With oil and u.s. housing prices heading downward, talk of recession is increasing on both sides of the border. Economists, however, are reluctant to join in — and with reason: they don’t want their forecasts to become self-fulfilling prophecies, given the impact of consumer, investor and business confidence on economic activity.

But when a recession threatens, advisors have to make sure clients are comfortable with their investments. And as oil prices and energy stocks tumble, some clients may want to reduce their Canadian equities exposure. This may be appropriate in some cases, but it’s not generally a good idea to sell when markets are heading south. So, how do you calm your clients’ fears?

Economic slowdowns are to be expected and are usually healthy, say economists, because they damp-en excess demand and inflationary pressures. Furthermore, most economists expect oil prices to remain high — at least, over the medium term. And if recessionary pressures build, the central banks have room, thanks to recent interest rate hikes, to cut short-term interest rates substantially in order to boost their economies.

Economists are currently forecasting economic growth in 2007 of 1.9%-2.9% in the U.S. and 2.3%-2.9% in Canada.

The U.S. slowdown is the result of weakness in the housing market. Some economists believe house prices will stall at or near current levels, while others suggest they could drop by as much as 10% on average. Normally, a 5%-10% drop in house prices would push the economy into recession. In this case, however, analysts think business investment will remain strong because companies have little debt and high profits.

Economists also believe U.S. exports will remain strong because of reasonable growth in Europe and Japan and even faster growth in emerging markets. This is aided by a lower U.S. dollar, which has made U.S. exports more competitive. Most economists also expect declines in interest rates to help stimulate the economy.

In this scenario, oil and metals prices will move down but not plunge. Few economists expect oil prices to drop below US$50 a barrel during the current slowdown — and, by historical standards, that’s still high. Currency movements should also be relatively small. In this case, manufacturers in Central Canada could be hurt by slowing U.S. demand and a still-high Canadian dollar, but in the West continued strong resources prices should keep growth strong.

But this perfectly reasonable scenario depends on continued consumer confidence. U.S. consumers have been using their home equity as piggy banks or ATMs. If house prices fall, consumers could become alarmed as the wealth they thought they had accumulated dwindles. That could cause many to decide they can no longer afford to make discretionary purchases.

If a lot of consumers start thinking that way, a recession is almost inevitable, particularly as businesses — no matter how much cash they have — won’t make new investments if a downturn seems imminent.

Montreal-based National Bank Financial Ltd. is forecasting only 1.9% U.S. growth next year, while Toronto-based TD Bank Fin-ancial Group is predicting 2.3% and Bank of Montreal, 2.9%.

Here’s a look at the six key factors that you should keep an eye on:

> U.S. Housing. BMO assistant chief economist Paul Ferley believes a 5%-10% drop in the average U.S. house price could cause a recession. But he’s not expecting that; indeed, he doesn’t foresee any significant drop, just a stabilizing of prices at or near current levels.

NBF, however, is predicting a 10% drop in the average U.S. house price. But, like Ferley, it isn’t forecasting a downturn, although it puts the odds of a recession at a high 40%.

TD is expecting a 4% decline in U.S. house prices. And while it, too, doesn’t think that will cause a recession, it says the odds of recession are “real.”

Although NBF thinks a recession in the U.S. will be avoided, its ana-lysis of the U.S. housing market is a bit scary. The number of unsold houses in July was 3.3 million, up almost 1 million from a year earlier. Furthermore, there’s been a lot of speculative activity, with the share of mortgage lending for non-owner-occupied homes at 17% in 2005, almost three times higher than than the average in the 1990s. Speculative investment will dry up even if prices merely stall, let alone start falling.

@page_break@> Interest Rates And Inflation. High oil prices and the lower value of the US$, which has been pushing up the cost of imports, have been the main factors leading to rising inflation in the U.S. Few economists believe this higher inflation has become embedded in the system through wage increases, so price increases should moderate with the slowing of the economy. If that’s the case, then the U.S. Federal Reserve Board has room to lower short-term interest rates. NBF believes the Fed will act quickly and aggressively to avert a recession by lowering its target rate by 200 basis points to 3.25% by the end of 2007.

Toronto-based Royal Bank of Canada doesn’t expect the same drop in rates, but that’s because it doesn’t think they are needed. It is forecasting U.S. growth of 2.7% in 2007, even with the Fed fund rate declining only 50 bps by the end of 2007. Royal Bank economists believe the economy is still strong enough to generate some inflationary pressure; it’s forecasting core inflation, which excludes food and energy, of 2.9% in 2007, vs 2.4% this year.

NBF expects the Bank of Canada to match the Fed and take the overnight rate to 3.25% at the end of 2007. In this case, however, that’s only a 100-bps drop. Royal Bank foresees only a 25-bps drop for the Canadian rate.

> Business Capital Spending. Most economists are forecasting 4%-7% growth in business capital spending in the U.S. next year and 7%-10% in Canada, where there are big energy and other resources projects.

Normally, business capital investment is as cyclical as housing because companies tend to delay investments when the economy slows. In this case, three factors should keep spending going. First, corporate balance sheets are strong and profits are high in both countries, so there aren’t the usual financial reasons to be cautious. As well, U.S. exports are expected to continue to experience strong growth, thanks to increased competitiveness due to the declining US$ over the past few years and to a more moderate slowdown in Europe, Japan and emerging markets. And, third, resources prices are expected to remain high, albeit with some declines expected in the short run, so there’s an incentive to increase capacity in that sector.

However, companies aren’t foolhardy. Even with lots of cash, they won’t go ahead with projects if they think demand for their products is weakening significantly. And, as with consumer confidence, once concerns about a possible downturn take hold, they tend to balloon.

> China. The country has a huge appetite for imports as it industrializes and urbanizes its economy. This has sent resources prices soaring — to the great benefit of Canada and other commodity producers. But China is importing all sorts of items, many of which are produced in the U.S.

China is concerned that its economy is growing too fast — which could generate an inflationary spiral — and is trying to engineer a “soft landing,” with growth slowing to 7%-8% annually from more than 10% a year in recent years. In a developing economy such as China’s, growth of 5% or less is equivalent to a recession.

The worry is that the Chinese monetary authorities could miscalculate and slam on the brakes. If that happens, export growth to that country will come to a halt, with resources and their prices particularly affected.

For the U.S., a significant slowing in China could be the straw that breaks the camel’s back. For Canada, it would be even worse, given our huge exposure to resources both in our economy and on the Toronto Stock Exchange. Energy and materials accounted for 43.5% of the S&P/TSX composite index as of Sept. 29.

The surge in resources has generated increased interest in Canadian financial services, the other big sector on the TSX at 31.7% of the index, pushing the price/earnings multiples of Canadian banks above those of their U.S. peers. Those prices could come down as well if interest in Canadian investments fades.

> Oil And Metals Prices. Most economists agree resources prices are likely to remain high for at least the next few years, and possibly much longer, if supply doesn’t increase as a result of new discoveries or technological developments that cut the cost of alternative fuels. What isn’t clear, however, is how tight the supply/demand situation will be — and how much of the current price for oil relates to speculators and/or concerns about supply disruptions from weather, political upheaval or terrorism. New York-based Merrill Lynch & Co. Inc. , for example, thinks commodity prices are 60% more than what supply would dictate.

Most analysts expect some easing in prices with the U.S. slowdown. Although China may be the driver of resources prices, the U.S. is still the largest consumer. However, a few economists, including those at CIBC World Markets Inc. , expect the prices to keep climbing. CIBC is forecasting US$80-a-barrel oil in the second quarter of 2007. That’s based on double-digit year-over-year growth in Chinese oil demand and limited additions to supply.

CIBC is overweighted in energy, although it has scaled this back by reducing its recommended weighting for natural gas producers. It particularly favours oilsands and other crude oil-rich producers, as well as the “fast-expanding” uranium subgroup. It says world mine production is meeting little more than half of present reactor needs, and prices are still far below past cyclical peaks. CIBC is also overweighted in gold — in which it favours smaller-cap producers — and says the outlook for base metals remains bright.

However, NBF is underweighting all energy except coal and consumable fuels, and oil and gas storage and transportation, which are neutral. It is expecting oil to be US$50-US$55 a barrel by the end of 2007. NBF is neutral on gold and other precious metals, and is underweighted in the rest of materials.

> Currencies. Most economists expect the C$ to remain high at around US90¢. Of the six forecasts examined, only Royal Bank’s says the loonie will come down significantly, predicting US85.5¢ for the end of this year and US80.6¢ at the close of 2007.

Royal Bank sees the easing of commodity prices having a bigger impact on the C$ than the others. It is assuming US$62.50-a-barrel oil in the fourth quarter of this year and US$67 at the end of 2007.

Most economists believe the US$ will gradually move lower. The currency is still clearly overvalued, given the country’s huge current account deficit, which sits at more than US$800 billion. IE