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Sell Canadian equities, buy bonds: Bank of America

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While the Bank of Canada becomes more hawkish on interest rates due to a brighter outlook for the Canadian economy, economists at Bank of America remain 'skeptical' of such a view.

In a note to clients, Bank of America Merrill Lynch says Canada is bumping up against its growth limits. As a result, they are warning investors to steer clear of risky investments such as equities and instead park their money into bonds.

“The softening growth momentum and skepticism in the growth outlook suggest that investors reduce risk appetite,” Neil Dutta, economist at Bank of America Merrill Lynch, says in a note to clients. “We expect several false alarms of BoC tightening over the next year-and-a-half before the BoC actually moves. This should create near-term trading opportunities in the short-end of the bond market.”

Dutta says the Canadian economy will be hurt by a pullback in consumer spending, a slowdown in the U.S. economy and a high loonie.

While the economy has historically been driven by trade, the recovery since the recent recession has instead been driven by domestic demand -- with the level of real exports about 8 percent lower than before the recession. Dutta says this time around consumer spending and residential investment were the main drivers of the economic recovery.

Even more cyclical components of GDP, such as autos, business investment and inventories, are now approaching their long-run averages, Dutta says, which could restrain growth going forward.

“Demand can always push growth above long-run equilibrium levels; the relative overinvestment in housing is an example today,” he says. “Currently, Canada is bumping up against its growth limits. However, as Europe remains in recession and the U.S. slows, Canadian aggregate demand will likely weaken, reopening the output gap.

Dutta says Canadian households are already getting the message about high debt levels -- something Bank of Canada Governor Mark Carney has repeatedly called the biggest risks to the economy. While growth in consumption has exceeded income since the recession, Dutta believes Canadian households are nearing the point where they begin to spend less than they take in.

“While lending standards remain easy for Canadian businesses, they have tightened for Canadian households,” he says. “In recent months, the growth in household credit has moderated.”

And he says a slowdown in the U.S. economy “presents significant downside risks” to the Canadian economy, as Canada’s export sector remains highly dependent on the U.S. -- which accounts for three-fourths of exports.

“Moreover, Canada has steadily been losing market share in the U.S.,” he says. “In the mid 1990s, Canada accounted for roughly 20 percent of U.S. imports; now, the share has dropped below 15 percent.”

ALL BEAR MARKETS MUST END SOMETIME

Not everyone agrees with Dutta’s call.

Don Coxe, strategy advisor at BMO Financial Group, says now is the perfect time for investors to beginning trickling back into equities, particularly in the U.S. -- even though the S&P 500 is at nearly the same level it has been for 13 years.

“You can’t find the bottom in stocks but you can say that bear markets don’t last forever,” he says. “It’s time to start tiptoeing back in and go in with what looks like the group that has the best fundamentals and is cheapest relative to even the past five or 10 years -- and that’s the commodity stocks.”

Coxe says the biggest factor in enticing investors back into equities is record-low bond yields.

“There’s a zero rate of return on cash, therefore…for the first time ever you can say ‘Well if I own good stocks where the dividends are going to grow I’m going to do better than I would in a three-year bond,’” he tells BNN.

Coxe also says investors only need to look at regional banks in the U.S. for a sign that the world’s largest economy is beginning to turn a corner.

“The main street banks in the United States…have been outperforming the stock market solidly in the last six months and that has been an indicator that has never failed to tell you that the U.S. economy has better underpinnings than a lot think,” he says.

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