March 2008

Caution, for now

The U.S. economy entered 2008 in a precarious condition. For financial markets, what’s at stake isn’t whether some ivory tower economists eventually decide, months from now and after many data revisions, if America’s first two quarters showed a bit of growth or a slight decline. Instead, the fate of equity markets largely involves how the global financial system weathers the credit storms centred in a troubled U.S. housing market, and its ability to underpin growth over the medium term.

For the next few months, there will be enough bad news from the financial system to create fears of a more protracted stall and to warrant a cautious stance for investors. Worldwide banks have, as we write, taken a US$140 billion write-down on mortgage-related assets (with some US$100 billion in North America) and have also absorbed billions in formerly off-balance sheet vehicles into their books.

More red ink is likely due to be unveiled when U.S. banks return to the confessional during April’s earnings season, and odds are that we’ll be hearing more from major European banks as well. U.S. house prices appear to be en route to a possible 20 per cent peak-to-trough decline, with a climb in sub-prime delinquencies in the 30 per cent range. Doubts about the health of bond insurers are bringing charges against hedged positions. All told, we could be looking at an aggregate hit in the range of US$265 billion when the dust settles on sub-prime and related mortgage assets.

Canada’s economy is in better shape and less at risk of an outright recession given the absence of a housing and mortgage crisis here, but the deep ties to the U.S. economy will mean a bite will be taken from the manufacturing sector, with implications for related equities. Credit market conditions have ballooned spreads and created a tougher funding environment for banks. We’ve maintained an underweight recommendation for financials during the past couple of months, alongside reduced weights in U.S.-exposed manufacturing exporters. In greater favour are equities tied to Canadian consumers or global resource demand, both of which are in better shape, as well as utilities, where dividend yields will easily surpass those on bonds.

If the credit crunch were left unchecked, equities would be facing not only a correction but a protracted bear market. However, that doesn’t appear to be the case. Major banks have successfully tapped into global pools of capital to the tune of US$70 billion so far, thereby avoiding the lending contraction forced on balance sheet-challenged Japanese banks after their real estate crash in the early 1990s.

Central banks are rushing to the rescue, with the Fed likely en route to a 2.0 per cent funds rate and the Bank of Canada likely to up the pace of its own rate-cutting efforts. In addition, fiscal stimulus is close to enactment stateside and was already delivered in Ottawa’s mid-year statement last October.

Those efforts should begin to bear fruit beyond mid-year. Even if U.S. housing starts only level off or fall more slowly, that will reduce construction’s quarter-to-quarter drag on growth. In Canada, softness in manufacturing will be covered by the benefits of monetary and fiscal stimuli for domestic demand, including retailing. Low yields will ultimately encourage investors to explore generous spreads in corporate bonds, many of which have been unduly tarred with the same brush as those with U.S. real estate exposures. As earnings expectations improve for 2009, we look for a spirited rally in Toronto Stock Exchange stocks in the latter part of this year.

Feb. 6, 2008

By Avery Shenfeld, managing director and senior economist, CIBC World Markets

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