July 24, 2010 Outlook

The Bank of Canada prime lending rate went up, which could increase costs to companies, depressing earnings and reducing stock values. It remains to be seen how the economy will react. Because rates were very low to begin with, they are simply returning to a more normal level. Short term rates are back down to 1.52%. Inflation has dropped to just 1.00% which, if it persists, makes future interest rate increases less likely. So it seems that the only  likely risk of a recession is linked to policy error, such as raising rates too much too soon.

Mortgage rates have not moved. Even though short-term interest rates are rising, long-term rates are holding steady. The yield curve has flattened slightly, but house prices should be unaffected. This is good news, as the wealth effect will cause people who are earning more to spend more, supporting the economy. If house prices or stock prices were to fall, consumers would be more likely to reduce spending and focus on saving.

Professional investment managers are having a hard time with this environment. They see nothing to indicate whether stocks will jump 10%-15% or fall 10%-15% first. If they fall, people who are calling for a double dip will be exultant, even though the market level wouldn’t come close to March 2009. At the same time, it would provide a great buying opportunity. Experiencing another correction wouldn’t be surprising, since there are very real concerns about the health of various economies around the globe. What we do know is that the market isn’t becoming unrealistically inflated.