National Bank Financial is predicting 3.0% growth for Canada this year, accelerating to 3.5% in 2005.

In its latest economic outlook publication, NBF says the Canadian economy will be stimulated by the strength of the U.S. expansion, but that its growth potential is limited by currency appreciation. It forecasts the Canadian dollar at US75¢ by the end of 2004 and US78¢ by the end of 2005.

“If we are right, and given the rise in energy and steel prices, manufacturers will not be hiring much in 2004 and 2005,” it says. “In many other sectors of the economy, the work force was not reduced apace with the slowing of activity in 2003 and producers will meet demand in 2004 and 2005 by increasing their output per worker. In other words, a cyclical gain in productivity is likely. For this reason we expect rather modest employment increases, 1.7% in 2004 and 1.5% in 2005.”

The stronger loonie would boost imports however. “Lower import prices will encourage Canadians to import more — especially with the revival that we expect in machinery and equipment investment, which is highly import-intensive,” it says, but it would hamper foreign travel to Canada. “However, we think that the trade surplus will contribute to growth in 2004, at the opposite of 2003.”

Consumer spending grew at 5.5% annually in the first quarter and the households savings rate fell to a historic low of 0.5%, NBF notes. “For the remainder of the year we expect consumer spending to grow somewhat more slowly than disposable personal income – 2.8% in 2004 and 2.2% in 2005. Residential construction is likely to show strong growth in 2004 and then plateau in 2005.”

As for the financial markets, NBF says, “The environment for bond investors suddenly seems less hospitable. The recent developments arouse fears of reliving the U.S. tightening episode of 1994. Over the 12 months ending in January 1995, the Canadian bond market generated a total return of -6.07%.”

“The amplitude and swiftness of the Fed change of course will be critical to the returns generated by different classes of assets,” it points out.

There is clearly a need for substantial tightening in the U.S., with the real fed funds rate at -0.80%, NBF notes. “Thus a return to the historical average would seem to require substantial tightening, even inflation is stable over the coming months.”

However, it sees risks that argue for a more gradual tightening, including: high oil prices, record household debt in the U.S., the frothy US housing market, persistent overcapacity in the US economy, and fears that China could slow its economy too abruptly to avoid overheating. “All factors considered, the Fed seems likely to raise its policy rate about 250 basis points over the next 18 months, compared to a rise of 300 basis points over 13 months in the 1994 tightening.”

NBF notes that stock markets opened the year strongly, but have faltered of late due to the uncertain state of the U.S. job market, ongoing trouble at certain Canadian technology companies, and the bombings in Madrid. “Since then the market has also been eyeing the approach of U.S. monetary tightening,” it notes.

But, it also points out that, “from a technical viewpoint, it is encouraging to note that the stock indexes have so far generally remained above their 200-day moving averages, which suggests that their recent hesitations are not necessarily the beginning of a bear market.”