Investing in the year ahead

As we begin the New Year, the prospects are bright. The stock markets are performing well. Interest rates continue to be low. Economic growth appears to be strengthening. Except for a couple of obvious trouble spots, like the cattle industry, all seems reasonably right with the world.

But if we have learned one lesson over the past few years it is not to be complacent and to expect the unexpected. It would be nice if 2004 were different: a nice, boring year in which nothing exciting happens and we can get on with our investing lives. Unfortunately, that’s not the way it’s likely to be.

The problem is that we can’t predict the unpredictable. So you’ll have to stay alert and be ready to change course if the circumstances warrant.

With that caveat, based on the patterns and trends we can discern as we begin the New Year, here’s what I think will develop.

Interest rates will start to move
The interest rate scenario is an intriguing one. By all rights, the U.S. Federal Reserve Board should be making noises about starting to tighten, given the recent strength of the American economy and the rise of thstock markets. Instead, Alan Greenspan and associates have gone out of their way to suggest that rates in the States will remain low for a considerable period of time. Some economists now suggest that it may be 2005 before we see them begin to rise. I’m less sanguine. If the U.S. economy continues to gather momentum in the first half of the year, I think the Fed may start to tighten in late summer or early fall.

Here in Canada, it is a different story. Our economy is sluggish and the latest mad cow shocker is not going to help matters. The loonie continues to defy gravity and is now pushing towards the US78c range. The Bank of Canada has already hinted that it may cut interest rates if our dollar gets too high in an effort to let some of the air out of the balloon. I think that is exactly what will happen, and sooner rather than later. Look for a quarter-point cut this month, with another one later in the winter if the loonie is still over US76c.

From an investment perspective, this scenario suggests that money market funds will continue to offer poor returns in 2004. The average Canadian money market fund returned only slightly more than 2 per cent last year and you’ll be lucky to get even that over the next 12 months. GICs will also continue to offer stingy yields, as will Canada Savings Bonds and similar products.

The Canadian dollar will stabilize
My impression is that the Martin government will be supportive of any effort by the Bank of Canada to bring some order to the currency markets. As I have pointed out before, the high loonie is not helping government revenues one bit. Many companies are reporting that they have lost millions of dollars in profits as a result of the dollar’s rapid rise, and that translates into less corporate tax money for Ottawa and the provinces. Exports have also taken a big hit. Few people want to see our currency back in the US65c range, but virtually everyone in the business community would like a pause in its headlong rise to provide time for adjustment to the new reality.

It is possible that the loonie may push a little higher, but my hunch is that we are now going to start to see some action from Ottawa in an effort to apply the brakes. It would not surprise me to see the loonie move back to the US75c range within a couple of months and then trade within a fairly narrow band of US74c to US76c through the rest of 2004.

Next page: What’s the outlook for the stock markets?

The stock markets will go higher
The year just ended was a bad one in many ways, but for stock market investors it was heaven. The grinding bear market that began this century finally touched bottom in October 2002. Since then, it’s been almost all good news. The S&P/TSX Composite Index ended 2003 with a gain of 24.3 per cent, according to Globeinvestor.com. In the U.S., the Dow gained 25.3 per cent, the S&P 500 added 26.4 per cent, and the Nasdaq Composite rose an amazing 50 per cent.

We are unlikely to see a repeat of those numbers in 2004. Historically, the first year of a bull market is usually the strongest, after which momentum slows. For example, after a slump in 1984, the Dow rebounded with a gain of 26.66 per cent in 1985, close to its increase in 2003. The following year, 1986, was not as strong, but the Dow still added another 22.58 per cent. By the third year of the rally, 1987, it was out of steam and gained only 2.26 per cent.

For those who sat on the sidelines last year, the message is clear. Even though you may have missed the biggest gains, there is still time to make some money before the new bull market runs its course. An increase of 10 per cent to 15 per cent in the North American markets in 2004 is not only possible but likely, barring unexpected developments.

Income trusts will continue strong
2003 was another good year for the sector with the S&P/TSX Capped Income Trusts Index rising 23.7 per cent. Prices of the good income trusts are much higher today than they were last January and yields are down. By almost any measure, the sector appears to be overvalued and poised for a pull-back. That will eventually happen, but not until interest rates start to rise. That is not likely to occur soon; in fact we will probably see rates decline in this country before they begin to move up again.

This augers well for continued strength in the income trusts sector in the first half of 2004. But as we turn from summer into autumn, we may begin to see some prices retreat and yields rise as the likelihood of rate increases strengthens.

Bonds require some caution
Bonds have been overpriced in relation to stocks for some time but as long as interest rates stay down we are not going to see a bear market in bonds.

But 2004 could change that. If the economic recovery gains momentum, we should see bond prices start to ease and yields rise. Long-term bonds will be the most dramatically affected. So if you’re worried, stay short-term.

In summation, the year ahead should be a good one for stocks, a decent one for income trusts, a so-so one for bonds, and a poor one for cash-type securities. Of course, that’s if everything plays out as expected – which it most likely will not.