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Picking stocks best chance for good investment returns in 2006 amid economic slowdown

by Wayne Cheveldayoff, 2005-12-15

If the world economy slows as predicted by economists at New York investment bank Morgan Stanley, it won’t be easy for Canadian investors to make money in our stock and bond markets in the coming year. Capital gains are likely to come only from picking the right stocks.

The picture painted by the group is one of slowing economies worldwide, including China and India, further increases in U.S. interest rates, substantially weaker energy prices, and a return to U.S. dollar weakness.

If the forecast comes true, rising interest rates definitely would not be good for bonds, which decline in price when interest rates are going up, and would be a hindrance to much of the income trust sector.

At the same time, weaker energy prices would take their toll on Canada’s energy sector, which was the driver behind the S&P/TSX Composite’s approximate 20-per-cent gain in 2005 (January 1 to December 8).

Without the push from energy, Canadian stocks on average are more likely to match, or perhaps lag, the gains in U.S. stock indexes. In 2005, the S&P 500 was up only 3.6 per cent and the Dow Jones Industrial Index showed no change.

“As I look to 2006-2007, I see the downside risks outweighing those on the upside by a factor of two to one,” writes Morgan Stanley chief economist Stephen Roach in a December 5 article entitled “Looking to 2007: Slowdown Coming” published in the firm’s Global Economic Forum at www.morganstanley.com.

Just back from a visit to China, he sees that economy slowing to 7.6 per cent growth in 2006 from 9.5 per cent annually over the past two years.

His intelligence gathering leads him to believe that Chinese bank lending will slow sharply next year as commercial banks there rein in the excesses of old open-ended credit growth and focus instead on profitability and shareholder value after recent ownership changes.

“The result is likely to be a surprisingly sharp slowdown in bank-funded fixed asset investment – a welcome development for an unbalanced Chinese economy that is in danger of letting its investment boom turn into a breeding ground for excess capacity and deflation,” says Mr. Roach.

“Given China’s outsized claim on global resource demand, such an investment slowdown could also lead to surprising drops in oil and other industrial commodity prices.”

In the United States, Mr. Roach believes the overly indebted American consumer “could well be squeezed by the twin pressures of a post-bubble housing market and higher energy costs.

“Contrary to widespread perception, U.S. consumers are now in the process of cutting back discretionary spending in response to the energy shock of 2005. Growth in real consumption is tracking an anemic 1.5-per-cent pace in the fourth quarter, down from the nearly 4-per-cent trend of the past decade.”

He also points out that with the Fed tightening, individuals’ debt-service obligations will be rising due to the proliferation of floating-rate mortgage loans that were taken out at below-market “teaser rates” over the last several years.

Add to this a likely turn for the worse for the U.S. dollar early in 2006, along with continued major current account imbalances and tests of central bank credibility as the year progresses, Mr. Roach concludes “if my risk assessment is correct, financial markets could be in for a rude awakening.”

In a December 8 article, Andy Xie, a Morgan Stanley economist based in Hong Kong, describes a pessimistic outlook for oil prices. He says the winter bounce in prices won’t last long and the oil price “could surprise on the downside in 2006 and may drop below U.S. $40 per barrel (versus $60 per barrel at the time of writing).”

He believes the market has exaggerated China’s long-term demand. With the Chinese government plans to decrease energy consumption per unit of GDP by 20 per cent over the next five years, “China’s oil demand may grow by only 4 to 5 per cent per annum in this decade, half of what the market expects.”

If he is right about oil prices, oil stocks could end up being a drag on the S&P/TSX composite in 2006. In that scenario, the Canadian index, with an energy weighting of 25 per cent, could underperform the Dow and S&P 500 – a dramatic reversal from 2005.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.

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©2005 Wayne Cheveldayoff