Most economists are quietly optimistic about the outlook for 2008. Despite the turmoil in credit markets — and the economic uncertainty it occasions — most economists surveyed for Investment Executive’s annual economic forecast believe we will sneak through 2008 without a recession or a deep downturn.

When liquidity of non-bank asset-backed commercial paper dried up this past summer, the U.S. was already at some risk for a recession. Dropping U.S. housing prices had created recession-like conditions in housing-related industries. Some economists — Stéphane Marion, assistant chief economist at Montreal-based National Bank Financial Ltd. , among them — were putting the odds of recession at 50%.

But the majority view, then and now, is that there will be little spill-over to other sectors and the U.S. economy will continue to grow, albeit slowly. Increased competitiveness resulting from the lower U.S. dollar will make for strong export growth and cuts to short-term interest rates will provide stimulus.

Those same economists also expect the Canadian economy to fare slightly better than the U.S.’s. Our housing market is in better shape, and markets for resources from the western provinces are strong. Nor do economists think the high Canadian dollar will hurt exports enough to dampen our economic growth to the point at which it is less than U.S. growth.

One exception is financial and economic consultant Lloyd Atkinson of Toronto; he maintains Canada will lag the U.S. In his view, only increased government spending is supporting Canada’s present growth. He argues that with the U.S. economy slowing, Canadian manufacturing hurt by the high C$ and resources prices edging downward, growth of much more than 2% is unlikely — unless government keeps spending freely.

Atkinson and other economists think the high C$ is spurring manufacturing exporters to increase their spending on new machinery and equipment, thereby boosting productivity and allowing them to remain competitive. Because the high C$ lowers the price of machinery and equipment that is bought in the U.S., the incentive to increase capital spending now is strong.

So far, credit market turmoil is having little effect on the overall Canadian economy — and may never have a major impact. The key is the financial institutions. No one knows whether the writedowns they have made so far reflect their total exposure to ABCP, says Carlos Leitao, chief economist at Laurentian Bank Securities Inc. in Montreal, or whether there is more to come. As a result, we don’t know how much the capital ratios of these institutions and, thus, their ability to make loans will be affected.

There’s also the issue of yearend capital requirements for financial institutions. If there are no excess funds, there will be less interbank lending than is needed, thereby worsening the situation and potentially creating a full-blown credit crisis.

But most economists don’t expect this. Leitao notes that financial institutions are coping in innovative ways, pointing to the US$10 billion in manditory convertible notes that Switzerland-based UBS AG is selling to a Singapore government investment fund. This offsets a US$10-billion writedown of U.S. subprime holdings that UBS is expected to take. Leitao expects to see more of this type of solution from other financial institutions.

It will, however, take time to resolve the credit market problems, warns Warren Jestin, chief economist at Scotia Capital Inc. in Toronto. He doesn’t expect normal markets until late spring or the summer of 2008; even then, there will be the lingering issue of how to price credit risk. It will take time to reinvent or replace the short-term non-bank credit market and for investors’ risk tolerance to improve. Credit spreads may remain wide, he says, and there could be continued volatility.

Assuming the credit market problems are resolved without a crisis, most economists expect the U.S. to grow by about 2% in 2008 and 2.5%-3% in 2009.

NBF’s Marion is the pessimist among financial services economists, expecting a mere 1.1% rise in U.S. real gross domestic product this year and only 1.6% in 2009. He believes the U.S. is walking a thin line and that a further 10% drop in national housing prices would probably push it into recession. House prices are already down 6%.

Although Scotia Capital’s Jestin isn’t as pessimistic, putting the odds of a U.S. recession at 25% or lower, he doesn’t think the U.S. will bounce back from the slowdown quickly. “The risk isn’t recession,” he says. “The risk is much slower growth in the U.S. in the coming years.”

@page_break@He cites both the U.S. Federal Reserve Board and former Fed governor Alan Greenspan saying that the non-inflationary trend rate of growth in the U.S. is now 2%-2.5%.

Demographics are working against strong growth in the U.S., Jestin argues. Labour markets are tight and skills are in short supply. In addition, he doesn’t expect the strong productivity growth that propelled the U.S. economy in the late 1990s and early years of this decade to repeat itself. This will challenge both businesses and governments. Companies will have to keep an eagle eye on costs, compete for market share and find innovative ways to grab the attention of consumers. Governments face huge investments in infrastructure, but highway and bridge construction doesn’t necessarily win votes. As well, environmental concerns will affect the type of infrastructure that is put in place.

Atkinson doesn’t agree with Jestin’s prognosis. The U.S. is the edge of another revolution in technology, he says, that will spur big gains in productivity. Furthermore, he believes the U.S. has less of a demographic problem than other industrialized countries. Because it didn’t enter the Second World War until the end of 1941, the U.S. doesn’t have the same baby-boom bulge as other countries. As well, the U.S. birth rate is an average of 2.1 a woman, which is enough to maintain the population. Canada’s birth rate is 1.5; Western Europe’s, 1.3.

Among those surveyed, Atkinson and Ted Carmichael, chief economist at J.P. Morgan Chase Canada, have the highest forecasts for U.S. growth, both at about 2.5% this year and 3% next year. Atkinson’s position is that housing prices rose 50% between 2000 and the 2006 peak, so even a 16% decline leaves many homeowners in good shape. He also points out that there aren’t enough subprime mortgages to produce a major impact on U.S. consumer spending even if they all defaulted. “Subprime mortgages are truly small potatoes,” he says.

When it comes to Canadian growth, Avery Shenfeld, senior economist at CIBC World Markets Inc. , has the highest forecast, at 2.7% for 2008 and 3% in 2009. This isn’t surprising because he is also forecasting the highest oil prices. He’s expecting an average price of US$95 a barrel in 2008 and, although he doesn’t provide a specific number for 2009, he does expect upward pressure on oil prices to continue over the medium term.

In Shenfeld’s view, it’s the high oil price will keep the C$ high.

What’s interesting is that Jestin forecasts a US$1.09 C$ at the end of 2009, even though he expects oil to fall to an average price of US$86 a barrel this year and US$80 in 2009. Jestin argues that even US$80-a-barrel oil implies significant investment in Canada, both in resources and infrastructure.

As well, Jestin expects the downward pressure on the US$ to continue for the medium term. First, he says, the U.S. hasn’t been able to reduce its huge current account deficit, despite a more competitive currency. Second, it faces major fiscal issues in the next decade as it tries to provide adequate health care and social security to an aging population.

Again, Atkinson disagrees with Jestin’s assessment. The US$ will strengthen on the back of the continued strong productivity growth he foresees. “The U.S. is still the most flexible and dynamic economy,” Atkinson says. This will pull the C$ down to US78¢ by the end of this year, he says, and keep it around US80¢ in 2009.

Carmichael doesn’t go along with Atkinson on this. He thinks a fair value for the C$ is around US95¢. But he believes it will be more than that until Canadian short-term rates fall below U.S. rates. He doesn’t expect that to happen for the next two years.

Most economists aren’t worried about inflation. It’s low in Canada, and the economic slowdown in the U.S. should push it lower there. However, Leitao says, there’s a risk inflation could become a problem in the U.S., given tight labour markets, high oil prices and a falling currency. Part of what’s keeping inflation down in Canada is lower prices for imports; in the U.S., import prices are rising as the currency falls.

This creates a conundrum for the Fed. It must lower interest rates to provide liquidity in the face of credit market problems, even though inflationary pressures may indicate a need to keep rates stable or even raise them.

Leitao expects the Fed to raise rates once the credit crunch and the risk of recession is over, forecasting a U.S. 91-day Treasury bill rate of 4.7% by the end of 2009. Others seem to agree, with all but Marion expecting the rate to surpass 4%. IE