The U.S. financial markets and economy are in the grip of a prolonged, violent sneezing fit caused by the contagion of a crumbling housing market. And no one knows if Canada’s economy will catch that particular cold. But it may not matter. The global economic outlook is weakening — and that’s a virus Canada can’t expect to avoid.

Both the global credit crunch and the growing economic woes south of the border have their roots in the sliding U.S. housing market. Falling house prices, rising mortgage defaults and foreclosures are the toxic mix that is clogging the balance sheets of U.S. banks and choking off credit. And the effects of that credit crunch are filtering down into the real economy in a negative feedback loop that is eroding domestic demand, weakening employment and hampering economic growth.

Notwithstanding the efforts of the U.S. Congress, Treasury and the Federal Reserve Board to craft a bailout plan to relieve the banks of some of their illiquid mortgage-backed assets, there’s no sign that the underlying problems in the U.S. housing market are improving. The latest data from the S&P/Case-Shiller home price index, released in late September, show that prices are still plunging in the U.S. The index was down by 16.3% year-over-year for the month of July, led by an almost 30% decline in Las Vegas. (There were similar large drops in several other markets.) All 20 of the metro markets surveyed reported a year-over-year decline.

Of course, Canada is not immune to the economic winds blowing up from the U.S. But there is some fear that not only could Canada be caught in the U.S. downdraft, we could also have our own homegrown housing meltdown, too.

In a recent report, Merrill Lynch Canada Inc. economist David Wolf warns that there are signs that Canada could soon be facing a housing-induced slump of its own. In particular, he points out, Canadian households are in a similar position to those in the U.S. and Britain, the latter of which is also going through a housing crisis at the moment. Canadians are running financial deficits that are on par with those of both Americans and the British.

“These data imply that the Canadian household sector is now overextending itself as much as the U.S. or Britain ever did,” the report notes, “challenging the consensus view that Canadian lenders and borrowers have been far more conservative through the cycle.”

Indeed, the Merrill Lynch report suggests, the market view appears to be that household deficits are “somehow more sustainable in Canada.” The report disagrees, however, warning that the day of reckoning will eventually come to Canadian households, too.

“The clear ‘tipping point’ in the U.S. was the emergence of falling house prices in the summer of 2006,” the report notes, “kicking off the vicious circles that have brought the financial system and the wider economy to the brink.” House prices are just starting to fall in Canada, it continues, and inventories of unsold homes are rising.

“From this perspective, the absence of a Canadian credit crunch to date may be cause for concern, not comfort,” the Merrill Lynch report frets. “We believe that markets remain overly sanguine with respect to the prospects for the Canadian housing market, the financial sector and the overall economy.”

Other economists, however, dispute the comparison among the housing situation in Canada and the troubled markets in the U.S. and Britain. A report issued by the economics department of the Bank of Nova Scotia stresses that while there are risks in the housing Canadian market, there are also significant differences between the Canadian market and those markets that have severely crumbled.

Among other things, it points out that Canadian households are much less leveraged than U.S. households; our mortgage markets are much healthier — they have much less subprime exposure, more conservative products and less speculation; and, house prices are less inflated. In addition, securitization is less of a factor in Canada. Most mortgages remain on banks’ balance sheets and those that have been securitized haven’t been recycled into collateralized debt obligations or off-balance sheet vehicles. All in all, says the Scotiabank report, Canadian lenders have behaved more prudently.

These points are echoed by CIBC World Markets Inc. in a recent report, which notes that while house prices in Canada will probably continue to ease in the coming months, there’s no reason to expect that Canada will experience the same type of plunge that’s overtaken U.S. house price.

@page_break@The CIBC report also points to the fact that Canadian households are notably less leveraged than those in the U.S., that real estate speculation hasn’t been widespread and, most important, “at its core, the U.S. meltdown is a subprime story.

“Eradicate subprime from the U.S. housing market and, instead of the most severe house price meltdown since the Great Depression, you get a trivial moderate cyclical slowing,” the report maintains, “something along the line of what we are currently experiencing in Canada.”

Still, the Merrill Lynch report isn’t calling for a full-on real estate meltdown in Canada on the scale of what’s happening in the U.S.: “But given the emerging lessons of the U.S. and British crises, and given the parallels that we believe exist in Canada, we cannot understand how one can dismiss the risk that an adverse feedback loop between the housing market and the financial services sector could produce a rather worse outcome for both in Canada than the sanguine consensus currently expects.”

The Merrill Lynch report concedes some of the more confident analysts’ points, noting that Canadian households do have more home equity and Canadian lenders have avoided many of the crazy practices that went on in the U.S. “But have these factors eliminated the risk to the Canadian market,” the report wonders, “or just allowed it to hold out longer?”

The report stresses that in the current environment of heightened economic uncertainty, it is important for market players, workers and policy-makers to face up to any nascent risks and attempt to mitigate them, if possible.

Only time will tell whether the Canadian housing market devolves into a negative feedback loop. In the meantime, these nasty phenomena are increasingly evident in the U.S. economy — sparking worries that good old-fashioned U.S./Canada contagion will ultimately besiege the Canadian economy, too.

Apart from housing, other data points — such as same-store sales, auto sales, business and consumer confidence readings, and jobless claims — are signalling a deepening economic downturn in the U.S. In a recent research note, Royal Bank of Canada’s capital markets division suggests that the data indicate that economic growth is slowing and the financial crisis is spreading to the real economy. RBC warns that both the crisis and the resulting economic damage are likely to continue.

Indeed, a variety of economists have become worried about a severe recession in the U.S. A report from New York-based brokerage firm Morgan Stanley Inc. warns that two adverse feedback loops threaten to turn the mild recession it has forecast into a severe downturn. Those loops are the well-known one, the credit crisis, and the prospect of a global slowdown that hurts U.S. exports, feeding through to weaker employment, declining income and slowing consumer demand. “Both threaten an economy now on the brink,” the report warns.

New York-based rating agency Moody’s Investors Service Inc. is also worried about negative feedback loops. In a recent report, it warns that as both companies and consumers cut back on spending in response to the dimming economic outlook and tighter credit conditions, this could further crimp economic growth, putting still more pressure on corporate balance sheets. Moody’s indicates that it is most worried about companies whose businesses are heavily reliant upon Europe, Japan and North America, in which the pace of economic activity is visibly slowing.

Its not just Canada that suffers when the U.S. slumps; the whole world feels the effects. TD Bank Financial Group’s latest quarterly forecast issued by its economics department has trimmed its growth prediction for the U.S. economy to 1.1% for 2009 and downgrades its outlook for global growth as well, predicting that the world will be in a mild recession next year, before rebounding in 2010.

The TD forecast notes that the U.S.-driven financial turmoil “is, in fact, a global event and the weakness in the U.S. is being transmitted abroad.” It points out that several economies are already in or on the brink of recession in addition to the U.S. and Britain, including Spain, Ireland, Italy, Japan, Germany and France. Those who hoped that the global economy would be saved by a decoupling from the U.S. will be disappointed, the TD forecast says.

The U.S. weakness, however wretched it proves to be, will inevitably spill over into Canada. The TD forecast stresses that the U.S. still accounts for 75% of Canada’s international trade and represents almost a third of Canadian corporate funding. Also, weaker growth in the U.S. will probably undermine commodities prices, which have been a big source of Canada’s recent economic strength.

Add in the weaker domestic housing market and the ongoing turmoil in manufacturing, says the TD report, and Canadian real GDP growth in 2008 will fall to 0.7% from the 1% previously forecast; TD economists see growth of just 1.2% in 2009, before a recovery takes hold in 2010.

That said, the TD report admits that such forecasts are larded with uncertainty, given the prominence of credit worries right now: “Confidence and financial stability could be restored sooner than we imagine, leading to an earlier and sharper recovery. However, just as likely in our view is that the financial sector woes and the interaction with the economy will prove more intractable than we have assumed.”

While the magnitude of economic forecasts may be decidedly uncertain, the direction appears to be conclusively downward, and that is starting to affect market calls. National Bank Financial Inc.’ s recent report, in which it has dimmed its economic forecast, also lowered its earnings outlook and stock market targets, reducing its 12-month S&P/TSX composite index target to 12,200 from 12,800.

CIBC is somewhat more bullish, but a recent report saw it reduce its targets for the S&P/TSX as well, forecasting the index to finish the year at about 13,000, rising to 14,000 by the end of 2009. “With Europe clearly in recession and Japan and the U.S. looking little healthier,” it says, “the world growth outlook is the weakest in years.”

That gloomy outlook means the Canadian economy will surely struggle in the year ahead, too, whether a domestic housing meltdown is in the cards or not. IE