Canada Performing Above It's Weight Class

The recession risks are even less in Canada. The economy had strong momentum in the first half of 2007, with real GDP advancing at a 3.9% annualized pace in the first quarter and 3.4% in the second quarter. While the recent financial turmoil and the lingering problems in the asset-backed commercial paper market will temper the pace of expansion in the coming quarters, the impact should prove modest.

There is no reason for Canadian lenders to tighten their credit standards in a significant way, since they were never loosened like in the United States. The subprime mortgage market in Canada was only roughly 5% of mortgage originations in 2006, compared to 25% Stateside. Exotic mortgages, like negative amortization mortgages, and low introductory teaser mortgage rates are not part of the Canadian landscape. The continuing pressure in short-term private sector financing rates, with a wider spread on Banker Acceptance (BA) rates over their government counterparts may have a negative impact in the near-term, but we believe that conditions will normalize over time. And, the current levels of borrowing costs for the economy suggest that the financial turmoil has had less impact than the equivalent of a quarter point tightening by the central bank.

Financial institution lending could be tempered by a reduced ability to securitize mortgage loans in the near-term. This is the process whereby a lender parcels up loans and sells them into financial markets to free up funds for other loans, and slightly more than 20% of Canadian mortgage loans have tended to be securitized in recent years. Nevertheless, the prevailing strong balance sheets of the financial sector in Canada imply that this effect should be fairly small.

The main conclusion is that the direct impact of the financial turmoil is likely to modest. However, the bigger fallout will come from some indirect effects of the recent financial volatility. As already mentioned, the U.S. economy will deliver a weaker performance in the coming quarters, which will dampen demand for Canadian products. The U.S. is currently the destination for 76% of Canadian exports, which represent about 24% of Canadian real GDP.

The impact of waning U.S. demand will be compounded by the rise in the Canadian dollar which reached parity in September. The currency appreciation has been fuelled by narrowing Can-U.S. negative interest rate spreads, advancing commodity prices, and weakness in the U.S. dollar that can be tied to concerns about the economic outlook and the massive U.S. current account deficit.

Looking forward, the Canadian dollar is expected to average close to, or slightly above, parity over the next six months, but then trend down towards 95 U.S. cents by the end of 2008. This will weigh on economic growth. Based on historical relationships, the outcome should knock about 0.6 percentage points off economic growth over the next 12-18 months.

So, the export side of the Canadian economy is likely to face an extremely difficult time in late 2007 and throughout 2008, but this will be largely offset by continued strength in the domestic economy.

Canadian real estate does not have a glass jaw

In contrast to the U.S. experience, the Canadian housing market remains in strong shape, with housing starts running well above the 200k mark and with resale markets delivering record activity levels in the first half of the year. In contrast to the price declines south of the border, resale home prices in Canada are on track for a 10% gain this year. There is a powerful regional dimension; but even outside of the booming real estate markets in the west, conditions in central and eastern Canada are solid.

Contrary to the periodic fears that it is only a matter of time before Canada experiences a U.S-style housing correction, we do not believe that there is a bubble in Canadian real estate. Prices and sales have been driven by economic fundamentals, not speculation. And, the vast majority of property developments are being done on a pre-sold basis. Eroding affordability would have cooled markets by now, but the introduction of 35- and 40-year amortization mortgages has thrown fuel on the fire. Once the impact of these new financial products wanes, Canadian housing will cool. If there are risks in Canadian real estate, they are concentrated in a few cities where price growth has been the most dramatic.

Domestic demand and high commodity prices provide a solid core

Beyond housing, the domestic Canadian economy has extremely good foundations. Despite substantial job losses in export-oriented manufacturing, the unemployment rate is at a 33-year low and the employment rate is close to a record high. These tight labour market conditions are fueling robust personal income growth. Corporate balance sheets are in great shape, reflecting the past strong growth in corporate profits. This has been supporting solid business investment growth, which could have been even stronger had Canadian firms taken greater advantage of the falling prices on imported machinery and equipment when expressed in Canadian dollars. Government fiscal balances, at both the federal and provincial levels, are the envy of the industrial world, which is positive for public sector consumption and investment. It also suggests that there is scope for fiscal policy to respond to any severe economic challenges that could arise.

Prices for many commodities are at remarkably high levels, and given the outlook for continued strength in the global economy there is little reason to expect commodity prices to retreat materially. However, the benefit of high prices on profitability has been offset to some extent by rising input costs and an appreciating Canadian dollar.

Interest rates are also not restraining economic growth in a material way. After tightening monetary policy by a quarter point in July, the Bank of Canada was likely prepared to raise interest rates in September to combat the possibility that inflation would not return to the 2% monetary policy target in the near-term. However, the uncertainty created by the financial market credit crunch induced the Bank to shift gears and stand pat. And, the appreciation in the Canadian dollar since the last fixed announcement date and the recent weaker U.S. economic data suggest that the Bank will stay on the sidelines on October 16th. Thus, the real overnight rate in Canada is likely to remain at modestly above 2% in the coming months, which is not a particularly restrictive stance to monetary policy.

Bank will keep its guard up

Putting all of the pieces together, our expectation is that Canadian economic growth will slow to an average pace of 2.3% in 2008. As a result, our economic forecast is little changed from our June assessment. Since potential GDP growth for Canada is estimated to be 2.8%, our forecast for 2008 implies that no significant economic slack will develop until late that year. And, this strengthens our view that markets are dead wrong in expecting rate cuts from the Bank of Canada.

Moreover, the continued tightness in labour markets will likely keep pressure on unit labour costs and result in renewed inflation concerns at the Bank of Canada. The inflation worries are expected be compounded by news that core consumer inflation accelerates in the final months of 2007 to an annual pace of close to 2.6%. This suggests that the next move for monetary policy is a tightening – not an easing – and it is why we have put a quarter point hike in December in the base case forecast.

This is a wildly off consensus view, but it is important to remember that the Bank was prepared to act to stem inflation in September. In the wake of the recent financial turmoil, the combination of a stronger Canadian dollar and slightly tighter monetary conditions means that the Bank will have less tightening to deliver in the future to constrain inflation. But with inflation likely to accelerate in late 2007, after exceeding the 2% target for more than a year, the Bank is expected to tighten policy by one quarter point just to demonstrate to markets their intent to keep inflation expectations well anchored.

Don’t bet against growth

To wrap up, the Canadian economy remains robust and is well positioned to weather the fallout from the recent financial volatility, which includes a stronger Canadian dollar and a weaker U.S. economy. Recent developments are unlikely to derail the economic expansion, but they will lead to an extended period of subpar growth. However, this was something that the Bank of Canada was intent on engineering before the financial turmoil hit. And, it worth noting that while the economic growth rates for Canada and the U.S. will be similar, the Canadian performance will be only slightly below its 2.8% potential, whereas the U.S. will be well below its idling speed of 3.25%. The key Canadian challenge is that the weakness will be concentrated in a few industries – such as manufacturing, tourism, hospitality. The outlook also has a strong regional dimension. Economic growth will cool in the west, but remain above the national average. Meanwhile, the pace of economic expansion in central Canada and parts of eastern Canada will remain below the national average.

We are not complacent about the downside risks to the economy, which have increased. If the U.S. outlook proves to be too optimistic, then so is the perspective on Canada. The key vulnerabilities relate to the U.S. consumer, and this means close scrutiny is called for with respect to data releases on employment, income, spending and personal borrowing. However, the risk is something to be vigilant about monitoring; it is not the most likely scenario.
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