Canada's persistently high unemployment rate, now hovering just below 10%, looks set to rise with 12 more months of private cost-cutting initiatives expected. These will in turn pave the way for increased company earnings. With predicted earnings growth of 8-10% signalling a positive outlook for equities, the general consensus is that Canada is positioning itself to outperform the US markets in the next two to three years.

Canada is enjoying a very stimulative environment," says Dan O'Reilly, vice president at RT Capital Management in Toronto. He is positive on both the equity and bond markets, but warns there will be no significant increases like last year. With the yield curve set to flatten through upward pressure from the US, bonds will produce a mildly positive return but, he says, "there will be some deterioration in the first half". The Bank of Canada has been very aggressive in using the strength of the Canadian dollar to ease monetary policy but O'Reilly believes that "they've played most of their cards there". However, he does not expect a major deterioration on longer-term bonds.

O'Reilly affirms the key factors that will be driving the market will be earnings, primarily in cyclical groups. He anticipates a rotation out of interest-sensitive into cyclical groups, with the most attractive sectors including late cyclicals, paper and forests and even consumer stocks. "We have a very positive interest rate for the consumer," he says. "We're beginning to see a pick-up in housing sales, in retail sales, and autos are doing well."

This improvement should ripple through into some of the merchandising stocks that have lagged so far in the past few years. "The market is expanding quite nicely. We're expecting rapid growth in the technology and the industrial products area."

Stephen Browne, president of Mutual Asset Management in Ontario, takes a cautious approach on bonds "after the big double-digit returns in the past couple of years, we need to keep our feet on the ground more". Short-term bond rates are now lower than the US, with significant narrowing of spreads from the long end, where he says the market is "very much tied to the US".

In the long term, he says, "we'll see these differentials stay very tight and maybe trade on top of the US long rates with a continuation of a steep yield curve in Canada". And while he feels stocks will remain quite constructive, "because we see continuation of growth in the US", he is expecting a sideways move in the equities market, and even "a little more choppiness, some more volatility than in 1996". However, he sees the domestic energy sector as an "extremely positive environment" for foreign invest ors, with the oil exploration and drilling sectors attracting strong interest.

Stephen Gaultier, portfolio manager at Pictet in Montreal, is neutral on the short-term equity market, expecting some downward pressure on prices, but joins the popular belief that the market will outperform the US, due to improved earnings growth in the next 18-24 months: "We expect earnings to go up in the next two years by a rate of about 15%".

Commodity and metal prices are already increasing, pulp and paper prices are stabilising after almost 12 months of downward pressure, and the Canadian banks are showing good profit growth. Gaultier recommends the real estate, retail and industrial products sectors, particularly Alcan. "Look at sectors that will benefit from a stronger economy," he advises. However, he is equally cautious on the bond market, and expects some downward pressure. He thinks the Bank of Canada will keep inflation in check somewhere be-tween 1% and 3%, "but if rates go up in the US on long bond buying by 1%, then you have to expect rates in Canada to go up at least 50 basis points". Rachel Oliver"