Europe has also shown signs of gathering momentum. After years of subdued economic performance, 2000 in Euroland should see real GDP growth exceed 3%. Europe now seems poised to experience some of the strongest low inflation growth in decades. Under the new common currency, the Euro, we expect European corporations to continue restructuring their operations in order to boost productivity while both monetary and fiscal policy throughout the Euro zone will be supportive of strong economic performance in 2000.
The broadening of economic growth will enable a healthy transition away from excessive reliance on the American economy as the primary driver of global growth. Due to a series of economic shocks starting in southeast Asia in 1996 much of the world’s economy outside of the United States has been struggling. This is now changing enabling the reversal of some of the imbalances that have built up during this period. Because the U.S. economy has been so strong, the American market has pulled in exports from the rest of the world resulting in a record trade deficit which over the longer term is not sustainable. We expect economic growth in the United States to remain too hot for the Federal Reserve’s liking during the first half of the year which will result in a series of increases in short term interest rates until the economy cools in the second half of the year. A slower U.S. economy will alleviate the trade deficit since it has been the relative differences of economic growth rates between the United States and the rest of the world that has largely caused the trade imbalance.
We are increasingly more optimistic about the outlook for the world’s second largest economy, Japan. The Japanese economy after a decade of poor economic performance now appears to be moving in the right direction. The Japanese government has put in place policies that are encouraging a restructuring of the economy. Most critical to this process has been the restructuring and recapitalization of Japan’s banking system. Unlike other parts of Asia where the economic recovery has been swift, the recovery in Japan will be slower. Japanese banks are still working their way out of a mountain of non-performing loans that will continue to impede the pace of recovery. But the important point is that restructuring is now under way not just in banking but in other industries as well.
The Canadian economy much like its U.S. counterpart will remain on a strong growth path during the first half of the year. Some slowing in the second half in response to a slowdown in the United States is likely since Canada has been benefiting from strong export sales to the U.S. market. We expect the strong employment gains during the latter stages of 1999, to continue helping boost spending by Canadian consumers. As well the broadening of the global economy will support commodity prices in 2000 reversing the trend that severely impaired the profitability of many of Canada’s natural resource companies between 1996 and 1998.
Inflation
The U.S. economy will remain the most inflation prone amongst the G7 group of countries. The risk of a serious outbreak of inflation, though is still relatively low. Industrial capacity in the United States still has some slack and very few industries are indicating they have much pricing power. This may change as the global economy gathers momentum, but this has to be weighed against still excess capacity in the global economy. The area of most concern in terms of potential price pressures emanates from the very tight labour market conditions in the United States. Wages have been rising but these increases have been offset by very strong productivity gains during the past four years. Looking ahead a critical element of this inflation puzzle will be whether productivity can continue at such a strong pace in light of the economy bumping up against its capacity constraints.
Outside the United States the inflation risk will remain low. Canada’s inflation rate after adjusting for the volatile food and energy components should still stay close to a very low 2%. In Europe inflation has picked up in some of the smaller European countries but within the largest European economies such as Germany, France and Italy inflation rates are extremely low. These low rates will enable Euroland to grow at relatively strong rates of growth before inflation is an issue. Similarly in Japan deflation not inflation is still potentially a more pressing issue for monetary policy. With Japan’s economy now potentially embarking on a self sustaining recovery the deflation risk will ease, but Japanese monetary policy will maintain an accommodative posture in order to ensure the durability of the recovery.
Currencies
We think 2000 will also be year of transition for the currency markets. The imbalance of economic performance in the world that resulted in the U.S. economy as the primary engine of growth also had some manifestations in the global foreign exchange markets. The strength of the economy and the associated strength of America’s stock markets has acted like a magnet on global investment capital driving up the value of the U.S. dollar against other global currencies. This began to change last year and it is a trend we think will continue in 2000 as investment opportunities continue to become more apparent outside the United States.
The new Euro launched at the beginning of 1999 has progressively lost value against the U.S. dollar and now based on some measures of fair value is estimated to be 20% undervalued against the dollar. We expect the Euro to strengthen in 2000 moving back to the level the Euro was originally launched at some 10-15% higher than year end levels.
The resurgence of the Japanese stock market in 1999 and the prospects for a self sustaining recovery in Japan has strengthened the yen against the U.S. dollar. But given Japan’s fledgling economic recovery it is not in the best interests of Japan to see the yen appreciate much further. A stronger yen will make Japan’s exports less competitive. We expect the yen/dollar relationship to remain a fairly tight one in 2000 ranging between 100 to 105 yen.
We are optimistic the Canadian dollar will strengthen against its U.S. counterpart this year. Canada’s economy is on a strong footing and we expect any interest rate increases engineered by the Federal Reserve to be matched by the Bank of Canada. The gap between Canadian and U.S. bond yields has now been virtually closed making Canadian debt instruments more competitive compared to a year ago when Canadian interest rates were significantly below levels in the United States. We expect commodity prices to rise this year, which increases the prices that many Canadian natural resource companies receive for their exports. Canada is now running a small current account surplus with the rest of the world effectively reducing Canada’s reliance on foreign investment flows. We expect the Canadian dollar to appreciate towards the $1.40 level by year end from roughly $1.47 at the end of 1999.
Fixed Income Markets
Due to the strength of both the U.S. and Canadian economies, we expect interest rates to head higher over the first half of 2000. We expect both the Federal Reserve and the Bank of Canada to raise rates by as much as 50 basis points during this period. Until the U.S. economy settles down to a more moderate and sustainable rate of growth, monetary policy in the United States will engineer whatever interest rate increases are necessary to ensure a slowdown. This will result in a difficult period for bonds and we expect bond yields to creep a little bit higher in North America during the first part of the year. While we expect short term rates to increase by 50 basis points, we expect bond yields to creep higher by 25 to 50 basis points. The bond markets have just come off one of the worst years ever so potential for a significant rally in the bond market is now developing. We think this will happen as the U.S. economy begins to slow during the second quarter of the year.
Equities
Our view that 2000 will be a year of transition for the global economy towards more synchronous growth worldwide forms the basis for our outlook for the global equity markets. For a number of years market leadership within the world’s major equity markets has been confined to large companies who have still been able to grow earnings at a strong rate in spite of the strong disinflation forces that have been sweeping through the world economy. In a world where pricing power has been scarcely evident reducing costs and rising productivity has been paramount. Technology stocks, in particular, have been the primary beneficiaries of this phenomenon and have accounted for much of the stock market gains in 1999. We think this will begin to change in 2000.
Overall we think stock market returns in 2000 will be close to the potential rate of earnings growth. The profit outlook for North America is still favourable. Corporate earnings in the United States are expected to grow next year at between 8 to 10% while firmer commodity price should keep the profits of Canadian corporations advancing by at least 10%. If interest rates rise by more than we anticipate these potential returns will be pared back somewhat. Based on the broader market averages we expect the Canadian market to outperform its U.S. counterpart. This view is enhanced further by our expectation that the Canadian dollar will appreciate moderately in 2000.
While we do not discount the potential of the technology stocks to continue providing some of the best long term investment opportunities, we are concerned that valuations in many of technologies varied sectors are not sustainable and have reached levels that can only be justified by extraordinary rates of earnings growth extending for years in the future. For many of the tech stocks we doubt this will be likely. In the U.S. market, where technology stocks now comprise 26% of total market capitalization up from 10% in 1990, we think better relative value can be found in other sectors such as financial services. Rising interest rates last year severely hampered the performance of the financial services sector. This sector now trades at a sizable price discount to the overall market despite the fact that operating earnings have continued to grow between 16 to 20% a year.
While market valuations in Europe are stretched, we like the prospects for Europe’s stock markets particularly those on the continent. Europe is now embarking on a potentially long period of low inflationary growth during which European corporations will continue to restructure in order to boost productivity. Similar to North America we expect equity returns to parallel the growth rate of earnings in Europe which are expected to grow by roughly 10% this year. Again, the risks to these types of forecasted returns are their sensitivity to rising interest rates. We see this as less of a risk in continental Europe, compared to North America where we expect the Federal Reserve to raise rates in the first part of the year.
In Asia, the outlook remains positive. Economic growth in non-Japan Asia is accelerating and Japan appears to be emerging from a long period of economic stagnation. While the Japanese economy is not entirely out of the woods, economic growth this year should be marginally positive. Compared to North America, Japan is playing catch up in a number of areas including economic growth, corporate restructuring, technology and household ownership of equities. In spite of strong equity market returns in 1999, we think the recovery in Asia will continue which will be a positive for the region’s equity market in 2000.
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