Economic Slowdown ≠ Market Meltdown - November 2006

Richard J. Wylie CFA
Vice President, Investment Strategy
Assante Wealth Management

Since bottoming out on October 9, 2002, North American equity markets have amassed considerable gains. By the end of October of this year, the S&P/TSX and the Dow Jones Industrial Average had both managed to post new record highs. Hong Kong’s Hang Seng Index was the only other major market that could claim a new high thus far in 2006. However, it now appears that a softening in North American economic activity is at hand. It is likely that a moderation in monetary policy will emerge if sufficient slack appears in the two economies. Meanwhile, lingering inflation fears continue to raise questions about the timing of any rate cuts by the U.S. Federal Reserve Board and the Bank of Canada. While a lower interest rate environment would signal concerns over corporate profitability, historically, equities have responded favourably to a decline in administered interest rates as seasoned investors look to the inevitable rebound in both profitability and the broader economy.

What about U.S. growth?

The current U.S. business cycle has been fuelled by considerable strength in the housing market and Americans’ ability to convert home equity into consumer buying power. Nevertheless, since reaching their peak of over 7.2 million units (annualized) in June 2005, existing home sales have declined steadily, hitting 6.2 million in September of this year. The 16% drop has also been reflected in sales of new homes and residential investment in upgrades. Housing starts have also been hit, as they dropped 14.6% in October 2006 alone on their way to their lowest level in more than six years.

The weakness in the U.S. housing market has spread and forward-looking manufacturing data are not favourable. Stepping back to the bigger picture, overall, real U.S. GDP grew by only 1.6% (annualized) in the third quarter, a significant weakening from the 2.6% that prevailed in second quarter. This is the weakest growth posted since the first quarter of 2003. While most recent U.S. labour data has been surprisingly strong, the longer-term trend toward weaker job growth is fairly well entrenched. In addition, retail sales, construction spending and industrial production have all moderated. The most recent report of the Institute for Supply Management indicated the purchasing managers were concerned about future growth. It revealed a 51.2 overall index reading. This indicator is now at its lowest level since June 2003, with the backlog of orders falling to 44.5, well into the “contraction” (below 50) range.

...and inflation?

Inflation remains the chief concern of the Federal Reserve. Using the Fed’s preferred inflation measure, the core PCE deflator (which measures the amount of money individuals spend on goods and services and excludes volatile food and energy components) as a reference, price growth has remained largely contained within a 1% to 3% range for several years. Despite the run-up in energy and other commodities, inflation has been relatively tame. This is particularly true when compared to the double-digit increases experienced during the early 70s and 80s. The most recent quarterly report showed that the core PCE deflator was up only 2.3% (annualized) in the third quarter, a measured slowdown from the 2.7% recorded in the second quarter.

On the domestic front

Not surprisingly, weaker U.S. economic activity has exerted a significant influence on our domestic economy. While recent statistics show that Canada has continued to broaden its export market, the merchandise trade surplus with the U.S. has been on a downward trend since it hit $11.0 billion in October 2005. Conversely, the deficit with the rest of the world has improved. After steadily increasing to a record $4.5 billion in April 2006, it has been reduced by a third, as exports have outpaced imports. Thus, while Canada is become less reliant on trade with the U.S., it still consumes the lion’s share of our exports. In the first three quarters of 2006, the U.S. was the destination for 79.6% of our exports – that compares to 81.1% for the same period in 2005.

Real Canadian GDP growth was only 2.0% (annualized) in the second quarter (the latest available) – the slowest pace since the third quarter of 2003. As well, the Bank of Canada lowered its growth forecast for 2006 to 2.8% from 3.2%. This means that it is looking for growth that is no better than 2.0% in remaining two quarters of the year. The forecast for 2007 has also been revised downward to 2.5% from 2.9%. The BoC has indicated that while risks are largely balanced, there is a greater chance of weaker growth than there is of higher inflation.

As in the U.S., the efforts of the Canadian central bank to control inflation have borne fruit and price pressures have been largely contained over the past decade. In its most recent quarterly report the BoC indicated that it was expecting an easing of inflationary pressures. According to the BoC, “As the economy returns to potential and pressures from housing prices ease, core inflation should return to 2% by the middle of 2007, and stay there through to the end of 2008.”

What about the market?

As an economic slowdown translates into broadly weaker corporate profitability, investors have become justifiably concerned with the direction of the markets. The world’s major central banks have gained credibility over the past several years for both their efforts in fighting inflation and their attempts to soften the “hard landing” at the end of the normal business cycle. Looking at the markets since 1994, investor response to the easing in monetary policy has been positive.

As illustrated in above, periods of central bank “easing” have generally been accompanied by market gains (see Appendix 1 – the easing period encompasses the time from the first announced rate cut, to the subsequent first announced rate hike). In the U.S., the S&P500 gained an annualized 19.5% (on average) during these periods. The most recent example was an exception as the market declined 4.8% at an annualized rate. In this case, the end of the business cycle coincided with a bursting of the tech bubble and high-profile accounting scandals, and these had to be wrung out of the market. It is important to note that at the end of 1999 the P/E ratio of the S&P500’s stood at 34.1. By comparison, at the end of October 2006 it was almost half that level at 18.5. The positive results during periods of easing are not quite as strong in Canada, where an average 9.5% (annualized) was added to the TSX. In the domestic market, the retrenchment from the tech bubble also played an important role. However, with one stock (Nortel) representing more than a third of the value of the entire index at the time, the removal of this imbalance was a uniquely Canadian phenomenon. During this episode, the TSX lost an annualized 13.5%. The other exception was an unusual period in 1994 when the Bank of Canada undertook a brief easing at the same time that the Fed was raising interest rates.

Conclusions

• Both the U.S. Federal Reserve and the Bank of Canada have fought hard to achieve their current level of credibility on the inflation front. They are expected to continue to act in a measured fashion to ease monetary policy when needed.
• While slower economic activity typically results in softer corporate profitability, lower interest rates and the expectation for an improvement have historically been supportive for the equity market.
• Investors that have put cash to work during slower economic periods have traditionally reaped the rewards when the inevitable rebound occurred.

The information contained herein consists of general economic information and/or information as to the historical performance of securities, is provided solely for informational and educational purposes and is not to be construed as advice in respect of securities or as to the investing in or the buying or selling of securities, whether expressed or implied. Neither Assante Wealth Management (Canada) Ltd. nor its affiliates, or their respective officers, directors, employees or advisors are responsible in any way for any damages or losses of any kind whatsoever in respect of the use of this report or the material herein. This report may not be reproduced, in whole or in part, in any manner whatsoever, without the prior written permission of Assante. Copyright © 2006 Assante Wealth Management (Canada) Ltd. All rights reserved.