Economists predict slowdown, not disaster

(January 2008) The dark clouds looming over the economic landscape may appear scary, but five of Canada’s top economists say investors should not overreact to every minor scrap of news. They agree that 2008 will see a slowdown in the U.S. economy but point out that there are some bright spots that should not be overlooked.

“I’m not prepared yet to say that the U.S. economy is in a recession, but we sure aren’t far from it. It will feel like a recession,” said Sherry Cooper, chief economist, BMO Capital Markets, speaking at the Economic Club of Toronto’s annual Economic Outlook meeting.

She predicts that American economic growth will likely be under 1% in the first half of 2008 but that aggressive easing by the Federal Reserve will see a slight rebound in the latter half of the year.

“The U.S. is the centre of the sub-prime mess, and I do believe we are in a crisis,” she pointed out. “The number of defaults, delinquencies and foreclosures will continue to rise very rapidly because the number of adjustable rate sub-prime mortgages that will be reset continues to grow dramatically. We won’t see a peak in resets until March.”

So far there have been about $100 billion in write-downs related to this market, but Cooper estimates the banking industry will be forced to write off an additional $250 billion by the time the crisis ends.

While she says that no one knows where the “toxic waste” is buried, the salvation of the American banking sector could be the massive pool of liquidity on the global market, particularly in the form of sovereign wealth funds. The fly in the ointment, however, is that America becomes increasingly protectionist in election years, and foreign ownership of its banking sector may not be politically viable.

Much of the capital required to prop up the U.S. banks could come from China, which currently holds about a trillion dollars in foreign reserves. As the developed economies of Europe and the U.S. slow, China’s growth is expected to ease slightly, to about 10.5%, according to Warren Jestin, chief economist, Scotiabank.

Related Stories

To Clients: Staying invested long-term

“The most important aspect of growth for China is going to be coming domestically and in their own market: Asia,” Jestin said. “The Asian market now is about 1.5 times larger than the NAFTA market, and it’s growing twice as fast.”

China’s emerging middle class has been repeatedly touted as a driver of growth not only in China but around the world.

“Our forecast is very similar to Sherry’s — let’s say 2% growth in North America, a slowdown in Europe to slightly under 2%, and the U.K. will decelerate fairly substantially,” Jestin said. “In aggregate, 2% may be the speed limit not only for this year but perhaps for the next five.”

Among the emerging markets, Latin American growth could hit 5%, he says, while Eastern Europe’s could top 6%. But Asia ex-Japan is still likely to be the world-beater, with growth hitting 8%.

Don Drummond, chief economist at TD Bank Financial Group, predicted that the Canadian economy will grow by 1.9%, fuelled largely by domestic consumptions and corporate capital expenditures.

He suggested that the Bank of Canada may even re-examine its tolerance for inflation, possibly lowering the target rate from 2% to 1.5%. Not only would that require tighter interest rates but it would force Canadians to reconsider their own expectations for investment returns.

“There tends to be a steady relationship between interest rates and the rate of inflation, so if Canada did persistently drop to a 1.5% rate of inflation, you would expect all of your rates of return to come back a half a percentage point,” he says. “The inflation target that the central bank has is one of the central pillars of how the Canadian economy operates.”

Within the Canadian market, the commodities sector could see a bit of a slowdown as prices ease, according to Craig Wright, chief economist, RBC Financial Group. That should trim some of the value from the Canadian dollar, but the manufacturing sector should not expect any respite.

“We take a more moderate view of the Canadian dollar, but still fairly lofty levels, ending the year at just over 90 cents. It will provide some relief,” he says, but the manufacturing sector faces greater problems, specifically the outsourcing of production to low-cost economies.

To compete with lower-cost producers, manufacturers will need to dramatically raise their productivity or, better still, boost innovation. Either route will require capital, and in that respect, the high dollar is a blessing, especially since lending has all but dried up.

Fixed income investors will continue to prefer government debt over corporate, as they strive to avoid sub-prime exposure.

“We’ll really have two very distinct bond markets this year,” says Avery Shenfeld, chief economist, CIBC World Markets. “For fixed income markets that just love bad times, the next few months will look a lot like the last couple of months. We’ve already had a significant rally in both the Canadian and U.S. bond markets, but I would suspect that [at the longer] end of the curve, we could see some further returns.”

But later in the year, bonds could fall out of favour again, particularly if equity markets take off again. Shenfeld even suggests that fears over the sub-prime mortgage market are overblown, pointing out that 2008 is an election year in the U.S. and that no one wants to see a million Americans lose their homes before they go to the polls.

If the much-predicted catastrophe is averted, then Canadian bonds could sell off as early as the second quarter, he says, driving yields higher to about 4.40% on the ten-year bond.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(01/09/08)

Steven Lamb