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A Need for Caution in 2008

By Dr. Peter Andersen

The credit shock from subprime mortgage defaults and foreclosures will be a growing problem for the U.S. economy. It will push it close to a recession in 2008. For now, Canada is not being affected as much by the credit shock as the United States is. However, Canadian exports will be hurt by the coming slowdown in U.S. consumer spending. Canada’s new home builders and renovators will therefore have to be very careful in making plans for 2008.

No Rate Cuts in Canada
Canada’s growth momentum means that the Bank of Canada is unlikely to match U.S. Federal Reserve rate cuts in the months ahead. The latest economic indicators still point to robust domestic economy in Canada. There is underlying strength in consumer and business sector demand. The Bank of Canada estimates that Canada’s economy is now operating further above its production potential than was estimated in July.

Canadian Dollar Will Stay High
Tight labour markets in Canada are pushing wage inflation higher. Employees are now, on average, earning 4.2 per cent more per hour than a year ago. This is the highest rate of increase experienced this decade. It makes rate cuts less likely, despite the historical high of over 102 cents U.S. for the Canadian dollar (CAD) and Canada’s relatively low inflation rate. The currency market senses that the Bank of Canada will be slower to cut rates than the Fed. As a result, the CAD has moved higher against the USD in anticipation of favourable international interest rate differentials.

World Oil Price Is Setting New Records
The rise in the world oil price to a new all-time high is providing a special boost for the CAD. Crude oil has traded near a record above US$86 per barrel. The risk to oil supplies from a possible Turkish attach on northern Iraq is the latest supply concern to hit the world oil market. The weak U.S. dollar is also pushing up oil prices. OPEC sells its oil in USD prices and is losing purchasing power in other currencies. Middle-eastern oil producers are therefore not unhappy to see higher USD prices.

Dramatic Contrast Between Canadian and U.S. Housing Markets
Canadian lenders did not participate in the risky sub-prime, Alt-A and jumbo IO lending that has caused all the problems in the United States. Canada’s existing housing market is looking at a new record for sales transactions this year. Sales activity in 2008 is expected to subside but is still forecast to be the second highest level on record.

House Prices Not Falling in Canada
House prices are still going up in Canada in response to strong demand. In fact, they actually show substantial gains. Existing homes are expected to show an average increase of 9.9% in 2007. New house prices are also up. The largest increases in new house prices are in Alberta, Manitoba and Saskatchewan. Ontario shows modest but respectable gains in the two to six per cent range. Windsor is the only CMA in Canada showing a yr/yr decline in new house prices.

Housing Starts Much Stronger than Expected
Canadian housing start forecasts are still optimistic even though housing is not as affordable in Canada as it was last year. The latest monthly data for Canadian housing starts were much stronger than expected. The annualized housing start rate in the 3rd quarter moved higher to an average 244,300 units. This is the highest quarterly starts rate since the housing cycle began in 2002. It looks like national starts for the year 2007 could exceed last year’s total of 227,395 units.

Economic Slowdown Coming in Canada
With the U.S. economy likely headed into a period of relatively slow growth and the Canadian dollar so high, Canada’s export-dependent economy can be expected to feel the impact. The sharp and sudden rise in the CAD means a big cut in cash flow for companies selling products or services priced in USD. It also means a competitive shock on non-exporting producers from cheaper imports coming into Canada. The ones benefiting are retailers and wholesalers selling imported goods in Canada.
In the months ahead, we can expect widespread serious cost cutting by Canadian businesses. The bottom line is that business conditions will be getting more difficult in Canada, even if there is no U.S. recession. Forecasts for real GDP growth in Canada in 2008 are being marked down to around 2.2%. This would compare with an estimated 2.5% growth rate in 2007 and last year’s 2.8% growth performance.

Peter Andersen, a CHBA economist, is president of Andersen Economic Research Ltd. of Toronto. The firm specializes in economic research and forecasting for the Canadian home building industry.

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