Wednesday, December 14, 2011

2012 Projections -- a dilemma

My head says be true to your beliefs and analysis, my heart says the world will muddle through!

Each path has a very different outcome for Canada, and only in a few times in history have the pressures of change been more powerful.  In one corner we have China, the engine of growth for Canada with its insatiable demand for raw materials -- the core of Canada's strength.  In the other corner we have China the  65 million empty apartment massively over-invested economy battling inflation and a weakening economy.   Data out of China is famously unreliable, certain data points used to be useful (energy consumption) but over the past decade China's government has made this data less reliable.  Economists have used coal consumption (the primary source of China's energy) as a barometer, but even these datapoints have become contaminated.  Its a little like the USSR of old, not only was the Kremlin lying to the world, it was lying to itself; the pressure to make the numbers look good are as powerful in China, as advancement is dictated by an ability to achieve the stated goal -- today the goal is lower inflation -- guess what happens to the relevant data then!

China is only one of Canada's problem.  America should pull-out of its weak economy (although ECRI believes that a recession is baked in the cake), the American political system is paralyses by a dysfunctional congress and a weak President.  The ability of the US system to address external shock is probably at its lowest in since the early 1900s (ok so I may be exaggerating -- but there is no will to act).  Europe is a massive mess that will certainly end badly for all those involved.  The inability of Germany and France (the rest are not guiltless, but they are powerless) to even frame the full extent of the problem means that by early January trouble will be serious (again).

Despite all this my heart says that the world will muddle through.  In reality (and this is why I discount this scenario) muddling through is Canada's best chance of moderate to strong economic growth.  I would expect a wave of nationalistic fervour across Europe in 2012:  "Buy (insert country here) goods" with the national flag and maybe even a "green" tinge of "its better to buy locally".  However, nationalistic fervour doesn't affect the import of raw materials -- and that is something Canada is very good at producing.  Assuming that the world muddles through then Canada should expect continues strong economic growth -- in part because of very accommodative financing costs but also because Canada's national income continues to rise (in the US it has fallen back to its 1997 level).  The muddle through scenario would see Canada's interest rates remaining low (maybe slightly higher than now), the CAD remains near or at parity with the USD, and that inflation remains under controle (that's the though one).  My guess is that Canada could expect a 2.5% to 3% GDP growth in 2012.  

All bets are off in Europe implodes, first off Canadian interest rates would rise, why because CAD bond holders have done very well in 2011 -- both in currency and in the dramatic drop in yield.  When the "solids" hit the fan you sell what you can not what you should.  Canadians rely a great deal on foreign lenders (one of Mark Carney's many headaches).  Should foreign bond holders start to liquidate it would put pressure on yields (upward) and the currency (downward) that would squeeze liquidity out of Canada and  could cause a recession (as credit may become more difficult -- and expensive).  Household would feel the pain, because so many Canadian mortgages are on a floating basis. On that basis, the CAD could fall to its "fair value" of 92/94 to the USD, interest rate would hover around 2/3% and a recession would ensue. On the bright side inflation pressures would disappear!

Normally, during a US election year the risk of such outcome is low -- in general economic policy becomes more accommodative, and the US northern neighbour would benefit from this, but the above mentioned gridlocked washington means that the bullets available are few and far between.  Although QE3 is an option history shows that its ability to stimulate the economy is negligible.  Therefore the "normal" expansion during a US election year should be discounted in 2012.  

What's an investor to do?  David Rosenberg said it best buy strong North American company's debt instruments or stocks (which pay a dividends), Sovereign bonds should be shunned -- returns are ludicrous and the risks of global contagion (for good or bad reasons) is too high.  It may be that corporate bonds are less risky than sovereign bonds for 2012....   

There you have it -- Canadian growth or recession, but it has nothing to do with Canada and everything to do with what occurs in the rest of the world



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