Many economists and investment managers expect the U.S. to continue to enjoy healthy economic growth. But some are worried about a significant slowdown and a few are convinced a recession is inevitable.

There are numerous reasons for concern, including high consumer debt loads, rising interest rates, soaring oil prices, the possibility of a housing market bubble and deficits in both the fiscal U.S. budget and its current account.

Although Canada’s prospects are tied to the U.S., there are key differences. The negative effect of the high Canadian dollar on manufacturing exports and export revenue has caused Canada to underperform the U.S. And Canadian growth may be slower still next year. High oil prices — while positive for the producing regions — have had a negative impact on most of Canada. Also, foreign investors, who view Canada as a resources-based economy, could exert additional upward pressure on the C$.

In fairness to the optimists, the U.S. has had strong growth despite the negative effects of very high oil prices and rising short-term interest rates. This suggests underlying strength. But it is underpinned by continued low long-term rates, including mortgage rates, which have kept house prices rising and household wealth increasing.

The failure of long rates to move upward is puzzling. Normally, long rates move with short rates, although not necessarily to the same extent. In this case, long-term rates have fallen slightly while short-term rates have risen. Recent 10-year U.S. treasuries were at 4.21%, vs 3.52% for three-month T-bills.

Most analysts expect long rates will rise. Bank of Montreal, for example, forecasts a 10-year rate of 4.5% in the fourth quarter, rising to 5.5% as of 2006 yearend. That compares with 3.75% for three-month
T-bills in the fourth quarter, going to 4.5% at the end of 2006.

But rising rates will not significantly affect U.S. growth. Because of high oil prices, BMO expects growth to slow in the next six months to an annual rate of 3.2%-3.3% — which will keep a lid on short-term rates. If oil prices come down as expected next year, to average less than US$50 a barrel, increases to short-term rates will resume in the second half of 2006. BMO expects 3.4% growth in 2006, slightly less than the 3.7% it’s predicting for this year.

Assistant chief economist Paul Ferley warns there is some risk: too much stimulus in the economy would force the U.S. Federal Reserve Board to bump short rates up to 4.5% sooner than expected.

Oil prices are a key factor in the outlook, but there isn’t much agreement about the degree to which they dampen growth nor the point at which they could push the economy into recession.

Irwin Michael, president of Toronto-based I.R. Michael Investment Counsel, which manages the ABC funds, doesn’t think we have to worry unless oil goes above US$70. Nor would he push the panic button then. It is a matter of seeing “what the elasticities of demand are,” he says — that is, whether US$70-plus oil would change behaviour and significantly reduce demand.

Michael puts his faith in the American consumers’ love of shopping. “Their lifestyle is to spend,” he says. He also notes the firm housing market and gives Fed chairman Alan Greenspan “full marks for containing the economic expansion and insuring that the economy did not fall over a cliff with 9/11.”

Dissenters vary from those predicting slower growth to those expecting a severe recession.

Both CIBC World Markets Inc. and Bank of Nova Scotia have long been worried about the imbalances in the U.S. economy. Neither, however, is talking recession, forecasting U.S. 2006 growth of 3.3% and 3.1%, respectively.

The more middle-of-the-road TD Bank Financial Group, however, is becoming more pessimistic. Although it forecasts U.S. 2006 growth of 3.1%, it sees growth slowing in the second half to an annualized quarterly rate of less than 2.5% by mid-year.

TD calls the expected slowdown “a payback for the way in which the prior expansion borrowed against the future.” This slowing would, in TD’s view, cause the Fed to lower the U.S. federal funds rate to 3.75% by the end of 2006 from 4.5% in the first half of the year. (It’s noteworthy that neither CIBC nor Scotiabank expect the federal funds rate to reach 4%, which may explain why they don’t see the slower second half that TD is forecasting.)

@page_break@The negatives in the U.S., says TD, include “higher interest rates, record consumer debt loads, a tapering off in mortgage refinancing activity, an absence of new fiscal stimulus and only modest growth in global demand.”

Then there’s oil — which will take 0.5-0.7 percentage points off 2006 growth. TD assumes oil prices will be in the US$40-US$45 range.

What keeps the U.S. growing is its exports. Despite modest world growth, exports are expected to increase by about 7% in 2006, thanks to a more competitive U.S. dollar. In addition, TD expects a 10% increase in business investment next year.

TD notes that retained earnings and profits as a share of gross domestic product are both at record levels: “It is not in firms’ best interests to sit on cash indefinitely as excessively conservative business practices can be detrimental to underlying profitability and competitiveness.” The bank views this as a reasonable scenario but says that both Americans and financial markets are dissatisfied with the 3.5% growth rate in the first half of this year. That means a slowdown will not be well received.

At the beginning of the year, National Bank Financial Ltd. had a more pessimistic scenario than TD. It expected rates to rise to 4.5% by the yearend 2005 to contain inflation, curtailing U.S. growth to just 2.4% in 2006 . However, it has since increased its growth forecast to 3.5%, based on higher than expected business capital spending, a positive contribution from trade, a decline in oil prices to US$42-US$45 next year and the wealth effect of rising house prices. As with the others, NBF has been surprised by the continued low long-term rates.

This is NBF’s base case. It does, however, maintain the odds of a recession in 2006 are rising and are now about 30%. A key concern is the “exuberance” of the housing market. “With an increasing proportion of households choosing variable interest rates and interest-only options to finance their homes, it is fair to say that a reality check could ensue as monetary policy goes from accommodative to restrictive,” says Clement Gignac, chief economist and strategist, in a recent report.

CIBC and TD are also concerned about increasing use of interest-only mortgages (see page 42).

NBF expects the federal funds rate to hit 5% at the end of 2006.

Gignac suggests a neutral weighting for U.S. equities. He would increase it, he says, when “convinced that the end of the Fed’s tightening campaign is in sight and that monetary authorities have been able to achieve a soft landing in real estate.” He would scale it down if there’s no oil price relief and continued overheating in the housing sector.

For Canadian stocks, Gignac recommends underweighting because of the possibility of a “domino effect on the Chinese economy and on commodity prices” if the Fed cannot achieve a soft landing in housing. U.S. consumers are China’s most important customers. Also, he says, investors “should not feel too guilty about taking profits. Past experience (real estate in 1988-90, gold in 1993, Nortel Networks Corp. in the late 1990s) suggests that good sector and geographical diversification is much better than always trying to match or beat the Canadian equity benchmark.”

Nandu Narayanan, chief investment officer at Trident Investment Management LLC in New York and manager of several funds for CI Fund Management Inc., is also pessimistic. The U.S. is in a “credit-financed boom,” he says, characterized by “exponential growth of credit [from which there is] no soft landing that can be expected when the bust occurs.”

Narayanan says monetary policy is much more stimulative than people think. Declines in the prices of manufactured goods, caused by competition from China, should be producing overall deflation. Thus, core inflation (excluding food and energy) of 2%-2.5% is high and should have resulted in much higher interest rates. As it is, consumers are being encouraged to keep boosting their spending.

Ross Healy, president of Toronto-based Strategic Analysis Corp. , has the grimmest scenario — a “brutal recession” that’s likely to start next year as housing and equity prices fall. The tough times will probably last the two to three years that it will take for very overextended U.S consumers to get their finances back in order. As he expects the recession to be accompanied by a lower US$, the Fed won’t be able to cut rates, which, in any event, won’t be effective because consumers would be battening down the hatches. Nor would the the U.S. government — with its huge deficits — be in any position to apply fiscal stimulus.

The only plus is that corporations are generally in good financial shape. While they will suffer from poor sales, they will emerge relatively unscathed. The two sectors likely to be hit the hardest are technology and banking. Tech sales are already falling and margins are compressing; banks have huge amounts of consumer loans and mortgages on their books and have also been lending to hedge funds, says Healy.

The sector that shouldn’t be hurt much is energy. Even with a brutal recession, Healy
says, oil prices will not sink below US$35 a barrel and may well stay above US$40.

It will take time for the current bullish sentiment in the markets to dissipate, given how long it’s been in place. Investors will have time to increase their cash position, he says.

He warns, however, that the next few months will be confusing for investors, with some evidence suggesting continued good growth and other data indicating an increasing possibility of recession. IE