Having turned the corner in 2010, Canada’s economy continues to inspire a positive outlook despite some uncertainties, according to the latest Economic and Financial Outlook by Desjardins Economic Studies.

The study, released this morning, said the outlook for Canada’s economy is overall optimistic. The main sources of this sanguinity are the S&P/TSX, which has outperformed the S&P 500, and the strong loonie that has steadfastly been holding above parity with the eagle.

On a global scale, however, all’s not rosy. The recent enthusiasm about the global economy eases while inflation fears are beginning to affect the financial markets.

Investors are becoming increasingly sensitive to the political and social strife in Arab nations, responsible for the bulk of global oil supply. “The rise in oil prices triggered by supply fears is therefore jeopardizing economic growth, adding to the many challenges that industrialized nations are confronting,” said the report. “However, if the strains remain relatively contained at this level, most countries will emerge more shaken than hurt, that is without too much damage to their economies.”

Oil prices remain front and centre as the biggest uncertainty when it comes to the future of the global economy. Considering that the ripples of spreading revolt can take current problems to Saudi Arabia, one of the biggest oil producing nations, risks of a surge in crude prices are high and its impact around the world could be major.

From a Canadian perspective, rising oil prices are an opportunity.

“Not only will domestic demand continue to benefit from the rise in consumption and business investment, but everything indicates that Canadian exports will increasingly profit from accelerating global demand.”

Currency concerns
The strength of the loonie proves to be a two-sided coin exposing a dichotomy in Canada’s economy. On one side, a strong Canadian dollar hurts provinces that export semi-processed or finished products. On the other, it provides an opportunity for those same businesses to invest in productivity-boosting technology.

The dollar’s strength will prevent exporters from taking full advantage of the upswing in the global economy. The report suggests the loonie will hold above parity until at least the end of 2012.

And while some indicators are starting to suggest that the loonie is ripe for a correction, the reality is that many factors are currently highly favourable to Canada’s dollar, the study noted.

“Over the last few years, the correlation between oil prices and the Canadian exchange rate suggests sustainable parity against the greenback when crude is over U.S.$85/barrel.”

The recently announced national account figures showed “a highly positive contribution from international merchandise trade”, thus allaying fears raised over strong currency.

“Another reassuring factor is that the potential for short-term gains by the Canadian dollar seems smaller, as oil and gold prices should retreat as tensions in the Arab world dissipate,” the Desjardins study read.

Additionally, the tragic turn of events in Japan put downward pressures on prices and the Canadian dollar risks a further fall if investors decide to take flight to traditional safe-havens, such as the U.S. dollar or precious metals.

Canadian stocks and bonds
The report forecast bond yields will rise gradually and that “the low for bond yields is well behind us.” While assuring that more increases over the coming quarters can be expected, it also cautions that many risks—a potential oil shock and budget crises in Europe and the U.S.—will curb the ascent of yields.

However, Canadian bonds are expected to continue to benefit from the country’s relatively sound public finances. A superior performance could be forthcoming once the U.S. Federal Reserve begins to raise its key rates as well.

The forecast for the stock markets, however, doesn’t inspire the same level of confidence. It warns of continued volatility while pointing out that the optimism over the U.S. economy has been eroded by ongoing geopolitical turmoil.

“An upswing is likely in the medium term, insofar as some tensions begin to ease but investors should expect a period of instability over the near term.”

Commodities as a prop
Recovering from the last market trough, the S&P/TSX index outperformed the S&P 500, largely due to the Canadian index’s 50% allocation to commodity stocks, compared to 17% for the American index.

“Soaring commodity prices are a critical driver behind the S&P/TSX’s growth and if current tensions take oil prices to slightly higher levels, the index could keep benefiting in the near term,” said the study. But it warned “too rapid a spike would have the opposite effect, as fears about global economic growth would prompt investors to abandon stocks in favour of safer assets.”

Inherent risks

While the global economy has been showing encouraging signs since the end of 2010, risks have also multiplied. The full impact of Japan’s earthquake on its economy remains unknown. The spread of Arab revolution remains a key concern as the spike in oil prices threaten to derail the recovery. Then, although momentarily eclipsed, there are risks stemming from the still unresolved European debt crisis and runaway inflation in China, issues that remain a major source of uncertainty.