Merrill Lynch is predicting that the TSX will lose 4% in 2008, and that
interest rates are headed south too, as economic growth slows.

Between slowing global growth, mixed commodity prices, and a weaker US
dollar, Merrill foresees “ a less favourable external backdrop for the
Canadian economy and financial markets, given Canada’s leverage to global
conditions and its disproportionate exposure to the US.”

“Canada is destined to play a primary role in global economic rebalancing
away from American demand, given its proximity to the US, its openness to
trade and its strong currency. The effects should be seen in a move to
current account deficit in Canada, sharpening contrast between strong
domestic demand and weak net exports, lower inflation and overall weaker GDP
growth as Canada’s economy is thrown off-balance in 2008,” it predicts.

“In terms of the important point forecasts, we are looking for 1.7% real GDP
growth in 2008, down from 2.6% in 2007, while core inflation falls from 2.2%
to 1.5%,” it says.

This lower growth and inflation will demand lower Canadian interest rates,
Merrill adds. “Accordingly we expect the Bank of Canada to ease a further
125 basis points through 2008. We see the Fed going even further, implying
some upward pressure on the Canadian dollar, but with countervailing
outflows (particularly of capital) playing a stabilizing role,” it says. It
expects the currencies to remain close to parity in 2008.

“BoC easing should also be bullish for bonds, but with long yields already
seemingly below fair value, looser monetary policy should be seen more in a
steeper curve than an outright rally. We see Canada 10-year yields remaining
close to 4% through 2008, with the 2s-10s curve steepening to 75 bps.
Canada-US spreads should widen, but less so than in 2007,” Merrill predicts.

“We see a challenging 2008 for Canadian equities, as earnings continue to
decelerate, and as Canada’s disproportionate commodity and financial sector
weightings transition from help to hindrance. Our end-2008 TSX target is
13,300, 4% below the end-2007 close,” the firm forecasts. “Our portfolio
strategy remains conservative and our counsel little changed from a year
ago, preferring foreign exposure to domestic, bonds to stocks within Canada,
and defensives to cyclicals within the equity market.”