Welcome to 2006 and the new reality. It brings high levels of debt that are not necessarily sustainable; an aging population that is challenging the balance sheets of countries and companies; the U.S.’s increasing reliance on foreign investment to remain liquid; and China’s huge economic force, which is being felt around the world. Global economic patterns are changing rapidly, and some of the old rules will have to be thrown out.

For investors, the four key questions are:

1. Can U.S. consumers continue to add to their debt load?

2. Can the U.S. Federal Reserve Board manage another soft landing?

3. Has inflation subsided for good?

4. Can and will foreign investors continue to finance the U.S. trade and fiscal deficits, thereby keeping the U.S. dollar from plunging?

An increasing number of strategists and money managers are answering “yes” to these questions, and that’s why they expect a relatively good year in 2006. The consensus is for slower but still decent global economic growth — what they are calling a “mid-cycle pause” or “correction” — accompanied by benign inflation and little change in currencies.

There are, however, those who are not so sure. They think we are moving closer and closer to a major downturn, which will include a recession and a falling US$ — although they say it may not happen this year.

“The cyclical factors are fine, but structural imbalances are huge,” says Nandu Narayanan, chief investment officer at Trident Investment Management LLC in New York and manager of several funds for CI Investments Inc. There is a good chance cyclical momentum could keep global growth at 4%-5% this year, he says, but the global imbalances — the U.S. trade and fiscal deficits and the high level of U.S. consumer debt — will produce a crisis at some point, resulting in a very severe recession and a big adjustment in the US$.

Ross Healy, president of Toronto-based Strategic Analysis Corp. , also thinks there will be a recession. “A normal business cycle correction is one thing, but a balance sheet correction is a bigger deal and takes longer,” he says. Even after such a correction, U.S. growth would probably be sluggish, around 2%-2.5% a year. As a result, he says, “We could have a period similar to the 1970s, when we didn’t reach a new high in equities for a decade.”

But Lloyd Atkinson, an economic and financial consultant in Toronto, doesn’t buy it. He is at the other end of the spectrum, and considers this “old world” thinking. He sees no problems with U.S. debt loads, be they consumer, trade or fiscal. He thinks strong productivity growth will provide consumers with the wherewithal to keep spending. He also expects continuing inflows of foreign funds because of the attractiveness of U.S. equities and the Asian and European central banks’ desire to prevent a big drop in the US$.

Then there is the middle ground, on which we find those who believe we’ll get through without a recession. But, they say, the twin U.S. deficits and the overleveraged U.S. consumer pose significant risks to global economic stability. They think the Fed will have to lower interest rates to keep the U.S. economy from slowing too much and see continued downward pressure on the US$, although they expect the decline to be gradual.

Some, including Leo de Bever, executive vice president of global investment management at Manulife Financial Corp. in Toronto, think the U.S. consumer will fall apart at some point, although de Bever is “amazed at how resilient the consumer has been.” He also says there may be something in the notion that central banks can now manage the economy better.

De Bever does, however, point to some negatives that either aren’t going away or are just emerging. In the first camp are the funding of pensions for aging populations, particularly in Europe, as well as European economic rigidities, especially in the labour market, that keep the region from getting on the road to strong growth.

Among the new negatives are the problems at General Motors Corp. and Ford Motor Co. that threaten the very existence of the companies and are going to require very painful restructuring.

Another concern is the impact of China’s building capacity in various sectors and the buying up of Western companies. Steel and aluminum producers, for example, that are currently benefiting from Chinese demand may suddenly find themselves in a world awash with product. And that’s an obvious example. In almost any area you can name, the Chinese can decide to do it themselves once they see how it’s done. And they have the wherewithal, given their huge savings invested in U.S. treasuries. This is very different from the development of most emerging countries, which have relied on foreign direct investment to fund their growth.

@page_break@China is not yet a dominant economy, in the sense that it is self-sufficient and able to rely on domestic demand to grow. It is still dependent on exports to the U.S. But China’s development plays a crucial role in global economic policy. Without China, the answers to the critical questions above would all be “no.”

After all, it is inexpensive goods from China that are keeping inflation down despite high oil and metal prices. (Narayanan is alone among the strategists and money managers surveyed in thinking inflation is a problem. “Inflation is higher than anyone thinks,” he says. “The market is assuming 2%-3% globally, but it’s north of 4%.”)

This means real interest rates no longer need to go to the 5% levels that were required in the past to quell inflationary pressure — and that often significantly slowed growth in consumer spending and produced recessions. Even with the increases in U.S. short-term rates over the past 18 months, real rates are only around 2%, less than the “neutral” 3%-4%.

In addition, Chinese and other Asian central banks’ purchases of U.S. treasuries both support the US$ and keep long rates down, even when short rates rise. Low rates provide additional support for consumers because they keep mortgage rates down and provide support for housing prices, a major source of consumer wealth. Low long rates also support equity markets because the return on fixed-income is not very attractive.

Not many global managers see opportunities to invest directly in China. It’s not a capitalist society with a focus on the bottom line. The priority is jobs for the countless thousands leaving the rural areas and moving into cities in search of work and better lives. If the economy isn’t growing at 6% or more a year to absorb these workers, there could be widespread social unrest.

Not surprising, Atkinson prefers U.S. stocks. But while Clement Gignac, chief economist and strategist at National Bank Financial Ltd. in Montreal, and Fred Sturm, chief investment officer at Mackenzie Financial Corp. in Toronto, also consider U.S. valuations attractive, neither is as bullish as Atkinson.

Gignac thinks expectations for U.S. earnings are too optimistic and would hold off buying until they come down. He expects a marked slowdown this year but not a recession, although he puts the odds of a downturn at a significant 30%.

Sturm is just generally cautious because he doesn’t foresee strong upward momentum in the markets. He recommends “focusing on micro issues rather than defining macro trends.” This means concentrating on individual companies’ valuations and prospects and certain subsector themes, such as health care.

Most others think U.S stocks are overvalued compared with other regions and are underweighting them. Both Peter O’Reilly, global money manager at I.G. International Management Ltd. in Dublin, a division of Investors Group Inc., and Bill Sterling, chief investment officer at Trilogy Advisors LLC in New York, which manages a number of CI funds, have slightly underweighted the U.S.

Sterling offsets this by overweighting Europe, Japan and emerging markets, while O’Reilly has overweighted his portfolio in continental Asia, particularly Korea. O’Reilly maintains you have to pick and choose in Europe, and he is finding it hard to find value in Japan. He much prefers Korea.

John Arnold, portfolio manager at AGF International Investors Inc. in Dublin, is more negative still on the U.S., with only 30% of assets in U.S. equities, vs 60% in Europe. Arnold also likes Korea and Taiwan.

De Bever feels U.S. stocks are so overvalued that they will either suffer a 25% correction or move sideways for a considerable number of years. He is not enthusiastic about Europe because of the structural reforms that are still needed, but he expects Manulife investments there will make money “sooner or later,” although some of that will come from declines in the US$ over the coming years.

Not surprising, neither Healy nor Narayanan likes the U.S. Narayanan is picking opportunities in Europe and is overweighting Japan. He “doesn’t mind” emerging markets but would stick to the broad index. However, both he and Healy really like energy. They think oil prices will continue to rise, and neither thinks a downturn will produce much of a damper. Healy is sticking mainly to Canada and mainly to energy stocks, while Narayanan also likes Russia.

Sturm has five questions both advisors and investors should always be asking. If they can’t answer all with a definite “yes,” he says, it’s time to be cautious:

1. Are stocks going up? The answer is “yes” but not as broadly as two years ago, so that’s only mildly positive, he says.

2. Is investor sentiment sufficiently cautious so that we know we aren’t paying top dollar? Hedge funds need to be watched, Sturm says. When they are net long, the market is nearing a peak. When they are net short, as now, a rally is likely but would tend to last no more than a few months.

3. Are central bankers trying to accelerate the economy and stock markets? Currently they are shifting from neutral to “tapping the brakes slightly.” In the mid-1990s, once investors felt the Fed was nearing the end of its tightening, equities advanced sharply. But over the long term, stocks tend to decline moderately after the last rate hike. One question is whether Ben Bernanke, the new Fed chairman as of Jan. 31, will feel the need to make his mark. If so, he could raise rates above what’s needed. However, Sturm believes, Bernanke sees deflation as the greater risk, which would mean the U.S. is nearing the end of the tightening.

4. Are stock valuations broadly attractive? Sturm answers “yes” to this, both in the industrialized world — particularly in the U.S., where equities have stalled over the past 18 months — and in emerging markets, thanks to commodity prices. He adds that companies, flush with cash, are expected to buy back their stock.

5. Can we anticipate robust economic growth? The answer here is: growth, yes; robust, no.

One other factor is the U.S. presidential cycle. Over the past 100 years, U.S. presidents have implemented the toughest measures in the first two years of their administration and then tried to accelerate the economy in Years 3 and 4. We are in Year 2.

In this environment, Sturm “prefers to stay with large, high-quality companies that are strong rather than chasing incremental returns from more average firms.” Large-cap firms in the U.S. are “now showing constructive signs of repair over the past five years,” he says, “and may see resurgence in next few years as the U.S. equity market comes into a more favourable cycle.”

Sturm also sees opportunities in emerging markets but says individual investors are better partnering with experienced managers. “It’s much easier to get gut feel for TD Bank Financial Group than to understand ICICI Bank in India. Yet long-term growth opportunities for Indian banks are better.”

No one is excited about fixed-income because interest rates are so low. The yield curve is also pretty flat, with long rates not much above short ones. Most expect the curve to steepen. The majority see this happening through a decline in short rates, but some expect long rates to climb. Sturm thinks long bonds are best to hold now but bondholders need to be prepared to trade them. He also recommends some cash and suggests gold as an insurance policy in case things go sour.

Narayanan is very bullish on gold. He has a target of US$600 an ounce for the end of this year, vs the recent US$519, and thinks it could reach US$1,000 an ounce in three or four years.

Gignac also has a US$600 target for Dec. 31: “It’s not a bad idea to have 5% in gold.”

Healy is less enthusiastic about gold. He says it will probably go up if the US$ weakens, but he’s not a gold bug. He wouldn’t recommend gold stocks, which he thinks are very highly valued relative to their prospects, but bullion itself could be a good idea.

Risks to the outlook centre on the U.S., specifically the consumer and the willingness of investors, particularly Asian banks, to fund the twin U.S. deficits. But there are other risks, including further increases in oil prices, whether generated from strong growth in demand or sparked by supply disruptions due to political events in producing countries; inflationary pressures from high energy and metals prices; political turbulence in any of a large number of non-oil-producing developing countries; a pandemic; and the ever-constant threat of major terrorism attacks.

Here’s a look at the risks and prospects in the major regions:

> The U.S. The first issue is how there can be so much disagreement about U.S. consumers. The answer is that it depends on what numbers you look at. Healy says consumers borrowed about US$600 billion in 2005. Even if they simply stop borrowing, let alone started paying off debt, the economy would be thrown into a severe recession. Atkinson counters by pointing out that consumers’ assets have been rising faster than their liabilities, so their net worth is rising. They aren’t highly leveraged, and can easily afford to borrow more.

Healy also points to the “negative” savings in the U.S., saying this indicates no room to manoeuvre. But, Atkinson says, the savings number is meaningless. It is arrived at by subtracting spending from income, but spending includes both money put aside for retirement and money taken out of retirement plans.

Then there’s the question of how squeezed consumers’ disposable incomes are by high oil prices and rising interest rates, how much they would be affected by a cooling housing market and what kind of wage gains are likely.

Atkinson points out that monthly payments on mortgages are at much lower levels than they were in the 1980s, so he sees no reason to think consumers are being squeezed.

Rising gasoline and heating costs are very visible and grab attention. But because housing costs are such a big part of most families’ budgets, consumers are much more affected by mortgage rates. If short rates come down later this year and long rates stay steady, mortgage payments will remain affordable.

However, psychology also plays its part. Consumers could become alarmed if housing prices fall. There have recently been housing bubbles in Britain and Australia. When interest rates rose, housing prices fell. And there are numerous signs the housing market is turning into a buyer’s market, says Trilogy’s Sterling, such as the rising inventory of unsold homes in California, Florida and the northeastern U.S. He adds that first-time buyers are finding real estate unaffordable; these first-time borrowers are needed in order to have a strong market. He expects housing prices to edge downward. There’s a risk that long rates could shoot up, in which case house prices would drop significantly.

Gignac considers real estate the biggest risk and he sees “exuberance” in the East and West Coast markets. Financial institutions may swing to very tight conditions for mortgages. In addition, he says, “You never know which 25 basis points will bite” in terms of consumer attitudes to taking on more debt.

Atkinson believes real wage gains will continue. But that requires strong productivity growth, and some analysts think it will slow. This group includes the International Monetary Fund, which expects a 3% gain in 2006, after gains of about 5% in the previous three years. That leaves room for generous wage increases, but, in many sectors, competition from China on goods and India on services precludes significant wage hikes.

Purchases of U.S. treasury bonds by central banks, especially in Asia, have provided sufficient funds to finance the U.S.’s twin deficits. Atkinson thinks this will continue because a big drop in the US$ would hurt the competitiveness of companies in many countries. But others worry that a sell-off of US$ by hedge funds could push the US$ down significantly. There’s also the possibility that a more severe slowing of U.S. growth than expected would cause a corresponding slowdown in Asia, in which case central bankers wouldn’t be able to afford to buy U.S. treasuries at anywhere near the same pace.

> Europe. No one is excited about Europe and everyone is discouraged by continued economic rigidities, especially in the labour market. There are some signs that the addition of 10 eastern European countries to the European Union is forcing labour in western Europe to be more cooperative, but it is not yet widespread. De Bever says many European companies don’t want to make the hard decisions — management teams are leaving those decisions to their successors. But there is real danger in that: in the meantime, a competitor could find a new way to operate and the first company’s business could wither.

Both Atkinson and de Bever are also worried about the coming pension crisis in Europe. “Most western European countries have very few private pension plans, and the public plans, either explicitly or implicitly, promise to provide about 70% of pre-retirement income,” says Atkinson. “The dilemma is that, 20 years ago, everyone worked to 65 and died at 70; today they retire at 50 and die at 80.”

Attempts to raise the retirement age have resulted in people “taking to the streets.” He suspects it will take a crisis to force governments to deal with the issues.

> Japan. Most analysts believe Japan has emerged from its 15 years of slumber. Reform has vastly improved the banking system and there has been substantial corporate restructuring. Exports to China have gotten the economy moving and asset prices are moving upward. With the end of deflation, consumers should begin spending. But, longer term, Japan, too, has to cope with an aging population.

> Emerging markets. Strategists and money managers are generally positive on the Third World, but are more enthusiastic about some areas than others. Asian countries have the best prospects, although Indian equities are deemed expensive and the possibility of social unrest hangs over Thailand and Indonesia. Brazil’s prospects are the best in Latin America, and there are opportunities in Mexico. Chile and Argentina are considered too expensive. There is little enthusiasm for eastern Europe except for Russia, which is mainly an oil play (although some see opportunities in the consumer sector). There are also possibilities in Morocco, South Africa and Turkey. IE



Catherine Harris is Investment Executive’s economics editor and the editor of this report.