2005 may prove to be a challenging year for investors, said TD economists in a report released today.

“The economic outlook is for moderate growth, subdued inflation and continued gains in corporate profits. However, this positive economic backdrop may not translate into strong investment returns,” remarked Craig Alexander, associate vp and senior economist, TD Bank Financial Group, in a release.

The three major financial asset classes — cash, bonds and equities — are likely to deliver low to mid single digit returns in 2005.

The return on short-term money market assets will rise as the Bank of Canada gradually tightens monetary policy. “The Bank has stressed that the Canadian economy is operating at close to full capacity, suggesting that monetary policy is likely to be tightened in the coming months,” said Alexander. Consequently, the overnight rate is expected to increase from the current 2.5% to 3.5% by the end of 2005. “However, the Bank would be less aggressive in raising rates if economic growth slows unexpectedly to significantly below a three% pace. Accordingly, we look for cash to provide an average return of 2.5 to 3.25% in the coming year,” he said .

Canadian bond prices will grind lower, reflecting central bank rate hikes and a sell-off in U.S. Treasuries. A well diversified basket of bonds is likely to return 2% to 4.5% in the coming year. A superior performance might be provided by overweighting shorter dated bonds and corporate bonds, say TD economists.

Concerns over high oil prices, a slowdown in China, unstable geopolitics, central bank rate hikes and a further correction in the U.S. dollar may weigh on equities in 2005. As a result, Canadian and U.S. equities, as represented by the S&P/TSX and the S&P500, are expected to provide a total return of 3% to 6% in the year ahead.

International equities may outperform, reflecting stronger profit growth in some regions (such as Asia) and lower valuations in many markets overseas.

TD economists say sectors with stable earnings and high dividend payments may prove the most attractive. Commodity prices are expected to experience a pullback in 2005, but the level of prices should remain highly profitable for most commodity industries.

Movements in exchange rates will affect the performance of international assets in Canadian portfolios. Although the Canadian dollar is expected to float in a range of US81¢ to US85¢, the recent powerful rally in the loonie vis-à-vis the greenback highlights the importance of diversifying holdings of foreign investments.

The pattern of single-digit returns is likely to continue. “Investors who are still hoping for sustained double digit returns from the major financial asset classes in the years ahead are likely to be disappointed,” said Alexander.

TD Economics forecasts that the average annual return from most portfolios over the next decade is likely to be in a range of 6% to 8%.