More Serious Challenges than at any Time since the Dot.com Collapse
Both the U.S. and Canadian economies have been growing strongly since the first quarter of 2002. That was when corporate profits started to pick up, and they have been rising ever since. Therefore, 2007 is the sixth year of healthy activity in the economies of both countries.

However, both countries now face more serious challenges than at any time since the dot.com collapse in 2001. In the U.S., housing starts have been on a sharp decline since the beginning of 2006. In the latest months, they have been about half their peak level.

There were cyclical factors that brought about the decline in housing starts, but there was also the exceptional circumstance of the subprime mortgage crisis. Beginning in 2006, the cyclical factors were rising interest rates and a leveling in house prices. The former lowered affordability and the latter caused speculators to abandon the market. Once it is clear that a house price surge is abating, the impetus to keep buying and reselling disappears.

“Long in the Tooth” cycles and the Subprime Mortgage Crisis
This summer, however, a “monkey wrench” was thrown into the housing gears. At six years, the current economic cycle has become “long in the tooth”. As cycles mature, increasing turbulence is quite common. That turbulence is often the result of some excess or version of a “get rich quick scheme” that happened earlier in the cycle as the economy was expanding — think savings and loans fiasco, the dot.com collapse, junk bonds and now NINJA mortgages (i.e., mortgages given to individuals and households with no income and no jobs or assets).

The proliferation of adjustable- and teaser-rate mortgages had built-in explosive devices set with specific timers — two and three year periods (2007 and 2008 respectively) after which interest rates would climb dramatically and monthly payments would increase by as much as $1,000.

Why does this happen? Why is it that in every cycle, some new wrinkle is added to the financial asset mix that is of questionable legitimacy? It is because during the good times, many people are prospering and as a result, few want to upset the apple cart.

No wonder mortgage defaults ensued. The problem was magnified by commercial paper held by financial institutions, both in the U.S. and around the world, which had some portion of subprime mortgages in their asset mix. This caused a crisis of confidence in financial institutions and froze liquidity.

The Federal Reserve Board acted quickly to restore confidence by lowering the federal funds rate, first by a dramatic 50 basis points, then later by a further 25 basis points (100 basis points equals 1.0%). Other steps were also taken to pump money into the economy and make funds available to lenders with valid needs and good financial backing. At the same time, there has been a serious tightening of lending standards to avoid this problem in the future.

Deflationary House Prices in the U.S.
Initially, households at the lowest end of the income scale were most affected. These were the individuals and families that were unable to hold onto their homes. The secondary effect, however, has been more serious. The build-up of inventory of unsold houses, both new and resale, particularly in certain geographic markets (e.g., Florida, California, Las Vegas, Atlanta, etc.) has caused house prices to moderate, or stabilize, or in many cases, actually decline.

Once residential markets take this turn (i.e., deflationary house prices), the likelihood that potential homebuyers will make a commitment becomes much less likely. Why buy now when prices may drop more in the future? This is the primary reason that new homebuilding in the U.S. has taken such a deep slide. (It is also a cautionary tale for Canadian housing markets.)

Furthermore, there is a broader economic issue. When homeowners see the value of their principal property (i.e., their home) declining, what impact does this have on their spending patterns? Consumer spending is 70% of the U.S. economy. (It is 55% in Canada.) The importance of consumer spending in the U.S. economy is the reason that economic pundits are watching retail sales and consumer confidence indicators with such interest. The coming gift-giving season will be a particular harbinger of future economic activity in 2008.

U.S. Weathering the Storm with a Fair Amount of Resilience
So far, indications are that the U.S. economy is weathering the economic storm with a fare amount of resilience. Naysayers point to at least one potential trouble spot ahead. Oil prices may continue to climb and any increase in gasoline prices will cut into disposable incomes. On the positive side, however, relatively strong stock markets (despite a recent 5% slide from their peak) do support homeowner wealth and ongoing solid jobs growth provides the incomes to keep consumer spending on a roll.

The fact that the U.S. economy is perhaps at a crossroads is one reason that forecasters are couching their stated expectations in terms of percent possibilities of a slowdown or recession, generally given as about a 25% to 33% possibility during most of the presentations made during this fall’s outlook conference season.

It must also be remembered that much of what happens in a free market economy is self-correcting. The cut in the federal funds rate has continued a process that has seen the U.S. dollar drop dramatically versus almost all other major currencies over the past five years. This is helping to reduce the huge U.S. trade deficit.

At the same time, however, the drop in the federal funds rate caused the U.S. dollar to decline and the Canadian dollar to rise to the point where parity was achieved on September 20, 2007. This leads into a discussion of the economic circumstances now facing Canada.

Canada’s Economy Firing on Nearly All Cylinders
Canada’s economy has been firing on almost all cylinders. This has been truer of western Canada than the east, but even in eastern Canada, business conditions have been more than just fine. As a case in point, several of the Atlantic provinces have 30-year-low unemployment rates. The Québec economy has come roaring back and Ontario is getting by on its knowledge-based industries, a vibrant investment sector in Toronto and Japanese auto making strength.

As for western Canada, strong world commodity markets, more than any other factor (supported by particular growth in China), have caused “mega-boom” conditions in Alberta and Saskatchewan and “mini-boom” conditions in British Columbia and Manitoba. For many years, workers from Atlantic Canada (particularly Newfoundland and Labrador) have been moving to work in the Oil Sands of Alberta. In the latest annual measure of interprovincial migration, it is clear that workers from Québec and Ontario have also been “Alberta bound”.

Prices in Canada Must and Will Adjust Lower
The currency movements in the U.S. and Canada have opposite implications for general price inflation in both countries. In the U.S., import prices are climbing. In Canada, they are falling. Furthermore, in Canada, the impact of any future rise in commodity prices (which are usually specified in U.S. dollars) will be blunted.

Also for Canada, the Canadian dollar at or near par will provide a great deal of incentive for price adjustments lower simply because of the spotlight thrown on differentials with respect to the same products sold south of the border. Everybody can now do the math.

Finally, Canadian goods and services providers will have to keep prices down to match the foreign competition. This will be import to maintain export sales to the U.S. Furthermore, there is an important anomaly with respect to another key currency, the Chinese Yuan. The Yuan, since it was partially allowed to float in mid-2005 has been appreciating versus the U.S. dollar. During the same period, however, it has continued to fall versus the Canadian dollar. Chinese goods keep getting cheaper when sold in this country.

The bottom-line implication is that there will be increasing inflationary pressures in the U.S. as long as the economy continues to expand at a decent pace. The U.S. is expected to perform fairly well in 2008 if for no other reason than that housing markets, even if they do no better than level off, will stop acting as a drag on the economy as they have done throughout 2007.

Also, the U.S. has gone through some restructuring of its major industries that should pay dividends going forward. For example, recent labour agreements between the United Autoworkers and the former Big Three automakers have reduced the burden of “heritage costs” (medical and pension benefits for both current and retired workers) and also established that U.S. locations will receive priority consideration with respect to future investments.

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