2006: Year of the downgrade

Written by Stephen Poloz

EDC Economics has just released its latest semi-annual Global Export Forecast. The theme this time is “Beyond the Summit: Navigating the Descent” which sounds a little foreboding.

The premise behind the forecast is that the global business cycle is alive and well. It is easy for people to think otherwise, because global business cycles evolve so slowly that they tend to be mistaken for trends. But in the past 10 years, there has been only one global business cycle: a slowdown in global growth during the various crises of 1997-98-99, then the tech wreck and 9-11, then a sputtering recovery in 2002, a fulsome one in 2003, and a boom in 2004 and into 2005.

In short, the sweetest part of the global cycle is behind us. The world grew by more than 5% in 2004, and this momentum carried into the first half of 2005. That is too fast to be sustained, so either a moderation will occur naturally or the always-vigilant central banks will make certain of it. The world will not fall off a cliff — rather, a moderation to more sustainable growth rates is in store.

Throw a major energy price rise into the mix and we have a recipe for both stagflation and Dutch disease. Stagflation will see slowing growth as measured inflation picks up. Dutch disease will see energy sectors boom and other sectors come under stress. This stress will come from a combination of higher raw materials prices and slower growth in sales. The latter, in turn, will intensify competitive pressures and limit firms’ ability to pass along higher energy costs.

In short, a recipe for significantly slower growth in corporate earnings. Companies that looked very healthy during the past 18 months, and attracted plenty of low-cost financing, will begin to reveal their weaknesses in this more challenging economic environment. Highly indebted countries will reveal their faults, too, and a busy global electoral calendar will bring those faults under the microscope. A much tougher credit environment, with less leverage than we see at present, in which investors will be more appropriately compensated for the risks they are taking.

On the Chinese calendar, next year is the Year of the Dog. That is too harsh a metaphor for the situation we are forecasting, which is more of a post-boom normalization than a big deterioration in conditions. Nevertheless, we think it appropriate to call 2006 the Year of the Downgrade.

Canadian exporters find themselves in a very stressful environment, and there is little relief in sight. Economic growth and export sales are moderating, and will moderate further. Interest rates are rising, and they will rise further. And the Canadian dollar is at a very high level, and is likely to remain above 80 cents until we get a significant downward move in oil prices. And exporters’ customers will be under stress, too, bringing credit and political risks back onto the front burner.

The bottom line? Exporters should not extrapolate their experience of the past 18 months into the future. A more cautious plan is now in order, as the global business cycle matures.

November 3, 2005

The views expressed here are those of the author, and not necessarily of Export Development Canada.

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