FIRST QUARTILE ECONOMICS

Capital Markets Weekly

Friday, December 19, 1997

The big story in Canada during the last week is the further weakness in the Canadian dollar which closed the week at U.S. 1.4310 or 69.88 cents. Not only was this a break of the magic and so called psychologically important 70 cent level but it now suggests a test of the record low 69.13 cents (1.4465) set in 1986. Beyond that the next target of relevance would be 1.5000 or 66.66 cents(kind of a demonic target if you will). With the Bank of Canada having raised the Bank Rate by 50 basis points the previous week currency markets remain unimpressed by the monetary support in place and appear to be insisting for some more interest rate hikes. And who could fault the markets for this given Thursday's report of a mere $500 million trade surplus for October which if maintained could result in a Q4 Current Account Deficit near $30 billion versus $24 billion in Q3, i.e. these very classic reasons for currency weakness that will not dissipate quickly.

On the positive side for Canadian interest rates was the huge drop in the November Consumer Price Index to a year over year trend of 0.9 percent from 1.5 percent in October. The CPI excluding food and energy also stood at 0.9 percent in November so there is nothing particularly temporary about the new level of inflation. In particular, the domestic inflation climate remains excellent for long term interest rate levels but of course the currency scenario bodes poorly for short and mid term interest rates over the next several months. I can’t say I know how low the C$ wants to go near term before the central bank succeeds in establishing stability via higher interest rates and open market C$ purchases but I do not believe the Bank is shaking in its boots either. After all is said and done, this is a perfect opportunity to get interest rates higher and cool the economy off before all the slack (output gap is used up). It means the emerging potential spike in domestic money market rates should prove temporary and lead to renewed fixed income capital gain opportunities later in 1998.

Big picture-wise the U.S. bond market still looks very good especially the long end. While many remain wary about the source of recent gains in long bond prices (flight to quality from Asia in particular) it is unusual for flight to quality cash to significantly accumulate in long bonds. It is also prudent to be suspicious of any market move that materializes in December. Nevertheless, U.S. inflation looks very good at 1.8 percent year over year and the case for a global economic slowdown, courtesy of Asia, just seems to get stronger every day. The IMF has just made downward revisions to every country's GDP outlook for 1998 and given the nature of such initial revisions, bigger revisions are eventually likely.

For equity markets in Asia and particularly Japan it remains doubtful that the full risks of economic slowdown and lengthy economic rehabilitation are factored into equity prices. Accordingly, the worst is probably still ahead and in turn this will act as a restraint on European and North American equity prices. A lot of individual investors, via equity mutual funds, have not seen a bear market in equities and their staying power has yet to be tested.

From an asset mix perspective bonds should be favored over equities during the next several months.

Friday, December 19, 1997.

By Frank Hracs -First Quartile Economics

Weekly Archives

Capital Markets Weekly, December 12, 1997

Capital Markets Weekly, December 5, 1997

Capital Markets Weekly, November 28, 1997

Capital Markets Weekly, November 21, 1997

Capital Markets Weekly, November 14, 1997

Capital Markets Weekly, November 7, 1997

Capital Markets Weekly, October 31, 1997

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