Investors have become more upbeat about the economic outlook, and for good reason, say TD economists in a new report.

The forecast for stronger economic growth and continued low inflation in the United States, Canada and overseas has significant implications for the performance cash, bonds and equities says TD.

“Equities are likely to outperform cash, which, in turn, will fare better than bonds in 2004,” said Craig Alexander, associate VP and senior economist at TD Bank Financial Group.

.”Just as the U.S. recession in 2001 dragged the rest of the world down with it, a U.S. recovery in 2004 is expected to be the catalyst for an improvement in the global economy, including here in Canada,” suggested Alexander. Despite the pickup in economic growth, “inflation will remain under wraps, as most major economies have large pools of untapped labour and equipment that will take some time to absorb,” observed Alexander. This economic outlook has direct implications for the performance of financial assets in 2004.

TD says the prospect that the Canadian economy will be operating at close to full capacity in 2005 is expected to prompt the Bank of Canada to begin raising rates in late 2004. That policy tightening will lift the return investors receive on cash, but only modestly, leaving the average for next year in a range of 2.5% to 3.25% — well below the expected long-term annual return of 4.6%.

Bond yields will trend upwards in 2004, as investors anticipate higher inflation and central bank rate hikes, says TD. “The increase in yields is good news for investors who buy bonds in the future for the higher coupon payment, but implies capital losses for those trading the instruments,” remarked Alexander.

“After delivering an outstanding performance in 2000 through 2002, with average annual returns in excess of eight per cent, bonds will underperform equities and cash next year,” noted Alexander. The yield on a two-year Government of Canada bond is expected to increase by roughly 80 basis points over the course of 2004, while the yield on 10-year bonds will advance 50 basis points. Falling bond prices mean that a well-diversified basket of federal, provincial, municipal and corporate bonds is likely to provide a slim return of 1.5% to 2.5% in 2004.

“The acceleration in economic growth is expected to support high single- digit growth in after-tax corporate profits in Canada, the U.S. and the developed economies overseas, which should be supportive to equity prices,” said Alexander. U.S. after-tax corporate profits are expected to rise by 9% in 2004, but the impact on equity prices may be tempered by a weakening in the U.S. dollar that will make U.S. stocks somewhat less attractive to international investors.

In Canada, the recent rapid appreciation in the Canadian dollar will limit after-tax corporate profit growth to 6% in 2004 says TD. “Overall, the expected growth in corporate profits combined with the dividend yield on the stocks listed on the major equity exchanges suggests that the total return on Canadian, U.S. and international equities will be similar, ranging from 6% to 9%,” stated Alexander.

The report Investing in the 2004 Economic Recovery is available in PDF format on TD Economics’ Home Page at: www.td.com/economics.