Sunday, December 17, 2006

Hi All,

Here's is some more evidence that we are not looking into the abyss. Changes that were made to our economy over the last 20 years (Free Trade, Privatisation, the ending of Federal Gov't deficits, and changes to our tax structure) are paying off. As is mentioned near the end of the article, the BoC of is not forced by high inflation to raise rates and thus ending the party.

For the Vancouver market I see a moderating stabilisation of the market and then a gentle rise in the Spring.

Looking forward to you thoughts!

HEATHER SCOFFIELD

Globe and Mail Update

Canada's economy is in a rut, but economists say it won't take much to lift it out.

Recent U.S. data and some signs of strength in Canada suggest that the continent may be ready to exit the doldrums by the middle of next year From today's lethargic 2-per-cent annual pace, the Canadian economy is widely expected to kick into a higher gear within about six months, edging up to almost 3 per cent.

And if that's the case, the current downturn will be one more proof that the economy is generally on an even keel, with the ups and downs much less pronounced and much less painful than in previous decades.

“It's certainly no disaster,” said Avery Shenfeld, a senior economist with CIBC World Markets Inc.

The reluctant recognition by Bank of Canada Governor David Dodge last week that Canada was indeed enduring a slowdown jolted observers and sent the Canadian dollar sinking. But things probably won't get much worse than they are now, economists say.

Canada has just come through two quarters of sluggish growth and this year's fourth quarter and the first half of are expected to be much the same.

But with a bit of help from American consumers, Canadian governments and central banks on both sides of the border, Canada's economy should pick up by next summer.

There are signs that help is on its way. Data for retail sales in the United States last week was surprisingly strong, rising 1.0 per cent in November — despite continuing troubles in the housing market.

For now, the U.S. economy has some strong signs that it is struggling: the decline of the housing sector, falling employment in construction, and withdrawals of mortgage equity, points out Michael Gregory, senior economist with BMO Nesbitt Burns.

But it also has some encouraging signs: energy prices are falling, equity markets are rising, interest rates are low, and tight labour markets mean wages are accelerating and jobs are secure. Business investment is strong, and consumers are showing signs of resilience.

For Mr. Gregory, the key signal that the tailwinds are beginning to win out over the headwinds was the fact that applications for new mortgages are rising.

“It has definitely turned,” he said. “It's definitely a sign that people are taking out mortgages to buy houses.”

The fate of the U.S. housing market is important for Canada's economy, partly because American consumers draw much of their spending power from their real estate wealth, and partly because Canada's exporters supply many of the materials used in building and furnishing new homes.

The softest spots in the Canadian economy have been exports and manufacturing — both which would benefit from a recovery in U.S. housing.

Still, few economists want to declare the housing rout over, and consumption could yet become weaker in the United States, said Don Drummond, chief economist for Toronto-Dominion Bank.

But that's where central banks come in, he adds. He expects the U.S. Federal Reserve will cut its benchmark interest rate by three-quarters of a percentage point starting next spring, helping to boost the U.S. economy.

In Canada, many economists believe the Bank of Canada will cut rates a little bit as well, once it sees that inflation is well under control.

The Canadian economy could also get a lift from a slow depreciation of the currency, back down to the 83-cent (U.S.) level, said David Wolf, economist and strategist with Merrill Lynch Canada Inc. And with elections pending in Quebec, Ontario and at the federal level, significant fiscal stimulus is probably on the horizon, he said.

Economists differ in their estimate of the timing of the turnaround for Canada and the United States, but they agree that the downturn, for Canada, has been shallow by historical standards.

The manufacturing sector has suffered deeply, with tens of thousands of jobs lost, and profits taking a hit. And exporters have struggled to deal with the rapid rise in the Canadian dollar.

But the damage has not spread too far, and Canadian households have been able to depend on low interest rates and a healthy job market.

Interest rates and inflation are the main difference between this downturn and downturns of the past that turned into recessions, said Mr. Drummond.

In the past, inflation was usually high when the economy lost steam, and the central bank had to raise rates to fight inflationary pressure, exacerbating the downturn, he said.

“Those other cycles went down a lot further because they were monetary-induced slowdowns,” he said. Now, with rates relatively low and inflation in check, “we don't need to slam the breaks on the economy.”

And while Canada's recovery depends to a great deal on what happens in the United States, the fact that the Bank of Canada has kept its key rate below U.S. rates is helping the economy maintain some strength now, and will help it recover more quickly than the United States, Mr. Shenfeld said.

“They [the Bank of Canada] protected the domestic side of the economy,” Mr. Shenfeld said. “They made a wise decision.”

Friday, December 08, 2006

Housing starts edge higher in November (And htere is still strenght in the Vancouver Market)

Hi All,

This is some tangible evidence of what I have been seeing over the last few weeks. It has slowed because of the holidays, but I forsee a busy New Year.

Looking forward to reading your thoughts!


ROMA LUCIW

Globe and Mail Update

The pace of new-home construction edged higher in November, led by strength in condos and apartments, but the overall market is still expected to pull back next year as the economy cools.

Housing starts climbed less than 1 per cent to 225,000 units from 223,200 units in October on a seasonally adjusted basis, the Canada Mortgage and Housing Corporation said Friday. Economists were expecting a rise of 220,000.

Rishi Sondhi, an economist with Royal Bank of Canada, said the report indicates that new home activity "remains decent."

For the second straight month, the gains were driven by the multiunit starts, a volatile segment that gets knocked about by the start of construction on large-scale apartment buildings, and also includes semi-detached homes, townhouses and condos. Urban multifamily unit starts jumped 5.7 per cent to 105,600 units, after surging 23-per-cent in October.

The gains in the multiunit category offset declines in the construction of detached single-family homes, the bellwether component of the new homes report. Urban single-family housing starts, the bellwether component of the new homes report, dipped 4.2 per cent to 87,900 units in November.

David Tulk, an economist at Toronto-Dominion Bank, said multiple-unit starts were bolstered by increasingly scarce land in urban centres like Vancouver and Toronto, as well as declining affordability for detached homes in cities like Calgary.

He expects growth in multiple unit projects will remain robust as Canada's cities" continue to attract new immigrants, while "single unit starts will likely feel the brunt of the cooling housing market."

November's CHMC housing data contained huge regional divides, with activity in the Prairie and Atlantic regions bustling while the rest of Canada declined.

Urban starts dropped 11.7 per cent in Quebec, 7.9 per cent in British Columbia and 3.8 per cent in Ontario. Gains in new home construction were seen in the Atlantic and Prairie regions, with urban starts rising 21.4 per cent and 26 per cent, respectively.

To date, Canada's housing market has defied expectations and avoided the sharp downturn unfolding in the U.S. Canadian building permits surged to their second-highest level on record in October, according to a report released earlier this week, making a mockery of consensus forecasts for a drop.

Most economists expect that strength will wane next year.

”With a slight dip in both economic and employment growth forecast for the coming year, housing starts in both the singles and multiples segments are expected to moderate," sad CHMC economist Bob Dugan.

Jacqui Douglas, an economic strategist with TD Securities, also agreed that an easing is in the cards. ”We expect to see the Canadian housing market make a gradual downward shift, as the economy slows and higher interest rates have an effect.”

TD's Mr. Tulk forecast housing starts will remain solid at 205,000 next year and 195,000 in 2008, on the heels of this year's projected tally of 228,000.

New home construction will be "buoyed by reasonably low inventories of new and existing dwellings" as well as strong economic fundamentals such as low unemployment, higher disposable income and reasonable levels of affordability.

Mr. Tulk pointed to a new generation of home buyers - the echo generation - who will boost sales. "This cohort has been moving into the 25 plus age category, providing a large pool of first time buyers, which when combined with continued immigration, will provide further support to this mature stage in the housing cycle."

Tuesday, December 05, 2006

Bank of Canada stands pat on interest rates (Bank of Canada leaves interest rates alone)

Hi all,

Looks like rates are going to stay where they are for the time being and could very well drop.

TAVIA GRANT

Globe and Mail Update

The Bank of Canada left its key interest rate unchanged at 4.25 per cent, as expected, and said rates are at the right level to achieve the bank's inflation targets over the “medium term.”

The central bank's overnight lending rate has been steady since May, though many economists are expecting a rate cut next year. In Tuesday's statement, the bank gave little indication that it plans to lower interest rates in the coming months.

It still sees core inflation and overall inflation in Canada converging at 2 per cent in the second half of next year.

“In line with the bank's outlook, the current level of the target for the overnight rate is judged at this time to be consistent with achieving the inflation target over the medium term,” the central bank said.
Related to this article
Bank of Canada Gov. David Dodge speaks to members of The Sydney Institute and the Canadian Australian Chamber of Commerce in Sydney on Monday.

Bank of Canada Gov. David Dodge speaks to members of The Sydney Institute and the Canadian Australian Chamber of Commerce in Sydney on Monday. (Rick Rycroft/AP)

The most important change to the central bank's statement was removing a reference to the economy as operating above capacity, noted National Bank Financial. The bank dropped the reference amid expectations of weak economic growth in the second half of this year.

“This is an important development as it is the first step for opening the door to fine-tuning of monetary policy in 2007 (read rate cuts),” said economists Stéfane Marion and Paul-André Pinsonnault in a note.

“Should job creation take a downturn, we would anticipate the Bank of Canada to alter its risk assessments of the economy and its inflation outlook as soon as...January,” they said, adding that they expect a rate cut in March.

The central bank said its outlook for Canadian economic growth and inflation through to 2008 is “essentially unchanged” from its views in October.

However, “some recent indicators suggest that output growth in Canada and the United States in the fourth quarter of 2006 may be a little weaker than previously expected,” the bank said.

The bank again noted that a risk remains that the U.S. economy could slow more sharply than expected, leading to lower Canadian exports.

“The bank judges that, overall, risks around the inflation projection are roughly balanced,” it said.

The Bank of Canada makes its next interest-rate decision on Jan. 16, followed by its monetary policy report update two days later.

Tuesday, November 28, 2006

More good news for the Vancouver Property Market! (Canadian interest rates should stay steady, OECD says)

Hi All,

For all those who may have been reading about a "bubble" in the market, here is more evidence that this is not the case. We are seeing a soft landing with none of the calamities forseen by those preaching doom in the blogoshpere (Vanhousing Blog is a perfect example).

So to all the Cassandras, here is one more dose of reality and to all those who are interested in pertinent and useful information from an active market participant, keep reading!

TAVIA GRANT

Globe and Mail Update

Canadian interest rates shouldn't budge unless wage pressures flare up, the Organization for Economic Co-operation and Development said Tuesday.

It noted that economic activity has eased recently because of higher interest rates, terms-of-trade losses and weaker exports. Growth is expected to benefit from some pick-up in foreign markets, though domestic demand will likely slow.

“In the context of on-target inflation and a modest pick up in activity, the Bank of Canada should keep its policy rate constant so long as no nation-wide labour market pressures come into view,” the OECD said in its semi-annual economic outlook.

The Bank of Canada's key lending rate has remained unchanged at 4.25 per cent since May.

The OECD predicted the Canadian economy will growth 2.8 per cent this year and 2.7 per cent next. It's expected to quicken to 3.1 per cent in 2008. Domestic demand is seen easing over the next few years.

In the meantime, inflation pressures will likely remain “limited,” because of lower energy prices and only moderate wage increases.

The OECD also cut next year's global growth forecast for all 30 of its industrialized member countries to 2.5 per cent -- the lowest rate since 2003 -- from its previous forecast of 2.9 per cent..

“Rather than a major slowdown, what the world economy may be facing is a rebalancing of growth across OECD regions,” the report said.

It sees an unwinding of “cyclical differences,” with activity cooling in the U.S. and Japan, and gathering speed in Europe. Any slowdown should remain “well-contained,” it added.

Thursday, November 23, 2006

Realtors want tax breaks for small landlords (This could have major implications for Canada's overall inflation rate and property market stability)

Hi All,

Tax implications are a huge influence on an owners decision to sell a property.

Capital Gains Tax on the proceeds of a sale of a non-primary residence can be exorbitant and deters successful real estate investors from selling properties.

A lack of supply in a market with excess demand drives up prices and does so quickly. The bigger and more popular the asset the more effect it will have the economy as a whole. Economics 101 stuff.

Real Estate is the single most expensive asset the average person will ever buy. The market for this asset is a major engine in a Canada's GDP and has a big impact inflation and the Bank of Canada's decision on interest rates.

Up to the June/July of this year, Vancouvers property market was very hot. Listings were in very short supply and sold very quickly and prices were increasing by more than 1% per month. This situation was common across the country.

The Bank of Canada, increased interest rates because of concerns about inflation, specifically, home price inflation in Western Canada.

30-35% of Downtown's stock of condo's is owned by investors. Had these people been able to sell their properties tax free, the quick price increases would not have occurred.

There would have been a slower increase in price that would have lasted longer, because the Bank of Canada would not have intervened as early to cool the market. Prices would have gone up and as high as they eventually went, but would have done so in a more stable and measured manner.

A liquid market is a stable market.

Looking forward to hearing what you think.

ROMA LUCIW

Globe and Mail Update

A group of Canadian realtors is calling on Federal Finance Minister Jim Flaherty to extend capital gains tax relief to small landlords, saying the move will level the taxation playing field and encourage property owners to update and maintain rental housing.

The Canadian Real Estate Association, which represents 88,000 full-service realtors, is asking Mr. Flaherty to allow landlords with smaller holdings and fewer than five employees to defer capital gains and capital cost allowance taxes when they sell their investment property, provided they put that money into another investment property within a year.

The Conservative government campaign included a pledge to provide individuals and companies with the ability to defer capital gains taxes by allowing them to reinvest proceeds within a certain time frame. Prime Minister Stephen Harper spoke of introducing rollovers for shares, bonds, mutual funds and family cottages. He did not, however, mention small investment properties.

Mr. Flaherty is slated to unveil his economic plan today and he is expected to signal the need for more personal and business tax cuts to help preserve Canada's living standards.

CREA does not expect the minister will unveil any measures related to small real estate investors Thursday, but is nevertheless forging ahead, trying to secure meetings with Mr. Flaherty's office and other members of parliament. They have been calling for similar measures since 2001.

"The Conservative government said they were going to address capital gains tax," said James Brennan, a spokesman for the CREA. "They left the door open to deal with the issue of capital gains tax as a whole."

In a paper submitted to the House of Commons Standing Committee on Finance last month, CREA said their proposed changes to the tax legislation would alleviate current inequities that place small real estate investors at a "significant disadvantage" when compared with many other investment vehicles.

"The Income Tax Act effectively eliminates the incentive for many property holders to consider a sale due to the impending tax burden," the paper said. "The situation is particularly punitive for the small investor" who manages property but is denied the tax benefits given to larger investors because they have less than five employees.

The CREA also said that small investors are currently holding onto their investment properties to avoid the tax hit that would arise from selling and re-investing. The high taxes preventing reinvestment in income property are stunting Canada's productivity and labour mobility.

"Households can now move their belongings, stocks and bonds, but are unable to move their real property investments without facing substantial tax consequences," the CREA said.

The economic spinoffs of having a real estate transaction take place are notable, Mr. Brennan said, since most renovations take place around the time a property is bought or sold.

Flaherty considers tax cut for foreigners

Hi All,

I have had to deal with this issue many times during my time as a realtor. This tax harkens back to the days rigid currency controls and has a big impact on otherwise straightforward investment decisions.

HEATHER SCOFFIELD AND STEVEN CHASE

Globe and Mail Update

Finance Minister Jim Flaherty is contemplating elimination of a key tax on foreign investors as a way to ease access to capital and assuage the energy sector after his move to tax income trusts.

Withholding-tax rates vary according to the type of investment and the country, but the 10-per-cent tax on Canadian interest that U.S. investors pay is in Mr. Flaherty's sights, several sources say.

Negotiations with the United States have been on-again-off-again to have both countries lower their withholding tax on cross-border investments for years, but Mr. Flaherty is looking for ways to revive the talks, three well-connected Bay Street sources say.

“I know for some time the minister has been looking to get the job done,” one source said.

The federal government's attempts kicked in to high gear this month, after complaints from the energy sector that the tax on income trusts would drive away foreign investment.

There is no evidence that an announcement is imminent, but Bay Street has been cheering him along.

“These withholding taxes are probably an impediment to investment flows,” says Finn Poschmann, director of research at the C.D. Howe Institute.

In the short term, Ottawa gives up some tax revenue, but in the long term, improved investment flows and better access to financing for Canadian companies make up for the loss, he argues. Access to venture capital in particular could be improved, he says, mainly because Americans would bring capital and managerial skills by taking larger stakes in Canadian companies.

While it's unclear whether withholding taxes will show up in Mr. Flaherty's long-term economic plan Thursday, it would make sense to include a reference, Mr. Poschmann said.

“It would be natural to see a move on withholding taxes as part of a prosperity agenda.”

As a general rule, Canada slaps a 25-per-cent tax on disbursements to foreigners — dividends, interest and royalties. But like many other countries, Canada has bilateral treaties that lower that tax for individual countries.

With the United States, Canada generally levies a 15-per-cent withholding tax on dividends and a 10-per-cent tax on interest payments of various kinds. In turn, the United States taxes interest paid to Canadians at a rate of 10 per cent. Although taxpayers on both sides of the border get tax credits from their own country for tax withheld by other countries, the credits don't come close to making up investors' losses.

As a result, the withholding taxes have acted as a deterrent to Americans investing in Canada and to U.S. financiers underwriting Canadian firms and projects, analysts say.

Canada's share of the world's foreign direct investment has slowly declined over the past year, and the elimination of withholding taxes could help reverse the trend, analysts argue. The move would make it easier for Canadian companies to expand beyond Canada, and encourage foreign firms to invest here.

The private sector has estimated that the short-term net loss to government revenue is small, about $100-million a year. However, federal government estimates suggest the number could be more than double that.

Ottawa will probably not move to reduce or eliminate any withholding tax until the Americans agree to reciprocate, several insiders said, but that's not beyond the realm of possibility.

“It would only be done in the context of a bilateral treaty,” one source said. “You'd also have to have agreement with the Americans, which I don't think would be a problem because the United States has eliminated withholding taxes on every treaty it has signed in recent years.”

A coalition of dozens of companies on both sides of the border has long lobbied for action on withholding taxes. And in a recent submission to Mr. Flaherty, the Canadian Chamber of Commerce put the issue near the top of its list of things the federal government should tackle to improve capital flows and investment.

It called on Ottawa to negotiate with major tax treaty partners the elimination of withholding taxes on dividends, royalties and interest payments.

It also asked Ottawa to immediately revive negotiations for tax changes under bilateral treaties with the United States and other major trading partners.

“The imposition of withholding taxes on interest, dividends and royalties has an immediate, negative impact on productivity,” the chamber argues.

The taxes impede cross-border capital flows, act as a tariff on the importation of capital and knowledge, and raise the cost to Canadian business of accessing foreign technology, the submission says.

“It's not a good tax, and it's not bringing in billions, so you should get rid of it,” said one Bay Street source.

He believes that the country's economy as a whole would benefit from the elimination of the withholding tax, with or without reciprocity from the United States, since Canadian companies would benefit from lower borrowing costs through more foreign competition to finance Canadian business.

Canadian lenders, such as the chartered banks, may not immediately appreciate the foreign competition, he conceded.

“But if you look at it broadly, it would be beneficial to Canada.”

The downside of the elimination of withholding taxes is mainly political.

The move would likely prompt critics to say Canada is giving away money to foreign companies and foreign governments.

Wednesday, November 22, 2006

Housing market crash not in the cards for Canada

Hi All,

This is a continuation of the last post i wrote and dovetails nicely with my comments. I look forward to hearing your comments!

ROMA LUCIW

Globe and Mail Update

Canada's hottest housing markets will not suffer the price crashes seen in some U.S. regions, in part because the speculation and high-risk mortgages that fuelled the activity south of the border are not rampant in this country.

A survey by realtor Century 21 Canada found the massive price increases seen across Canada over the last five years have slowed in all but a few areas. Meanwhile, the U.S. housing situation is dire. U.S. home prices have dropped drastically in recent months, with popular markets such as Florida, California, Nevada and Arizona experiencing the steepest downturn.

Don Lawby, the president of Century 21 in Canada, says there are economic and financial factors that differentiate the housing markets in the two countries.

“There is more speculation in the U.S. than we have seen in Canada,” Mr. Lawby said. “Lenders in Canada don't have the same lending policy as the U.S. For the first time in history we have interest-only mortgages. In the U.S., they've had them for years.”
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The Globe and Mail

Some Canadians are using non-conventional or riskier mortgages — such as interest-only financing — to buy their homes. However, a recent study by CIBC World Markets found that non-conventional mortgages make up about 5 per cent of the Canadian market, a small amount when compared with about 20 per cent in the U.S.

Because Americans can deduct mortgage interest from their income tax, people are using their houses like cash machines, Mr. Lawby said. “Once you start doing that, you treat your home as a different vehicle rather than as a place to live,” he said. “So people try to make money off the value of their homes, and that pushes up the value of homes faster.”

Over the last six months the median price of all existing U.S. homes dropped 11.5 per cent to $200,000 (U.S.) from $223,000, according to the U.S. National Association of Realtors.

Economics is another major factor that will support Canada's housing market, Mr. Lawby said. Even Ontario, where rising energy prices, a high Canadian dollar and a slowing U.S. economy are weighing on the manufacturing sector, is unlikely to undergo a steep decline in prices.

“In Ontario, the bottom line is that the provincial economy will continue to support stable housing prices,” Mr. Lawby said. In his opinion, increased production at auto plants run by Honda and Toyota, as well as government spending on construction of highways, hospitals and schools, will support the provincial economy.

House prices in select Ontario communities have risen between 0 and 6 per cent in the last six months, Century 21 data showed, a sign that price increases are slowing. In the last five years, prices in the same markets for similar homes surged between 27 and 106 per cent.

The Century 21 study found that the hottest housing markets over the past six months was Edmonton northeast, where prices shot up 36 per cent, Red Deer, where prices rose 19 per cent, North Vancouver, where prices climbed 12 per cent, and the west side of Vancouver west side, where prices rose 10 per cent.

The release did not address whether housing prices in British Columbia or Alberta are expected to rise or fall.

Monday, November 20, 2006

Market Update For the week of November 20th

Hi All,

The Downtown Market has stabilised with not much price appreciation since June/July. Up to that time I would add 1%/month when I would list properties. Since then I am not adding any increase in price when I list properties.

To discuss this further please contact me at any time.

Thanks,

Mike

(Thanks Chuck D for the blogging tips!)

Tuesday, November 14, 2006

ALBERTA’S RISING WAGES: A TIDE THAT LIFTS ALL BOATS

October 3, 2006

Alberta’s red-hot job market has grabbed the spotlight in recent years. Average hourly wages in the province have posted the greatest increase in the country, rising by a cumulative 17.4 per cent since the beginning of 2002 through the second quarter of 2006, eclipsing the 10 per cent rise in the rest of Canada. Seeing as Alberta’s resource sector, primarily energy, has acted as a rainmaker to the provincial economy, the perception is that the strong wage growth observed in Alberta has also been driven by the resource sector. Since inflation is also rising substantially in the province – since the start of the year headline CPI is averaging about 4 per cent on a year-over-year basis – the concern is that if the wage gains are concentrated in the resource sector, other workers in the non-resource sectors, particularly those in the lower-paying industries, could be left behind. Surprisingly, that has not been the case. In fact, the greatest wage gains have occurred in the non-resource sector, which has led to a narrowing of the wage gap between the higher paying and lower-paying industries. The ultra-tight conditions in Alberta’s job market (highlighted by the record low unemployment rate of near 3 per cent) have forced firms in the non-resource industries to raise wages substantially higher, in order to retain workers and compete with the higher wages already paid in the resource sector. Indeed, it appears that with respect to wages, the strength in Alberta’s resource sector has been a tide that has lifted all boats.

Average hourly wages in Alberta top the nation

Blessed with being Canada’s fastest growing province and a primary beneficiary of the strong global demand for oil and gas – to a lesser extent metals – Alberta has experienced the greatest labour shortages and the highest wage growth recorded in the country. High energy prices, leading to hefty profits, have underwritten Alberta’s robust business investment activity. This has played a large part in tapping out the regional labour market, resulting in an all-time low unemployment rate of 3.1 per cent in February and averaging 3.5 per cent for the year. Even with an influx of migrants from neighboring British Columbia and Saskatchewan, and to a lesser extent the rest of Canada, there have been labour shortages. The situation has become so severe that many firms have had to offer wages far above the national average, or scale back their operations or risk shutting down because of a lack of employees.

To put the province’s wage growth into context, average hourly wages across Canada excluding Alberta advanced by a cumulative 10 per cent since the start of 2002. In the same period, Alberta’s average hourly wage has gone up by a whopping cumulative 17.4 per cent. In fact, Alberta’s average hourly wage has risen from the third highest in the nation in the first quarter of 2002 to the highest at $20.99 in the second quarter of 2006. This is a considerable feat considering it took place over such a short period of time. The statistics may even understate the degree to which workers have benefited from the commodity boom. Given the extent of the labour shortages, it’s likely that many workers are putting in a significant amount of overtime – a fact that will not be reflected in the hourly wage.

So, Alberta is booming and wages are soaring, but whose wages have benefited the most? You might expect it to be those employed in the natural resources industries. Surprisingly, that has not been the case.
Rainmakers have seen the slowest pace of wage growth

Alberta’s industries can be divided into three categories: rainmakers, direct beneficiaries and indirect beneficiaries. Given the significant impact the commodities’ trade has had on Alberta’s economy, we felt the moniker “rainmaker” would best represent the natural resources sector. Direct beneficiaries are industries which are either likely to support or advise the rainmakers, such as transportation and warehousing, or are likely to benefit from the additional income rainmakers inject into the provincial economy, such as financial services, real estate and insurance. Indirect beneficiaries are industries that you would not necessarily expect to benefit directly from the commodity boon, though they may benefit indirectly. Examples would be the public sector, while it is not tied into the commodities trade, the increased tax revenue collected by the province may translate into raises for government workers.

Historically, wages in the rainmaker industries tended to be the highest, followed by the direct beneficiaries and then the indirect beneficiaries. This ranking remains unchanged. In the second quarter of 2006 wages in the rainmaker sector were the highest at $25.50, followed by the direct beneficiaries at $19.97 and the indirect beneficiaries at $16.59. However, interestingly enough, this gap has narrowed. While wages in the rainmaker sector advanced by a cumulative 5 per cent over the last five years in current dollars; it wasn’t at the fastest pace across the three groups. In fact, it was the slowest. Wages in the indirect beneficiary industries advanced by 20 per cent and those in the direct group rose by 16 per cent over the same period. This trend is certainly counter-intuitive, especially in the indirect beneficiaries sector. Why would the sector that has no ties to the commodity boom see the fastest pace of wage growth and the rainmaker sector see only modest wage gains?

It’s a classic case of demand outstripping supply. Since rainmakers offer the most competitive level of wages, they would have little problem attracting or retaining workers. Indeed, this gives rainmaker firms little reason to raise wages. All else equal, people gravitate towards a higher pay and those already in the sector aren’t likely to move to a lower paying industry. You can see this effect in the employment data. Employment in the rainmaker sector has gone up by a massive 40 per cent over the last five years, while employment in direct and indirect industries has gone up 13 per cent and 10 per cent, respectively. It’s pretty clear that the lower paying industries are struggling to find workers and have had to increase wages at a more substantial rate to maintain their operations. On the whole, this is why you have seen wages rising faster in the non-rainmaker sectors. Fortunately for many of these firms, the additional income that has been flowing into the provincial economy still makes it profitable to pay their workers higher wages.

Jobs unique to the primary sector reap the greatest benefit

However, you may wonder how the rainmakers sector has seen the slowest pace of wage growth when the anecdotal evidence suggests otherwise. Keep in mind, that while wages may have advanced by about 5 per cent in the rainmaker sector since 2002, it doesn’t necessarily mean everyone in that sector has seen their wages rise by that amount. There would be differences across jobs within the sector. You would expect workers in occupations unique to the primary industry, such as oil sand workers and miners, to have seen tremendous wage gains. In fact, when you look at wages at the occupation level, it’s clear that these workers have indeed been one of the biggest beneficiaries of the commodity boom. Wages for oil sand workers and miners have skyrocketed since the start of the boom, up by a massive 42 per cent or $6.80 an hour – the most of any major occupation group and vastly outpacing the rainmaker industry average. It should be noted that while average hourly wages is an appropriate and accurate means to measure worker gains, it has drawbacks. Performance incentives, such as bonuses and special payments may not be reflected.

Bottom Line

On the whole, it appears that the recent commodity boom which resulted in record-high corporate profits has also bolstered wages in Alberta. It’s not unexpected that wages of jobs unique to the primary sector – oil sand workers and miners – have skyrocketed. Yet, surprisingly, on aggregate, the rainmaker industry in Alberta has seen the slowest pace of wage growth. In fact, it’s wages in the other sectors that have advanced the fastest. The relatively high wages in the rainmaker industries and their insatiable appetite for workers has literally “sucked” up all the slack in the labour force and begun to draw workers away from other sectors – which on average are lower-paying. As a result, the non-rainmaker industries have had to drastically boost wages to retain workers or else shut down or curb production. Going forward, assuming there continues to be no significant slack in Alberta’s labour force and corporate profits and hiring remains strong in the rainmaker sector, we should see a continued narrowing of wages between the rainmakers and the other areas. Indeed, the strength in the Albertan labour market is a tide that lifts all boats.

Steve Chan, Economist
416-982-6420

THE DECLINE AND FALL OF THE U.S. HOUSING MARKET: WILL THE BROADER ECONOMY FOLLOW?

October 2, 2006

The U.S. housing sector directly contributed more than $2 trillion to the national economy in 2005 and accounted for one-quarter of real GDP growth. Don’t expect a repeat performance any time soon. Data over the past five months show that the housing market is in the midst of a correction. The supply of detached resale homes has hit a 13-year high, affordability has eroded to late-1980s levels, and all three major housing markets – new, existing and construction – have absorbed double-digit declines in activity relative to last year.

The question is not whether the housing market correction will dampen U.S. economic growth over the next year. It will. The cliffhanger is whether it can single-handedly tip the economy into a recession. Indeed, the current housing cycle is already mirroring trends leading into past recession cycles. So why would it be different this time?

To evaluate the risk of an economy-wide recession, we cannot look at the housing sector in isolation. Other factors also enter into the equation, such as interest rates, inflation, labour market conditions, inventory overhang and the overall health of Corporate America. These influences bear little resemblance to patterns seen in prior pre-recession cycles, and we believe this tips the scale in favour of an economic slowdown rather than a recession.

The importance of housing in the American economy

The real estate sector has been punching above its weight in the American economy since the housing boom gained traction in 2002. More and more jobs, incomes and consumption have become leveraged to the performance of the housing market over the past four years – leaving little doubt that a housing correction will have knock-on effects to the broader economy. In fact, housing-related indicators alone leave the impression that a recession is just around the corner.

There are three main ways in which the housing boom has weaved its way through the economy. There is the direct link of residential investment, which accounts for 5.5% of real economic activity, a share that has risen a full percentage point in just four years. This sector has consistently contributed about half a percentage point to real GDP growth since 2002, twice its historical norm. Over the next year, however, the opposite is expected to be true, with residential investment shaving half a percentage point from annual economic growth. On its own, this would be a barely audible hiccup in the economic expansion, but residential investment has been a heavyweight in influencing recent labour market conditions.

Construction and real estate jobs are to credit for one-fifth of all American job growth in the past four years. This is remarkably disproportionate to its size in the labour market. For instance, the construction industry accounts for less than 5 per cent of all jobs. Not surprising, regions that had the greatest gains in home prices during the boom also experienced the most robust demand for construction workers. New England can thank the construction sector for more than one-third of all job growth over the past four years (August 2002-August 2006). The respective shares in California and Nevada are similarly high at 28 and 24 per cent. A pull back in housing, therefore, presents a clear and present danger to employment, and hence incomes and consumption across America.

And the impact from housing doesn’t end there. The third and biggest influence has come through two arteries of consumption: direct housing-related purchases and the wealth effect. The former includes the likes of furniture, appliances and other expenditures related to household services and operations. These purchases accounted for just over 18 per cent of the real economy in 2005. Meanwhile, housing wealth effects have been fueled by the rapid appreciation in home prices coupled with record levels of refinancing and home equity withdrawals. Unfortunately, the peak in refinancing has already long passed and if current declining trends continue through this year, refinancing activity will have slumped over 60% from 2003. Meanwhile, cashed-out home equity is projected to fall by 40% in 2007 alone!

The significance of this should not be overlooked. In the past three years, we estimated that housing wealth effects accounted for, on average, 2 percentage points of the annual growth in real consumer spending each year. The U.S. is now facing a situation where the unwinding of housing wealth effects will drag consumption growth. The second quarter of 2006 presents some preliminary evidence that this process is already underway. According to our proxies for capital gains and cashed-out equity, quarterly declines in both marginally detracted from real consumption growth. Even so, the overall wealth effect continues to support spending growth because the biggest driver is real estate assets valued at nearly $17 trillion in inflation adjusted terms. But even here cracks are forming. This measure expanded by just half a per cent in the second quarter, marking the slowest pace since 1997. As overall wealth effects continue to reverse course, we estimate that it could shave at least a full percentage point from real GDP growth over the next 12 months.

How close is the U.S. to a recession?

With all these dire predictions, would there be an outright contraction in U.S. economic activity? There is significant risk of a recession in 2007 or early 2008. However, the most likely outcome remains a mid-cycle slowdown. Although a number of housing indicators are mirroring the path of past recession cycles, the data provide an incomplete picture and can often send false signals. Interest rates, inflation and employment are also material in shaping the economic landscape.

Starting with the housing market backdrop, the news is somewhat glum. There is a strong link between real estate assets and recessions. The annual growth rate in inflation adjusted real estate has contracted in three of the past four recessions. On average, asset growth hits a trough of -3% following several quarterly declines that either preceded or coincided with the start of the recession. Currently, this seems a long way off since real estate assets were still expanding by a healthy 7% annual clip in the second quarter. However, the slowdown in the quarterly growth rate is a red flag. In addition, the annual pace of growth for detached real home prices moved deep into negative territory (-5.3%) in August, which does not bode well for the wealth measure in the third quarter. But, readers should bear in mind that there are also instances when price growth dramatically slows or turns negative that does not coincide with recessions. The mid-1990s offers a perfect example of repeated false signals, though a mid-cycle slowdown did ensue.

Sharp double-digit declines in the annual growth of housing starts in August also put this indicator in bad company for either a recession or cyclical slowdown. But, the data is inconclusive on which one it would be because single-family housing starts contract steeply in both cases. The only distinguishing feature is that activity during a recession cycle remains in the red for a longer period of time. For this outcome, we’ll have to wait and see, but what we do know is that construction activity in the most recent quarter has already contracted to a greater extent than the initial backslide leading into an average recession cycle.

Another possible signpost that the U.S. is on the cusp of a recession is if purchases of big-ticket housing items begin to contract on a quarterly basis. Falling expenditures on items like furniture and household equipment tend to precede a recession by 1-to-3 quarters. This has yet to occur in the present economic cycle, but we would not be surprised if it did. However, the bigger economic determinant is if a contraction in spending for non-housing items follows in toe. When this occurs, a critical threshold of consumer confidence has been breached.

Consumers hold the key to economic expansion…

In past recession cycles, consumer spending was undermined by three critical variables: inflation, interest rates and unemployment. There is good news on all three fronts in the current economic cycle. The graph below shows that present inflation behaviour is more akin to periods of mid-cycle slowdowns than recessions. U.S. core inflation typically accelerated ahead of recessions and was at least double current levels. Because movements in inflation and interest rates are highly intertwined, acceleration in the former usually prompted the central bank to respond with higher interest rates – often causing monetary policy to overshoot to the point of choking off domestic demand. This is evident in the graph on the following page, where the real fed funds rate climbs, on average, about 2 percentage points over the course of four quarters preceding a recession. The current cycle has produced an equivalent amount of tightening, but it has been gradual by comparison, occurring over eight quarters. Equally important, the level of real interest rates remains a full 2 percentage points below peak pre-recession periods. So in both cases, interest rates appear to be only tapping on the brakes, rather than driving the economy to a full stop.

This may account for why household credit is still showing little sign of stress, even at this late stage in the monetary tightening cycle. There has been much made of recent up-ticks in foreclosures and delinquencies, especially in states that have a notorious reputation for the use of riskier debt products, such as California and Nevada. Yet, the national level of delinquency rates remains low. And, in the subprime market, California and Arizona still ranked as the lowest delinquency states in the U.S. even though both have a disproportionate amount of non-conventional mortgages. In the first quarter of 2006, negative amortization loans represented 9 per cent of new mortgages in the U.S. In Nevada and California, those respective shares were 22.5 per cent and 21 per cent.

With this in mind, we fully recognize that the high use of ‘exotic’ mortgages does present a near-term risk to the economic expansion. In 2005, nearly 40% of new mortgages were either negative amortization or interest-only products. What’s more, it is estimated that $1 trillion of adjustable rate mortgages will adjust in 2007, or about 8% of outstanding mortgage loans. However, once again we take comfort in the inflation-interest rate link. Without the shackles of high inflation in the current cycle, we believe the Fed will react quickly to an economic slowdown and will cut interest rates by 100 basis points in the first half of 2007. This should help alleviate the interest rate strain on some of the more vulnerable credit holders.

The labour market backdrop is the third factor supporting the outcome of a mid-cycle slowdown. The final scenario graph below has two useful insights. First, the current labour market looks to be paralleling the path of a cyclical slowdown, referring to the fact that there has not been a material deceleration in job growth that typically precedes a recession. Meanwhile, growth in real wages per employee has recently accelerated, which is opposite to pre-recession behaviour. Second, the amount of new jobs relative to total employment is much lower in the current cycle than either of the scenarios of a recession or mid-cycle slowdown. This is good news because less job buildup going into a slowdown provides some insulation against the risk of mass job layoffs.

This possibility is further enhanced when we consider that the job boom that typically takes place in post-recession periods did not occur after the 2001 recession. Rather, corporate restructuring scratched nearly 3 million jobs from payrolls between 2001 and 2003. And, in some sectors, employment restructuring has yet to cease. For instance, the manufacturing sector continues to shed jobs five years after the official end of the recession.

Current lean employment structures provide some reassurance that aggressive job cuts are not waiting in the wings. This is a vital component to any economic cycle, because mass layoffs cause a sudden interruption in household income that is highly destabilizing to an expansion. Total wages in the economy amount to over $4 trillion, which is more than five times the amount of mortgage equity withdrawal.

…but Corporate America is in driver’s seat

But, the security of job growth ultimately hinges on the response by Corporate America to an economic slowdown. Even here we find a number of key positive features in the present cycle. For one, the ratio of prices to unit labour costs is typically falling heading into a recession period. This is definitely not the case in the current cycle, plus the ratio is at a historical high reflecting the fact that businesses have successfully constrained unit labour costs to lift profits. Second, corporate liquidity and savings have never been better. If the U.S. economy was nearing a recession, growth in retained earnings would normally be slowing, but the opposite has occurred. Given that retained earnings are at a record level, firms should not find themselves in dire straights as demand growth tapers off, especially if the slowdown extends a short period of one year, as we predict. And, as we already mentioned, job restructuring occurred only three years ago, so there’s not much fat to cut off these bones.

The final corporate variable that provides comfort is the historically low inventory-to-sales (I/S) ratio. Inventory swings have proven to be highly disruptive during an economic downturn and can often hasten job layoffs. When consumer demand growth trails off, I/S ratios tend to rise, causing firms to aggressively liquidate on-hand stock. The Fed estimated that this inventory adjustment process accounted for, on average, one-quarter of the overall slowdown in real GDP growth during postwar recessions. This is quite a powerful influence from a sector that represents a mere 0.5 per cent of GDP.

In the current economic cycle, I/S ratios across all sectors – retail, wholesale and manufacturing – are already flirting with record lows. In fact, these ratios have been extremely lean since 2004, the start of the Fed tightening cycle. So, it’s quite possible that firms have long been bracing for an economic slowdown. Low I/S ratios relative to past norms should limit the severity of an economic downturn, while also mitigating some of the negative risks that naturally flow to the job market.

Conclusion

We are not blind to the obstacles faced by the U.S. economy, such as a negative savings rate and high debt service costs. If the consumer back finally breaks, look for preliminary signals to emerge in the form of steep contractions in housing-related expenditures and escalating debt defaults. But, we remind readers that there is no single variable that can push America into a recession. The health of the economy is dependent on a confluence of many factors. Although recent trends in the housing sector are closely paralleling events leading into past recessions, deteriorating wealth effects and falling home prices alone do not portend a recession. The environment for interest rates, inflation and corporate balance sheets bears no resemblance to past recessions. We believe these factors will dominate, preventing the mass job losses that would compromise income growth and the ability for households to meet debt obligations and future expenditures. So, to return to the question we posed in the introduction as to whether the housing correction will lead to an outright recession, the likely answer is “no”. The economic indicators are precisely in line with previous mid-cycle slowdowns, such that the U.S. economy is more likely to bump along the 2 per cent mark for a one-year period, than contract outright.

Beata Caranci, Senior Economist
416-982-8067

CANADA’S IMAGE AS A GLOBAL RESOURCE GIANT

Special Reports

October 25, 2006

Canada has always been perceived as a nation with an economic base deeply rooted in natural resources. This message has long been transmitted through Canadian equity and currency markets, where buying and selling has often been closely tied to swings in world commodity prices. At no time has this dynamic been more apparent than in recent years. As world commodity prices have shot up since 2002, few stock market indices around the world have surged by more than the S&P TSX, while few currencies have strengthened to a greater extent vis-à-vis the U.S. dollar than the loonie.

At the same time, what is the likelihood that this image of Canadians as “hewers of wood and drawers of water” has become out of step with reality? Although few would deny that the country’s resource sector remains alive and well – and continues to be a major economic generator, it is equally hard to refute the fact that the Canadian economy has undergone structural changes over the past 25 years that have shifted in the economic balance from goods-producing to a number of service-producing industries.

In this report, we take a closer look at the economic contributions of the resource sector both today and in comparison to the past. We conclude that despite facing a multitude of headwinds over the last few decades, the resource sector has managed to evolve and adjust, thus maintaining its impressive position within the nation’s economic fabric. What’s more, with the consensus having formed around the expectation that commodity markets have entered a “new era” of higher prices, both the perception and reality of Canada as a global commodity powerhouse are almost certain to remain in place. In the final section, we discuss the implications of this conclusion for investors.

Predictions of resource sector’s demise unwarranted

The boom underway in commodity markets is even more dramatic when placed in context of the general sentiment that prevailed a mere 5-6 years ago. In the late 1990s, the “new economy” industries of information technology were growing at a hectic rate, spurring chatter of a virtuous cycle of productivity-led growth and prosperity well into the future. At the same time, the fortunes of the “old economy” resource sector – as defined in the topic box below – continued to sour. In fact, some forecasters even went as far as to predict the eventual demise of Canada’s resource industries. Others (i.e., Sachs et al) referred to the “curse of natural resources”, warning that resource-based economies would experience significantly lower growth than those that devoted scarce capital to rapidly-expanding knowledge-based industries.

As we now know from 20:20 hindsight, those predictions proved to be way off the mark. The high-tech sector stumbled badly in 2001-02 – demonstrating that those areas were not immune to resource-style boom-bust cycles – while world commodity markets would ultimately bounce back, halting the 15-year secular downtrend in prices.

The abrupt turn in the fortunes of world commodity markets has reflected a confluence of factors on both the demand and supply sides of the equation. Over the past decade, demand for most commodities has picked up strongly, owing to rapid industrialization of China, India and other developing economies. In contrast, gains in supply of commodities such as crude oil and metals have lagged behind, constrained by cuts implemented to exploration budgets in the 1990s. Accordingly, supply-demand balances for many commodities have tightened significantly. Other global factors also swung in support of commodity prices, including a structural decline in the U.S. dollar and the rekindling of global inflationary pressures that provided a boost to real asset prices.

While an improvement in fundamentals got the ball rolling in 2002-03, the momentum has been sustained in part by growing investor enthusiasm. Notably, the commodity market has also become increasingly attractive to large institutional investors – such as hedge funds and pension funds – in view of abundant liquidity, declining relative returns on fixed-income investments and the launch of exchange-traded funds (ETFs) and other investment vehicles that have facilitated direct investor participation in commodities. It has been estimated that as much as $100 billion in investment funds have been directed into commodities worldwide over the past few years.

Canada has moved into the spotlight

In addition to gaining direct commodity exposure, many investors have opted to take the more traditional – and indirect – approach of participating in the commodity rally through either purchasing shares of resource companies or investing more broadly in commodity-oriented markets. Markets that have attracted increased attention include the likes of Australia, New Zealand, Norway, Finland and – above all – Canada.

* Since 2003 – the first full year of the commodity rally – Canada’s S&P TSX has outshone other major world indices by returning roughly 14% per year on a compound annual basis.

* Over the same period, the Canadian dollar has climbed by a total of almost 40% against the U.S. dollar in real terms, ranking second to only the Brazilian Real.

* Data on portfolio investment reveal that foreign purchases of Canadian equities surged by 4.5% of GDP over the 2003-05 period, outstripping most other industrialized countries, including Australia. Moreover, figures released so far this year suggest another banner performance in 2006, with some $17 billion in net foreign purchases in the first half alone.

* After posting weak inflows of foreign direct investment (FDI) in 2003 and 2004, Canada has emerged as world-leading magnet since early 2005. The spate of high-profile foreign acquisitions of Canadian firms announced in recent months suggests that 2006 will be no different.

Certainly, not all of the strong international investor interest in Canada can be chalked up to the resource boom. In fact, the country’s investment climate began to take a turn for the better in the mid-to-late 1990s, when governments moved to put their fiscal houses in order, cut their debt-loads and lowered personal and business taxes. The restructuring put in place by the private sector during, and in the aftermath of, the early-1990s recession also began to bear fruit. Furthermore, Canadian producers enjoyed success penetrating the U.S. market following the implementation of the 1988 Free Trade Agreement (FTA), which assisted in transforming the nation’s current account position from deficit to surplus. However, the improvement in commodity markets over the past few years has considerably turned up the momentum in favour of Canada.

Canada’s resource sector a global powerhouse

Although foreigners’ take on Canada is influenced by media images of a nation with vast forests, abundant rivers and wide-open frontiers, research shows that Canadians themselves see this country in a resource light. A survey carried out by Natural Resources Canada in 2002 – which corresponded to a low point for commodity markets – revealed that 41% of respondents surveyed viewed resource industries as the number-one economic contributor in Canada. Admittedly, that proportion was down from the 48% reading recorded in 1993. Still, more individuals continued to perceive resources as a bigger driver than either manufacturing or services. And, if this survey were held today, it would undoubtedly point to a rebound in the importance of the sector in Canadians’ eyes.

How well does the data line up?

If that’s the perception, what is the data telling us about the sector’s actual contribution? In the accompanying table, we provide a snapshot of GDP and employment shares for the sector as a whole and its key industries. More detailed figures are included in Annex 1 on page 16.

The combined activities of Canada’s primary and resource-based manufacturing and service industries contribute 13% to Canadian real (inflation-adjusted) gross domestic product, ranking second to only financial services (19%) in terms of importance. At 1 million jobs, the resource sector is also the second largest employer in Canada, although its share of total employment is a more modest 7%. Moreover, while energy stands out as the largest resource industry in terms of real output, the mining and forestry industries come out ahead in terms of relative employment shares.

What may come as a surprise to some is that this relative output share of resources has not changed all that much in the past 25 years. In 1981 (the first year comparable data are available), the share of real GDP attributable to resource activity stood at 15% of GDP, or only 2 percentage points higher than its current share. This relatively stable trend may go some way in explaining why Canadians and investors alike continued to look at Canada through a resource lens even during the difficult markets of the late 1980s and 1990s.

Output share understates true importance

The real output readings confirm that the resource sector still carries considerable weight in the Canadian economy. Still, they understate the true footprint left by the commodity-based industries on the national landscape. For one, these are average figures. In some provinces and territories – notably in the N.W.T., Alberta and Newfoundland & Labrador – the resource share of real output climbs to more than 20% or double the national average. In all jurisdictions except PEI, Nunuvut and Ontario, resource exports make up at least one third of total provincial-territorial exports. Further, many smaller communities in Canada are dominated by resources. As many as 350 communities across the country are dependent on the forestry sector while more than 100 are highly reliant on the mining industry. Even in Ontario, which has a relatively small resource share of about 8%, some smaller northern communities like Greater Sudbury have resource shares as high as 15-20%.

Second, while the share of Canadian real output attributable to resources is significant, it pales in comparison to the contributions made by the sector to income, exports and government revenues:

* Corporate profits – natural resources sector’s operating profits accounted for about one-quarter of total operating profits in Canada in 2005, led by surging bottom lines in the energy, and to a lesser extent, the mining sectors. In contrast, financial performances in the forestry sector have remained under pressure.

* Capital spending – last year, the resource sector accounted for almost 40% of total private non-housing investment ($67 billion) in Canada. Of this amount, the energy sector contributed $56 billion or 32% of the Canadian total.

* Wages and salaries – while comprising only 7% of employment, the sector’s share of total labour income in Canada tips the scales at 9%, reflecting the relatively high wages paid by resource companies.

* Foreign Direct Investment (FDI) – almost two-thirds of the $40-billion-odd foreign direct investment in Canada was allocated to resources.

* Trade surplus – in 2005, the resource sector accounted for 40% of total Canadian goods exports, with all three areas making significant contributions. Even more impressively, with exports of energy, forestry and minerals far outstripping imports, Canada is running a massive $93-billion trade surplus in the resource sector. Indeed, without the resource sector, Canada’s sizeable $55 billion merchandise surplus would transform into a $38 billion shortfall.

* Government revenues – direct royalty payments of resource companies to provincial governments alone amounted to $21 billion in 2005, or about one-tenth of total provincial revenues. That figure excludes the substantial corporate and personal income tax payments made by companies and their employees to governments, since these figures are not available.

* Large companies – resource companies occupy 10 of 50 spots, or one in five, on the list of Canada’s largest private and public companies based on asset size.

* S&P TSX index weighting – in 2005, the resource-oriented energy and materials sub-indices together comprised 43% of the market capitalization of the overall S&P TSX Composite Index, split between energy (28%) and materials (15%).

* Public and private equity raised – Among the $47 billion of new public and private equity raised in Canada last year, some $15 billion (one third) was attributable to oil and gas and mining industries alone. Of that amount, oil and gas made up $11 billion and mining about $4 billion.

Finally, these statistics cited above represent only the direct contributions to gross domestic product from the resource sector, but exclude indirect contributions, including the increase in economic activity that flows from, say, purchases by resource companies of machinery and equipment, financial services and transportation services. It has been estimated that for every dollar in mining production revenue, an additional 41 cents in gross revenue is generated across other industries. Forestry’s “multiplier effect” is even higher, at 65 cents. Hence, the economic impact of swings in resource activity quickly adds up, especially in the smaller resource-based communities.

Canada’s resource sector a big player internationally

Based on the evidence presented thus far, it is fair to say that the fortunes of the resource sector remain a critical cog in Canada’s economic wheel. But, the country’s status as a favorite resource play has also a lot to do with its prominent position on a global scale. Canadian listed companies lead the world in raising equity for exploration and mineral development, while about one-fifth of mineral exploration expenditures are targeted for Canada, surpassing all other countries. Even more impressively, this country is a world leading producer in virtually every resource area – a diversity that is unrivalled throughout the world, save perhaps Russia. However, Canada is second to none if its relatively low political risk and open access to the large U.S. market are also factored into the equation.

International comparisons on resource dependence are made difficult by the fact that output data are not directly comparable. Still, rough estimates carried out by TD Economics using data from Global Insight along with government industry output figures confirm that few countries in the industrialized world are as dependent on their resource sectors. For example, other G-7 economies record resource-to-GDP shares in the 5-10% range – lower than Canada’s 13% – with the U.S. and France occupying the bottom end and Germany at the upper end. Outside of the G-7, Norway’s resource share of total output stands at about 30%, well above that of Canada, while Finland and Australia are in the same ballpark at 11-13%. Still, an important differentiation is that in contrast to Canada’s highly-diversified resource cluster, Norway’s resource sector is heavily concentrated in energy products, Finland in forestry and Australia in mining and metal products.

Resources make up more than 40% of S&P TSX

Perhaps the most striking comparison is the share of resources in stock market industry weights. As noted earlier, within Canada’s S&P TSX Composite Index, energy and materials represent more than 40% of the total. (Indeed, if a third group – financials – was also included, these three areas would represent a stunning 70-75% of the index). In stark contrast, the average world stock market – as measured by the MSCI World Index – has a total of only 14% devoted to these two resource areas.

Canadian resource sector has evolved

These striking statistics – at least to some extent – reflect a sector that is currently enjoying its best times since its hey-day in the 1970s. A decade ago, life was considerably more challenging for resource producers, when commodity prices were following a one-way ticket down and earnings were under pressure. There were also sector-specific challenges, such as the imposition of U.S. duties on Canadian softwood lumber shipments in the mid-1990s.

Yet, through it all, the resource sector managed to expand, thus maintaining its position as one of Canada’s largest drivers of economic activity and jobs. Better still, this area continued to post a rising contribution to Canada’s trade surplus – which was no easy feat in view of the dampening impact on export earnings from declining commodity prices.

Resource companies ramp up productivity

Some of this resilience can be attributed to the sector’s success in raising productivity. In the 1997-2005 period, growth in output per hour in most resource-based industries exceeded the average of the Canadian business sector of 1.5% per year. In three areas – forestry, primary metals and coal mining – productivity growth came in more than triple the average tally. These gains have widened the productivity gap between the resource sector and other areas of Canada’s economy. The level of output per hour worked in oil and gas extraction is now four times that of the Canadian average. In most other resource areas, the gap ranges between 10% and double.

Churning within the sector

As importantly, the sector has evolved with changing markets and needs, with some declining industries being replaced by emerging stars. Success on this front is critical in an area which is dominated by the production and extraction of non-renewable resources. Canada’s diamond industry has come from virtually nowhere 10-20 years ago to emerge as third largest producer on the planet. In other cases, industries coped by moving to expand their businesses in new markets. Along with metals companies, pulp and potash producers have been successful in penetrating the rapidly-growing Chinese market.

Perhaps the best example of strength in exploiting new opportunities is in the nation’s energy sector. As conventional crude oil production and reserves began to taper off in the 1990s, the industry turned its attention to feeding the hungry U.S. appetite for natural gas. In fact, few Canadians recognize that natural gas has overtaken crude oil in terms of value of production, and is a much larger contributor to both Canadian exports and to government coffers. (See TD report, “Why is it Always Oil? The Untold Story of Natural Gas,” released February 2006).

More recently, however, declining conventional reserves of crude oil and natural gas – combined with high energy prices and new technological innovations – have shifted strategies toward development of unconventional sources, such as crude bitumen, coal-bed methane and coal gasification. In particular, Alberta’s oil sands is poised to attract in excess of $100 billion in new investment over the next decade in order to develop a share of the region’s massive proved reserves of more than 170 billion barrels. By 2025, it is estimated that oil sands production will reach more than 4 million barrels per day, which could place Canada third or fourth on the list of world’s top oil-producing nations.

Correction likely in 2007, but longer-term outlook bright

With a growing number of forecasters upgrading their long-term projections of resource consumption in light of the insatiable demand for commodities from China and other developing Asian economies, the long-term prospects for commodity markets have strengthened considerably. Put simply, as evidence of this longer-term secular uptrend in demand and prices emerges, the period of low prices during the late 1980s and 1990s will become an increasingly distant memory.

That said, along this long-run path, resource markets will always be prone to periodic corrections. And, in our view, a number of commodity markets are ripe for a significant downward adjustment on the heels of the hefty gains recorded in recent years. The major catalyst for this adjustment is expected to be mid-cycle slowdown in the U.S. economy, a global locomotive that consumes as much as 15-25% of most global commodities. This cooling-off period is projected to lead to a slackening in the sector’s supply-demand fundamentals, and perhaps even importantly, put a damper on the high levels of investor enthusiasm that have recently permeated commodity markets. Indeed, recent selling pressure indicates that these concerns have already begun to manifest themselves within forward-looking markets. Since the summer, crude oil and natural gas prices have pulled back sharply, pushing the S&P TSX Energy index down by some 15%.The S&P TSX Materials index is down by about 8%.

As we discuss in more detail in the monthly TD Commodity Price Report, commodity prices are expected to experience bouts of downward pressure until mid-2007, before regaining their footing in the second half of next year in line with a strengthening U.S. economy. This setback will not be lost on the Canadian economy. Just as higher prices have catapulted profits, exports and government revenues into the stratosphere, falling prices will not come without a payback. Still, in light of the fact that the anticipated drop in prices represents more of a temporary correction than a return to a bear market, respective resource contributions to the Canadian totals will remain high in the coming quarters, while employment and output shares continue to hold at their recent levels of 13% and 7% respectively.

Keep in mind that not all resource industries face the same near-term prospects. In our view, crude oil and base metals appear vulnerable to price corrections in the order of 10-33% by mid-2007 from average levels in September (see chart on previous page). In the case of nickel, which has shown signs of particular froth, the pull-back is likely to be even larger. Notwithstanding the fact that prices for these commodities will remain relatively high from a historical perspective, the abrupt change in fortunes is likely to cause some temporary unease. Most concerning are the near-term challenges facing Canada’s forestry sector, as lumber producers battle with declining U.S. homebuilding activity and pulp and paper makers confront increasing international competition and, in some markets such as newsprint, falling structural demand.

At the other end of the spectrum, prices for precious metals and natural gas are expected to record modest gains over the near term. In the case of bullion, an ongoing depreciation in the U.S. dollar will provide support to prices, while natural gas demand benefits this winter from a return to more seasonal temperatures compared to last year.

An additional near-term risk facing the resource sector is on the cost side. Over the past few years, increasing shortages of labour and materials have led to sky-rocketing project costs, particularly in the oil patch. In fact, between 2003 and 2005, cost estimates for several multi-year oil sands projects were revised up by 20-65%. Upward cost pressures are likely to subside to some extent in the coming months as growth in overall resource activity eases and material costs simmer down. At the same time, however, wage pressures facing producers are expected to remain stubbornly high, especially in view of the scarcity of skilled employees and ongoing labour demand requirements for multi-year oil sands expansion plans.

Leveraging strength to confront long-term challenges

The healthy longer-term picture for commodity prices and global demand will enable the resource sector to tackle a number of challenges from a position of relative strength. We list some of these challenges in the text box on the previous page. For instance, it will be critical for producers in the oil patch to step up their efforts to cut greenhouse gas emissions and reduce water use through new technologies and processes. In the forestry sector, the need to confront the pine beetle infestation in Western Canada, increasing production in developing markets and/or structural market changes will take centre stage. More generally, resource players will be facing many of the same pressures experienced in other sectors, including the impact of an aging population on the sector’s already-stretched talent pool and growing infrastructure deficiencies. And, while the productivity performance of Canada’s resource sector stands out at home, it lags behind some of its key international competitors, while comparatively low R&D levels of Canadian companies may leave our domestic resource industries at a long-term disadvantage.

Still, just as Canada’s resource sector has proved resilient in the past, one cannot underestimate the sector’s ability to take on these longer-term challenges head on. Significant investments by the sector in new capital, training and research will be necessary. Moreover, governments will need to turn their tax, regulatory and other policy levers in order to ensure that Canada’s climate for resource investment remains among the best in the world.

Conclusions and implications for investors

The long-term outlook for Canada’s resource sector is favourable. As such, resource-related activities will remain a major driver of real output and job creation in this country, as well as make disproportionately large contributions to national income, exports, capital spending and government revenues. In this context, the current perception of Canada as an international giant in the area of resources and a key global resource play is unlikely to fade any time soon.

This resource growth potential will continue to open up doors for attractive equity returns in Canada over the medium-to-longer run. Investors will be able to get a piece of the action by investing in Canadian publicly-traded companies, many of which will likely take on increasing global reach. In addition, more direct exposure to the commodity market can be gained through a number of recently-created commodity-linked funds that are available to the retail sector. While investor interest in commodities will ebb and flow, these new vehicles are likely to prove more than just a fad. Furthermore, new innovations on that front are almost certain to emerge down the road.

Foreign acquisitions a concern to investors

Canada’s comparative strength in resources not only provides opportunities for investors, but challenges as well. The first centres around the impact of consolidation within the global resource sector, and more specifically, foreign acquisitions of Canadian players. Armed with their significant financial weight built up over the past few years, Canadian companies are well-positioned to expand abroad. And, to some extent, these firms have been taking advantage of global opportunities that have arisen. Yet, it is the foreign takeovers of this country’s prized resource names, including Falconbridge, Inco, Domtar and Placer Dome, that have been dominating the headlines over the past few years.

Much of the debate about foreign acquisitons has focused on their potential hit to both output and jobs in Canada. Although there is an argument that the underlying asset (i.e., the resource) is fixed on Canadian soil, thus mitigating the risk of large investment reductions and layoffs in Canada, there are fears about the possibility that head offices would be consolidated in the new home country, demand for business services and financial-market activities in Canada would fall and top Canadian talent would move abroad. Still, the case is not clear-cut. For instance, Canada could be well-positioned to benefit in the event that the domestic operations of the foreign-controlled firm are strengthened by the synergies and diversity of the larger entity, not to mention the rewards of knowledge transfer from the foreign acquirer.

A Statistics Canada study, released in July 2006, went some of the way in alleviating fears regarding the economic impact of takeovers. It found that both the number of head offices and head-office employment in Canada actually increased over the 1999-2005 period, owing to births in new foreign head offices.

As the debate about economic impact of takeovers rages on, the investment community has some legitimate concerns about the side-effects of foreign takeovers. Although the elimination of the foreign property rule by the federal government in 2005 has given pension funds and other large institutional investors free rein to invest their funds abroad, they still tend to allocate as much as 25% to Canadian equities. Over time, pension fund managers are almost certain to review the appropriateness of their asset mixes. In the short run, however, the disappearance of some of Canada’s large corporate powerhouses could force these managers to re-invest their assets in an ever-shrinking pool of less liquid names.

Investors need to be mindful of risks

A second important issue relates to risk. While it is clearly the case that the combination of sound fiscal policy and low inflation have made the Canadian economy as a whole less prone to wild rides than in the past, the truth of the matter is that resource output and income will always be more vulnerable to abrupt changes in fortunes than other major sectors. And, this is challenge is unlikely to change soon, especially with commodity prices becoming increasingly influenced by fickle global investment flows and often determined by factors outside of Canada’s borders (and in many cases, through the actions of less politically-stable countries). Moreover, as we point out in the text box on page 13, the direct link between resource prices and the performance of Canadian equity and currency markets, if anything, appears to have strengthened in recent years. Putting it all together, notwithstanding our belief that Canada’s long-term economic and investment picture remains rock solid, there is good reason to believe that volatility will remain the watchword in Canadian financial markets going forward.

As we argue in a September 5th, 2006 report entitled, 10 Reasons Canadians Should Invest Abroad, an excellent way for domestic investors to manage the risk of excessive short-term gyrations in Canadian markets is to take better advantage of geographic asset diversification. Despite the elimination of the foreign content rule and the fact that Canada’s equity market is less than 4% of the global total, Canadian investors have apparently been moving the other way. Although mutual funds are only part of the investment universe, a survey released by the Investment Funds Institute of Canada showed that the value of investments in U.S. and foreign mutual funds stands at only 22% of total holdings, down from 38% in 2000. As we point out in that report, geographic diversification may actually improve investment returns without increasing risk.

Derek Burleton, AVP & Senior Economist
416-982-2514

Natasha Apollonova, Economist
416-982-2555

For the full report in PDF format - including all charts and tables click here.

IN THE SHADOW OF THE U.S. SLOWDOWN: LOCAL CONTEXT KEY TO GLOBAL GROWTH

Special Reports

October 27, 2006

The defining feature of the global economy over the next four to six quarters will be the U.S. slowdown and recovery. It’s no secret that when it comes to global growth and downturns the major industrialized nations increasingly dance to the same tune. In the mid-1980’s and mid-1990’s, when the U.S. experienced mid-cycle slowdowns, growth similarly slowed in Canada, Japan, and Europe with varying lags. Encouragingly, no major economy experienced a recession during either of these slowdowns and, in fact, global economic growth outside of the U.S. actually accelerated in both cases.

The forthcoming period of U.S. economic weakness is unlikely to be any different. TD Economics forecasts that world economic growth will slow by one percentage point from 5.0% in 2006 to a still strong 4.0% in 2007. The mellowing U.S. consumer will be responsible for knocking 0.2 percentage points off global growth through diminished imports and an additional 0.1 percentage points in lost impetus through forgone profits from foreign companies’ operations in the U.S. Adding in the additional 0.2 percentage points lost from the U.S. itself as economic growth there slows from 3.4% in 2006 to 2.4% in 2007, this would lead global growth in 2007 to slow only to 4.5%. The remaining half a percentage point lost in 2007 is unrelated to the U.S. slowdown, highlighting the fact that the local context will govern global performance.

For this reason, the present report focuses on some of the potential risks to the domestic resilience in these regions. Their performance in turn tends to have an impact on nations with whom they have close ties. This offers the unique potential to offset a moderate U.S. slowdown. How likely this is to happen depends less on the slowdown itself, and more on existing domestic conditions and how policymakers respond. These responses will be key as the world slips into the shadow of the American slowdown.

EU – pay now, grow later

The birthing pangs for the Eurozone have passed, and adolescence has shown the potential for growing strength. After a lackluster 2005, the Eurozone has been enjoying an investment-led boom, with growth through the first half of 2006 moving at its fastest clip since 2000. Productivity growth, coupled with efforts to constrain costs, have fueled exports, especially in global export leader Germany. While moderating global demand will present challenges in the coming quarters, these challenges will be softened by easing commodity prices and the brief nature of the expected slowdown. In fact, most of the pullback we expect in overall growth in the Eurozone for 2006 will be a mix of needless self-inflicted pain courtesy of monetary overtightening together with responsible fiscal reforms which will boost potential growth in the future.

The European Central Bank (ECB) will play a pivotal role. Year-over-year headline inflation eased from 2.3% to 1.8% in September, and is now near the ECB’s “less than but close to 2 per cent” target. The ECB, however, also targets money growth (M3) directly as part of its twin pillars of monetary policy. M3 is a broad measure of money, which includes cash held by individuals as well as by banks. As banks lend the cash they hold in deposits, the money supply increases. This causes inflation if the process of money creation exceeds the underlying growth in the real economy. In the Eurozone, consumer credit growth has quadrupled in three years, corporate borrowing is growing at its fastest pace ever, and growth in lending to households for home purchases is still rapid but decelerating . This has led M3 growth to accelerate to an 8.2% annual pace in August. While coincidently this is roughly the same pace as in Canada right now, the ECB has cited it as a risk despite the fact that there has been little discernable pass-through into inflation. As a result, financial markets now expect the ECB to raise rates one more time this year and possibly further next year. The ECB has failed to meet their M3 target since inception, so it’s difficult to say how effective or determined they will be in the future but there are three potential risks. The first is that since the effect of each interest rate increase will take 12-18 months to work its way through the economy, there is a real danger of over-tightening. Secondly, given that investment spending accounted for over two-thirds of Eurozone growth in the second quarter of 2006 and one-third of growth over the last year, higher interest rates may quash its most vigorous sector. Thirdly, there are concerns consumer demand may not be robust enough to withstand higher interest rates. While recent consumption growth for the Eurozone has been moderate, the level of consumption in the largest continental economy, Germany, has not grown in five years.

Meanwhile, fierce global competition has restrained Eurozone wage growth and savings have fallen to support what spending there has been. Despite rapidly growing housing wealth in many European countries, the difficulty of borrowing against one’s home equity in such large markets as Germany, France, and Spain hinders consumers from spending more. These prospects have started to weigh on some of the forward-looking indicators. The consumer and business outlook appears to have peaked, while in the European bond market, yield curves have been flattening – a signal of slower growth ahead.

Driving some of the dampened economic outlook is a tightening in fiscal policy which will reduce near-term economic growth but offer prospects for a more robust economy in the future. All Eurozone members are supposed to limit annual government borrowing to no more than 3 per cent of GDP; however, numerous countries have failed to meet this criterion year after year. Preliminary Italian budgets suggest the government may reduce spending by as much as one and a half percentage points in 2007 in order to fall below the 3% threshold. Germany announced they will meet the target in 2006, one year ahead of schedule, yet will go ahead with an increase to their value-added tax of three percentage points on January 1, 2007, which will shave about three-quarters of a percentage point off 2007 real GDP growth. The impact of the contraction in fiscal policy across Europe may be further exacerbated if the ECB decides to raise interest rates further, as higher taxes induce higher prices. ECB tightening would not be helpful, but fiscal consolidation, if successful, will prove a one-off drag on economic growth in 2007, but will promote faster future economic growth through reduced debt service costs, lower interest rates, and a higher level of private investment.

It is precisely because they lack many of the Eurozone’s structural problems that the United Kingdom is poised to outperform its continental cousins. The Bank of England is likely to raise their policy rate to 5.00% in November in the face of a robust consumer base fueled by the strongest wage gains among the major European economies and decade-high employment in the service sector. While several continental economies face the risk of housing bubbles, the U.K. housing market has already corrected and is once again growing at a healthy pace. Moreover, with a mortgage market more akin to that of Canada and the U.S., home equity withdrawals in the U.K. average 2% of after-tax income per year and have a larger bearing on consumer spending than in any other EU member.

China – time waits for no man

China’s response to the U.S. slowdown will be coloured by their desire to maintain a stable expansion and continued employment growth. China’s policymakers have meticulously and successfully managed the details of economic development for some time in their quest to accomplish in decades what took a century in the U.S. and Canada. Over the last decade, the annual growth rate of the Chinese economy has averaged 9%, a notch slower than the 10% average seen in the two prior decades. These earlier decades saw wide swings, however, with the real growth rate fluctuating between 4-15%, as opposed to 8-10% in the last decade. The authorities see a growth rate between 8-9% for the economy as sustainable, and more importantly, as a crucial factor in maintaining economic, political, and social stability.

Income inequality, though, jeopardizes that stability. Nearly six in ten Chinese live in rural areas, with the majority earning their living through subsistence farming. Export-oriented urban centres, meanwhile, attract workers from these rural areas and drive Chinese wages and inflation up. To date, Chinese inflation has been reported to run about 2% lower than in the U.S. But with 60 per cent of the population only marginally sharing in the gains from growth, any inflation can prove politically costly as rural households’ expenses grow faster than their earnings. To remedy this situation in the long-run, central government plans call for 300 million people – the equivalent of the entire U.S. population – to move from the rural areas to urban centres over the next two decades, bringing rural population shares in-line with those in the U.S. and Canada. In fact, it is not output growth, per se, that authorities are eager to maintain, but employment growth. In the first half of 2006, one million new jobs were added each month, about 20 per cent faster than the pace in 2005. Meanwhile, pricing pressures continue to build and the government is left with subsides and price controls which become more expensive to maintain the larger the wedge between urban and rural prices becomes.

The more pressing disconnect for Chinese policymakers lies in the financial sector. The Great Wall of China may have successfully kept out the Mongol armies, but Chinese attempts to wall off financial flows have resulted in mounting pressures on the central bank and domestic banking system as a whole. The authorities’ actions are not necessarily misplaced. Experience in developing countries shows a negative relationship between inward capital flows and growth performance. In other words, those countries which have attracted the most foreign investment have also, on average, experienced slower rates of economic growth. It is not entirely clear why this has been the case, but one possible explanation is that underdeveloped banking systems in many developing countries tend to inhibit economic growth. Those countries with well-developed banking systems – secure consumer deposits, efficient lending, liquid stock and bond markets, futures and other hedging tools to manage inflation and foreign exchange risk, accounting services, bankruptcy laws, etc. – have largely been spared this fate. While China prefers domestic banks develop these services, progress has been slow and their recent decision to allow the first foreign bank to provide renminbi-denominated financial products is a sign of the importance the authorities place on speeding this process up.

The Chinese stock market has also floundered in recent years as the authority’s desire to maintain strict control and stability has been directly at odds with an efficient stock market. After reports of corruption surfaced in IPO sales in the 1990s, authorities required that two-thirds of any new shares issued be non-tradable shares held by the state. This insulated share prices from competitive pricing as the shares held by the government – nearly two-thirds of market capitalization in 2006 – were seen as a tool to ensure stable employment, rather than increasing productivity. As a result, the domestic Chinese stock market (A-share market) averaged an annual loss of 12.6% a year from 2001-2005. Repeated heavy-handed approaches to remedy this situation failed until a resolution in 2005 led to agreements to convert four-fifths (in market cap) of these non-tradable shares into regular shares. As a result, the A-share market is up more than 50% (in local-currency terms) in the first nine months of 2006.

Nevertheless, time waits for no man. Chinese reluctance to allow greater exchange rate appreciation does stimulate employment growth, by making their exports cheaper, but at the expense of fueling inflation as well as kindling protectionist sentiment abroad. The U.S. Congress recently stepped back from threats to impose a 27.5% tariff on all imports from China, while the EU went ahead with a 16.5% tariff on shoe imports from China. As global growth slows, Chinese authorities may be even less inclined to allow the exchange rate to appreciate in order to avoid a double whammy of falling demand and rising prices for their exports. This would likely further fan the flames of protectionism. Meanwhile, Chinese foreign exchange reserves will shortly top US$1 trillion. This is a direct result of their management of the exchange rate. While a small portion was used to recapitalize ailing domestic banks, these reserves only have limited productive uses. In addition, since two-thirds of these assets are held in U.S. dollars, they will lose value when and if the renminbi is allowed to appreciate. Chinese authorities are thus hard-pressed to balance their preference for managed growth with the reality that they can’t control everything.

Japan – 3…2…1½…1¼...1...Liftoff?

Liftoff for the Japanese economy is premised on a clean break with its economic past. We believe the prospects are good Japan will once and for all make just such a break, with Japanese economic growth easing from the 2.7% pace expected this year to 2.0% in 2007. Unlike the sizeable slack expected to build in the Canadian and U.S. economies, 2.0% is roughly the potential growth rate for the Japanese economy without causing undue inflationary pressures. We therefore expect the Japanese economy will continue to run on all cylinders.

The concern has been the fact that Japanese consumer prices are unchanged from their level in 1993. In other words, inflation has been nonexistent for over a decade. This state of affairs fostered a general economic malaise that confounded repeated attempts to restore economic normalcy. But hope abounded for 2006: three years of accelerating growth, strong capital investment, and the Bank of Japan’s (BOJ) first interest rate hike in six years declared the defeat of deflation. Furthermore, a weak inflation-adjusted (real) yen is helping to push export growth in the third quarter to its fastest pace in two years, in turn driving industrial production. While there has been a gentle weakening of the Yen/USD exchange rate for a little over a year, the lack of inflation in Japan relative to its trading partners has left the real exchange rate at its weakest level in over two decades. It is this real exchange rate, rather than the nominal, which drives trade flows. Nevertheless, while this same currency weakness may partially explain the contraction in Japanese imports currently underway, it also highlights the failure to date of the final stage of the ignition sequence – the consumer. While there is still hope everything will move according to script, soft spending and income data for July and August suggest consumption may contract in the third quarter for the first time in two years which is not very promising.

In light of this, Japanese policymakers privately welcome the weak yen, even if they’re publicly hesitant to do so for fear of upsetting the U.S. This has also made monetary policy quite complicated. The Bank of Japan (BOJ) wants to avoid fueling an investment bubble with low interest rates and put some distance between the target interest rate and the zero-floor in order to give themselves some margin for maneuverability down the road. However, recent revisions to the CPI data showed deflation continued into 2006, and higher interest rates would only serve to further delay consumer spending, as well as lift the yen and lower exports. With early indications that capital spending may be moderating and unwinding inventories could weigh on growth in the near term, it is doubtful the BOJ will be able to raise rates before year-end, with a sizeable minority in the market not expecting another rate increase for at least a year.

The Japanese tea leaves are further clouded by a new government that recently took office. The Prime Minister himself has limited economic experience and, in fact, was criticized during his campaign for a lack of specificity on his economic plans. While his cabinet choices suggest a continuation of pro-market reforms, recent nuclear testing by North Korea could dominate much of the political agenda for the coming year. This is a risk should the economic situation unexpectedly deteriorate, but since public attention is fairly focused on the need to trim government debt and address long-term social security funding, this is of limited concern otherwise.

The Axis of Growth

In the web of global demand, who picks up the slack from a weakening U.S. economy is a peripheral concern, and indigenous factors are set to dictate the success of the international economy in riding out the current U.S. slowdown. While the EU, China, and Japan hold the greatest potential for carrying the torch forward, the pace of economic growth in all three appears close to cresting. Moreover, each is carrying its own unique vulnerabilities. Of the three, China has the greatest potential vulnerability to the U.S., with concern whether rural/urban and export/domestic imbalances will shake anything loose. This is balanced with entrenched stability and the insurance US$1 trillion in reserves provides. In the EU, the risks of monetary overtightening, fiscal contraction, and possible weakness in housing are balanced by the chance that investment and consumer spending prove resilient. Lastly, Japanese risks of a soft recovery and return to deflation are offset by the stimulative level of the currency and interest rates and optimism consumer spending might yet materialize. With the downside risks held in check, there will be enough juice in the global tank to coast through 2007 at a muted – but still strong – 4% growth rate. This will be one percentage point less than 2006 but still a full 1-1½ percentage points higher than the slowdown in 2001-2002. However, should the one-in-four chance of a U.S. recession materialize, the pace of world economic growth would slow by an additional 1½-2 percentage points in 2007 and 2008 relative to our current forecast. All things considered, the shadow cast from a U.S. economy, which is set to slow to a near 2% annualized pace of growth for the next four quarters, suggests that the global expansion will only temporarily moderate before picking back up in late 2007 and 2008.

Richard Kelly, Economist
416-982-2559

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