FIRST QUARTILE ECONOMICS |
Exports rose by over 5 percent, fueled by a comparably strong U.S. economy but in response to the firmness in the domestic economy, imports posted a double digit advance. As a result, even though the Canadian economy has achieved great strides on the competitiveness front during this decade, the trade surplus virtually collapsed from levels approaching $40 billion in 1996 to the $10 billion zone by late 1997. Combined with the $30 billion or so Canada sends abroad in interest and dividend payments to those holding Canadian securities and stakes in Canadian corporations, the so called Current Account balance swung from a brief period of balance in 1996 to near record levels by Q3 1997. The late year difficulties of the Canadian dollar that have carried over to 1998 are closely linked to this renewed external imbalance.
1997 was the year the Canadian Federal deficit converged towards zero for the first time since the early 1970s. Although the federal government has given no figures, everything points to a very successful year on the fiscal front which has in turn alleviated the financing pressures in domestic credit markets. With Canadian inflation in virtual dormancy below 2 percent the Bank of Canada was still in an interest rate reduction mode as of early 1997. By the spring of 1997, the entire Canadian interest rate structure was below that of the United States while the Canadian dollar remained in a state of unusual calm. Domestic bond investors reaped the benefit of rising bond prices while equity market gains continued strong until the fall.
The influence of the U.S. equity markets was paramount in leading the way towards ever higher equity values last year but trouble began to brew in the Asian economies and financial markets by early summer. One by one, a number of previously high flying Asian economies, fueled by internationally provided credit began to experience currency devaluations, then higher interest rates and rapidly reduced economic growth outlooks. Falling equity markets have persisted to the present as the true economic picture in Asia remains unclear.
Mathematically, Asia is a minor influence on economic prosperity in North America, in the sense we export very small proportions of our total output there. Hence, reduced Asian demand, even a region wide recession would not be enough to derail an otherwise well based global economy, namely, North America and Europe. However, while this appears to be the preliminary thinking on the matter, Asia’s difficulties have spread more than initially expected. For example, the curtailment of construction activity ahead has already contributed to sharp declines in metals prices which in turn contributed to sharp declines in related stocks in Canada. Secondly, combined with a relatively mild North American winter the reduced Asian demand for energy products has pushed oil prices down over thirty percent from early 1997 levels.
As 1998 begins, the impact of moderating input prices will prove most favorable on domestic inflation pressures this year. As well, there is a sense that Asian exports will decline considerably in price in the months ahead and this too will keep a lid on any near term inflation pressures. One of the best barometers of the inflation outlook is the price of gold which has traded below U.S. $280 per ounce during the first week of January (a decline of some 22 percent from early 1997).
The consequences of contained inflation have shown up in the U.S. bond market in the form of the lowest long term interest rates in thirty years. As a side effect, the flow of investment towards bonds has been at the expense of equities. For example, as of early 1998 the U.S. stock market is up a handsome 26 percent from the same time last year but the gain over the past six months has been only 4 percent. In Canada, the figures are less impressive with an 11 percent gain for 1997 and essentially zero overall gain during the past six months.
So what lies ahead in 1998? Canadian short term interest rates have risen by over 1 percent during the last six months as the Bank of Canada has worked to prevent a dramatic plunge in the Canadian dollar. Unfortunately, the primary source of the currency weakness, the large imbalance on the Current Account, will remain for quite some time and there is unlikely to be a quick rebound in the currency that would result in lower money market interest rates.
Fortunately, the fiscal situation should improve further in 1998 and this at least should insulate Canada from the type of currency and interest rate volatility experienced on numerous occasions during the past two decades. Similarly, with Canadian inflation around 1 percent, the case for significantly higher interest rates is simply not in place. Look for a greater moderation in GDP than generally predicted in 1998 and this should cool some of the strong import demand, the pressure on the dollar and short term interest rates. Canadian equity markets have been dominated by weakness in resource stocks in recent months while other sectors have held in reasonably well. On balance, the potential for corporate profit growth has eased in recent months amidst the prospects for slower economic growth (some domestically induced, some caused by a slower U.S. economy, and then some Asian influence). The danger, as I see it, is that potential equity investors overlook this phase of equity market consolidation and expect a quick resumption of the type of price gains seen during the past two or three years. Expectations about equity market gains are always greatest just before the opposite starts to happen! While there is a lot of advice out there to the effect that the market always goes up over time and that trying to time the market does not work, the secret to compounding wealth over time is to avoid the typically huge losses that occur during bear markets.
There is nothing wrong with staying out of the stock market over the next several months given the type of choppiness seen since October. If you must buy now, go for companies that are down 25 to 50 percent from their recent peaks while stocks that are still near their highs or are only down a few percent are likely to be available for lower prices by mid-year. If you don’t want to risk anything, try Treasury Bills and if equities suddenly look good again, there is a small penalty for cashing in early.
Friday , January 9 , 1998.
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