Feb 13/08
North American & International Economic Highlights

All signs from the US suggest that the situation will get worse before it gets better. The next 4-6 months will see continued weakness iin almost all aspects of the US economy—led by the housing market, followed by consumers and business investment.  It is clear by now that an unprecedented housing downturn is unfolding. The level of housing starts is already 50% below the level seen in 2006, and at around one million units per year, it now equals the number of excess unsold houses in the US. Put differently, American builders can take a full year off before we see the level of housing inventory in the US returning to normal. Same goes for existing home sales, which fell by no less than 30% in 2007—the fastest pace of decline seen in any other post-war real estate meltdown. This cannot be positive for house prices, which are already 8% below their 2006 peak. By any estimate (house prices vs. income or vs. rent or some other housing market fundamentals such as demographics and unsold inventories), house prices will probably drop by an additional 10%-12% by the end of the year. With house prices falling, the share of Americans that face a negative equity position (a mortgage larger than the value of the house) is rising. By the end of this year, no less than 50% of those who took a mortgage in 2006 will be in negative equity position.

And from here the path to even higher default rates is clear. The 60+ day delinquency rate on the 2006 subprime vintage is already 25% and will probably reach 35%-40% by year end. The 2007 vintage is even worse, with delinquency rates rising even faster. Overall, we expect total losses on subprime and related mortgages to reach $265 billion. Note that to date, banks have written down just under $150 billion. The Canadian market is being punished despite the fact that the fundamentals here are much better. A good example is the real estate investment trust (REIT) sector. Since mid-2007, Canadian REIT prices fell by almost 25% (and by close to 30% since reaching their peak in early February). That is 10%-points more than the drop in the financial index and three times the drop in the TSX as a whole. Interestingly, there has been a very high degree of correlation between the Canadian and American indexes, with Canadian REITs outperforming American REITs by only 4%-points during that period. That’s not much if you consider that the actual housing meltdown is happening south of the border and not here.

The point here is that if American markets are overshooting, Canadian markets are overshooting even more. While we do not expect much from the North American stock markets in the coming 4-6 months, we look for a nice rebound in the second half of the year—boosted by the Fed’s current monetary policy stimulus—which is by far the most aggressive policy since the post-war era.
The ongoing dramatic reduction in the fed funds rate will probably work to shorten the duration of the recession (if we are already in one). But it will also plant inflationary seeds for 2009. So if the story of 2008 is subprime and a recession, the story of 2009 will be inflation and rising interest rates.

Benjamin Tal
Senior Economist