World Economy Mid Cycle Correction Arrives

1
World EconomyMid Cycle Correction Arrives

• Presented at
• THE LEADERSHIP FORUMS
• ELECTRO-FEDERATION CANADA
• Presented by
• Maureen Farrow
• Economist/Strategist
• ECONOMAP INC.
• [phone]
• September 28, 2006

2
Long-Term Structural ShiftChanging
PlacesEconomic / Political PowerPacific
Replaces Atlantic
U.S. 1940 - 2000
Britain 1850 - 1940
India/China 21st Century

• 2000 Plus
• Rise of Asia
• China dominating manufacturing
• China India population world share 38
• GDP Share 19
• USA Today 21

• 1850 - 1940
• UK Dominated Industrial Revolution, Trade
• 1/3 of World under UK political influence

• 1940 2000?
• USA Dominates
• Major economic, political power challenged by
  Japan Tigers in 1980s

3
Long-Term Structural ShiftGlobal
DynamicsImplications

• Manufacturing power shifts.
• Commoditization of services.
• Rise of new Asian consumer class. By 2015 China
  and India will create 3 to 4 times the number of
  new middle class families that were created in
  North America, Europe and Japan between 1947
  1964 (Baby Boomers).
• Means strong commodity demand.
• Means strong energy demand.
• Likely translates into the most significant
  mining boom in history.
• Contained inflation environment.
• Low real interest rates.
• Currency realignment.

4
Current Cyclical SituationSofter Growth
Prospects to Prevail Starting Q3, 2006
Leading Indicator
5
Current Cyclical SituationSofter Growth
Prospects to Prevail Starting Q3, 2006
Moodys Survey of Business Confidence
Diffusion Index 4 wk MA
6
Mid-2006 Through 2007Cyclical Economic Themes

• The Challenges
• Mid-cycle correction arrives.
• Root of Risks
• Global synchronized monetary tightening goes too
  far.
• Geopolitical landscape escalates oil prices
  beyond US80 per barrel on a sustained basis.
• Middle East develops into full blown war.
• U.S. Current Account Deficit.
• Currency Realignment. (US dollar collapse).
• Offsets
• Asia continues to grow.
• Europe on tentative recovery path.
• United States economy moderating but recession
  should be diverted.
• Global inflation (headline and core) relatively
  well contained at single digit levels.
• U.S., UK, Australia and Canada monetary policy
  has room for stimulation if required.
• But These Are Dangerous Times!

7
Global Growth Peaked For This CycleRisk of
Stagflation and/or Recession
Real GDP Growth

• The Score Card 2002 2003 2004 2005 2006 2007
• U.S. Steady But Slowing 1.6 2.5 3.9 3.2 3.2 2.6
• JAPAN Challenged 0.1 1.8 2.3 2.6 2.7 2.0
• ASIA Solid growth
• - China 9.1 10.0 10.1 10.2 10.5 9.5
• - India 3.8 8.5 7.5 8.4 8.5 7.5
• EUROPE Recovery 0.9 0.8 1.7 1.5 2.5 1.8
• LATIN AMERICA On the Mend -1.3 2.7 5.8 4.2 4.8 4.1
  
• CANADA Bounces Back 2.9 1.8 3.3 2.9 2.8 2.6
• WORLD 1.7 2.6 4.0 3.5 3.8 2.8

8
Tipping Points

• Global Economic Shifts
• Geopolitics
• Middle East
• War on Terror
• West versus Islam
• Oil Supply / Security / Price
• Headline Inflationary Pressures
• U.S. Current Account Deficit
• Currency Realignment

9
Geopolitical BackdropA Decade of Conflict?

• Sept. 11 Triggered
• War on Terrorism
• Afghanistan
• Iraq War

• World Institutions Challenged
• U.N. - lacks credibility and backing of U.S.
• NATO
• E.U. - frozen
• WTO - breakdown of DOHA round

• Escalation
• War on terrorism escalates
• Afghanistan stalemate
• Costly and dangerous occupation of
  Iraq/rebuilding
• Middle East turmoil
• Palestine / Israel
• Israel / Hezbollah
• North Korea
• Iran

Conclusion

• World facing many more years of geopolitical
  tension.
• Rising defense budgets, higher energy costs,
  economic / financial volatility.
• Loss of credibility of U.S. and UK to take a
  leadership role.
• Political power shifting following economic power.

10
Risks to the OutlookOil Price Destabilization
11
World Oil ReservesSurplus Capacity and Production
12
United States Twin Deficits
U.S. Government Deficit
U.S. Current Account Deficit

• U.S. current account deficit hits record 7 of
  GDP in Q4, 2005.
• U.S. generates 85 of global current account
  deficits and is highly dependent on foreign
  investors to finance.
• U.S. now absorbing more than the recorded net
  savings of the rest of the world combined!

• Fiscal deficit (e.g., social security) ballooning.

13
Currency RealignmentEnd of Americo-Centric
Period Rise of China
U.S. Dollar - Trade-weighted Broad Index
The EURO
18 Sep 06 1.2671
13 Sep 06 108.24
Canadian Dollar
Japanese Yen
18 Sep 06 89.45
18 Sep 06 118.02
14
U.S. Economy Brakes Sharply in Q2, 2006Fed Key
to Managing Slowdown and Avoiding
RecessionPsychology of U.S. Consumer Now Key!
U.S. Real GDP
1999 2000 2001 2002 2003 2004 2005 2006 2007 4.4
3.7 0.8 1.6 2.5 3.9 3.2 3.2 2.6
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United StatesMid-Cycle Slowdown or Recession?

• POSITIVES
• Global Economic Recovery in Japan / Europe
  better export prospects for U.S. goods.
• Corporate Earnings still healthy. But at peak for
  this cycle. Means corporations can increase
  capacity and invest in competitive productivity.
• Non-Residential Capital Investment Picking Up
• Industrial
• Warehousing
• Commercial
• Hotels / Recreation
• Institutional
• Transportation
• But is it enough to counterbalance consumer
  spending softness?

• NEGATIVES
• Consumer Spending
• High debt levels
• Negative savings
• House prices flattening
• Softer job markets
• High interest rates
• Range bound confidence levels
• Energy price escalation biting into disposable
  income.
• Tight Monetary Policy
• Fed possibly overshot.
• Productivity Gains Moderating
• Current Account Deterioration
• Cost of War
• Budget implications
• International reputation
• Unpopular at home
• Mid-term elections will mark political crossroad

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U.S. Economy Begins to Slow in Q2/06Softness
Pronounced in the Manufacturing Sector
U.S. ISM Index Services
U.S. ISM Index Manufacturing
U.S. Total Non-farm Employment (Change)
U.S. Consumer Confidence
17
Replacement Capital Investment Cycle
PeakedCritical Non-Residential Spending Occurs
U.S. Equipment and Software
U.S. Non-Residential Structures
U.S. Average Age of Capital Stock
Source U.S. BEA
18
U.S. Housing Starts
19
Corporate Earnings Approaching Highwater Mark?
U.S. Corporate Profits Before Tax Share of GDP
Canada Corporate Profits Before Tax Share of GDP
20
Corporate Profits Remain Healthy But Growth to
SlowNot Good News for Equity Markets
Canada Corporate Profits Before Taxes
U.S. Corporate Profits Before Taxes
(With IVA CCA)
Canada Corporate Profits After Taxes
U.S. Corporate Profits After Taxes
(With IVA CCA)
Source BEA
Source Statistics Canada
21
JapanRecovery ChallengedMonetary Tightening
Commences Some Softness Reappears
Japan Real GDP QoQ change
Japan Core Machinery Orders change month ago
22
China Continues on Growth PathQ2 Economic Pace
AcceleratesCredit Directives Issued! Recent
Industrial Production Nos Moderate
Direction of Trade 2005 Major Export Major
Import Markets Suppliers of total of
total United States 21.4 Japan 15.2 Hong
Kong 16.3 South Korea 11.6 Japan 11.0 United
States 7.4 South Korea 4.6 Germany 4.6
23
India Steps ForwardQ1, 2006 GDP up 9.3 YoY
India Real GDP Annual Percent Change
India Industrial Production YoY Change
Direction of Trade 2005 Major Export Major
Import Markets Suppliers of total of
total U.S. 20.6 U.S. 7.8 China 10.1 China 7.0 Uni
ted A.E. 9.0 Belgium 5.5 U.K. 5.3 Singapore 5.2
24
European Recovery Starts to UnfoldMerkel Changes
Germanys Mood!ECB Tries To Move Monetary Dial
Back To Neutral!
Eurozone GDP
Germany GDP
France GDP
U.K. GDP
25
Resources Become Cornerstone of Canadian Economy
Economic Activity Shifts West and EastWeakness
Centred In The Manufacturing RegionsUnited Sates
Slowdown Takes its Toll
1999 2000 2001 2002 2003 2004 2005 2006 2007 5.5
5.2 1.8 2.9 1.8 3.3 2.9 2.8 2.6
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Growth Moves WestWeakness Concentrated in
Central CanadaReal GDP
2002 2003 2004 2005 2006 2007 CANADA 2.9 1.8 3.3
2.9 2.8 2.6 B.C. 3.5 2.7 4.0 3.5 4.0 3.6 ALBERTA
2.5 3.1 4.3 4.5 6.0 4.5 ONTARIO 3.2 1.6 2.7 2.8 2.
2 2.1 QUEBEC 2.7 2.1 2.3 2.2 2.3 2.2
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Canada A Mixed Bag
Canadian Building Permits
Canadian Manufacturing
Canadian Retail Trade
Canadian Unemployment Rate
28
Canada Housing Starts
29
Canada Non-Residential Construction
30
Canada Building Permits
31
Inflation No Concern
Forces
Forces
Positive
Negative

• Global economic slowdown
• Chinese Exports
• Walmart Effect
• Low Inflation Mentality
• Little Pricing Power
• Flat World
• Excess global capacity
• Low global wage rates
• Retrenchment in energy prices

• Energy Prices
• Commodity/Raw Materials
• Rising Interest Rates
• Health Benefits
• Productivity slowdown in U.S.
• Rising U.S. unit labour costs

Contained Price Environment
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Contained Price EnvironmentCore Inflation Well
Contained
Canada CPI ex food and energy YoY change
33
Canada / U.S. Interest RatesShort Term
34
Canada / U.S. Interest Rates Long Term
35
Canadian Dollar in U.S. Funds
Sept 18 89.47