Weekly Wrap-Up January 5-9, 1998

Closing Numbers

The North American bond markets benefitted from comments made by Federal Reserve Board Chairman Allan Greenspan, a strengthening currency market, and a continuing flight to quality this week. The Fed Chairman, in a speech in Chicago last Saturday, discussed the possibility of deflation in the US economy being a concern. While the overall focus of the Fed remains the diligent pursuit of price stability, primarily through the mitigation of inflationary pressures, the possibility of deflation is a real threat to economic stability as well. Deflationary pressure leads to a downward spiral of prices in an attempt to stimulate demand, ending in continued business slowdowns, increasing unemployment, and eventually, a recessionary economic period. That would be bad. The fact that Mr. Greenspan discussed the issue at all is an indication that the possibility of deflation is creeping into the minds of Fed policy makers.

Bonds also benefitted from the continuing financial turmoil in Asia. The Indonesia government brought down a budget that was far from austere, causing the financial markets to devalue the rupiah 25%, and decrease stock values in the country 40%. Investors moved into the bond market, extending duration on any pull back, as expectations are that North American bonds will remain a relatively safe haven for investment dollars, due to the perceived lack of volatility associated with fixed income securities. Buy bonds.

Economic data on both sides of the border showed a healthy economy with little sign of inflation and a continuing demand for labour. In Canada this week, industrial prices rose 0.6% in November, with raw materials declining 1.6%; international reserves fell $CDA 805 million to $CDA 17.97 billion as the Bank of Canada defended the currency; the help wanted index grew 2.3% in December and housing starts rose 0.2% in December. In the US, construction spending decreased 0.9% in November; factory orders rose 2.5% in December; new home sales rose 6.1% year-over-year in November; and PPI fell 0.2%, with the core rate dropping 0.1% in December. On a yearly basis PPI dropped by 1.2% overall, with the core rate rising a mere 0.1%, the smallest increase on record.

Economically, the largest numbers released this week were the unemployment figures for the two nations. The US headline rate of unemployment rose to 4.7% from 4.6%, however 370,000 new jobs were added, indicating that the US labour force is expanding, as more workers are entering the labour market. In Canada, the headline unemployment rate fell to 8.6% from 9.0%, as 61,700 new jobs were created. The employment gains by the Canadian economy were well received by the international markets, as the dollar strengthened on the prospects of another Bank of Canada move to increase interest rates to keep inflation in check. If you believe that the Canadian economy needs higher interest rates, and the Bank of Canada has been attempting to do anything but defend the currency, double check your introductory economics text books. Inflation is not a concern, and unemployment remains an issue.

The bond markets rallied throughout the week posting solid gains all along the curve, while a curve flattening bias remains. Supply came to both the US and Canadian markets causing spread based product such as Provincials, and corporate bonds to widen out versus the Government benchmark bonds. The Province of Ontario came with a $CDA 500 million long bond issue, again, at 33 basis points over the Canadian long bond. The institutional appetite for the bond was not theredue to the timing, and the bond was reportedly trading at 36 basis points back by the end of the week. The Canadian 30 year long bond shed 15 basis points this week to close at the lowest yield ever, at 5.73%. The US 30 year Treasury bond was 18 basis points to the good by the close Friday, yielding 5.74 basis points. The Canada/US long spread remains slightly in negative territory at -1 basis point, as a result of the Canadian currency doing a little better this week versus the US, as the US hit a five and a half year high against the Yen. (A basis point is 1/100th of a percent.)

The North American equity markets did not benefit from either the January effect or the flight to quality issues which the fixed income markets enjoyed. The stock markets in North America continued to suffer from the Asian flu this week, as investors, analysts, and traders re-assessed the risk to earnings of North American firms exporting goods to the Asian markets, and those facing domestic competition from increasingly cheaper foreign products imported into the North American economy. Firms like Newbridge Networks, and Inco who derive 14% and 30 % of there operating revenues from the Asian markets respectively, were not rewarded by investors this week. This was very true of the majority of financial, service manufacturing, and commodity based firms with significant exposure to the Asian markets.

Turmoil in Asian markets translated into lower equity markets worldwide. Indonesian stocks shed 40% of their value, while the Philippines and Malaysia declined 28%, Hong Kong dropped 17%, and other emerging economies saw the value of their equity markets decline significantly this week. This Asian sell-off translated into a decline in the North American markets. The TSE was the goat of the lot this week losing 6.54%, or 438.95 points to close the week at 6272.43. The DJIA dropped 4.83%, or 384.62 points, to close at 7580.42, unable to hold a sustainable break above the 8000 level. Both the Nasdaq and the S&P 500 lost nearly 5% on the week as well. Volatility continues to remain high in the equity markets as investors are beginning to realize that the troubles in Asia are not easily fixed, and a longer term solution will require some significant financial pain.

Next week will see if the markets can recover from the recent turmoil, or whether after licking their wounds on the week-end investors come back and sell it some more. With the weak commodity markets, it is unlikely the cyclical based resource firms are not going to perform well over the near-term. If the weather in the north-east of the continent cools down, the oil and gas industry may pick up, but with oil trading under $US 17 per barrel, and more capacity coming on-line from the Iraqi oil-for-food deal, it will have to get a lot colder. Look for more spread widening over the next couple of weeks in the bond markets, as a glut of supply is lining up to hit the markets, particularly in the corporate bond markets. Good trading.

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