Focus 2012 

excerpt from report by Derek Holt, MA, MBA, CFA  (Scotia Economics) Source: IMF September 2011 WEO.

Economic Outlook - Canada's Lessons for Europe and the United States

T H E M E & O U T L O O K

Fiscal Austerity Is the Only Sustainable Solution to U.S. and European Challenges

The night of the Quebec referendum on October 30, 1995, portrayed Canada at its worst. The palpable fear in the markets was keyed off deep, intertwined concerns about the country's fiscal, economic, and political circumstances. Recall this was a period when a respected U.S. financial daily slammed Canada as a "banana republic," yet curiously such references to its home country are absent today. I'm paraphrasing from memory, but it was also a period when the nation's political leaders dismissed capital markets critics as "armchair observers who wouldn't know how to run a country."

Such a market-unfriendly backdrop understandably drew the ire of rating agencies through multiple downgrades, as well as bond markets as the country faced the threat of a break-up and dissolution of the monetary union. Simply put, Canada then was Europe today and also carried shades of today's U.S. situation. Understanding this parallel is instructive toward explaining our forecast for further euro depreciation, soft global growth, and a cautious approach to the risk trade in 2012.

Within this context, the point to this article is to reject a popular argument from those who say Canada faced an easier time at restructuring its finances than either the United States or Europe would today. In our view, their argument is historical revisionism at best, and a shameful affirmation of today's global fiscal malfeasance at worst. In what follows below, we argue that the United States and core eurozone economies face arguably easier conditions within which to pursue necessary fiscal and political reforms today than Canada faced back then - and yet Canada never resorted to the monetary printing presses back before the western world went mad in seeing this as the solution to decades of fiscal profligacy. We do so through 10 then-and-now comparisons, and our broad argument is that Canada's past experience lends support to Germany's current opposition to non-sterilized bond buying by the ECB and other shortterm solutions in favour of accelerated fiscal austerity and reforms.

The only long-run viable policy solution for the ultimate survival of the eurozone is through reining in the purse strings, as other policy options would only build upon imbalances and further intensify the odds that the eurozone experiment ultimately fails.

 As a consequence to its earlier sacrifices, Canada is today part of a dying breed of AAA-rated markets. Its status as the eighth-largest global bond market at face value somewhat hides the additional fact that fewer yet are AAA-rated among the world's deepest bond markets. Against the myth that this was easier for Canada to achieve during different times, what's amazing about the Canadian experience is that it was achieved during at least as trying, if not more troublesome, times after taking account of the full global and domestic picture at the time.

The country therefore offers an important lesson to nations like the United States and large parts of Europe that are delaying fiscal repair and punting the problem down the road toward a more ruinous crisis later.

All that said, our message is not one of arrogant neglect toward the present Canadian situation. The country has done well through the crisis, but resting on its laurels and pointing to past painful achievements is no way of ensuring that the country retains its advantages. Sources of concern today include: large Canadian trade deficits; still sizeable fiscal deficits at federal and some provincial governments; the increase in the general government debt-to-GDP ratio from a trough of 66.5% in 2007 to about 84% today following pre-crisis accelerated spending and the crisis stimulus response; high refinancing amounts on short-dated debt at combined levels of government; record high house prices by any measure; and, record high household leverage. They are, however, mitigated by a strong financial system, little external debt relative to GDP in contrast to Europe, excellent corporate balance sheets, resource riches, and a strong government financial asset position that translates into a net debt-to-GDP ratio of just over one-third.

This mixed assessment of the nation's finances for a trade-reliant country that is a price-taker across most industries makes it prudent to continue to pursue measures that extend its relative success. It is through this understanding of the ultimate fiscal and broader policy challenges facing the global economy that we present our macroeconomic and financial market forecasts. Further, whether U.S. and Canadian equities are cheap or not against this macro backdrop depends critically upon whether one thinks valuations should be compared with the period of the 1990s onward, or prior history.

Our view is that the past two decades of leveraged excess remain a dicey period against which to compare current valuations, making it much more important for active investors to evaluate individual franchises for value in the market as opposed to broad market metrics.

This report has been prepared by Scotia Economics as a resource for the clients of Scotiabank.Opinions, estimates and projections contained herein are our own as of the date hereof and aresubject to change without notice. The information and opinions contained herein have been compiled or arrived at from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness. Neither Scotiabank Group nor its affiliates accepts any liability whatsoever for any loss arising from any use of this report or its contents.