It has been a record-breaking year for the capital markets in 2006. The S&P/TSX composite index and the Dow Jones both topped 12,000 for the first time ever, oil’s gone from US$60 a barrel to a record US$78 and back down again, gold hit a 26-year high of US$732 an ounce, and income trusts fell out of favour after the federal government announced it would begin taxing the stock market darlings. The 2007 outlook for the markets is somewhat mixed, with some predicting good times ahead and others expecting the worst. Institutional investors will want to fasten their seat belts and keep an especially close eye on the capital markets—the ride is going to be bumpy.

CIBC World Markets says the Bank of Canada will be forced to cut rates next year because the Canadian dollar has become a petro-currency like never before. The investment bank expects the loonie to appreciate above US$0.90, which could lead to a recession in Central Canada. To prevent that from happening, the Bank of Canada would be forced to cut rates by up to 100 basis points.

However, the Conference Board of Canada doesn’t expect the central bank to stand pat as inflation stays low. “Because of what’s going on in Central Canada, and out east in fact, they’ll be sitting on the sidelines,” says Pedro Antunes, director, national forecast at the Board.

For a pension plan, what really counts is what goes on with longterm interest rates. The challenge with that is long-term interest rates, to some extent, are really driven by supply and demand.

In 2007, pension plan sponsors will be looking to reassess both the risk and return and potentially derisk, says Peter Muldowney, business leader for Mercer Investment Consulting in Toronto. “That could actually increase the demand for real return and long bonds which despite what happens with short-term interest rates, could lead to either further decreases or at least no change in long-term yields,” he says.

That’s one of the dilemmas of bond investing. It happened in the United Kingdom when the pension firms started to invest in indexlinked bonds, the equivalent of our real return bonds. The yields fell to really low levels because of a function of demand and a lack of supply. This kind of problem could happen here as well.

Although it topped new records this year and then fell back down to earth, oil may not have peaked. Strong global demand, particularly in China and major oil-producing countries, should send crude to new highs and average US$80 a barrel in 2007. “I think we’re going to see oil prices continue to rise,” says Jeff Rubin, chief economist and chief strategist at CIBC World Markets in Toronto. “We are getting new increases in supply, but when we’re drilling 35,000 feet in the Gulf of Mexico, or we’re schlepping a ton of sand to get a barrel of oil, the supply curve is a little bit different.”

Plan sponsors overweight in energy would do well if that were to happen, but not everyone feels that way. TD Economics, the research subsidiary of TD Bank, believes an overhang in global supply has built up and oil is likely to keep heading lower. Recent global political issues have also failed to “have any meaningful upward pull on crude prices,” it says. With the fundamental supply demand conditions likely to weaken further, crude will decline before recovering in the second half of next year.

The outlook for the equity markets is just as mixed. National Bank Financial’s chief economist and strategist, Clement Gignac, in Montreal, is predicting a tumultuous year for the markets. He expects the S&P/TSX to hit 10,500, which would be equal to a 14% drop in where it was at the beginning of November. He says there is growing evidence of eroding productivity and labour cost pressures that will cause a slowdown in corporate earnings growth.

CIBC is in the bullish camp because nearly two-thirds of the TSX market capitalization is comprised of energy or interest-sensitive stocks. Considering its forecast of a decline in interest rates and a rise in crude prices, it expects the S&P/TSX to hit a record high of 13,500 in 2007, about a 12% increase from where it was in early November. With two very different forecasts, it’s best for institutional investors to stay cautious.

Alternative investments are becoming more popular, and managers are offering products that provide investment opportunities for pension plans, both large and small, to invest in. Pooled funds are becoming more popular, giving plans the ability to make a more straightforward investment because an outside manager takes care of all the investment choices. However, there is a price—performance-related fees if the investments do well—which may turn off some sponsors when they see the size of the fees they have to pay. Still, these investments are a nice complement to the traditional equity and bond markets and can improve the overall portfolio diversification.

“We’ve gone through some incredible times over the last few years, so I think plan sponsors have been sensitized to thinking about risk and not just return,” says Muldowney. “I think 2007 might actually be having also a little more focus on return enhancement. And that’s why some of these alternative strategies will get more time on agendas of plan sponsors as they determine what they want to invest in for the future.”

If next year is anything like this year, then plan sponsors should do fairly well. But no one can truly forecast what will happen. The best thing plan sponsors can do is focus on the long term instead of just worrying about tomorrow.

What the Bank of Canada expects

The Canadian economy is expected to keep growing in 2007, but will be hurt by a slowdown in the United States, according to the Bank of Canada.

Gross domestic product will slow to 2.5% next year, down from a projected growth rate of 2.8% in 2006.

Ontario will be hardest hit by a weaker U.S. economy, David Dodge, the bank’s governor, said in a speech in October.

“It is clear that the cyclical pullback in the U.S. housing and auto sectors is causing particular difficulties for Ontario,” he said. “Given the degree of integration of the Ontario and U.S. economies, this province will feel a significant impact from the U.S. downturn throughout the second half of this year and the first half of 2007.”

“When you consider that automotive products made up 44% of Ontario’s merchandise exports last year, it is clear that the U.S. downturn will likely affect Ontario more severely than other provinces.”

Overall, the Ontario economy will underperform the Canadian average in 2007, but should still grow nonetheless.

The bank’s projection is that core inflation should remain slightly above 2% before returning to 2% in the second half of 2007. Total inflation will continue to be affected by the cut in the Goods and Services Tax and trends in energy markets.

“We expect total inflation to remain below our 2% target, averaging around 1.5% from the fourth quarter of this year to the end of the second quarter of next year,” Dodge said. “Following that, total inflation should remain near 2% until the end of 2008.”

However, rising home prices and consumer credit growth could put upward pressure on inflation. The strong growth in prices and wages in Western Canada could also spread to other regions. On the downside, the main risk is that the U.S. slowdown could last longer than expected.

Craig Sebastiano is the associate editor, news and websites with BENEFITS CANADA.

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