Inflation is poised to surprise on the upside later this year, which will prompt the Bank of Canada to raise short-term interest rates by 1.5 percentage points, says Sheryl King, chief investment strategist for Merrill Lynch Canada.
The possibility of a run-up in rates, now pegged at 1 per cent, would lead to increases in the cost of many types of consumer debt, including the variable-rate mortgages popular with many homeowners.
Ms. King made the rate forecast following the investment bank's global outlook conference in Toronto, where senior market analysts for the firm lauded a slew of natural resource stocks and one strategist made a high-profile prediction that the debt crisis now afflicting European governments will spread to the United States, an event that would cause both the euro and the Canadian dollar to soar.
The possibility that the U.S. government could face a revolt by lenders, similar to the ones afflicting smaller countries such as Ireland and Greece, is one of the big fears in financial markets - but it isn't often mentioned as a likely scenario by investment strategists at major U.S. banks.
But David Woo, head of global rates and currency research at Merrill Lynch in New York, said it's a major risk factor.
"I think the biggest risk in the second half of this year is the risk of the European sovereign crisis travelling across the Atlantic to reach the U.S. shore," Mr. Woo said in an interview, after warning the institutional investors at the conference about the possibility.
A debt crisis could cause the U.S. dollar to plunge on world markets, taking the Canadian dollar from its current level of just over par to more than $1.10 (U.S.). The risk is real, if not immediate. Mr. Woo said this "is probably a 2013 story. I think the risk is definitely there."
He said a possible sign the United States is going the way of Europe is the recent turmoil in the municipal bond market, where indexes tracking securities issued by cities and towns have fallen about 10 per cent since peaking in late October.
"There is no scope for a bailout and they're running big deficits, so I think from that point of view this could be the first market in which [a] sovereign crisis concerning the U.S. starts to play out," he said.
In Canada, Ms. King said inflation is picking up because the economy is rapidly using up spare capacity from the 2008 recession. "I think that inflation in Canada is going to be the big story for 2011," she said.
The current core inflation rate, excluding such volatile items as food and energy, is running at about 1.4 per cent to 1.5 per cent, and it could nearly double to 2.7 per cent by the end of the year, leading to her forecast for higher borrowing costs.
Turning to individual stocks, Andrew Fairbanks, the bank's energy analyst, says his favourite oil stocks include Canadian Natural Resources , Suncor Energy , Talisman Energy , along with Petrominerales and Pacific Rubiales Energy , two companies emerging as major Columbian producers. Both Petrominerales and Pacific Rubiales have been on a tear over the last 12 months, but Mr. Fairbanks says they still have upside potential.
Oscar Cabrera, Merrill Lynch's base metals analyst, said Teck Resources "sits in the sweet spot" created by a high demand for coking coal and copper in emerging economies. The shares, currently around $64 (Canadian), could rise to $80.
While copper prices have been rising sharply, Mr. Cabrera said the frenzy for metals is likely to hit zinc and uranium next, benefiting producers of those metals.
Mike Jalonen, who tracks precious metals, said many gold companies are being evaluated at prices that assume bullion will trade around $1,200 (U.S.) an ounce, well below current levels around $1,385, suggesting "great opportunity for the sector."
He said rising profitability among gold producers will cause many companies to increase dividends, which will attract more U.S. investors to the sector.
Selected top stock picks for Canadian investors from Merrill Lynch analysts:
Canadian Natural Resources