• David Cockfield

A World in Transition


In case you haven’t noticed the world is changing and rapidly at that. An old Chinese curse “may you live in interesting times” comes to mind. These are without question interesting times.

For decades the Western World economies, North America and Europe, dominated the economy of the world. Japan rose as a challenge but with no material natural resources and despite its hard-working , but aging population, it soon faltered. The new emerging economic powers such as China, India, Brazil and a number of Far Eastern nations have natural resources and young populations and are challenging the Western World economies again. These new economies have workers who are willing to work hard to achieve the standards of living enjoyed in the West. Using Western technology these emerging world powers have been able to flood the Western economies with cheaper manufactured goods. This has eliminated huge numbers of manufacturing jobs in the Western World and put significant downward pressure on manufacturing wages. Until the world sees a better balance of living standards this pressure on the Western World’s standards of living will continue. There are some hopeful signs for the West, as China, whose middle class now exceeds the population of the U.S., is experiencing growing upward pressure on wages, making it less competitive. Domestic consumption of manufactured goods in China is also growing making the need to export less urgent. For the foreseeable future however, the Western World will struggle just to maintain their present standards of living. Job seekers will require higher levels of education and new jobs will likely be in the service industries.

The transition to a more competitive world has crept up on the Western World. Accustomed to years of growth interrupted by the occasional recession, we became used to patterns of consumption that are no longer supportable by our actual productivity. We made up for the shortfall by borrowing and piling up debt. We have now reached the limit of our ability to leverage and unlike in the past we are now unable to achieve the levels of economic growth that will let us grow out of our debt load. As mentioned in our past newsletters, this process of deleveraging – paying down debt, will likely last for years.

What does this all mean for North America and Europe? While many uncertainties remain, the following is our view of the probable course of events.

The U.S. while still facing significant government deficits is showing steady economic growth. The Treasury and Federal Reserve have the U.S. financial systems well in hand and the U.S. banking system is functioning and is reasonably solid. While there is economic growth, it is at a rate too low to absorb the overhang of unemployment, caused by the financial meltdown and housing collapse of 2008-2009. Typically coming out of a recession it is the small business sector that creates jobs, often in the process of competing with the larger corporations that have cut back services to customers in reaction to the recession. Unfortunately in this recession the banking sector was so badly battered, it is so far reluctant to provide the level of financing essential to get the small business sector rolling and hiring again. This bottle neck to growth seems to be in the process of changing, but slowly.

On a further positive note, the U.S. corporate sector, unlike the situation one would normally expect in a recessionary or slow growth period, is in excellent health. Corporations having cut back on expenses, are hoarding cash that is now measured in the trillions of dollars. The U.S. corporate sector is well positioned to expand, but with no incentives (that is competition from smaller competitors) plus the uncertainties in Europe, large U.S. corporations have been content to sit on their cash. A pickup in growth in the U.S. could well provide the incentive for these corporations to expand and begin hiring again. In this context there are some signs that the U.S. housing market has bottomed and is beginning to grow. To meet normal population and family formation growth requirements, housing starts in the U.S. on an annual basis should number 2.5 million units. In recent years the number fell to 500 thousand units. A return to more normal levels of housing construction and likely rising house prices would mean a major boost to the U.S. GDP, consumer confidence, and the value of bank mortgage portfolios.

A further positive development for the U.S. has been the easing of energy prices. Energy is a basic economic cost, as the recent falling inflation rates demonstrate. Looking further ahead, the continuing discovery of huge shale gas reserves in the U.S. and Canada, means cheap natural gas prices are likely for years into the future. New oil discoveries and the ongoing development of the oil sands could well make North America self-sufficient in fossil fuel requirements in the next decade. This would be a huge economic plus for the U.S. and its trade deficit, as it is a huge consumer of energy and imports a significant amount of oil.

From a Canadian prospective any improvement in the U.S. economy would be a positive. A recovery in the U.S. housing market would particularly revitalize our forest products industry. Our banking system remains in excellent shape, as does our housing industry. The slippage in world oil prices recently has been compounded in Alberta by transportation bottlenecks, that have dropped oil prices in Alberta to under $60.00 per barrel. Given projected pipeline expansion plans, this situation should not persist for too long. The Canadian economy still remains somewhat dependant on buoyant world commodity prices. From this standpoint China has been the major factor in demand growth for commodities and price setting for some years now. While the Chinese economic growth has slowed recently, this was due to government economic tightening in an effort to control inflation and curb real estate speculation. Both these objectives have been achieved and economic easing has begun. Given the political necessity to produce growth rates in the 8% to 9% range, we expect demand growth in the commodity sector will soon reflect a return of Chinese consumption growth to more normal levels.

The financial crisis in Europe has recently been the largest black cloud hanging over world economic prospects and financial markets. Given that we have never faced such a complex financial situation of such large proportions, any number of disaster scenarios could and have been constructed. The seeming inability of the members of the European Union to produce concrete solutions has had everyone fearing for the worst. Now at the eleventh hour there is a plan and remedies have been proposed. Financial markets have reacted positively to this news. The fact is that many more steps need to be taken, but there is now at least some forward momentum and expectation that the European Union will survive. Within the Union the belt tightening ahead for the members that have over spent and over borrowed is huge. Civil services need to be shrunk, pensions cut, restrictive laws repealed, subsidies eliminated – all in all more work and less play. The competitive pressures of the new world order that we are experiencing in North America apply as well in Europe. The process of reform in Europe will take time and effort, and will be less than popular with the populations that have grown accustomed to free handouts. Political unrest can be expected, and there are no guarantees that the political will to achieve the necessary changes will be there when needed. In the mean-time progress has been made and immediate disaster avoided. Hopefully a period of relative calm will allow financial markets to focus on what is actually happening, not what might happen.

We continue to recommend investment strategies aimed at producing predictable cash flow from fixed income coupons and dividends. Financial markets will continue to be volatile and unpredictable. Markets will reflect economic progress which will be slow and halting. Equities in Canada are now trading at historically low price earnings ratios reflecting the market’s heightened perception of risk. It is unlikely that price earnings ratios will decline much further. Equity market values for individual stocks in the future should rise or fall in line with earnings and dividends generated.


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