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Loonie predicted to reach $2 US in two years - October 8, 2007


Blog by | October 22nd, 2007


Can you say recession?

 

Good news: the loonie is soaring higher. Bad news: it's because the U.S. is in crisis

 

COLIN CAMPBELL AND JASON KIRBY | October 8, 2007 | Macleans Magazine

 

From the moment the United States government came into being in 1789, it was in the red. Saddled with a US$78-million debt from the revolutionary war, a fledgling Congress made it a priority to get out of hock, eventually setting limits on how much money the country could borrow. So much for that. Last week, U.S. Treasury Secretary Henry Paulson sent a stark message to modern-day legislators: on Oct. 1, America's IOUs will surpass the current debt cap of US$8.9 trillion. Unless Congress jacks up the limit yet again and piles on even more debt, the government of the world's largest economy will cease to function.

 

It's the kind of dire situation you would think might grab headlines, but it has raised barely a ripple. In spendthrift America, this is just par for the course. Since the Bush administration took office in 2000, America's national debt has ballooned by more than 50 per cent. Congress has already hiked its limit on how much the U.S. can borrow four times in the last five years. Meanwhile, American consumers, spurred on by low interest rates after 2001, racked up huge debt loads of their own. America's appetite for borrowed money seemed limitless.

 

Not anymore. As global financial markets seize up, and lenders come calling, alarm bells have begun to ring. Observers are talking seriously about the threat of a punishing recession. America's addiction to cheap and easy money has put the country's economy, not to mention the world's, on shaky ground. "What we've done as a society is borrowed a tremendous amount of money," says Peter Schiff, president of Euro Pacific Capital in Darien, Conn., nicknamed "Dr. Doom" for his dour outlook. "Now the bills are coming due and we don't have any money to pay it back." Surveying the threat of a crumbling housing market and rising unemployment, Schiff is brutally blunt. "We're screwed," he says. "It's not just going to be a mild recession. It'll be the worst one we've ever had."

 

The sinking reality of America's dire financial state has sparked a simmering panic in financial markets over the past several weeks, and that has been reflected in the plunging value of the U.S. dollar against virtually all world currencies, including Canada's.

 

As the Canadian dollar crested above the value of the greenback for the first time in three decades last week, shoppers celebrated by beating a path to cross-border outlet malls. But for a country whose economy is inextricably linked to the financial health of U.S. consumers, the rise above parity is anything but good news. The loonie's rise is not so much a resounding statement of confidence in the Canadian economy, but a reflection of absolute panic over the financial mess south of the border. Yes, Canada's abundance of minerals, oil and gas provides some protection against economic turmoil. But any claim that Canada can glide easily through a major U.S. recession, especially if it spreads to other parts of the globe, is seriously off base. Analysts are just beginning to come to grips with what the U.S. reckoning means for us.

 

Christopher Howard doesn't exactly look like a working-class hero, but for a few days earlier this month the former British businessman played the part when fears began to sweep through the U.K. that Northern Rock, Britain's fifth-largest mortgage bank, might fail. Bank failures aren't supposed to happen in this day and age, yet Northen Rock, caught off guard by the recent global credit crunch, had to be bailed out by an emergency handout from the Bank of England. Upon hearing that news, Howard joined thousands of other customers, desperate to withdraw their savings. When the manager of Howard's local branch refused to hand over his money, he and his wife staged a sit-in and barricaded the woman in her office. Never mind the one-time hotel owner was pulling out nearly $2 million to put a down payment on a home in Cyprus, he instantly became an icon for folks who feel helplessly caught up in the economic upheaval spreading around the globe.

 

Signs of anxiety are everywhere. American housing starts have fallen to their lowest levels in 12 years, while the number of mortgage foreclosures doubled last month. Economists predict the British economy is at the beginning of a serious downturn thanks to a dismal housing market that will lead to a recession there. Big merger and acquisition deals around the world are either stalled or falling to pieces, as deep mistrust sets in among major financial institutions. No one knows exactly where the bad debt bombs are buried. All around, investor and consumer confidence is in free fall.

 

Experts admit they are astonished just how fast things turned sour, even with all the warning signs. After the tech bubble burst in 2000, followed by the terrorist attacks in 2001, economists predicted a long and painful recession. The U.S. Federal Reserve, under then-chairman Alan Greenspan, slashed interest rates to one per cent. A deep recession was averted and low rates touched off a sustained housing boom. As quickly as tech investing fell out of style, real estate speculation came back in -- anybody could buy a house, with no money down and no credit record to speak of. Shares in Cisco gave way to condos in San Francisco. And as house prices soared, owners tapped their equity to go on a lavish spending spree. Few seemed genuinely concerned that once interest rates started to rise, millions of homeowners would be stretched to the limit. In fact, analysts widely and blithely predicted that inflation was a thing of the past, and interest rates might just stay low forever.

This summer, mortgage defaults began to soar as more and more Americans found themselves suddenly unable to keep up with rising interest payments. Investment funds heavily invested in sketchy mortgages buckled, touching off credit fears in other sectors. One estimate pegs potential losses in the mortgage market at US$200 billion -- a sum roughly equivalent to the GDP of Greece. Meanwhile, Standard & Poor's, the debt rating agency, believes U.S. corporations could default on loans worth US$35 billion by next year. As consumers tighten their belts, it will only exacerbate matters.

Even Uncle Sam is in a pinch. Demand for the dollar is sinking fast. Foreign investors and central banks in Japan and China own a huge chunk of America's public debt, and the fear is those investors will lose confidence in the U.S. dollar. As the dollar falls, Americans will have to pay more for the imported goods they rely on. Inflation follows.

There are plenty of other factors at play, but the simple truth is America's economy is built on people buying stuff, and their pockets are nearly empty.

When talk turns to recession, housing trouble is often the dry tinder that helps ignite the bonfire. Housing booms and busts precipitated the panic of 1837, the Great Depression, and helped trigger the long and deep Japanese recession beginning in the late 1980s. Why is housing such an efficient place for broad financial crises to start? Because housing is so directly connected to the idea of wealth, reflecting how much money people have, how much they can borrow and how much they can spend. In August, home sales slipped for a sixth straight month, hitting their lowest point in five years. Harvard economist Martin Feldstein predicts even a 20 per cent drop in house prices in the United States would cut overall wealth by $4 trillion. Consumer spending in the United States would drop by $200 billion. Enough, says Feldstein, to push the economy into retreat.

If the housing market troubles do set off a broader chain reaction within the U.S. economy, one sure signal that a recession is imminent will be unemployment. The latest U.S. numbers from August are already raising alarm. According to the U.S. Labour Department, 125,000 jobs have been lost since last February. "It's extremely unusual for the U.S. economy to lose jobs during the normal upswing of a business cycle," says Dean Baker, an economist with the Center for Economic and Policy Research in Washington. To many market observers the decline came as a nasty shock, and evidence that a second domino may have already dropped. The third, and arguably most serious, would be a drop in consumer spending. This month, the National Retail Federation forecast holiday sales in the U.S. This year will be the weakest in five years as fears set in about the job market.

The more you look, the more you'll find signs of trouble. For instance, the production of transport trucks, which is a good indicator of the strength of the industrial economy, has slowed noticeably in the past year, says Jayson Myers, president and chief economist of the Canadian Manufacturers and Exporters. Economists are also seeing worrying signs in the U.S. treasuries markets -- where long-term bonds are now paying out even less than short-term notes. This rare scenario, known as an "inverted yield curve" often foreshadows a broad economic slowdown or outright recession, as was the case with both the 1990 and 2001 slumps.

It's been so long since the United States and Canada lived through a full-on recession that people can be forgiven for forgetting how brutal it can be. Both countries went into an economic swoon in the early '90s. But for the genesis of the last severe recession, one has to look all the way back to the late 1970s -- a time of high oil prices, crisis in the Middle East, rising inflation, and a weak U.S. dollar. More and more financial experts are noticing the chilling parallels to today.

The United States at that time was suffering what president Jimmy Carter called a "crisis of confidence." Productivity was falling and Americans weren't saving for the future, he lamented. The economic doldrums contributed to Carter's 1980 election loss, but the worst was yet to come. By 1982, with Ronald Reagan in power, unemployment rose above 10 per cent -- the highest rate since the Great Depression. Oil prices shot up and inflation had spiralled to the highest level in 30 years. In a desperate attempt to contain rising prices, interest rates were sent through the roof. Average mortgage rates in the U.S. topped 15 per cent, compared to around six per cent today.

The downturn was sharp, but the saving grace of that deep recession was the speed of the recovery that followed. Pent-up demand for new cars and homes helped jump-start the economy in the mid-'80s. "There was a huge amount of room for the economy to grow," says Baker. Unfortunately, those same conditions don't exist today. There's no pent-up demand among people to buy cars and homes. Statistics show that people have spent the past five years buying everything in sight -- homes, cars, electronics and jewellery -- and putting it on credit. That all focuses intense pressure on the U.S. Federal Reserve's decisions on interest rates: cut too much and you'll spark ruinous inflation; leave them too high, and the building housing crisis could turn into a panic that slams the brakes on consumer confidence and spending. "You're going into it with a lot of really severe problems," says Baker. "And if the Fed makes the wrong call, it's going to be a nightmare."

In Canada, none of this has been cause for much concern, yet. The economy here, boosted by high commodity and oil prices, has proven remarkably resilient in the face of the subprime mortgage troubles. News that the Canadian dollar had reached parity with the U.S. dollar last week was heralded as yet another sign of the faith being placed in the Canadian economy. That has led many to believe that Canada can dodge the worst of any impending downturn. "The best news in Canada is that we have strong economic fundamentals," said Finance Minister Jim Flaherty last week. "The government is in a position of strength." Schiff, the U.S. financial adviser who is so down on America's prospects, would agree. He predicts the loonie will soar as high as US$2 within the next two years on continued U.S. weakness, combined with the fact that Canada is a net exporter of energy and other raw materials.

 

So does that mean the old adage, when the U.S. sneezes Canada catches a cold, no longer applies? Don't bet on it, says Daniel Racette, a professor at HEC Montreal's Institute of Applied Economics and a former adviser at the Bank of Canada. While it's true that rising demand for commodities in Asia and Europe provides some protection for the Canadian economy, the U.S. remains our biggest and best customer. "We're never insulated from what happens to the U.S.," he says. After all, at least 75 per cent of Canada's exports still go to the United States.

The rising Canadian dollar and weakening U.S. greenback have already left a mark on the Canadian economy -- the manufacturing sector has shed hundreds of thousands of jobs as the dollar has shot up in the past five years. And difficulties extend beyond manufacturers in Ontario and Quebec. The forestry company Tembec Inc. temporarily halted sales last week, saying it was no longer profitable to sell to the U.S. with the Canadian dollar so high. By one estimate, the forestry sector lost $45 million in the last quarter. Even companies that aren't directly exporting to the United States are likely supplying companies that do, notes Myers. "What's giving us a false sense of security is the strength of the Western economy. If you took Alberta out of the picture, the Canadian economy itself would be in recession."

And this is where one of the most crucial questions about the changing global economy comes in to play. A popular notion taking hold among observers is that countries in Europe and Asia, especially China, have "decoupled" from the U.S. In the past, the American consumer has been the fuel that keeps the global economy running. As the world's biggest importer, any slowdown in American consumer spending would quickly idle assembly lines in Asia. However, some analysts now believe emerging markets like China and India have become robust enough to shrug off any slowdown in the U.S.

The problem with that theory is that exports still account for nearly 40 per cent of China's economy, and much of that is still destined for American shores. In other words, the world is still highly dependent on the strength of U.S. consumers, and in the era of globalized trade, any serious downturn will spread around the world like an economic wildfire.

 

That spells trouble for, among other things, the oil boom in Alberta. The Economist Intelligence Unit, the analysis arm of The Economist magazine, recently published a report entitled "Heading for the Rocks." In it, researchers suggested weaker growth will drive commodity prices sharply lower this year and next. Most importantly, they predict the price of oil will tumble from US$81 a barrel today to as low as US$40 by 2008. At that price, many of Alberta's massive oil sands developments, with their ballooning budgets and multi-billion-dollar cost overruns, would simply cease to be viable. "If a recession hits, you have to reflect on what will happen to Japan, to China, who are counting on the U.S. economy to be importing from them," says Racette. Downturns there will push down demand for everything from nickle and copper to oil and lumber. "If the U.S. economy weakens, it's going to affect demand for exports across the board," says Myers. "You've got a pretty big swath of the business community that would be affected by this."

 

As always, there are some who insist that central banks should simply do what they did the last time: slash interest rates to the bone and keep the debt-fuelled party going. The problem with that is reflected in the U.S. dollar's recent plunge. Traders and money managers are increasingly worried that inflation is slowly slipping out of control. Even the Federal Reserve Board has hinted that it's worried about inflation. If central banks bow to pressure and slash interest rates too deeply, they could spark another bubble and a return to the exuberance that got us here in the first place. Eric Sprott, a Canadian hedge-fund manager well-known for his apocalyptic take on the U.S. economy, sees this as a very real possibility. "I suspect half a trillion dollars has been thrown at the world banking sector to try to hold it together and bail everybody out," he says. And of course there's the impact tumbling currency would have on the price of imported goods. "It would be unbelievable for people because their wages would never be able to keep up with the cost of buying things," he says. Ravi Batra, an economist at Southern Methodist University who studies the cycles of inflation in the U.S., notes that at the end of every decade there's been a rise in inflation. Given the severity of what has already unfolded in the housing market and the high cost of oil, he predicts this current cycle will be as bad if not worse than the one 30 years ago. "We are going to see spreading economic chaos, starting with the home mortgage crisis," says Batra. "The crisis will be so bad by the end of this decade, people will be demanding a major change in economic and tax policy."

 

Sprott and Batra aren't alone in their thinking. Even Greenspan, the former Federal Reserve Board chairman, has said the era of low inflation could be coming to an end. He believes prices will begin to rise at about four to five per cent a year, and could reach double digits by 2030. If that happens, central banks will have no choice but to hike interest rates dramatically to levels reminiscent of the 1980s. Twenty-five years may seem a long way off, but it takes that long to pay down a house.

There are still plenty of economists out there who dismiss talk of a deep recession in the U.S., and remain hopeful that the current crisis will prove to be a temporary setback in a long-term bull market.

It's more reassuring to listen to them, rather than the doom and gloom prophecies of Schiff, Sprott and others like them -- shouting from the street corner that the end is nigh. Yet many of the same voices heralding a painful downturn were the same ones who months, if not years ago, raised warnings about the subprime lending market -- where the current troubles were sparked. Yesterday's Cassandras look like today's shrewd forecasters.

It's also worth nothing that economists have a terrible track record when it comes to predicting recession. History shows that the majority of financial experts keep to their rosy outlooks until it's too late. Chances are, by the time most of them figure out it's coming, it will already be here. It may be more comforting to see the loonie's rise as a happy occasion. But the best advice is still hope for the best, prepare for the worst.