FIRST QUARTILE ECONOMICS |
As well , the difficulties in Asia remain a well documented potential source of price moderation in the year ahead in their own right while any emerging slowdown in U.S. economic growth will represent a further brake on price pressures. Therefore, with the latest U.S. CPI reading at 1.8 % yr/yr as of November there is room for significantly deeper lows in 1998. I had been calling for a potential reading of 1.5 % yr/yr, for the U.S. CPI, in the first half of 1998 but would not be surprised to see at least a brief spike closer to 1.0 %. Against this background, long term interest rates appear too high versus the current rate of inflation and the prospects for subdued inflation over the next several quarters.
The key early data on the U.S. economy for December has been the NAPM, or Purchasing Managers’ Index, reported on January 2. The index fell to 52.5 from 54.4 and points to a clear break in economic momentum in the past 3 months. Since Asian developments have not had time to have an impact on the U.S. economy yet, the combination of a natural slowdown in the economy and the eventual drag from Asia, could result in a broader economic deceleration than recently expected by the local economics community. This to me is the risk ahead and the consequences to financial markets will be mixed: fixed income instruments should generally gain in price but equities should continue to respond adversely to earnings disappointments.
For Canada, a clearer picture of the true direction of the Canadian dollar should soon emerge. December is often a flaky month for the currency and domestic interest rates and as 1998 begins there appears to be some sense that the intensity of the downward pressure on the currency has ebbed. This has allowed for a 50 basis point decline in 3 month Treasury Bill yields during the past week or so and corresponding declines in mid term bond yields.
I think it is too early to conclude the currency is out of the woods as its basic nemesis of a substantial current account deficit is still in place. In any case there is no reason to expect a significant recovery unless the Bank of Canada implements several more rounds of interest rate increases that would at a minimum eliminate the current negative spreads in the very short end of the yield curve. On a temporary basis, however, the Canadian dollar could strengthen to 1.40 USD or so from its present 1.4250 area before stalling out. During this period, if it works out this way, Canadian yields will tend to fall faster than their U.S. counterparts while Canadian equities (excluding resources) should tend to outperform U.S. markets as well.
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