Weaker U.S. will cast its shadow on Canada

By Vikram Barhat | August 12, 2011 | Last updated on August 12, 2011
4 min read

It’s been a dramatic week with the U.S. credit downgrade and the anxiety in Europe providing the two main acts. And as the stock market rollercoaster prepares to take a weekend break, dizzy investors are looking for some clarity on what’s happening and some perspective on what’s in store for them next week and beyond.

Despite the U.S. debt ceiling and rating downgrade getting most of the attention, it’s the ever widening contagion of the European sovereign debt crisis that caused the stock market rout of this week, says Dr. Sherry Cooper, chief economist, BMO Financial Group.

“This has been the issue that’s been plaguing us for over a year and fundamentally it is truly a decision of whether or not the Euro monetary union will continue; that is a huge decision that has to be made by the stronger economies within Europe,” says Cooper in conference call Friday.

The second important development, she says, was the downward revision of America’s long-term debt. “What it showed us is not only that the second quarter GDP figure in the U.S. economy was a mere 1.3%, markedly below what the market was expecting, but also that the period covering the economic recession showed a much deeper recession than what we had originally thought and a much weaker recovery subsequent to that which made the jobs numbers a lot more understandable.”

This led to the substantial sell-off in stocks as the world readjusted to the new American reality.

Cooper also underlined another reason for the recent volatility on the markets: last Friday’s announcement from Standard & Poor’s downgrading the U.S. long-term debt. “The Treasury market has rallied dramatically since then, reaffirming the fact that the U.S. Treasury market, even in this very troubled and uncertain time, is still the deepest, most liquid market on the planet and is still attracting capital as a safe haven.”

The rally in Treasurys, she says, is also a reflection of the new reality: a much weaker U.S. economy and much weaker recovery. It also reflects the fact that Federal Reserve chairman Ben Bernanke now believes that 0% to .25% Federal Funds rate is consistent with this new economic outlook, she added.

Bernanke’s recent statement is a conditional commitment, she says. If the U.S. growth numbers start surprising on the upside or if inflation rises, the Fed will respond by revising the fund rate accordingly. “It is the equivalent of a QE3; he is telling us he’s keeping overnight rate very low for a period, allowing long-term interest rates to come down dramatically,” says Cooper. “In my view it is a much more effective way of getting bond yields down than introducing a QE3 per se, which would require something bigger than $650 billion that he had introduced during QE2 for it to work.”

As for the Canadian economy, it can not remain unscathed by developments in the U.S.

“Canada has been impacted most by its trade balance and we do have a large trade deficit in Canada thanks to the fact that so much trade is with the U.S. and with Europe whose growth rate is also very weak,” says Cooper.

Interestingly, she forecasts weaker growth in Canada than the U.S. in both the second quarter and the second half of the year, although the annual Canadian figures are expected to exceed those of the U.S. due to a stronger first half of 2011.

Paul Taylor, chief investment officer, BMO Harris Private Banking, placed part of the blame on the equity markets, saying investors were unrealistic in their expectations in how debt levels were being handled both in the U.S. and Europe.

Taylor identified three areas that U.S. policymakers were struggling to address through their discussions: the tenuous economic recovery; bringing debt and deficit to more manageable levels; and restoring confidence in the political process.

“If you look at these competing objectives, it was probably unrealistic for the market to expect for the policymakers to stick the landing on this, and they clearly didn’t,” says Taylor.

It is the severity of issues in the eurozone, however, which has really spooked the markets, he says. The agreement that was struck a few weeks ago over Greece did not deal with the fundamental solvency issue related to Greece and its stock of debt.

“Perhaps the market was again unrealistic in its expectation of how policymakers would deal with global debt super cycle,” says Taylor. “It is a long-term structural issue that will weigh against economic growth going forward.”

Despite a dramatic reversal in the strength seen in markets Taylor keeps his outlook sunny. The silver lining to all the upheaval is that “on a forward P/E multiple basis we can certainly say that the North American markets trade at quite reasonable valuation levels.”

Not many would argue that gold has been a huge beneficiary as investors took a flight to safety looking for a spot to hide. Geoff Stein, portfolio manager and co-lead manager of the Fidelity Canadian Asset Allocation Fund says “investors have certainly adopted the view that gold is an all-weather hedge against risk.”

But apparently there’s more to the gold story. “Investors certainly have new ways to access gold today, through vehicles such as gold ETFs, but we generally access the gold opportunity through gold companies,” says Peter Drake, vice-president, retirement and economic research, with Fidelity Investments Canada ULC. “Today, gold companies are trading at a discount relative to gold bullion, and we’re trying to take advantage of that.”

The strategy clearly finds favour with Taylor, too. “With bullion trading at nearly $1,800, it is useful to point out that there’s still a meaningful gap between the price of gold bullion and the bullion price that has been baked into equity valuations of gold stock.”

Given the current economic environment it’s the non-cyclical sectors such as telecom, consumer staples and industrial where the investment opportunities can be found, he added.

Vikram Barhat