Quarterly Market Outlook
As at June 2006
Since 2002, our bullish view has been rooted in a belief that the
economy was entering a period of sustained growth with low inflation.
That balance becomes more and more difficult to maintain as the business
cycle ages. Although it has been four years since the last recession
and we need to watch the balance between growth and inflation carefully,
our view remains unshaken.
Recent data confirms the remarkable balancing act of economic growth
in North America and suggests a moderation of several important risks.
Investment returns should continue to benefit from a durable business
cycle with low interest rates, attractive equity market valuations
and buoyant corporate profits.
Risks are moderating…
Double digit gains in housing prices and rising energy costs had been
a growing threat to the economy’s balance. We haven’t viewed
the level of risk as critical but the recent moderation in both represents
a positive development.
Similarly, sluggish conditions in Europe and years of stagnation in
Japan had cast a cloud over the potential for this economic cycle.
However, Germany, the largest economy in the European Union, is now
showing signs of vigour and Japan looks to have begun a sustainable
economic expansion.
…inflation is mild…
Inflation remains the greatest risk to the business cycle but, here
too, near-term threats have diminished and longer-term expectations
are well contained.
…and economic growth is well-balanced
The North American economy is settling into a comfortable blend of
3 – 3.5% growth with 2 – 2.5% inflation. In Europe, growth
is stuck below 2.5%, inflation remains calm and the risk of recession
appears remote. In Japan, we look for growth moving up to the 2% level
and the end of deflation in 2006.
Short-term interest rates approaching ‘neutral’ levels…
The cycle of short-term U.S. interest rate hikes that began in mid-2004
is nearing conclusion as the Federal Reserve has restored short-term
interest rates to appropriate levels, without putting the business
cycle at risk. We now expect Canadian rates to match movement in the
U.S. The European Central Bank has just begun its own cycle of short-term
rate hikes, but the pace of increase should respect the Continent’s
still sluggish growth conditions and controlled inflation. In Japan,
any increases appear unlikely prior to late-2006.
…and may bolster returns in 2006
The final hike in the Fed Funds rate may be a seminal event for capital
markets in 2006. History has shown a strong bias toward stronger equity
and bond markets as it becomes clear that short-term interest rates
have peaked.
Longer-term bonds still expensive…
Our valuation models continue to highlight risk in longer-term bonds
in every major market. That said, following a sharp correction in prices
there is value creeping in. We believe that it’s still too soon
to move back to a ‘benchmark’ weight in fixed income, but
the proper time for that may be approaching.
…while equities remain well anchored
Equity markets continue to show the potential for average to above
average returns. Aside from Canada, which has benefited from rising
commodity prices, booming trade and a sound economy, global indices
remain at, or below fair value. A strong economic expansion with moderate
inflation, attractive stock market valuations and rising corporate
profits are the essential elements for a long bull market in equities.
Again this quarter, our recommended asset mix continues to favour equities
over bonds.
This will mark the ninth consecutive quarter with an above-average
recommended equity exposure. While the bull market is aging, the economy’s
even balance between growth and inflation and the recent moderation
of threats to that balance supports a bullish view, as do equity market
valuations and the outlook for corporate profits.
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