LOM Weekly Perspectives

There have been a number of upbeat data releases in the U.S., including one on manufacturing activity and another on consumer confidence. So, why is it that equity investors are so gloomy? It could be that the Enron debacle and a slew of revelations from other corporations is making them a bit nervous. For the first time, in a long while, they may be reflecting on the difference between image and reality. Now, any half-decent psychologist will tell you that understanding reality is not just a straightforward process of evident facts determining correct perception, but of perception selecting facts which in turn affect perception. How we perceive reality is filtered through a whole system of received ideas, ideologies and media presentation of events. Rational, cool heads are few and far in-between. The concerted efforts of those in media, marketing and public relations are aimed at truncating critical thought and promoting a particular presentation of reality.

The reality is that the quality of financial reporting has been deteriorating for years – and that’s no secret. Wall Street investment banks, corporate management, accounting firms, lawyers, and notably investors went along with the accounting manipulations until the earnings-growth machine finally sputtered. It is rather disingenuous for investors to suddenly claim that they have been conned by unscrupulous managers and accountants. The latter were only some of the players in a show that ran successfully for a number of years and received repeated applause and accolades from some of the folk who are now complaining loudly. However, despite these truths, and because of the current screams of pain, it is clear that for political reasons the show will not be allowed to go on exactly as before. At the same time, there are so many vested interests involved that it is unlikely we will get an entirely new production. There is going to be a political struggle over just what sorts of regulations are going to be implemented. Wall Street is definitely interested in presenting a cleaner image, because bread and butter issues are at stake. But don’t expect a sea change in how managers, accountants and analysts behave.

Currently, if we side-step the phoney numbers game, we can still say that the state of finances in corporate America, though rickety in some cases, is nevertheless broadly sound. Certainly, there are going to be some more bankruptcies and accounting restatements are going to make others look less pretty, but economic recovery will still mean an increase in "real" earnings growth. It is just that bottom-up consensus analyst forecasts have been somewhat rosy, thus far. For those in the market who base their decisions on fundamental analysis the quality of financial data is obviously important. The astute ones always interpreted the data carefully and stayed away from firms with complex organisational structures and obscure accounting practices. Their goal is to assess the intrinsic value of the firm and invest in inefficiencies that involve mis-priced securities. But, this task is made that much more difficult if they have to slog through numbers that are deliberately misrepresented. For those who use technical analysis, the quality of financial reporting is not crucially important. Mass psychology as evidenced in market action is of greater significance. This gives rise to pricing inefficiencies that can be exploited profitably.

Fourth quarter GDP just squeezed by into positive territory. As noted by all observers, it was biased upward by the consumer spending spree on vehicles, as households took advantage of 0% financing. It is a bit of a distortion because, to some extent, the extra spending borrows from future expenditures. In the interim, firms have reduced inventories dramatically. Now, the main question is whether consumers will be at the rendezvous to buy, as firms begin to increase output. There is little pent-up demand for cars and housing, as in a normal recovery from a downturn, and there aren’t many other sectors where big demand increases can occur. So, it may be slow going for the economy. Meanwhile, there are positive signs coming out of Europe and Asia - other than Japan. Also, the world trade picture is looking more positive. All of this argues for slow growth in the global economy rather than a rapid rebound. A decent pick-up in the U.S. economy is an important factor in generating growth elsewhere, via foreign exports to the United States. Another crucial assumption is that the Japanese economy does not deteriorate more rapidly than currently expected. Yes, there are definite risks but it looks like we will muddle through.

The slide of the Canadian dollar to lower depths has elicited some angry words from politicians, but nothing in the form of policy action. It has also renewed calls, among the responsible citizenry, for the adoption of the U.S. currency. Given the increasing integration of the two economies and the example of the European Monetary Union it is hard to escape the conclusion that ultimately a common-currency area is inevitable. Canadians have paid dearly for the economic mistakes of their governments over the past few decades, and leaving one less policy instrument in the hands of politicians who have occasioned the decline in the external value of the currency is a good thing - for those who value efficiency and responsibility.

But for now, the loonie is still alive and its prospects are actually brightening. One cannot rule out the possibility that it may edge a little lower in the near term. But looking further out, a recovery in the global economy and rising demand for commodities should boost the value of the Canadian dollar. By year-end it could be headed towards 1.50 relative to the greenback. We should also note that there is another propitious factor working in the background. During much of the last decade, the productivity growth rate in the United States was faster than in Canada. More recently, though, there have been signs that the gap has been narrowing - partly because productivity growth has been playing catch-up in Canada. Now, if the U.S. productivity performance turns out to be less impressive in the current recovery than it was during the nineties then Canada’s relative competitiveness may improve. This could help to underpin the loonie's strength.