Stock Market Woes
In stock market parlance, when the value of an index falls by 10% from its previous high, this is termed a correction; when it falls by 20%, then investors are dealing with a bear market. The table which accompanies this story shows June’s month-end closing numbers for the four major North American stock market indices. There have been further adjustments downward since then. Midway through July, the Toronto Stock Exchange is standing in “correction” territory and the other three indices qualify as bear markets. Investors have become anxious on four fronts: slowing economic growth; slowing profit growth; persistent inflation; and the prospect of higher interest rates.

Oil Price is Driving Inflation Rate
The first graph below plots year over year changes in the U.S. general price level (the Consumer Price Index) versus world oil prices. While this graph has a double-y axis, with the scales diverging by quite a margin (i.e., oil prices are much more volatile), the direction of change and the relative size of that change are remarkably consistent. In econometric terms, there is a strong correlation between the two series.

World oil prices are continuing to set record highs. Near-month future contracts for light sweet crude have recently surpassed $147 US per barrel. There are worries about supplies due to: Iran-Israeli saber rattling; rebel militia activity in Nigeria; and a looming strike by offshore rig workers in the Campos Basin of Brazil, which accounts for 80% of that nation’s output.

Oil as a Hedge against U.S. Dollar Decline
Furthermore, commodities in general (and oil specifically) are being sought out by investors as a hedge against U.S. dollar declines. Concern about the latter has come to the fore again as a result of uncertainty about the financial futures of the two U.S. mortgage giants, Fannie Mae and Freddie Mac. Those two firms hold about half of total U.S. debt. Fears that the government may soon have to assume some of that debt directly, as opposed to just standing behind it verbally, is further depressing the greenback.

Also, interest rates in Europe are being raised to fight inflation, which lends further upward bias to the Euro (now at $1.59 US) versus the greenback. With U.S. inflation running at 4.0% and higher for the past seven months, a move to raise U.S. interest rates may be hard to fend off much longer. This will work against an economy that has already seen a nearly 60% drop in housing starts and an auto market that is driving into some of the meanest and deepest potholes to be seen in many years.

U.S. Consumers Hard Pressed and Canadian Consumers feeling the Strain too
U.S. consumers are hard pressed to deal with falling house prices, high gasoline costs, a credit crunch and job losses. Canadian consumers are now starting to feel the strain as well. Job losses began in Canada’s export-dependent manufacturing sector, as the loonie climbed in value versus the U.S. dollar. However, job growth is now down-shifting in other areas as well, including the service sector.

Tightening of Mortgage Rules in Canada
In Canadian housing markets, which have been impervious to cutbacks so far, it is interesting to note that the government has just moved to reduce the likelihood of a U.S.-style mortgage-foreclosure problem by banning zero down payments and amortization periods beyond 35 years. These provisions will come into effect on October 15th. There may be a flurry of house-buying activity before then to get in under the wire.

In summary, one can only hope that this disturbing array of problems corresponds to the darkest part of the night, just before the dawn. Something has to give. The most likely, and possibly most welcome, candidate would be an easing in oil prices.

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