An economic forecast

When I think about economic forecasting, I think about the ability to know where economies, interest rates, markets, currencies, and oil prices are going to be in the next year or two. Who would not be interested in knowing the future?

I was especially excited to spend some time with one of the senior economists for TD Bank, Craig Alexander. I want to share with you some of Craig’s forecasts for the future.

World economic growth

World economic growth was spectacular in 2004 with growth rates in excess of 5%. In comparison, the average growth rate since 1970, which was only 3.7%. Craig expects 2005 and 2006 growth to slow to just under 4% which is still respectable world growth.

On a regional basis, Asia ex-Japan is expected to grow at 7% in 2005. One of the biggest contributors is China with growth rates running around 9%. At the other end of the spectrum, Europe and Japan have growth rates projected to be less than 2%.

Alexander feels you must be careful about translating economic growth to stock market performance. For example, even though Europe is projected to have slow economic growth, European stocks have some of the best P/E ratios in the world. Coincidentally, they also have high dividend rates and good performance opportunities. On the other hand, even though, the Chinese economy is the fastest-growing in the world, the stock market is still inefficient and volatile. Craig refers to the Chinese stock market as a cowboy market because it has poor accounting standards, poor regulatory controls and a higher potential for corruption.

Oil prices

Oil prices have spiked up to the mid $60 mark and getting closer to the highs of the late 1970s.

Craig feels that while prices may go higher on sentiment and short-term speculation, Oil prices are fair at the $55 per barrel mark. In his mind, if prices move higher and hit what some think will be the $100 per barrel mark, it is not sustainable over the long term.

Oil prices can definitely continue to rise in the short term, but prices will adjust downward as the world economy starts to slow especially in the US. Investors should consider taking profits and rebalancing portfolios, which is the most prudent behavior.

Interest rates

Craig feels interest rates will continue to rise in the US and in Canada. The biggest concern in the US is the housing bubble. The US must raise interest rates to try to engineer a soft landing in the housing market.

The US housing market is very speculative. For example, in California, 45% of all home purchases are purchased to be flipped for a profit. 65% of all purchases are being financed with interest-only mortgages. Rising interest rates will temper this euphoria.

Interest rates will also rise in Canada but we will remain at historically low levels. The Bank rate might move from 2.75% to 3.5%. At 3.5% we are still at low levels. It is expected that even though the bank rate rises, longer-term rates will remain level, which is likely to produce a flat yield curve.

Overall, Short-term interest rates expected to rise while bond yields should grind higher but still peak at historically low levels

US economy

There is a lot of concern over the US economy. The US is living far beyond its means. Every single day, they need $2 billion dollars of foreign injection just to subsidize US consumption.

Both the consumer and the government are in negative savings positions with very little opportunity to get back into positive savings rates. Only corporate America is in a strong savings position.

The housing market attributed to 50% of the US economy. Essentially as prices rise, consumers re-finance homes. Instead of paying down debt, they take out equity. They keep their mortgage payments the same because of lower interest rates. This refinancing has supported about half of the economic growth. The problem is this will end as interest rates start to rise and the housing prices correct.

Canadian dollar

The Canadian dollar has appreciated about 30% against the US dollar. While some experts argue for a Canadian dollar at par with the US, Craig feels that is not sustainable over a longer period of time. Proper parity is probably in the 80 to 85 cent range. Canada would face some severe economic ramifications if the Canadian dollar rose above 95 cent level.

Craig thinks the U.S. dollar likely to remain firm in the near term but may weaken in 2006. The Canadian dollar is likely to tread water, rising on U.S. dollar weakness, but giving up gains when commodity prices pull back.

Craig’s two cents

From an investment perspective, Craig feels diversified portfolios will deliver a 5.5 to 7.5% average annual return over a 10-year horizon. While it is his job to do short term forecasting, he stresses that “investors should stay focused on the long term. Short-term noise in the economy can be very distracting especially when the media exaggerates the short-term impacts.”

The key to success is to maintain diversified portfolios and make sure portfolio rebalancing occurs as specific sectors create most of the gains.

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