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Global Outlook 2006 – Chicken Little or Peking Duck? January 17, 2006 Presented by: Patricia Croft Vice President & Chief Economist Phillips, Hager & North Investment Management Limited Est. 1964 Outlook 2006 It’s All About Oil and Inflation Global growth still healthy and better balanced Some improvement in Europe and Japan – Canada remains strong Soaring energy prices have had little impact but… Storm clouds on the horizon Tightening Fed Housing bubbles and yawning current account deficit Protectionist sentiment Energy prices 70 0 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 US$/barrel Crude Oil Prices Still Elevated – Chicken Little? WTI Crude 60 50 40 30 20 10 Long-term Price of Oil Has Increased – But to $45 not $100 Days of $22-28/barrel are behind us Global demand shift Alternative resources take time to develop Refinery capacity is limited and inadequate Monetary Policy: Key Theme for 2006 Central bank monetary policy normalization Percentage points 4.0 Tightening since trough 3.50 3.5 Tightening in last year 3.0 Estimated distance from neutral 2.5 2.0 1.75 1.75 1.5 1.0 1.00 0.50 0.5 0.00 0.0 -0.5 U.S. Canada Australia U.K. Eurozone Japan Estimated neutal rate = LR core inflation target + LR potential real GDP growth rate House Prices Still High Index, 1994Q1 = 100 300 250 U.K. Australia U.S. Canada 200 150 100 50 1994 1996 1998 2000 2002 2004 Outside North America, Things Are Looking Up UK in a soft spot but has likely bottomed Europe doing better – interest rates still low Japan improving – end of deflation in sight? China still strong – now bigger and better Global growth holding up but likely to ease in 2007 as lagged effects of rate hikes start to hit home globally UK Economy on the Mend? 12 % change year ago 10 Retail sales Manufacturing output 8 6 4 2 0 -2 -4 -6 -8 1997 1998 1999 2000 2001 2002 2003 2004 2005 Will 2006 Be Europe’s Year? 20 Year-over-year % change 15 Real GDP Private expenditure Fixed Capital Formation Exports Italy France Germany Real GDP Private expenditure 20 Fixed Capital Formation Exports 15 15 10 10 10 5 5 5 0 0 0 -5 -5 -5 -10 -10 -10 2000 2001 2002 2003 2004 2005 2000 2001 2002 2003 2004 Real GDP Private expenditure Fixed Capital Formation Exports 20 2005 2000 2001 2002 2003 2004 2005 Japan’s Recovery – Is This the Real Thing? Corporate profits are improving and business investment is increasing Private consumption and employment are increasing moderately Exports and industrial production are picking up Risk is the impact of oil prices on both domestic and overseas economies 25 0 Jan-99 Apr-99 Jul-99 Oct-99 Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Percent of total Japan’s Reliance on China Growing but U.S. Still Top Dog Japan's key export markets 40 35 32.1 30 33.7 28.1 20 15 23.4 Export share, USA Export share, China Export share, Other Asia 14.1 10 5.1 5 China Vaults to Number Four Global Economy New GDP Old GDP Tertiary 32% Primary 15% Secondary 53% $1.6 trillion US Source: National Bureau of Statistics Tertiary 41% Primary 13% Secondary 46% $1.9 trillion US = 20% increase! China’s Far Reaching Impact It has altered world trading patterns, shifting income It has pressured wages of low skilled workers in rich countries It has helped companies increase return on capital without pressure from workers for higher wages U.S. Economy Remarkably Resilient Despite higher oil prices, natural disasters and consumer worries, real growth still strong Federal Reserve appears to be close to end of tightening cycle Biggest risk: U.S. consumer Negative personal savings rate Rising debt servicing costs Higher energy costs Real estate reliant Why is the Fed Still Tightening? 2 4.9% 88 3 86 4 84 5 Cap U LR avg = 81.4% 6 % 82 80 7 78 8 76 Q4 2005 Q1 2003 10 Q2 2000 Q3 1997 Q4 1994 Q1 1992 Q2 1989 Q3 1986 Q4 1983 Q1 1981 70 Q2 1978 11 Q3 1975 Unemployment rate (right) Q4 1972 72 Q1 1970 9 74 Capacity utilization rate, all industries (left) 12 % 90 US capacity indicators Will the Fed Tighten Too Much? Yield Curve is Flat But Real Rates Still Low US yield curve slope - 10-year Treasury bond - 3-month T-bill Percentage points 5 4 3 2 1 0 -1 % Real US 3-month T-bill rates 7 6 5 4 3 2 1 0 -1 -2 -3 Core Inflation Well Behaved – So Far US consumer price inflation Percent, Year-over-year 18 15 Core CPI 12 Headline CPI 9 6 3 0 -3 1960 1966 1972 1978 1984 1990 1996 2002 U.S. House Prices Continue to Surge Sustained low interest rates tend to fuel asset bubbles US Real House Prices 170 160 Index 150 140 130 120 110 100 90 1975 1980 1985 1990 1995 2000 2005 Source: Office of Federal Houising Enterprise Oversight, Bureau of Labor Statistics U.S. Consumer Using Home as a Cash Machine 12 Net equity extraction through cash-out refinancing As a percent of disposable income 10 8 150 6 100 4 50 2 Q1 2005 Q4 2003 Q3 2002 Q2 2001 Q1 2000 Q4 1998 Q3 1997 Q2 1996 Q1 1995 -2 Q4 1993 -50 Q3 1992 0 Q2 1991 0 % of disp income 200 Q1 1990 US$ Billions, quarterly rate 250 Source: "Estimates of Home Mortgage Originations, Repayments, and Debt on One-to-Four Family Residence”, Kennedy and Greespan, Federal Reservce 2005 Current Account Deficit Still a Dollar Risk US Dollar and Current Account Balance 2 150 1 140 130 -1 120 -2 110 -3 100 -4 -5 % of GDP (left) -6 Trade-weighted value of US dollar against major currencies (right) 90 80 -7 70 1973 1975 1978 1980 1983 1985 1988 1990 1993 1995 1998 2000 2003 2005 Index % of GDP 0 Canadian Economic Growth Strong But Unbalanced Higher energy prices benefit Canada as we are a net energy exporter However, high energy prices create a transfer of wealth from central Canada to Alberta The Canadian dollar has become a petro currency – a stronger dollar will further challenge the manufacturing base Fiscal policy is loose – monetary policy is tightening Canadian Job Creation Has Been Very Strong Cumulative job creation since January 2004 500 400 Total 350 Full-time 300 250 200 150 100 Nov-05 Sep-05 Jul-05 May-05 Mar-05 Jan-05 Nov-04 Sep-04 Jul-04 May-04 0 Mar-04 50 Jan-04 Thousands 450 Alberta Roars While Central Canada Reels 2006 provincial real GDP growth 7 6 4 % % 5 3 2 1 0 BC AL SK MB ON Source: RBC Financial Group QC NB NS PEI NL 16 14 12 10 8 6 4 2 0 -2 Provincial labour markets Unemployment rate (ytd avg %) Job growth (ytd % change) NL PEI Provincial retail sales and housing 15 ON BC SK MB AL AL BC CPI (ytd avg %) Wages & salaries (ytd % change) 8 7 6 % % QC 9 5 0 5 4 -5 3 2 -10 -15 NS Provincial price pressures Retail sales (ytd % change) Housing starts (ytd % change) 10 NB 1 AL SK MB QC NB BC ON PEI NS NL 0 PEI NS MB NL NB QC SK ON Canadian Inflation Indicators Flashing Yellow Capacity utilization and unit labour costs 90 8 Capacity utilization Unit labour costs 6 86 4 82 2 80 78 0 76 -2 2005 2002 1999 1996 1993 72 1990 74 1987 % 84 -4 Annual % change 88 For Now – Inflation Remains Tame 5.0 4.5 Canadian CPI inflation Core (excl. 8 most volatile items) Headline 4.0 3.5 % 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Bank of Canada Back in Tightening Mode Central bank policy interest rates 7 6 (%) 5 Bank of Canada U.S. Federal Reserve 4 3 2 1 0 2001 2002 2003 2004 2005 Canadian Dollar Was A Star in 2005 Performance of the Canadian dollar in 2005 20 18 Change in value against selected currencies from Jan. 1 to Dec. 31 2005 16 14 % 12 10 8 6 4 2 0 U.S dollar New Zealand Australian dollar dollar UK pound Euro Yen Outlook 2006 - Summary Global growth set to slow as weakness in the U.S. is partially offset by renewed vigor in Europe and Japan Canada strong for now – growing regional disparities will challenge policy makers Monetary policy normalization process to continue C$ overvalued – U.S. bear market at hand Risks Energy prices/house prices Geopolitical instability Mother Nature Protectionist sentiment Easy Monetary Policy has Encouraged Risk Taking 60 55 CBOE Volatility Index (VIX) Old VIX (based on S&P 100) New VIX (based on S&P 500) Black Monday 50 LTCM Above 40 = Panic 40 Gulf War II 35 9-11 Asian Crisis Gulf War I 30 25 20 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 10 Below 20 = Complacency 1987 15 1986 Index 45 Global Yield Curves Flattening Yield curve slope, current and year ago 10 year - 3 month yields, bps 250 year ago current 200 150 100 50 0 -50 Japan Eurozone Canada US UK Long Bond Yields Still Low and Range Bound 10-year government bond yields 7.0 2.5 6.5 2.0 6.0 5.5 1.5 % % 5.0 4.5 4.0 3.5 3.0 2.5 2000 1.0 Canada (left) US (left) Germany (left) Japan (right) 0.5 0.0 2001 Source: Datastream 2002 2003 2004 2005 Japan Soars – U.S. Sputters Major stock markets since Jan. 2004 Index: Jan. 1 2004 = 100 160 150 140 S&P 500 S&P/TSX MSCI EAFE (US$) Nikkei 225 130 120 110 100 90 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 P/E Ratios Have Converged 28 S&P 500 TSX MSCI EAFE 26 Ratio 24 22 20 18 16 14 12 1998 1999 2000 2001 2002 2003 2004 2005 Asset Mix Summary Overweight equities, neutral on bonds, underweight cash May add to U.S. or EAFE equity holdings Corporate earnings still strong – corporations flush with cash Valuation for stocks is reasonable, particularly in the U.S. Proximity to end of Fed tightening cycle is a positive factor