FIRST QUARTILE ECONOMICS |
On December 12, the Q3 Current Account Deficit should be reported well in excess of $10 billion and this should verify the fundamental downward bias in the currency at this stage. Given the still substantial negative money market spreads to U.S. interest rates, there appears to be a substantial but intangible goodwill factor holding the currency back from potentially greater weakness. The last bout of softness in the currency occurred two years ago, in the midst of the Quebec referendum campaign, and Canada may be due for some currency and interest rate fireworks shortly. Given that December is traditionally one of the weakest months for the C$, it could be an interesting market finale for 1997.
In general, I do not think Canada needs much in the way of higher interest rates to cool off the economy. While the Bank of Canada is very high on the economic outlook here, I still think there are some flaws in the outlook since so much of consumer spending during the past year has derived from a near elimination of the personal savings rate against a backdrop of only marginal real disposable income growth. I tend to think Canadian consumers have been lulled into a sense of economic optimism that could easily unravel if interest rate increases became a more frequent part of the evening news.
Accordingly, I think the odds have suddenly increased for the Canadian economy to slow down in 1998 as a result of near term money market volatility, i.e. the psychological impact of interest rates should multiply the magnitude of any increase. From a capital markets perspective, I remain committed to the prospects for lower long term interest rates as the supply of bonds will dwindle in 1998 but perhaps more so because I believe U.S. long rates will decline significantly in 1998. Canadian long rates should follow and bond investors will continue to benefit from longer duration exposure.
For equities, the Canadian market is being swamped with commodity price weakness and this trend likely has further to go. Even the bank stocks are vulnerable now as higher money market rates erode profit margins and a softer economy is a negative. In general, I think bonds will continue to outperform equities for a few more months, at which stage it will be time to rebuild equity weightings.
Internationally, the Japanese financial system remains in the emergency ward, although there is a virtual certainty the patient will survive. Nevertheless, the next several months will not be a sensible time for the U.S. to raise administered interest rates, since this could not possibly contribute to global economic stability. Look for the U.S. dollar to surge across the board generally through mid 1998 and for this to keep a continued lid on U.S. inflation. I still think the U.S. CPI will post a year over year growth rate of about 1.5 percent by mid 1998, which is why long Treasury yields should break below the lows of late 1993 and early 1995.
The data calendar ahead for the U.S. features the November Purchasing Managers Index on Monday and the November employment report on Friday. Both were bad news for the market a month ago yet interest rates edged lower in subsequent weeks anyway. I expect the data to be bullish for bonds with only moderate economic strength and 30 year Treasury yields will be testing 6 percent by Friday.
Friday , November 28 , 1997.
FIRST QUARTILE ECONOMICS |
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