Montreal, Canada

Canada has been red-hot. Foreign direct investment, international purchases of securities, a soaring real estate market and a commodity export boom have all provided a solid hedge against global financial turmoil since 2008. And the envy of the world, her banks withstood the bear market of the credit crisis with only limited losses on bank balance sheets.

Combined with a strong currency, the loonie, foreign investors have lunged into Canadian assets over the past two years as the country is increasingly viewed as a safe-haven amid global uncertainty. The loonie has gained a cumulative 35% since hitting a low more than seven years ago.

Americans have especially clamored to Canada, buying real estate, opening bank accounts and dumping U.S. dollars for the loonie as Obama’s economic agenda drives nervous money out of the country.

But Canada’s economy is now in the process of cooling as the economy slows over the second half of 2010.

Real estate has started softening since earlier this summer with bubbles in major cities like Vancouver and Toronto now compressing. New and existing home sales have declined sharply. Manufacturing continues to suffer as a strong loonie rips into exports; stripping out commodity exports out of the GDP equation paints a rather sobering picture for the economy, which remains highly reliant on energy exports.

The Bank of Canada, which was the first G-7 central bank to tighten monetary policy earlier this year, is now likely to keep a lid on rate hikes as softer economic data puts Governor Mark Carney on hold.

Finally, Canadian bank earnings are starting to soften as well. The big five in Canada have maintained their dividends (actually raised payouts since 2008) and generally harbor superior risk management than other Western banks. But they’re not immune to a slowdown in capital markets.

Royal Bank of Canada (RBC), the biggest bank in the country, reported an 18% drop in Q2 earnings as its European capital markets division took a hit as a result of the sovereign debt crisis.Thus far, only CIBC has reported solid numbers.

Over the next 12 months, the Canadian dollar will decline to reflect the growing reality of the global cyclical recovery. A more reasonable exchange rate lies in the C$1.10 to C$1.15 range – not par value or beyond.

Canada can escape from America for only so long; trade-ties between the two countries are intertwined with 73% of Canadian exports heading to America.

The economic reality of the United States is increasingly challenging over the next several quarters as bond prices begin to discount a recession or a marked slowdown. Canada got lucky the first time and escaped the brunt of the credit crisis’ wrath. It won’t be so lucky this time, especially if the U.S. heads back into recession and natural resource prices correct sharply. Canada’s bubble is starting to burst.