Biggest risks to Canadian markets in 2013

Canadian equity and currency markets are expected to grind higher in 2013, but there are some major risks that could cause steep pullbacks: namely the U.S. fiscal cliff, China's economic well-being and the troubles in Europe.

The good news

The Toronto Stock Exchange's S&P/TSX composite index, a key benchmark made up of nearly 250 issues, is set to climb next year as tense U.S. budget talks are expected to be resolved, while a recovering Chinese economy should prop up commodity prices.

Investors, economists and the general public closely watch stock market performance to gauge the value of companies. Rising stocks can point to upbeat business sentiment and buoyant economic times, while falling stocks signal the opposite.

The Canadian dollar is also expected to strengthen against the U.S. dollar in the next year, drawing support from the potential for a Bank of Canada rate rise ahead of the U.S., steady commodity prices and a relatively sound financial standing among global peers. A strong currency is a plus for consumers' purchasing power, but not so great for manufacturers. A high currency generally lifts the price of exports and eats into the bottom line of manufacturing companies.

The potential bad news

Canada remains highly vulnerable to external factors. Having earlier tapped fiscal stimulus and a housing boom to shelter the economy from sluggishness abroad, the country’s ability to set its own course is now much more limited, says Avery Shenfeld, chief economist at CIBC World Markets.

"Canada’s fate lies in foreign hands," Shenfeld says.

U.S. fiscal cliff: There has been much attention paid to the budgetary talks in the U.S., widely referred to as the "fiscal cliff" of tax hikes and spending cuts set for the new year. Many experts warn if no resolution is found then the U.S. economy could be hard hit, resulting in a sharp reduction in the U.S. budget deficit, which could tip the country into recession. That would result in a global negative ripple effect. "We are operating on the view there will be an agreement. The real question will be the sustainability of the agreement," said Paul Taylor, chief investment officer with fundamental equities at BMO Asset Management. "Will it be simply a Band-Aid solution that moves the problem a little bit down the road."

So that is the question occupying the minds of most market observers worldwide. Will the U.S. go over the fiscal cliff? It’s possible but not probable, added Bob Gorman, chief portfolio strategist at TD Waterhouse.

"While the gulf between Republicans and Democrats is wide, the consequences of inaction are well known and severe," he said.

China's recovery: China is a voracious consumer of commodities, gobbling up twice as large a portion of the world’s oil and three to four times as large a share of metals as a decade ago, according to CIBC World Markets. That's why the world is counting on China to recover and recent signs of stability have caused markets to cheer. But it's also why the economic well-being of China is also a major risk.

"The reality is that while hard landing risks may have faded, a return to the double-digit performance of the past decade isn’t in the cards," Peter Buchanan and Andrew Grantham wrote in the bank's outlook report.

"More modest growth there suffices to move the demand needle these days."

Europe's health: There was modest easing of fiscal drag in Europe this year, but the eurozone economy slipped back into recession. Intense austerity programs have deepened recessions, increased unemployment, and reduced trade flows both regionally and globally. As well, concerns about the debt crisis there have not vanished entirely.

"The recession will persist longer than forecast in the euro zone, although it will remain fairly slight," economists at Desjardins Group said.