Everything depends on the U.S. housing market and American consumers. If house prices stabilize and/or consumers are in better financial shape than believed, the U.S. and Canadian economies will slow only a little this year. But that’s a big if.
No one is talking “recession” in Investment Executive’s annual survey of 10 economists at Canada’s big banks and investment dealers, but they are certainly talking “slower growth.”
National Bank Financial Ltd. and UBS Canada both expect the U.S. economy to grow by only 2% in 2007, down from 3.3% growth in 2006. (Canada will slow to slightly more than the same pace.) In this scenario, average national house prices in the U.S. will fall 10% and interest rates will drop to 3.5% or less to avert a recession.
Montreal-based NBF’s assistant chief economist, Stephane Marion, expects the slow GDP growth to continue in 2008. George Vasic, chief economist and strategist at UBS Canada in Toronto, thinks both Canada and the U.S. will grow by 2.8% in 2008. Both expect significant drops in interest rates.
Marion puts the odds of a recession at 40%; Vasic, at 20%. Ted Carmichael, chief economist at J.P. Morgan Chase Canada in Toronto, puts the probability of a recession at 30% this year and 40% in 2008.
Carmichael is the only one of the 10 financial services economists surveyed who expects significant increases in interest rates. He thinks inflationary pressure will force the U.S. federal funds rate to 6% and the Bank of Canada rate to 5.5% by the first quarter of 2008. In his base case, this doesn’t have much impact on the U.S., which he expects will continue to grow by 2.6%, but it will push Canadian growth down to 2% in 2008.
Financial and economic consultant Lloyd Atkinson is much more optimistic. He thinks U.S. growth will remain slightly more than 3%, with Canada slipping to 2.6% this year and 2.5% in 2008. Not surprising, there’s no need to lower rates in this scenario. He puts the odds of a recession at 5% — and it’s only that high because you never now what could happen.
Bank of Montreal senior economist Sal Guatieri sees the U.S. slowing to 2.7% in 2007. But he expects both countries to grow by more than 3% in 2008. He also sees little change in short-term rates. He puts the odds of a recession at 20%.
Most economists expect the price of oil to stay in the US$60-a-barrel range. But NBF’s Marion sees oil prices falling to an average of US$48 a barrel in 2007 and US$45 in 2008; Atkinson is expecting US$52-a-barrel oil in 2008.
The fundamental question underlying oil prices is whether anything short of a U.S. recession will bring the price down to US$50 or less. Atkinson believes a moderate slowing will do the trick, while Marion feels growth of 2% will push them even lower.
Most economists expect the Canadian dollar to remain around US90¢ but Atkinson sees it dropping below US80¢ by the end of 2007. This is partly because he thinks cooling resources prices will pull the loonie down and, admittedly, he has one of the lowest oil price forecasts. But he also thinks the U.S. dollar won’t come under downward pressure, which isn’t the conventional wisdom. Most economists surveyed think the US$ will trend downward for some years, or until the U.S. current account deficit declines significantly.
Atkinson’s theory is that foreign central banks will continue to buy U.S. treasury bills because they don’t want their currencies to appreciate against the greenback. He expects foreign investors will continue to invest in U.S. equities because that’s where the best returns will be.
Here’s a more detailed look at what the economists expect:
> Growth. The critical determinant of U.S. growth and, thus, Canadian growth, is American consumers and how hard they will be hit by the current correction in the U.S. housing market. Marion and Vasic both expect a 10% drop in average national house prices, which haven’t dropped significantly since the 1930s. David Tulk, economist at Toronto-based TD Bank Financial Group, sees a 4% decline. The remaining economists don’t foresee much, if any, decline.
American consumers have been borrowing on their home equity for a number of years now and are highly leveraged as a result. The question is how near to the edge they are. Atkinson believes they are still in very good shape; Marion thinks any shock, such as a significant drop in the value of their homes, will force them to cut back on unnecessary expenditures.
@page_break@But there are a number of factors that should keep the slowdown in consumer spending moderate. As Atkinson sees it, the number of jobs are growing and wage gains are healthy — which should make consumers feel secure and provide them with additional cash to spend. Recent increases in U.S. stock markets will also provide some offset if the value of their homes decline.
Consumer confidence is fragile, however. Once people get worried, it’s hard to reassure them. And nothing hits home as hard as a drop in the value of a house. If house prices start tumbling across the country, consumers could become very alarmed. Add in a stock market
correction or another spike in oil prices, and the appetite for going to the mall could fade.
Consumers’ vulnerability to sliding house prices has increased because of the home-equity extraction that has fuelled consumer spending in recent years. Marion points out that the average American homeowner’s equity in residential real estate was 53.6% in the third quarter, significantly down from 59% in the first quarter of 1994.
What gives economists confidence that a recession will be avoided, even with significant slowing in consumer spending, is the strength of business capital spending.
High corporate profits have generated excess cash and corporate debt loads are low. Unless a recession looks imminent, businesses are likely to reinvest this cash in machinery and equipment to keep them competitive in the increasingly competitive global marketplace.
Indeed, Atkinson thinks the U.S. is on the verge of a capital spending spree such as occurred just before the start of new millenium, when companies were updating their technology. This surge, he say, will be fuelled by advances in data and voice storage, transmission speed and computer multi-tasking. He expects this to produce another round of strong growth in U.S. productivity.
Economists are also sure that if a recession was on the horizon, the U.S. Federal Reserve Board would move quickly and aggressively to lower interest rates and stimulate the economy — as long as inflation remains tame and there isn’t a lot of downward pressure on the US$, as most expect.
> Inflation. The average forecast for the rise in the consumer price index for the U.S. is 2.1% in 2007 and 2.3% in 2008. For Canada, it is even lower, at 1.8% this year and 2% in 2008.
The low rates are not surprising, given the Fed raised rates to ensure that inflationary pressure did not develop. But the U.S. labour market is tight, with unemployment low and jobs numbers increasing. The danger is that big increases in wages will force retail prices higher.
J.P. Morgan’s Carmichael is the only economist surveyed who thinks inflationary pressure will force further rate hikes. He’s concerned that declining excess capa-city globally and decreasing downward pressure on prices from China, along with strong wage increases in the U.S., could create an inflationary environment.
But the consensus view is that any inflationary pressure that might have emerged will be quelled by the economic slowdown.
> Current Account. Even with oil prices down from peak levels and metal prices likely to follow, Canada is expected to post large current account surpluses. The average forecast is $15.2 billion this year and $13.4 billion in 2008.
> Three-Month T-Bill Rates. Carmichael stands out with a forecast of 5% for the 91-day T-bill rate by the end of 2007. He doesn’t have a yearend 2008 forecast yet but expects the peak for the Bank of Canada overnight rate to be 5.5% in the first quarter of 2008, when the U.S. FFR hits 6%.
Marion has the low forecast for both years, and Vasic isn’t much higher. Scotia Capital Inc. is forecasting 3.5% for the end of this year, the same as Vasic, but sees the rate going up again in 2008.
> Ten-Year Bond Rates. Most economists are forecasting a pretty flat yield curve. Indeed, the average forecast is almost the same for both three-month T-bills and 10-year Canadas for the end of 2007, although 10-year bond rates are expected to be 40 basis points higher on average at yearend 2008.
The same applies to the U.S., with the average forecast for three-month T-bills at about 4.5% at the end of both this year and next, vs 4.6% this year and 5.0% in 2008 for 10-year treasuries.
The flattening of the yield curve is the result of low inflation and expectations are that it will remain relatively flat. This diminishes the premium needed to attract buyers to longer-term issues. As a result, an inverted yield curve, which we currently have, no longer signals that a recession is imminent.
> Canadian Dollar. Leaving aside Atkinson, who think the loonie is heading toward US77¢ by the end of 2008, the other economists put the C$ in the US84.7¢-US94¢ range at the end of this year and at US85.5¢-US94¢ the next — despite expectations that resources prices will ease and there will be further downward pressure on the US$.
The reason is simple. The consensus view is that even with some easing, resources and base metals prices will remain high, As well, most foreigners view Canada as a producer of resources, particularly oil. To put it bluntly, the loonie is a petrodollar. That means the C$ would have gone up in the past few years even without downward pressure on the US$. It also means that as long as resources prices are high — and that’s expected for the foreseeable future, given demand for resources in emerging markets, particularly China — the loonie will remain high.
But that view is not universal. Besides Atkinson, another dissenter is David Wolf, head of Canadian economics and chief strategist at Merrill Lynch Canada Inc. in Toronto. He sees the loonie heading to US80¢ by the third quarter of 2007. He also sees less foreign direct and portfolio investment in Canada and more Canadian investors diversifying globally. IE