Global Outlook 2006 – Chicken Little or Peking Duck? January 17, 2006 Presented by: Patricia Croft Vice President & Chief Economist Phillips, Hager & North Investment Management Limited Est. 1964
Outlook 2006 It’s All About Oil and Inflation t Global growth still healthy and better balanced t Some improvement in Europe and Japan – Canada remains strong t Soaring energy prices have had little impact but… t Storm clouds on the horizon l Tightening Fed l Housing bubbles and yawning current account deficit l Protectionist sentiment l Energy prices
0 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 US$/barrel Crude Oil Prices Still Elevated – Chicken Little? 70 WTI Crude 60 50 40 30 20 10
Long-term Price of Oil Has Increased – But to $45 not $100 t Days of $22 -28/barrel are behind us t Global demand shift t Alternative resources take time to develop t Refinery capacity is limited and inadequate
Monetary Policy: Key Theme for 2006 Central bank monetary policy normalization 4. 0 Tightening since trough 3. 50 Percentage points 3. 5 Tightening in last year 3. 0 Estimated distance from neutral 2. 5 2. 0 1. 75 1. 00 0. 5 0. 00 0. 0 -0. 5 U. S. Canada Australia U. K. Eurozone Japan Estimated neutal rate = LR core inflation target + LR potential real GDP growth rate
House Prices Still High Index, 1994 Q 1 = 100 300 250 U. K. Australia U. S. Canada 200 150 100 50 1994 1996 1998 2000 2002 2004
Outside North America, Things Are Looking Up t UK in a soft spot but has likely bottomed t Europe doing better – interest rates still low t Japan improving – end of deflation in sight? t China still strong – now bigger and better t Global growth holding up but likely to ease in 2007 as lagged effects of rate hikes start to hit home globally
UK Economy on the Mend? 12 % change year ago 10 Retail sales Manufacturing output 8 6 4 2 0 -2 -4 -6 -8 1997 1998 1999 2000 2001 2002 2003 2004 2005
Will 2006 Be Europe’s Year? 20 Year-over-year % change 15 Real GDP Private expenditure Fixed Capital Formation Exports Italy France Germany Real GDP Private expenditure 20 Fixed Capital Formation Exports 15 Real GDP Private expenditure Fixed Capital Formation Exports 20 15 10 10 10 5 5 5 0 0 0 -5 -5 -5 -10 -10 2001 2002 2003 2004 2005 2000 2001 2002 2003 2004 2005
Japan’s Recovery – Is This the Real Thing? t Corporate profits are improving and business investment is increasing t Private consumption and employment are increasing moderately t Exports and industrial production are picking up t Risk is the impact of oil prices on both domestic and overseas economies
25 10 0 Jan-99 Apr-99 Jul-99 Oct-99 Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Percent of total Japan’s Reliance on China Growing but U. S. Still Top Dog Japan's key export markets 40 35 32. 1 30 20 15 33. 7 28. 1 23. 4 Export share, USA Export share, China Export share, Other Asia 14. 1 5
China Vaults to Number Four Global Economy New GDP Old GDP Tertiary 32% Primary 15% Secondary 53% $1. 6 trillion US Source: National Bureau of Statistics Tertiary 41% Primary 13% Secondary 46% $1. 9 trillion US = 20% increase!
China’s Far Reaching Impact t It has altered world trading patterns, shifting income t It has pressured wages of low skilled workers in rich countries t It has helped companies increase return on capital without pressure from workers for higher wages
U. S. Economy Remarkably Resilient t Despite higher oil prices, natural disasters and consumer worries, real growth still strong t Federal Reserve appears to be close to end of tightening cycle t Biggest risk: U. S. consumer l Negative personal savings rate l Rising debt servicing costs l Higher energy costs l Real estate reliant
Why is the Fed Still Tightening? 2 4. 9% 88 3 86 4 84 5 Cap U LR avg = 81. 4% 6 % 82 80 7 78 % 90 US capacity indicators 8 76 Q 4 2005 10 Q 1 2003 Q 2 2000 Q 3 1997 Q 4 1994 Q 1 1992 Q 2 1989 Q 3 1986 Q 4 1983 Q 1 1981 70 Q 2 1978 11 Q 3 1975 Unemployment rate (right) Q 4 1972 72 Q 1 1970 9 74 Capacity utilization rate, all industries (left) 12
Will the Fed Tighten Too Much?
85 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 19 89 19 88 19 87 19 86 19 % 7 6 5 4 3 2 1 0 -1 -2 -3 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 Percentage points Yield Curve is Flat But Real Rates Still Low US yield curve slope - 10 -year Treasury bond - 3 -month T-bill 5 4 3 2 1 0 -1 Real US 3 -month T-bill rates
Core Inflation Well Behaved – So Far US consumer price inflation Percent, Year-over-year 18 15 Core CPI 12 Headline CPI 9 6 3 0 -3 1960 1966 1972 1978 1984 1990 1996 2002
U. S. House Prices Continue to Surge Sustained low interest rates tend to fuel asset bubbles US Real House Prices 170 160 Index 150 140 130 120 110 100 90 1975 1980 1985 1990 1995 2000 2005 Source: Office of Federal Houising Enterprise Oversight, Bureau of Labor Statistics
U. S. Consumer Using Home as a Cash Machine 12 Net equity extraction through cash-out refinancing As a percent of disposable income 10 8 150 6 100 4 50 2 Q 1 2005 Q 4 2003 Q 3 2002 Q 2 2001 Q 1 2000 Q 4 1998 Q 3 1997 Q 2 1996 Q 1 1995 -2 Q 4 1993 -50 Q 3 1992 0 Q 2 1991 0 % of disp income 200 Q 1 1990 US$ Billions, quarterly rate 250 Source: "Estimates of Home Mortgage Originations, Repayments, and Debt on One-to-Four Family Residence”, Kennedy and Greespan, Federal Reservce 2005
Current Account Deficit Still a Dollar Risk US Dollar and Current Account Balance 2 150 1 140 130 -1 120 Index % of GDP 0 -2 110 -3 100 -4 -5 % of GDP (left) -6 Trade-weighted value of US dollar against major currencies (right) 90 80 -7 70 1973 1975 1978 1980 1983 1985 1988 1990 1993 1995 1998 2000 2003 2005
Canadian Economic Growth Strong But Unbalanced t Higher energy prices benefit Canada as we are a net energy exporter t However, high energy prices create a transfer of wealth from central Canada to Alberta t The Canadian dollar has become a petro currency – a stronger dollar will further challenge the manufacturing base t Fiscal policy is loose – monetary policy is tightening
Canadian Job Creation Has Been Very Strong Cumulative job creation since January 2004 500 450 Total 350 Full-time 300 250 200 150 100 Nov-05 Sep-05 Jul-05 May-05 Mar-05 Jan-05 Nov-04 Sep-04 Jul-04 May-04 0 Mar-04 50 Jan-04 Thousands 400
Alberta Roars While Central Canada Reels 2006 provincial real GDP growth 7 6 4 % % 5 3 2 1 0 BC AL SK MB ON Source: RBC Financial Group QC NB NS PEI NL 16 14 12 10 8 6 4 2 0 -2 Provincial labour markets Unemployment rate (ytd avg %) Job growth (ytd % change) NL PEI Provincial retail sales and housing 15 ON BC SK MB AL AL BC CPI (ytd avg %) Wages & salaries (ytd % change) 8 7 6 % % QC 9 5 0 5 4 -5 3 2 -10 -15 NS Provincial price pressures Retail sales (ytd % change) Housing starts (ytd % change) 10 NB 1 AL SK MB QC NB BC ON PEI NS NL 0 PEI NS MB NL NB QC SK ON
Canadian Inflation Indicators Flashing Yellow Capacity utilization and unit labour costs 90 8 Capacity utilization Unit labour costs 6 86 4 82 2 80 78 0 76 -2 2005 2002 1999 1996 1993 72 1990 74 1987 % 84 -4 Annual % change 88
For Now – Inflation Remains Tame 5. 0 4. 5 Canadian CPI inflation Core (excl. 8 most volatile items) Headline 4. 0 3. 5 % 3. 0 2. 5 2. 0 1. 5 1. 0 0. 5 0. 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Bank of Canada Back in Tightening Mode Central bank policy interest rates 7 6 (%) 5 Bank of Canada U. S. Federal Reserve 4 3 2 1 0 2001 2002 2003 2004 2005
Canadian Dollar Was A Star in 2005 Performance of the Canadian dollar in 2005 20 18 Change in value against selected currencies from Jan. 1 to Dec. 31 2005 16 14 % 12 10 8 6 4 2 0 U. S dollar New Zealand Australian dollar UK pound Euro Yen
Outlook 2006 - Summary t Global growth set to slow as weakness in the U. S. is partially offset by renewed vigor in Europe and Japan t Canada strong for now – growing regional disparities will challenge policy makers t Monetary policy normalization process to continue t C$ overvalued – U. S. bear market at hand t Risks l Energy prices/house prices l Geopolitical instability l Mother Nature l Protectionist sentiment
Easy Monetary Policy has Encouraged Risk Taking 60 55 CBOE Volatility Index (VIX) Old VIX (based on S&P 100) New VIX (based on S&P 500) Black Monday 50 LTCM Above 40 = Panic 40 Gulf War II 35 9 -11 Asian Crisis Gulf War I 30 25 20 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 10 Below 20 = Complacency 1987 15 1986 Index 45
Global Yield Curves Flattening 10 year - 3 month yields, bps 250 Yield curve slope, current and year ago current 200 150 100 50 0 -50 Japan Eurozone Canada US UK
Long Bond Yields Still Low and Range Bound 10 -year government bond yields 7. 0 2. 5 6. 5 2. 0 6. 0 5. 5 1. 5 % % 5. 0 4. 5 4. 0 3. 5 3. 0 2. 5 2000 1. 0 Canada (left) US (left) Germany (left) Japan (right) 2001 Source: Datastream 0. 5 2002 2003 2004 2005 0. 0
Japan Soars – U. S. Sputters Major stock markets since Jan. 2004 Index: Jan. 1 2004 = 100 160 150 140 S&P 500 S&P/TSX MSCI EAFE (US$) Nikkei 225 130 120 110 100 90 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06
P/E Ratios Have Converged 28 S&P 500 TSX MSCI EAFE 26 Ratio 24 22 20 18 16 14 12 1998 1999 2000 2001 2002 2003 2004 2005
Asset Mix Summary t Overweight equities, neutral on bonds, underweight cash t May add to U. S. or EAFE equity holdings t Corporate earnings still strong – corporations flush with cash t Valuation for stocks is reasonable, particularly in the U. S. t Proximity to end of Fed tightening cycle is a positive factor
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