But it doesn’t look like Canada will hold its edge for long. If the oil boom fades and the financial market continues to bleed money from structured product losses, then Canada might face a serious economic slowdown.

At last count, total write-downs at Canada’s six largest banks stand at approximately US$11 billion. That’s roughly 5% of the total global sub-prime write-downs to date. Once US$11 billion may have seemed like a large loss, but now it pales in comparison to the US$200 billion banks have written off their books since last summer worldwide. It’s also far less than just Union Bank of Switzerland’s (UBS) cumulative US$38 billion in losses alone.

Canada, however, is not immune to the woes now affecting its largest trading partner, the United States.

Canada Is Already Slowing – Even During a Raging
Bull Market for Raw Materials

If you can look past the bull market in raw materials that has enormously benefited Canadian exports and the Canadian dollar, then you’ll see the country is starting to show strains in lending, housing, and manufacturing.

Indeed, a slowdown has already arrived. Canada’s economy contracted in the first quarter for the first time in five years. The economy slowed mainly because the surging Canadian dollar and weak U.S. auto sales caused a slump in auto manufacturing.

Meanwhile, some Canadian banks can’t escape the relentless wrath of sub-prime and other losses tied to illiquid structured financial products.

First quarter profits at Canada’s largest six chartered banks points to an acceleration of write-downs for Royal Bank of Canada (RBC) and Canadian Imperial Bank of Commerce, or CIBC.

Canada’s biggest six banks logged a first quarter profit of US$2.5 billion in the January to March period, down almost 50% from a year earlier when combined earnings were US$4.7 billion. Most of these losses, however, are tied to CIBC and Bank of Montreal – the hardest hit since 2007.

CIBC Hit the Hardest, While TD Escapes Sub-prime Wrath

Some Canadian banks have fared much better than their peers since the advent of the credit crisis last year. Of these, Toronto-Dominion Bank (TD) has almost escaped without any serious losses at all since last July. Meanwhile, the Bank of Nova Scotia has also easily absorbed modest losses tied to sub-prime and other structured products.

In fact, TD Bank ranks among one of the best-performing major banks in North America in 2008 – up 8% compared to a loss of 14% for the KBW Bank Index in the United States.

Here’s What the Best Performing Bank in North America Looks Like

But the story is altogether different for Canada’s other big banks.

RBC and CIBC now share the dubious distinction of being featured on the “sub-prime hit list.” Both banks are on the global banking sectors’ top 40 list for the largest write-downs and credit losses since the banking sector started hemorrhaging last fall. And Bank of Montreal (BMO) is ranked second only behind CIBC for posting rising losses tied to structured products and other write-downs in Canada. RBC is Canada’s largest bank by stock-market value.

From its all-time high last year, the Bank of Montreal has seen its stock plunge 31%. CIBC, which takes the booby-prize for Canada’s biggest loser in the sub-prime crisis because of its largest U.S. presence, is 33% off its best level.

CIBC has already written off a cumulative US$6.7 billion since the onset of the sub-prime crisis. That number is almost twice the figure posted by Canada’s other five largest banks put together.

Since last fall earnings have eroded and write-downs have accelerated. In short, the U.S. credit crunch that battered the U.S. housing sector has knocked the wind out of the banks’ sails. Everything from consumer and corporate lending to mortgages has been adversely affected as Canada finally begins to feel the impact of an American slowdown or recession. Over 85% of Canada’s trade is with the United States – the two largest trading partners in the world measured by the volume of goods and services.

But the news isn’t all gloomy. Dividends were largely unchanged over the first quarter while Bank of Nova Scotia actually raised its payout.

In addition to sub-prime losses, many banks were also hit by exposure in asset-backed commercial paper or ABCP. Other smaller lenders and brokers, including Canaccord Capital, saw losses in the hundreds of millions tied to illiquid short-term commercial paper.

Canada Now Slowing But Will Avoid Recession

The Canadian economy is now slowing in 2008. Stripping away booming oil and gas exports, the country’s merchandise trade balance is now in deficit. Without commodity exports, Canada would probably be in an economic recession.

First quarter GDP data confirm this trend. Manufacturing belts in Ontario and Quebec continue to suffer from a soaring Canadian dollar, up over 50% since 2002 versus the U.S. dollar while the unemployment rate is rising, housing is showing signs of slowing and commercial bank lending is gradually contracting.

The Canadian economy should escape a serious slowdown this year. The country’s trade balance and budget surpluses are indeed shrinking amid a slowing global economy but remain well managed compared to most industrialized economies.

Canada’s housing market is also in far better shape than America’s. That’s mostly because “zero-money down” was never a part of the country’s housing culture. But a continued strengthening of the Canadian dollar and more losses tied to structured investment products could tilt the nation into recession if combined with a significant decline in crude oil and gas prices.

ERIC ROSEMAN, Investment Director

Source: Even Commodity Rich Canada Is Not Immune to This Global Slowdown

I listened to various experts talk for over thirty minutes on Radio 5’s afternoon show last week about the high oil price. Not one mentioned Peak Oil. Not one mentioned out-of-control money supply. Not one mentioned increasing Asian demand..

Yes, oil is overbought; yes, oil is going to correct at some stage…but it’s not a bubble.

Then we had Anatole Kaletsky in The Times tell us the rising oil price ‘threatens to do far more damage to the world economy than the credit crunch.’ He’s right about that. Unless of course you’re long of oil in some form or other, in which case things are looking rather rosy.

Kalestsky goes on, ‘The present commodity and oil boom shows all the classic symptoms of a financial bubble, such as Japan in the 80s, tech stocks in the 90s and, most recently, housing’. Does it?

In a bubble supply overwhelms demand, yet prices continue to rise. In the 1990s tech companies with no earnings issued masses of stock; in the US housing boom-bust, builders built everywhere and there was an oversupply of inventory. Is there an oversupply of oil?

The chart below from IEA statistics shows oil supply and demand 2003-2007.

Since 2007, supply has remained constant at about 85 million barrels per day, while demand is now around 88 million barrels per day. No supply-glut there.

Kaletsky goes on to say that the Gulf is ‘crammed with supertankers chartered by oil-producing governments to hold the inventories of oil they are pumping but cannot sell’. Hang on, are you sure?

A bit of research reveals there are in fact ten supertankers ‘cramming’ the Gulf, with about twenty million barrels between them – or less than 25% of one day’s global demand. They are carrying heavy Iranian crude, just at the peak of the refinery maintenance season in Asia and the Mediterranean, when refineries have seasonal shut downs for repairs. It’s just a temporary lack of refining capability for heavy oil, that’s all.

It’s worth noting that just a few weeks back, when oil was $100, George Blake, a geologist who studies hard data, rather than an info-spinning journalist, noted an imminent shortage of refinery capacity in Canada and Australia and said it was going to shortly lead to $160 oil. He was laughed at and dismissed. As we touch $135, it’s starting to look now like one of the calls of the decade.

What about other commodities? Are they in a bubble?

So is this commodities bull market a classic financial bubble as Kalestsky asserts? Below is a long-term chart of commodities prices since 1749:

Since 1792 there have been five major bull markets in commodities. These lasted 23 years, 21 years, 23 years, 18 years and 12 years – an average of 19.4 years. The current bull market began around 2000, so we are 8 years in. If history is any guide, this bull market is not even at the halfway stage. Unless, of course, ‘it’s different this time’ and this is the shortest commodities bull market ever.

Let us assume that the unthinkable happens: China’s economy slows down sharply, or even contracts – and there are reasons why it could. Commodity prices slump and bring about economic hardship in the resource-producing countries of the world. In turn, these countries’ imports of capital and consumer goods from Europe and Japan decline.

We would then have the perfect setting for a global economic contraction with dire consequences for corporate earnings and asset prices.

Now, I concede that this scenario is not very likely to occur. However, on a recent visit to Dubai, I could see how it might unfold. I have been traveling to the Middle East since 1977, and I experienced first hand the oil boom of the late 1970s and the collapse in equity and real estate prices when oil prices fell in the early 1980s. About three years ago, on a visit to the Middle East, I felt that the gigantic equity boom would come to an end.

In 2006, most of the Middle Eastern stock markets declined by 50% or more, though the economies didn’t suffer. Yet, over the last three years, it has seemed to me that there is something not quite right about the enormous construction and economic boom that Dubai and other Middle Eastern countries are experiencing. (The world’s tallest buildings are going up there….) What if oil prices were to decline? But why would oil prices decline? Obviously, oil prices would decline because of diminished demand for oil from China and other rapidly growing emerging economies.

But why would demand for oil from China slow down or decline? Obviously, because of an economic recession! The assumption that the Chinese and other emerging economies will continue to expand rapidly may prove to be very deceptive. In recent years, the US has experienced a credit boom and China has had a capital spending boom. Both could come to an end at about the same time! I also wish to stress that there is enormous connectivity between all the world’s economies and that it would be wrong to assume that the present financial crisis, whose epicentre is the United States, couldn’t be followed by financial and economic crises elsewhere.

Also, if the Dubai boom was an isolated event, I wouldn’t be particularly concerned. But everywhere I travel I am left with the uncomfortable feeling that the current boom is surreal and unsustainable. The INDABA – the annual conference for natural resources professionals – which I attended earlier this year in Cape Town, has become a huge circus reminiscent of the consumer electronic shows held in Las Vegas in the late 1990s.

And whereas I have a relatively positive view of commodities, I doubt that all these mining executives (predominantly promoters and liars) will make as much money as they hope to, simply because exploration and mining development costs are soaring. Every major city around the world is also experiencing a huge condo and office construction boom, and in resort areas there are enormous developments of secondary homes.

Should the financial sector contract, as I believe will occur for several years, will all these new offices find tenants? I also wonder if all the condo and second home buyers are aware of the maintenance costs of their units and that in over-supplied markets prices can decline sharply.

Lastly, I think that investors fail to appreciate fully the process of deleveraging after a period of accelerating credit growth. In a credit-driven economy, a deceleration of credit growth will depress all asset prices and tip the economy into recession. In this respect, I am particularly surprised that analysts still expect S&P 500 earnings per share to increase to above US$110 in 2009.

Over the past few months, I have discussed corporate profits a number of times and shared with my readers my concern that we are in the midst of an earnings bubble, which has been driven largely by an explosion of financial sector earnings.

Richard Berner, chief economist at Morgan Stanley, recently published an excellent study entitled “Downside Risk for Corporate Profits”, in which he opines: “I think the earnings outlook will disappoint.

“The US economic outlook has darkened and fading operating leverage, dwindling pricing power, and deteriorating credit quality will squeeze margins. Despite the benefit of a weaker dollar, slower growth abroad seems likely to tame the overseas earnings boom” (Morgan Stanley Research North America, US Economics, March 17, 2008). In

Berner’s view, “the combination of slower growth and high operating and financial leverage in Corporate America made a contraction in earnings unavoidable even if the economy skirts recession”. (He is referring here to the corporate earnings decline in the fourth quarter of 2007.) “Lower marginal but higher fixed costs have increased operating leverage. Corporate America’s ability to exploit that leverage propelled earnings to record levels when growth was healthy. Strong increments to revenue went straight to the bottom line…. But leverage – both operating and financial – works both ways. Slower growth means that operating leverage is working in reverse, with decreases in revenues going right to the bottom line.”

Berner’s two principal concerns about US corporate profits relate to “operating leverage” and the fact that the “strength of overseas earnings” is about to be “challenged”. Operating leverage is at present far higher than in the 1990s, which, according to Berner, could mean that “a deeper recession, especially one that spreads abroad, would promote a much more serious profit squeeze.”

Berner shows that overseas earnings have increased from 15% of overall earnings 20 years ago to 31.5% at present, as “growth abroad – and the higher oil price that comes with it – are powerful engines for US earnings”. I may add that a weak dollar is another extremely powerful driver of overseas earnings as a percentage of total earnings. Also, that “growth abroad – and the higher oil price that comes with it – are powerful engines for US earnings” supports my view about the extreme connectivity we now have between economies in the global economy.