2005 Investment Outlook

Margaret M. Samuel, CFA, Director, The Empire Club of Canada; Stephen Pang, Grade 12 student, Earl Haig Secondary School; Richard W. Nesbitt, CEO, TSX Group; Bruce J. Robb, CFA, Managing Director, Head of Canadian Equity Sales, Merrill Lynch Canada Inc.; Christina A. Cavanagh, Executive Director, Toronto CFA Society; Morley W. Salmon, Chairman of the Board, Limited Market Dealers Association of Canada; Robert L. Brooks, Senior Executive Vice-President, Treasury and Operations, Scotiabank and Past President, The Empire Club of Canada; Joseph J. Oliver, President and CEO, Investment Dealers Association of Canada; Jim C. Kelly, Managing Director, Global Debt Markets, RBC Capital Markets; William F. White, President, IBK Capital Corp. and Director, The Empire Club of Canada; The Hon. Thomas A. Hockin, PC, PhD, President and CEO, Investment Funds Institute of Canada; Ted Larkin, Director of Research, Orion Securities; Barbara Stymiest, COO, RBC Financial Group; Bruce Shaw, Managing Director, Head of Sales, TD Newcrest; Susan Wolburgh Jenah, Vice-Chair, Ontario Securities Commission; and David Fleck, Executive Managing Director, BMO Nesbitt Burns Inc.

Introduction by William Whittaker

Most of us here at sometime in our lives have found ourselves agreeing with Ogden Nash in his "Hymn to the Thing that Makes the Wolf Go":

O money, money, money

I'm not necessarily one of those

who think thee holy,

but I often stop to wonder

how thou canst go out so fast,

when thou comest in so slowly.

Hopefully, the insights we will receive today from our three speakers will cause our net worth to increase not decrease!

I will introduce each speaker separately who will speak for 10 minutes or so on his particular topic.

Our first speaker is Nick Barisheff, the Founder and President of Bullion Management Services Inc, the Trustee and Manager of the Millennium BullionFund, Canada's first and only RRSP eligible open-end bullion fund.

Mr. Barisheff has been actively involved in the finance and investment business for over 25 years. During the 1970s, at the Investment Division of A.E. LePage, he was instrumental in the conception and implementation of a new dual licensing status--securities and real estate--for its members. As underwriting/listing manager, he pioneered the syndication of real estate and was responsible for residential and commercial investment projects nationwide. Subsequently, his consulting activities involved the development of an investment vehicle that allowed RRSP funds to be used for purchasing raw land and the sourcing of venture capital financing for a number of resort hotels, a chain of franchised medical clinics, and a software development company. Mr. Barisheff.

Nick Barisheff

The Outlook for Gold in 2005

It's January, the beginning of a new year, and the time when economists, analysts and even astrologers like to prognosticate about what lies in store for the next 12 months.

With respect to gold, opinions on the price vary from $400 to $500 per ounce for 2005. These opinions presume that current conditions will remain relatively stable, and if they do the $400-$500 range is reasonable. Since the range is quite broad, a review of some history and an examination of some current trends may be helpful in gaining additional insights.

First, it is important to realize that the 70-per-cent rise in the price of gold since 2001 is not because of any supply/demand imbalance, as an industrial commodity. Merely speculating on the price of gold ignores its other benefits and relegates it to a commodity with no more stature than copper or pork bellies. But gold has an important monetary role, as confirmed by the billion ounces still held by Central Banks, and by the clearing turnover of $6 billion daily by members of the London Bullion Market Association.

Although various paper proxies and gold derivatives can provide trading opportunities, they may not provide the wealth preservation and hedging benefits of bullion itself. In order to achieve these benefits, gold holdings must be in the form of fully allocated, segregated bullion with reliable custodial arrangements. Since mining shares and other gold proxies are either someone else's liability or promise of performance, they may not provide these benefits at a time when they are needed most.

Wealth preservation has been an attribute of gold bullion, and it is the reason gold has functioned as money for over 3,000 years. Although gold prices in local currencies may have fluctuated during both inflationary and deflationary periods, gold has maintained or even increased its purchasing power in both instances.

Gold's ability to preserve purchasing power was discussed in detail in an essay written in 1966 by none other than Allan Greenspan, entitled "Gold and Economic Freedom."

We have all heard that you could always buy a man's suit with an ounce of gold. I can remember that in 1971, the price of a basic car was about $2,500 or 71 ounces of gold. Since then, the dollar price of the car has increased 5-fold to $14,000, but for the same 71 ounces of gold, you can now buy two cars. This relationship holds true for real estate, oil, and the number of ounces to purchase the DOW, where the cost in gold ounces has either remained the same or decreased over the last 30 years.

The same cannot be said for paper currencies. Throughout history, currencies have come and gone as they were inflated away by emperors, kings and politicians. Since 1971, when the U.S. abandoned gold convertibility, the purchasing power of both the Canadian and the U.S. dollar has declined by over 80 per cent due to inflation.

Because of wealth preservation and hedging benefits, gold bullion cannot be viewed like other portfolio holdings.

The hedging benefits of bullion are achieved because gold is negatively correlated to traditional financial assets such as stocks and bonds. These hedging benefits become particularly pronounced during periods of economic stress. When you compare how poorly stocks, bonds, real estate and currency performed relative to gold during recent currency crises in Russia, South East Asia and Argentina, these benefits become apparent.

The old Wall Street saying, "Put 10 per cent of your money in gold and hope it doesn't work," is particularly applicable today.

Often when I mention this saying I am asked what it means. Why would you hope it doesn't work? Aren't you in the precious metals business?

Over the long term, a portfolio allocation of at least 10 per cent to physical bullion reduces overall volatility, improves returns and provides a form of portfolio insurance. With our investment portfolios, we would all like to maintain an optimistic outlook, hoping that the economy will continue growing and our investments continue appreciating. However, since financial markets are cyclical, it is only prudent to maintain some portfolio insurance, in the form of bullion, in case markets move against us. Even though we pay for house insurance year after year, we would still rather that our house does not actually burn down.

Unlike traditional insurance or other hedging strategies, bullion is an asset rather than an expense. It has a price floor approximately equal to the cost of mining it. Unlike stocks and financial derivatives, the value of bullion cannot decline to zero.

Because of the recent equity rally, many investors feel that the worst is over and there is no longer a need to diversify and hedge. However, an increasing gold price is like a financial barometer warning of an impending storm.

Is the storm over, or are we actually in the eye of a hurricane?

Leaving aside the impact of natural disasters, terrorist attacks and wars, are the economic conditions that have contributed to a rising gold price still relevant as we go forward into 2005 and beyond?

Are the financial vulnerabilities arising from a mortgage-induced real-estate bubble still present? Are the concerns expressed by both Warren Buffett and Alan Greenspan about the $200 trillion of derivatives exposure still present? By historical measures, are equity markets fairly valued? Will the looming peak in oil production and increasing global demand cause a continuous rise in the price of oil, thus impacting global economies and industrialized societies?

But the worst threat of all comes from the continuous increases in the money supply through the expansion of credit, at all levels. Simply put, there is an ever-increasing amount of paper money chasing a limited supply of physical bullion. Unless corrected, the inflationary growth of the money supply, federal budget deficit, trade deficit and current account deficit will cause the U.S. dollar to plunge in value while the gold price climbs. In looking forward to 2005 and beyond, we need to determine whether it is realistic to expect that this credit growth will be stopped or even reduced.

Today, the annual increases in the U.S. federal budget deficit are greater than the total federal government debt was in 1971. This is an alarming trend. Even during reported budget surpluses in 1998 and 1999, total government debt still grew year after year to the current level of $7 trillion. The U.S. is now paying over $300 billion in interest to holders of federal debt. If this rate of increase continues, eventually annual tax revenues will not be enough to even service interest costs.

Notwithstanding that the US Dollar Index has declined by over 35 per cent, the trade deficit grew to a staggering $600 billion in 2004, and now totals nearly $5 trillion cumulatively. The phenomenon of a growing trade deficit during a currency decline is without historical precedent. We don't have to look far to find the reason for this anomaly. Since the U.S. has outsourced a great deal of its manufacturing and is dependent on commodity and energy imports, the trade deficit has become an ongoing systemic problem. For the past 60 years the U.S. has enjoyed special privileges because of the dollar's reserve status and the willingness of foreigners to invest in U.S. dollar assets.

The US Current Account deficit now stands at over $650 billion, and represents about 6 per cent of GDP. But what has this got to do with the price of gold? This ratio is the highest since 1929. Most economists consider 5 per cent a critical level for current account deficit/GDP ratios. In the past, when third-world countries reached that level, a currency crisis followed.

Could the U.S. be the next Argentina?

This credit expansion has led to a total U.S. debt of $34 trillion--over 300 per cent of GDP--the highest level in history. In addition, we need to add $55 trillion in unfunded pension liabilities and Medicare obligations. In all, this mountain of debt requires that the U.S. borrows about $80 million per hour, and absorbs over 80 per cent of the world's savings.

Here is a startling fact: it now takes $7 of new debt for every $1 increase in GDP. How much confidence would you have in a corporation that needed to borrow $7 annually just to increase its gross revenues by a dollar? Clearly this cannot go on much longer.

No wonder Alan Greenspan recently warned that "foreigners' appetite to continue to invest in the U.S. may not be adequate to fully sustain the expected growth in the net indebtedness of the U.S."

Translated into English, his statement means that eventually foreign investors will stop lending the U.S. any more money.

No one knows for certain when that day will come. It may be next week, or several years from now. You may think that it cannot happen in the U.S., but history gives us numerous examples of excess debt leading to a currency collapse. Unless there is the political will to reduce or eliminate the current mountain of debt, the day of reckoning must eventually come. The longer it is postponed, the worse it will ultimately be. Since politicians are not known for their ability to control their spending and are not elected on platforms that propose unpleasant financial medicine, it is difficult to imagine that the steps necessary to fix the problem will be taken.

Canadians need to pay attention to these issues as well. While I have focused on increases in the U.S. money supply, you may be surprised to know that the Canadian money supply has risen at twice the rate of the U.S. Because of the fractional reserve banking system and global fiat currencies, the U.S. has exported credit bubbles to the countries that run a trade surplus with it. In Canada, we are particularly vulnerable to the state of the U.S. economy and its monetary policy. We depend on the U.S. to buy our exports, and U.S. dollars represent 50 per cent of our currency reserves. Canada is now the only G8 country without any gold bullion to back its currency.

Bearing this in mind, is it likely that the Canadian dollar will maintain its recent gains against the U.S. dollar?

Up to this point, we have simply assumed a continuation of current conditions. Maybe the U.S. and the global economy will "muddle through," and business will continue as usual. But is it really prudent to maintain a long-only bias in your portfolio and assume that the longest-running bull market in history will continue for another 20 years? After all, markets are cyclical, not linear. A 10-per-cent allocation to bullion for its hedging and wealth preservation benefits seems more than justified.

However, if one of the previously mentioned vulnerabilities experiences a trigger event, then bullion may provide impressive capital gains over and above hedging.

Since February 2002, the US Dollar Index has declined 35 per cent, wiping out $3 trillion for foreign investors. If the dollar continues to decline, the day will come when the world will no longer be willing to increase its U.S. dollar holdings. The US Federal Reserve will then be faced with a no-win situation: increase interest rates dramatically, or let the dollar fall.

If foreign investors get nervous and start selling some of their 10 trillion dollars' worth of U.S. dollar holdings, it may create a descending spiral of further dollar declines coupled with financial asset declines. If that happens, the line between hedging and capital appreciation will become blurred. In the 1970s, a loss of confidence resulted in the U.S. dollar declining 70 per cent in German marks and Swiss francs. Gold, however, experienced a 2,300-per-cent increase.

Historically, a reliable indicator for the trend direction of gold and equities is the DOW:gold ratio. When the ratio increases, it is a good time to be overweight equities and when it declines, it is better to be overweight gold. The ratio was 1:1 in 1935. In 1980, when gold was $850 and the DOW was 925, it again approached 1:1. The ratio peaked at 43:1 in 2001, but has steadily declined to its current level of 25:1. Richard Russell, publisher of the DOW Theory Letter since 1958, predicts that the DOW:gold ratio will once again be 1:1. The question is: "Will both gold and the DOW be at 1000, 2000, or 5000?"

As far-fetched as these possibilities may sound today, they may in fact come to pass. In 1989, investors would have found it hard to imagine the 80-per-cent decline in Japanese equities that ensued over the next 13 years. Equally difficult to foresee in the early '80s, when the NASDAQ was 400, was its rise to 5000. In 1971, when gold was $35 an ounce, no one imagined the 23-fold increase that gold would experience over the next nine years.

We now appear to be entering the second leg of the precious metals bull market, a time when institutions and hedge funds are beginning to invest in physical bullion. Because of the tremendous market-size disparity between financial assets and precious metals, bullion prices would rise dramatically if a minute percentage of global investors allocate 10 per cent to bullion.

While there is $50 trillion in global financial assets, there is less than $1.5 trillion in above-ground gold, less than $1 billion in above-ground silver and practically no above-ground platinum.

Eventually there may even be shortages. You can not simply print more bullion to meet demand. New mines take 5-10 years to bring into production.

In 2005 whether the price of gold will be $400 or $500 does not really matter. Would it have mattered whether you bought the NASDAQ at 400 or 500 in the mid-'80s? It is only important that you did not buy at 5,000.

No matter what the price turns out to be in 2005, it is still wise to put 10 per cent of your money into gold--and hope it does not work.

Introduction by William Whittaker

Our next speaker is Daniel Chornous, CFA, who is Chief Investment Officer of RBC Asset Management, Canada's largest mutual fund complex, with over C$45 billion in global equity and fixed income mandates, including the Royal Mutual Funds group of products. Mr. Chornous is responsible for the overall direction of investment policy and fund management at RBC. In addition, he chairs the RBC Investments Strategy Committee, the group responsible for global asset mix recommendations and global fixed income and equity portfolio construction for use in RBC Investments' key client groups including RBC Funds, Global Private Banking, RBC Dominion Securities and RBC Private Counsel. Mr. Chornous.

Daniel Chornous

2005: The Outlook Again Favours Stocks Over Bonds

After a strong finish to 2004, markets have stumbled through the first trading days of 2005. In Canada and the United States, yields have held within a 10-basis-point range, but stocks are already down a little more than 2 per cent. Have investors returned from the holiday break a little more circumspect, a little more concerned about what lies ahead for 2005?

There is, of course, plenty to worry about. War, terrorism, unstable oil prices, an on-again/off-again recovery in the job market, sluggish growth in Europe, the tenuous recovery in Japan and the risks that come with China's rise as a major economy all continue to represent significant risks to the outlook. More recently, the twin deficits in the U.S. and the currency volatility they contributed to have also muddied the water.

We recognize that the outlook seems a little murky going into 2005, but after 25 years in the investment business, I can say that every new year brings new concerns. Too much focus on challenges to the global economy has left many on the outside, looking in at what has been a rewarding period for investors since the fall of 2002. Excessive risk aversion is perhaps the legacy of the tech wreck, corporate scandals and recession that sapped investor confidence through the early years of this decade.

As it was at the beginning of 2003 and also at the start of 2004, our own view is constructive, at least with respect to the economy and stock prices. Not so, though, for fixed income markets where valuations are simply inconsistent with what we consider to be a balanced view of the outlook for growth and inflation as this business cycle matures.

Let me start with the broad contours of our current forecast.

Growth

The North American economy is settling into a sustainable, low inflation pace of growth. The economy is slowing, not buckling, and the moderation results from well planned and executed policy initiatives, not shocks. After averaging a 4.0-per-cent pace through 2004, we expect U.S. growth to move down to the 3-per-cent level for 2005.

In Europe, the economy's pulse remains weak, but late-2005 should show a slight quickening. For the full year, though, growth is unlikely to move above the 2004 average of 2 per cent.

Japan's growth has been volatile, centering on a 4.2-per-cent rate through the past four quarters but with spikes as high as 5.1 per cent and a weak finish to the year. This should not obscure the fact that the economy is finally showing the necessary pre-conditions for a sustained climb out of stagnation and deflation. For 2005, we look for a mild softening to the 2.5-per-cent level.

Inflation

Inflation risks appear less evenly balanced as the business cycle enters its fourth year of recovery/expansion. In North America, we expect little movement in core CPI above its 2.5-per-cent average for 2004, but upside risk cannot be ignored.

After averaging about 2.0 per cent through 2004, European inflation should slip to the 1.8-per-cent level as oil prices moderate and as growth remains sluggish.

In Japan, we expect the end of deflation in 2005 after a decline in consumer prices of about 0.2 per cent in 2004.

From here, inflationary pressures will receive even more of central bankers' attention as the last recession slips further into history and the pressures of a maturing business cycle are surfaced.

Currency Markets

Volatile currency markets have introduced an additional element of uncertainty through the past several quarters with the U.S. dollar now 14 per cent below its May 2004 peak, the euro up 12 per cent over the same period and the yen rising 10 per cent. With sentiment so negative toward the dollar as 2004 drew to a close, its recent rally is hardly a surprise, but the twin deficits in the U.S. continue to flag the dollar's vulnerability.

Over the year ahead, we look for further appreciation in the euro to the 1.38 level (currently at 1.33), a rise in the yen to 95 from its current rate of 104, a settling of sterling to 1.93 and a more muted climb in the Canadian dollar to 1.15 (inverse 0.87) from its current level of 1.23 (inverse 0.81).

The Canadian dollar deserves special attention. The speed of its climb-up 37 per cent from its 2001 low--took virtually everyone by surprise, and it has clearly had some impact on recent growth and the near-term outlook for the economy. But while the intensity of the advance is awesome, the fact that it has recovered should surprise no one. The Canadian dollar was deeply undervalued through most of the last decade and has simply been restored to its equilibrium level.

A little history is helpful here. Between the late 1980s and the late 1990s, the Canadian dollar fell despite progressive improvement in its fundamental underpinnings. First, the establishment of price stability with the Bank of Canada adopting firm targets for inflation was ignored, even though it resulted in Canada achieving the optimal inflation record of the G7 nations. Then the opening of trade and our success in gaining market share in the U.S., lifting trade from 25 per cent to 45 per cent of our GDP and increasing its value-added component at the same time appeared to have no impact on traders. And perhaps most impressively, the country's swing from deficit to surplus--a surplus that continues today as most nations struggle with a return to deficit spending--was glossed over by markets.

As unpopular as the statistic became, we have always viewed estimates of purchasing power parity (PPP) useful as a first step in gauging a currency's risk. For the Canadian dollar, PPP has been pegged in a range of US$0.80-0.85 for almost a decade. So why the long-lasting fall in the dollar? Because about one-third of the currency's movement is driven by the value of commodities, and Canada has almost no impact on that. The depression in raw materials' prices that began in the early 1980s masked improvement in domestic economic fundamentals.

Our view had always been that, should commodity prices ever stop falling, Canada's improving fundamentals would no longer be obscured, and the Canadian dollar would begin to reflect its true value. In the event, commodity prices not only stopped falling, but abruptly reversed and soared in 2003 and 2004, forcing the currency's adjustment into a very short period. The Canadian dollar is now fairly valued, so a lot of its buoyancy has probably been released. Nevertheless, we recognize that symmetry exists in the global foreign exchange market with currencies tending to move as far above fair value in their rally phase as they weakened during the preceding bear. This means that, at some point in the current cycle, prices above US$0.90 are a definite possibility.

Short-Term Interest Rates

Central bankers are only part way through adjusting short-term interest rates from historically stimulative positions to "neutral" levels typical of self-sustaining business cycle expansions. With growth pressures easing in North America and outside the U.K., not yet in evidence elsewhere, monetary authorities may have the luxury of stretching the cycle over an unusually long period, but the direction of rate movements and their ultimate levels are clear. We still expect a 3-per-cent fed funds rate by next Christmas, up from 2 per cent currently, although we recognize that the fed may choose to slow the pace of rate hikes if inflation remains calm. In Europe and Japan, whatever rate adjustments lie ahead are likely to be mild and late in the forecast horizon.

For Canada, where the firm dollar has already delivered an element of monetary tightening, we look for 91-day T-bill rates of 3.25 per cent, about 75 basis points above current levels.

Long-Bond Yields

We remain concerned that in every economy outside the U.K., fixed income markets are significantly overvalued. The decline in risk aversion that comes with a maturing economic expansion and the pressure of rising short-term interest rates will weigh heavily on bond prices, enough we think to move 10-year T-bond yields up almost 100 basis points from their current position. Canadian, Eurozone and Japanese bonds are also likely to sustain losses over the year ahead, although of a somewhat smaller scale.

The wide spread that existed between 10-year U.S. and Canadian yields as this cycle began has now all but disappeared, leaving Canada bonds much more exposed to yield movements south of the border. Now at about 4.3 per cent, we expect a move up to the 5.15-per-cent level over the coming 12 months and a resulting total return of -2 per cent.

For fixed income investors, earning suitable yields will probably require moving beyond traditional government debt. Investment grade bonds, high yield credits and even emerging market debt all offer significantly higher yields, but come with varying degrees of additional risk. They must be analyzed in the same fashion as equities and are difficult to source and trade in the size that most individual investors require. Nevertheless, these bonds deserve consideration, as their returns tend to track the profit cycle where the outlook remains positive. In simple terms, our upbeat forecast for growth suggests another good year lies ahead for corporate credit markets.

The forecasting business is tough. The economy is complex and full of moving parts, some of which are offsetting and some of which are not. Those of us, who have survived the inevitable bumps and shocks that expose whatever weakness exists in the most logical of views, have learned a very simple principle. There are two elements in any forecast: target and time. We need to offer a view on what level we expect for the economy or markets and also when those levels will be achieved. Longevity as a forecaster means never expressing the two elements in the same sentence. You have asked for both, and so I am exposed! Good luck with your investing through 2005.

Introduction by William Whittaker

Our final speaker is Jeffrey Rubin, Chief Economist, Chief Strategist and Managing Director of CIBC World Markets. Mr. Rubin has been one of the top-ranked economists in Canadian financial markets over the last decade. From 1992 to last year, Mr. Rubin, as Chief Economist, was responsible for economic research at CIBC World Markets both in Canada and in the United States. This year, Mr. Rubin also became the firm's Chief Strategist with the transfer of portfolio equity strategy to the Economics Department.

Mr. Rubin first caught the attention of financial markets in 1989 with his now-famous call for a 25-per-cent decline in Toronto real estate prices. He writes a national column for the Globe and Mail, "Ahead of the Curve," and frequently appears as a network commentator on federal budgets. Mr. Rubin.

Jeffrey Rubin

Thank you very much. I must confess that I probably disagree with everything I've heard so far today, but unfortunately don't have the time to rebut it.

I'm here to talk about the Canadian equity markets and I'm bullish on Canadian equities in 2005. Here's why.

There are two fundamental challenges facing the Toronto Stock Exchange (TSX) this year. The first challenge is from interest rates; the second challenge is from the exchange rate. Fortunately both are likely to turn out to be paper tigers, permitting the TSX to march to 10,000 by the year end and in the process yield a total rate of return of about 10 per cent. While that won't match last year's 14.5-per-cent return, it is sure going to beat holding cash.

The first pleasant surprise with the Canadian equity market this year will be the Canadian dollar. While global disenchantment with the U.S. dollar and the U.S. twin deficits has pushed the loonie above 80 cents, a stumbling Canadian economy is going to bring it back to the ground. By year end the Canadian dollar should be trading in the mid-70-cent range undoing much of the recent damage that the exchange rate has imposed on earnings growth.

The loonie faces a potentially larger decline against the euro which should continue to set new highs at the expense of the U.S. dollar in 2005. With trade exposure a tenth of Canada's, the European Central Bank's tolerance for currency appreciation is a lot greater than that of our banks. With the euro at least likely to hit 140, 145, Canadian forestry stocks could benefit from as much as a double-digit decline in the Canadian dollar against the euro.

Why won't the loonie continue to rise along the euro's coattails?

I guess the answer to that lies with what the Canadian dollar is. It is not a barometer of commodity prices; it is not an input into an economic forecast model. It is first and foremost a financial instrument and that instrument is driven by the relationship between Canada and U.S. interest rates. And that brings me to the second pleasant surprise for the TSX in 2005.

While there is little to suggest that the Federal Reserve Board has completed its tightening program, there is much to suggest that the Bank of Canada has. As we are already seeing from the growing toll of manufacturing job losses, some 50,000 over the last four months, and the economy coming to a virtual standstill in October, the Canadian economy does not work at 82 cents; it doesn't work at 81 cents; it doesn't work at 80 cents.

The appreciation of the Canadian dollar is going to provide all the braking power and even more braking power than the intended increases in interest rates, which the Bank of Canada so boldly advertised. No longer is the governor of the Bank of Canada talking about the need for higher interest rates. He may soon be talking about the need for lower interest rates.

Interest rate spreads, which have been supportive of the Canadian dollar's 30-per-cent appreciation over the last two years, are about to turn negative. And the only people I know who hold Canadian dollars at negative spreads to the U.S. are economists and there aren't enough of them to support the currency.

With some 40 per cent of the TSX in yield-sensitive stocks, the sudden disappearance of rate risk removes the single-largest obstacle to TSX performance. Not only will Canadian short-term interest rates not rise this year, they could well fall. Long Canadian bonds will certainly fall. With today's yield curve as steep as it is, simply the failure of the Bank of Canada to raise interest rates in 2005, after advertising that it had had hundreds of basis points of rate hikes to do, should resolve in at least another 30 to 50 basis points decline in long bond yields.

Even in the U.S. Treasury market, where the fed is still tightening and likely to continue, yields are falling, not rising. It may be of interest to bond market bearers to note that far from a mass exodus from the Treasury market a weakening greenback has spurred greater Central Bank buying of long treasuries, as central banks in China and Japan have to wrap up their buying programs to keep their own currencies in check. Such is not an act of generosity to U.S. taxpayers; such is an act of economic self-interest. But until the economies of China and Japan are willing to tolerate significant currency appreciation, they are tied buyers to the long end of the Treasury market and who knows at a euro of 140, 145, the European Central Bank may also be showing up at the Treasury auctions.

The stockmarket, and in particular dividend paying stocks, will continue to be a major beneficiary of declining interest rates as of course will the long bonds. With long bond yields now barely above the dividend yields in sectors like telecommunications, banks and utilities, the allure of dividends has never been more attractive. A 15-per-cent rise in dividends last year saw dividend-paying stocks on the TSX outperform non-paying ones by a ratio of four to one. With dividend payout ratios still low by historic standards and ample free cash, similar dividend growth this year should see dividend payers outperform non-dividend stocks by a comparable margin.

Last year our strategy portfolio outperformed the TSX by 70 basis points, largely on the basis of a heavy overweight in the oil and gas sector. After a nearly 30-per-cent rise in valuations in that sector, some might argue that now is the time to sell. If indeed last year's spike in crude prices was simply a cyclical blip, they would probably be right. But if instead the rise in crude prices reflected a secular shift in global energy demand this is no time to sell, particularly if we are getting close to a peak in conventional crude production.

Admittedly I don't know if crude prices will match our forecast of $50 for 2005. It has averaged about $48 over the last 60 trading days. But I do know, that barring a sudden global recession, the energy market is not going to be any materially slacker this year than it was last year or for that matter in 2006 or 2007.

While the energy intensity of G7 economies has fallen markedly, the same cannot be said of the rapidly industrializing economies like China. And it is precisely these energy-inefficient economies that global production is stampeding to. Globalization, by that I mean the mass export of jobs and production from high-wage countries to low-wage countries, is a very energy-intensive process. While such movements are driven by desire to arbitrage huge differences in global wage rates, they have the effect of moving production from energy-efficient economies to energy-inefficient ones. That's why global crude demand grew at over three times its 25-year average last year with China single-handedly accounting for 40 per cent of the growth. China has already surpassed Japan as the second-largest oil-consuming economy in the world. The sudden acceleration in crude demand witnessed over the last couple of years is not a cyclical blip but a structural shift driven in large measure by globalization.

Throughout the last four years, the oil and gas valuations have consistently trailed cash flow as investors continue to value energy stocks according to a make-believe world of $25 oil. Even so, the sector's capitalization has doubled to a 20-per-cent share of the TSX over the last four years. A world of $50 oil points to another 15 to 20-per-cent upside in oil and gas stock valuations.

While the 10-per-cent return from the TSX should beat bonds, although not necessarily the return from long bonds, the greatest beneficiary of falling interest rates is not the equity market but rather the income trust market. This year we are including income trusts in our strategy benchmark reflecting the reality of an over $100-billion-plus market. Returns from the CIBC World Markets Income Trust Index last year was 28 per cent, double the total return from the TSX composite. Trusts should once again lead the path in terms of asset returns this year.

Broad-scale exposure to declining long-term interest rates either through dividend yielding stocks, income trusts, or long-duration bonds should be the key to one's investment strategy for 2005. Add to that a healthy dose of skepticism about future oil supplies and investors should have another good shot at a double-digit return.

Thank you very much.

The appreciation of the meeting was expressed by Margaret M. Samuel, CFA, Director, The Empire Club of Canada.