announced it would begin taxing the stock market darlings.

The 2007 outlook for the markets is somewhat mixed, with some predicting good times ahead and others expecting the worst. Advisors will want to fasten their seat belts and keep an especially close eye on the capital markets — the ride is going to be bumpy.

Economic growth

The overall economy will primarily face pressures from abroad, with domestic spending remaining sturdy, though foreign demand will fall off.

“The problem will be with the American, not Canadian, consumer,” says Don Drummond, chief economist and senior vice-president, TD Economics. He predicts growth will be limited to just 2.1% in 2007, “marginally below its potential pace of 2.8%.” In the U.S., he expects growth will miss its potential pace of 3.3% by a full percentage point.

“The challenges of the export sector are plain to see on manufacturing, which has shed more than 170,000 jobs in the past two years,” Drummond says. “Exports will be hard-pressed to expand at even a meagre 1% rate in 2007. Meanwhile, import growth should remain reasonably firm, underpinned by domestic demand.”

Interest rates

CIBC World Markets says the Bank of Canada will be forced to cut rates in 2007 because the Canadian dollar has become more of a petro-currency than ever before. The investment bank expects the loonie to appreciate to above 90 cents US, which could lead to a recession in Canada’s manufacturing heartland.

To prevent that from happening, the Bank of Canada would be forced to cut rates by up to 100 basis points. However, the Conference Board of Canada doesn’t expect the central bank to stand pat as inflation stays low. “Because of what’s going on in central Canada, and out east in fact, they’ll be sitting on the sidelines,” says Pedro Antunes, director, national forecast, at the Board.

Real estate

On the upside, Canadian household finances are seen to be relatively healthy. Housing prices have not experienced the same run-up as in the U.S., resulting in lower debt loads.

“The cooling housing market will take some zip off of real estate appreciation in the coming year,” says Drummond. “But the absence of a market collapse should position real estate assets to still rise by a 6 to 7% clip in 2007, which is consistent with historical norms.”

Energy

Although it made new records this year and then fell back down to Earth, oil may not have peaked. Strong global demand, particularly in China and major oil-producing countries, should send crude to new highs, an average $80 US a barrel in 2007.

“I think we’re going to see oil prices continue to rise,” says Jeff Rubin, chief economist and chief strategist at CIBC World Markets in Toronto. “We are getting new increases in supply, but when we’re drilling 35,000 feet in the Gulf of Mexico, or we’re schlepping a ton of sand to get a barrel of oil, the supply curve is a little bit different.”

TD Economics believes an overhang in global supply has built up and oil is likely to keep heading lower. Recent global political issues have also failed to “have any meaningful upward pull on crude prices,” TD says. With the fundamental supply/demand conditions likely to weaken further, crude will decline before recovering in the second half of next year, the bank believes.

Equities

The outlook for the equity markets is just as mixed. National Bank Financial’s chief economist and strategist, Clément Gignac, is predicting a tumultuous year for the markets. He expects the TSX to drop to 10,500, which would be equal to an 18% drop from mid-December levels.

Gignac says there is growing evidence of eroding productivity and labour cost pressures that will cause a slowdown in corporate earnings growth.

CIBC is in the bullish camp, noting that nearly two-thirds of the TSX market capitalization is comprised of energy or interest-sensitive stocks. Considering its forecast of a decline in interest rates and a rise in crude prices, it expects the S&P/TSX to hit a record high of 13,500 in 2007, about a 5% increase from mid-December.

Craig Sebastiano is associate editor, Benefits Canada

(12/22/06)