January 8, 1998
Nicholas Bratt, Managing Director, Head of Global Equities, Scudder Kemper Investments, Inc.
Terry Shaunessy, President and Managing Partner, Gordon Capital Corporation
Jeff Rubin, Chief Economist, CIBC Wood Gundy
THE CANADIAN EQUITY MARKET FOR 1998
Chairman: Gareth S. Seltzer, President, The Empire Club of Canada
Head Table Guests
John MacNaughton, President, Nesbitt Thomson; Rev. Bill Middleton, Armour Heights Presbyterian Church; Roger Dent, Director, Yorkton Securities; Joseph Oliver, President and CEO, Investment Dealers Association; Susan Crocker, Senior Vice-President, Equity and Derivative Markets, The Toronto Stock Exchange; Bob Barootes, Director of Sales, Gordon Capital Corporation; The Hon. Tom Hockin, President and CEO, The Investment Funds Institute of Canada; Lawrence Bloomberg, Chairman, First Marathon Securities; and Blake Goldring, President and COO, AGF Management Limited.
Introduction by Gareth Seltzer
Each year at this time we look for thought about how the year will unfold and in many ways many of us also take an increasingly personal interest. We need therefore to be very well advised. We have three speakers. I'll introduce them to you in the order in which they will speak.
Nicholas Bratt is Director of the Global Equity Group for Scudder Kemper Investments. Now Scudder Kemper Investments is one of the world's leading investment organisations managing over $200 billion around the globe for all types of accounts. In 1997 Scudder Stephens and Clark joined the Zurich Group and Zurich Investment Group was combined with Scudder to form a new entity. Mr. Bratt is perhaps one of the world's leading international analysts and investment authorities. He serves as a member of the portfolio team for accounts across the globe and is President of the Brazil Fund, the Scudder Spain and Portugal Fund, the Korea Fund, the International Bond Fund for the firm, the New York Fund, and others. He resides in New York City. We are pleased that he has joined us today. Thank you Mr. Bratt.
Next to speak will be Mr. Terry Shaunessy, the President and Managing Partner of Gordon Capital Corporation as well as Director of Research. Mr. Shaunessy was a Director of Research and Sales at Merrill Lynch Canada Inc. After serving as Managing Partner and Equity Portfolio Manager for Griffin Investment Counsel from 1991 to 1997, in July he joined Gordon Capital as President and we welcome him here today as well. Thank you Mr. Shaunessy.
Closing the meeting will be the very well known Mr. Jeffrey Rubin, Chief Economist and Managing Director of CIBC Wood Gundy Securities. Ranked as the number-one economist in Canada by institutional fixed income investors and institutional equity investors for a number of years, Mr. Rubin regularly advises many of the largest fund managers in North America, Europe and the Far East. Now economists rarely get to achieve very well known stature but Mr. Rubin you are recognised and you are recognised as an exceptional forecaster as well as articulate panelist and we are pleased that you have agreed to join us today.
Ladies and gentlemen, please welcome your three speakers and I'd like to start off with Mr. Bratt.
Mr. President, Rev. Sir, members, honoured guests, thank you very much for coming to listen to my remarks today and for inviting me to this occasion.
I have been asked to talk about the outlook for global markets and I've been asked to speak for less than an hour, indeed to try to cover them in about 12 minutes. A tough challenge and I'm not going to cover all global markets but what I am going to try to do is to cover some of the major markets to give you a sense of those kinds of things that you should be looking out for in terms of assessing their prospects.
Nineteen ninety-seven was a particularly challenging year. None of us expected the strength that we saw in North American markets and in European markets nor the catastrophe that took place in Asia, particularly in the smaller markets there, nor the extraordinary strength of the U.S. dollar.
I am not going to make simple forecasts for each of the global markets over the next 12 months. I thought it would be more useful and more interesting to share with you the specific indicators and developments which will determine the performance of the stock markets.
In August of last year, the SET had doubled in 29 months. That is the fourth time in this century that this has happened. Previous occasions were 1929, 1956 and 1987. You all know what happened shortly after those dates. Consensus view I would say about the U.S. stock market is that it is going to continue rising modestly--maybe up to 10,500 or 11,000 on the Dow Jones. Our view is not as optimistic. Equities are likely to do less well than in any of the last three years and, although I am an equity person to the core, I would be willing to concede that bonds probably do provide an attractive alternative to equities at the moment. The primary reason for this is the support interest rates will get in a downward direction as the result of conditions in the world at large at the moment.
So what are the key indicators to watch, particularly if you look at the U.S. stock markets?
One is the level of confidence. At the moment it is very high whereas if you look at the level of confidence in Asia it is almost totally non-existent. Isn't that an interesting paradox?
The second thing to look at clearly is the evolution of the Asian crisis and let me be very clear that the specific problems in Japan, in Korea, in the South-Eastern Asia countries and China, although they are linked, are actually different.
Another is the outlook for corporate profits. We would suggest that corporate profits are going to be disappointing in consensus expectations.
Another is the behaviour of mutual fund investors, particularly in the United States. There is a great danger that there are millions of investors that now regard the stock market as a low-risk, high-return savings medium. We all know that stock markets are not low-risk. There is a debate about whether inflation or deflation is the major trend. As recently as six months ago people were concerned about inflation. Isn't it interesting how quickly people have now become concerned about deflation?
Another is the trend in interest rates. We think it is increasingly likely that we will see not only a flatter curve but we may well see an inverted curve.
And finally the U.S. dollar which has been so strong recently. We think there's a likelihood that towards the end of this year it may start weakening.
So much for North America. What about European markets very quickly? Our views there are quite constructive for four major reasons.
Firstly, in Europe there is a trend towards lower interest rates and this will support the bond market and the equity markets there. These markets are currently benefiting from a liquidity glut. There is undoubted momentum towards introduction of the euro, a common European currency, and as a result of this momentum we are seeing continued harmonisation of interest rates. This has the effect of lowering interest rates particularly in the peripheral countries such as Italy and Spain.
Secondly, we expect to see continued corporate restructuring in Europe moving across different sectors. We have already seen major consolidation in the pharmaceutical and chemical sectors. We think we are going to see substantial structural changes in the financial sector. Recently, for instance, we saw a major German insurance company buy a French insurance company and a Dutch financial services company buy a Belgian bank. There are hundreds of further major transactions of this kind which will take place over the next five years.
Thirdly, there will be finally a cyclical recovery of economic growth in Europe. Indeed, and this will surprise you, it is conceivable that over the next 12 months Europe may be the fastest growing region in the world. This will have a beneficial effect on corporate profits and the level of unemployment which is at very high levels and a major objective for governments in Europe is to lower unemployment. This should lead to increased incomes, higher spending and consumer demands and a pick-up in capital spending.
And finally we also know that the pace of mergers and acquisition activity is accelerating.
And yes, I'm not going to chicken out. I am going to make a few comments about the Asian markets which have been so dreadful since the summer. I don't have time to go into all the reasons why we have had this debacle but what I will tell you is that from the point of view of investors it is now in the hands of the governments and the policy makers. It is impossible for me here to tell you what I think is going to happen in the various Asian markets because we don't know at this stage what the various governments are going to do and how they are going to respond to the crisis. It is extraordinarily depressing to read in the newspaper for instance that the Indonesian government, having gone to the IMF and asked for help, a week later introduced a budget which flaunts the guidelines the IMF has tried to introduce there. The governments in the region continue to behave in such an irresponsible fashion you will see the crisis there continue for years to come. Alternatively, you have the example of Korea, where fortunately for the Koreans by coincidence they had an election and for the first time in their history the Opposition Party won. So they have a clean slate and they can start from ground zero and maybe put in place the right kinds of policies. From the point of view of investors, this indeed provides us with some very exciting challenges because I'm convinced that there will be very significant differences in the performance in the markets of Asia depending on the particular policy steps adopted by their governments.
Let me conclude by sharing with you the types of policy steps that we would like to see because those will be the triggers that point us in the direction of which markets to emphasise and which markets to avoid.
Proper monetary and fiscal frameworks must be put in place. Secondly, provisions must be enacted for effective banking sector supervision. Thirdly, deregulation and liberalisation measures must be put in place. Fourth, more corporate and statistical transparency is needed and finally, painfully, bankruptcies must be allowed as well as acquisitions even by foreigners. If these measures are implemented in a serious way it will be a sign that a real change is taking place. Asia will experience a painful transition period following which it should experience a new period of vibrant and sustained growth.
Thank you very much for your attention.
It is a pleasure to be with you this afternoon to share some thoughts on the Canadian equity market for 1998. In preparing my remarks, I reviewed the research from the analysts at Gordon Capital, I read the year-end summaries of the market for 1997 in various journals and newspapers and I surveyed the consensus forecasts of GDP, inflation and interest rates from some of the most respected economists and market seers in the industry. This work has led me to the inescapable conclusion that in the next 12 months, the market will do exactly what the market wants to do and if anyone gets it right it will be purely coincidental. With that as a disclaimer allow me to share some thoughts with you.
In my opinion, the biggest single influence on the equity markets has been, and will continue to be, the downward trend in interest rates. Despite many years of good economic growth and job creation, inflation has remained low and that has allowed interest rates to decline. In view of the deflationary forces at work around the world I see no reason for this situation to change. In the near term, short rates may be unusually volatile due to the foreign exchange markets but I see this as only a temporary phenomenon. Consequently, long-term interest rates in Canada should remain in a range of 5.5 per cent to 6 per cent which in turn implies that the equity market will not be adversely affected on this front. That unfortunately is the good news.
The downside of a benign interest-rate environment is that companies are unlikely to raise prices so that earnings growth in the next year will be modest and probably below expectations. The current 1998 IBES forecast of earnings for the TSE 300 is $380--up 14 per cent from 1997's expected levels. Given the uncertain outlook for commodity prices I think that the chances are slim that we will get anywhere close to this number; in fact I believe that TSE earnings will be about $350--up about 5 per cent on a year-to-year basis.
Therefore, I predict that the TSE 300 will be bound by a range of 7200 on the upside and 6000 on the downside. Moreover, I expect that my upside target will be achieved in the second half of 1998 when Asia is on the mend. Consequently, the TSE should produce a total return of 8 to 9 per cent which would imply that stocks will continue to be the leading asset class. Moving from the general to the specific let me touch upon the four major sectors of the Canadian market.
First--the interest-sensitive sector. If I am correct in my assessment of the direction of interest rates then the interest-sensitive group should hold onto the gains that have been achieved over the past two years and may even add modestly to those gains. In 1997, the financial stocks returned 52 per cent following a 55-per-cent gain in 1996. For 1998, financials are more likely to be market performers. Bank earnings will continue to rise but the pace will slow. Also due to their active involvement in the capital markets there could be some earnings surprises. By my calculations capital markets activities contribute roughly 20 to 25 per cent of the banks' bottom line. I am sure that there will be fewer trading opportunities in 1998 than in 1997 and that could negatively affect results. To date we have seen two big U.S. banks--Chase Manhattan and JP Morgan--blow their quarterly earnings with trading losses and the same thing could happen with our banks. Fortunately healthy dividend yields will limit the damage that exuberant young traders may inflict upon the banks so that this area is unlikely to be a source of major concern.
Similarly, the consumer sector of the market seems healthy. If Canada grows by 3 per cent in 1998 employment growth will continue and consumer confidence should remain high, which is good news for retailing and merchandising stocks. The big weights in this sector, Imasco and Seagram along with names such as Canadian Tire, Hudson's Bay and Loblaws are expected to be market leaders. In addition, top flight communications companies such as Shaw Communications will produce above-average market gains.
The industrial group is a little more problematic to forecast than the interest-sensitive and consumer groups. In the war of convergence, technology hardware companies such as Newbridge and Nortel will remain beneficiaries but with heart stopping swings. Transportation companies such as Air Canada and CN Rail should benefit from our domestic economic outlook. However, industrial companies that compete globally may find the going to be very tough given the competitive devaluations in Asia. It is in the export-oriented stocks that we see the most potential for portfolio damage in 1998.
Finally there is the poor beleaguered natural resource sector. The year 1997 will no doubt go down as one of the most painful times for shareholders of commodity-sensitive stocks. Starting with the Bre-X fiasco in the spring and ending with the rout in base metals and oil prices in the fourth quarter, the decline in these stocks has been nothing short of breathtaking. In fact who would have thought that by year-end 1997 the market capitalisation of the Royal Bank would be greater than the entire Integrated Mines Index. In other words, on December 31 1997, a single share of Royal Bank would purchase a share of Alcan, Cominco, Falconbridge, Inco, Noranda and Sherritt plus 75 cents in change. Clearly, anyone who considered the Canadian market as resource-oriented was sadly mistaken. But where do we go from here?
My guess is that commodity prices will remain soft until Asia gets its act together. Consequently, resource stocks with merit will be those that are low-cost producers. Among those beneficiaries would be Alcan in the base metals, Cameco in uranium, potash in the fertiliser industry and Barrick and Greenstone in the gold sector. Moreover, I expect that the resource sector will be a prime area for mergers, acquisitions and consolidations. I think that it will be corporations rather than institutions that start the ball rolling and bid up these asset-rich companies. Obviously if the TSE 300 is to get anywhere near the 7200 level that I described as the upper band of the range then the resource stocks have to be the fuel for the market! In short, the greatest potential returns with the greatest potential risk.
So there you have it. Those are my predictions for 1998. While the market certainly does not seem as sexy as it was two years ago, it still has the potential to return 8 or 9 per cent over the next 12 months which in a world of 2-per-cent inflation is a most acceptable real rate of return.
Amidst all of the uncertainty and volatility of the last two months one thing is crystal clear. The equity market and the bond market cannot both be right. A mere 8,000 Dow is still calling for a robust U.S. economy in which profits can maintain the double-digit pace of the last five years. But 30-year U.S. Treasury yields which have come within a whisker of all-time lows are already discounting that the U.S. economy will succumb to the Asian flu.
For my money the equity market has the economy basically right. The equity market has good reason to be jubilant, with the Dow having made up almost all of the ground ceded in left-over scare. And since the Asian contagion was first cited in Thailand fears and belt-tightening have faded into obscurity. By any reckoning those fears would have been considerable given that the U.S. economy pumped out 700,000 jobs over October and November, the unemployment rate sank to an uncyclical low and average hourly earnings have been growing at the fastest pace in seven years. Take Asia out of the picture and there is little doubt that the Fed would have raised rates 25 if not 50 basis points at the December FONC. What the bond market seems to be forgetting is that its judgments of the future are conspiring to undermine its own forecasts. While trade impacts can shave a quarter, a half a point, on '98 U.S. growth, surely interest rates matter too. Plunging rates provide the economy with octane as it needs particularly an economy which is the most dependent on its domestic market of any in the G-7. The stock market is correctly betting that the stimulus of low interest rates will more than offset the drag on U.S exports. Whether or not stocks are the right place to invest your money depends to a large extent on how long it takes the bond market to figure out the economy because the economic stimulus of long-bond yields being near 40-year lows is perhaps the most compelling reason why the equity markets' view on the economy is right.
Left to its own devices the bond market could easily be lulled into another six months of complacency. The news from Asia will only get worse. At a minimum, take the IMF forecast for the region and cut it in half. Projected slowdowns are about to turn into protracted recessions. And the spectre of recession is not just hanging over the newly industrialised tigers but over the big boys as well with Korea and Japan facing increasingly bleak economic prospects.
But the Treasury better keep an eye on what's going on in its own back yard. And before climbing on the deflationary bandwagon the bond markets shouldn't lose sight of the fact that two-thirds of the U.S. economy is made up of services which not only have no linkage to falling commodity prices but have little connection to foreign competition.
Americans may be able to easily substitute cheaper-priced imports for American-made goods but Americans don't go to see their doctors in Tokyo, they don't pay rent in Seoul, and they don't go to baseball games in Bangkok. While the competitive threat of Asian imports is going to rob manufacturers of the pricing power that they might otherwise have, price specialists in the service sector will continue to grow. Already at 3 per cent, inflation in the service sector was running a good two percentage points ahead of that in the goods' sector with no sign of abating.
That's largely because services is the most labour-intensive sector in the U.S. economy. While the cost of other factors of production--capital, energy, resources--are being bid down by sinking Asian economy, the price of American labour is on the rise and it will continue to be on the rise with sustained growth in the U.S. economy. Even if wage and services inflation don't show up in a consumer-price index the bond market will be disappointed with the U.S. economy. Another year of close to three if not 3-per-cent growth will clear a market of any deflationary delusion, probably resulting in a 50-to-75 basis-point backup in long-term interest rates.
While troubling Asian economies have dampened U.S. interest rates they've had the exact opposite effect on Canadian rates--a curious result given that the Canadian economy by virtue of its much greater dependence on trade, its much greater exposure to the resource sector, is far more at risk from the Asian flu than the U.S. One might have thought that monetary policy in Canada would have tried to give the economy support at a time when its export sector faced such serious challenge. Under speculative pressure, well before the Asian disaster began, sinking commodity prices have added a new dimension. Foreign exchange crises are rarely bullish for economic growth and this one is unlikely to prove an exception. The Bank of Canada's game plan for a gradual tightening of monetary policy has been scuttled by a currency that is being battled on all fronts. Not content with the gradual change that the Bank of Canada originally had in mind, the foreign exchange market is demanding nothing short of interest-rate parity with the Federal Reserve Board. Those expectations have left the Canadian dollar clinging to all-time lows in the face of an increasingly aggressive Bank of Canada rate at best. Every passing month has seen the market raise the ante with the Bank consistently missing the ball. Twenty-five basis-point hikes have given way to 50 basis-point moves and still the market clamours for more. Another half-point increase in interest rates is already effectively priced into the foreign exchange market. As the Bank sticks with its policy of supporting the Canadian dollar there will likely be more moves beyond that. By spring it will have raised interest rates at least 200 basis points.
What are the consequences of such action on growth? In my view much worse than the Bank of Canada has yet to acknowledge. Its official growth target of 4 per cent appears increasingly improbable against the backdrop of rapid-fire interest rate hikes. While the Bank has defended its rate hikes by pointing to the stimulus of a falling Canadian dollar, such stimulus is fictitious in a context of depressed commodity markets and shrinking export market. How stimulative can a 69 or 70-cent dollar be when gold prices are at 18-year lows, nickel prices at four-year lows and oil and lumber prices are off 30 per cent. These prices can only point to further production cutbacks and layoffs in the export sector under any exchange rate machine.
It's the inherently contractionery impact of falling commodity prices that has convinced the Reserve Bank of Australia to hold the line on interest rates even though its currency has suffered a much steeper depreciation from 74 cents to 64 cents. In fact it's the very linkage between currency and commodity prices that has convinced that land to reject the notion of a monetary conditions index as an accurate barometer of monetary policy. Slavish obedience to a monetary conditions index has resulted so far in over a 250 basis-point rise in interest rates in New Zealand over the last four to five months.
When commodity prices collapse, the appropriate monetary response in resource-based economies like Canada, Australia and New Zealand, should be in support of the economy, not to exacerbate the impact of the currency with a big domestic interest rate hike. In my view there is little rationale for the Bank of Canada rate defence of the currency. Neither of the Bank's traditional arguments against currency depreciation seem to have much validity in today's economy. Despite what is already a 4-per-cent depreciation of the currency in the last six months, consumer-price inflation is below the 1-per-cent level, hardly a threat to price stability. And the notion that the falling currency would result in an overheated export sector seems patently absurd against a backdrop of plunging commodity prices.
The Bank of Canada has yet to identify precisely exactly what calamity awaits the Canadian economy if it should allow the dollar to fall to 67 or 68 cents. What is clear is that a 200 basis-point hike in interest rates is going to sap momentum of domestic demand at a time when the export sector is no longer the engine of economic growth. Instead of the Bank's 4-per-cent growth target fourth-quarter over fourth-quarter growth is likely to be little over 2 per cent. Perhaps 2.8 per cent on a year-over-year basis. Well there will be no shortage of countries in Asia that would kill for such growth this year. That suggests that the Canadian economy will be treading water. Those growth prospects offer little hope of the economy making any meaningful progress at reducing its unemployment rate. Consumer spending is particularly vulnerable since all of the growth last year was financed by a draw down in the personal savings rate which at 1.5 per cent stands at an historic low. With interest rates rising quickly a further decline in the savings rate can no longer be counted on to finance the rapid growth and spending that we have seen over the last year. Instead consumers will be constrained to gains in their after-tax income. Barring a last-minute change of heart from Mr. Martin in this upcoming budget those gains in after-tax income aren't likely to be big enough to finance more than half of last year's spending growth.
Turning to the domestic debt market, a rapidly flattening yield curve and a return to large current account deficits will put pressure on Canadian bond yields as Canada once again finds itself in need of considerable external financing. With short-term interest rates rising rapidly, the yield curve is losing the anchor that had held long Canada yields through Treasuries. At the same time weak global commodity prices are likely to keep the current account deficit near $20 billion. One way or another that deficit is going to have to be financed externally and it's most likely to be done in the fixed-income market. Canadian bonds will have to offer an attractive yield premium to Treasuries if they are to underwrite the current account deficit. The market may not have to wait that long to see those trends. The next 50-basis-point hike by the Bank of Canada is likely to push Canadian yields above Treasuries beyond the five-year part of the curve.
In closing, the Bank of Canada faces an important choice. It can follow the footsteps of the Feds and choose to support economic growth or it can stick to its guns and defend the currency at all costs. If it continues on its present course, we can safely count on another 75 basis-point hike in short-term interest rates with all the forecast risks shaded to even larger increases. If so the Bank will not be waging a war on inflation but on economic growth. It is not too late for the Bank of Canada to shift gears but old habits are hard to break. Which leads us ladies and gentlemen to ponder but a single question: Can a bank change? Thank you very much.
The appreciation of the meeting was expressed by Blake Goldring, President and COO, AGF Management Limited.