On February 5th, we produced an economic update on the U.S. outlook in conjunction with the announcement of a fiscal stimulus package by Congress. At that time, a number of leading indicators left the impression that the U.S. was capable of skirting a recession, however, real GDP growth was still expected to slow to a crawl in the first half of the year, averaging just 0.5% annualized. With growth projections just a hair off of the zero-threshold, we knew it wouldn’t take much to knock the U.S. economy into contraction territory. This risk has now become a reality in our economic outlook. We believe the history books will log 2008 as a recessionary year for the U.S. economy. However, this outturn may not be obvious by looking at the headline GDP figures alone, which will be temporarily skewed up when consumer spending is boosted from the fiscal stimulus package in the second and third quarters of this year. Even as this goes on, we expect to see broad-based job losses that extend into the first half of 2009, which, in turn, will depress real personal income once transfer payments are stripped away. And, business investment is also expected to contract throughout 2008 and most of 2009. Together, these factors are qualifiers for a recession according to the National Bureau of Economic Research (NBER). In fact, jobs and incomes were cited as the two most influential factors that led to the 2001 recession markers by the NBER.

The boost to consumer spending from the fiscal stimulus in this cycle will have a limited impact on the overall American economy because much of the consumer boost will be met through imports and a drawdown of inventories. And, since the stimulus is temporary in nature, the economy will settle right back into the funk in the second half of 2008 and early 2009. As a result, we expect real GDP growth to turn in a dismal 1.1% performance in both years. However, the seeds will be sown for a sustained recovery in the second half of 2009. By then, housing will be able to modestly contribute to growth after having found a bottom in early-2009, the Fed’s hard work on liquidity and massive interest rate cuts will be getting some traction, and the export market will continue to benefit from the momentum in global demand.

The Canadian economy will bear the markings of the U.S. downturn in two important respects: slumping exports and disparity in regional economic growth. The net trade balance was a considerable drag on real GDP growth last year, but some of that impact was masked in the headline figure because domestic demand was on fire. Although we believe the dichotomy between trade and domestic demand will persist through our forecast horizon, it’s unreasonable to expect Canadian domestic demand can be fully insulated from a U.S. recession, so the split personality of the economy will not be as pronounced this year. Furthermore, the drag from the U.S. will not be felt evenly across Canada. Those provinces with a heavier manufacturing base and, in particular, low net exports of high-demand resource products, are going to be the ugly ducklings among the flock. The primary candidates are Ontario and Quebec.

With a number of the largest economies in Canada to bear the biggest economic impact from the U.S. recession, Canada will only narrowly miss entering into a recession itself, and will ultimately produce equally soft real GDP growth of 1.1% in 2008. However, an important distinction between the two countries is that the composition of growth in Canada will be fundamentally sounder than that of the U.S. and the rebound in 2009 will be slightly stronger at 1.8% when the U.S. recovery begins to heal Canada’s trade sector. Cooling domestic demand growth in Canada won’t change the fact that the underpinnings are day and night relative to its U.S. counterpart. Among the differences, Canadian housing markets are flourishing, while consumers are already benefiting from past fiscal stimulus and strong income growth. These factors won’t come apart at the seams in 2008, especially when an additional 150 basis points in monetary stimulus of central bank cuts is added into the equation.

Recession – made in the U.S.A

Since our U.S. economic update in February, a number of unfavourable developments have unfolded. Among the five leading indicators we have been following to gauge economic momentum, three are now flashing red for a recession.(1) The first indicator – building permit issuances – had been flagging recession for over a year, suggesting it has lost its predictive power in this cycle. However, job losses and the broad-based nature of those losses in each of the first two months of this year was influential in prompting a shift in our view to a U.S. recession. If the job losses had remained contained to the usual suspects – manufacturing and construction – the U.S. consumer would have found some refuge from negative housing wealth effects in wage growth, because jobs and incomes matter more than wealth when it comes to meeting day-to-day living expenses. This support is now in question. In January and February, 10 of 15 industries posted year-to-date losses in jobs. And, the 6-month annualized change in private sector employment dropped to 0.1%. There are no instances since the 1960s when this indicator decelerated to as low as 0.6% without a recession ensuing within 1 to 3 months. The data are now well within that threshold.

The third recession-marker indicator is the ISM index, which has fallen into contraction territory twice in the past three months and is dangerously close to our point-of-no-return recession threshold of 46.0. In addition, the deterioration in this index was mirrored by the non-manufacturing ISM index in January and February, suggesting that downtrodden sentiment among producers is increasingly widespread.

Alongside this mix of bad-news data, the last two months have also brought forward an intensification of both the housing downturn and risk aversion in the credit markets. In regards to the latter, central bankers are implementing one measure after another to inject liquidity in order to stave off a devastating crisis of confidence in the investment community, but to little avail. The near-collapse of Bear Stearns in mid-March caused an eruption in market jitters. The cost of funding among financial institutions subsequently worsened, with the spread between 3-month Libor and Treasury Bills widening to 190 basis points on March 17, mirroring spreads seen at the end of last year. The heightened risk-premium on borrowing between financial institutions is showing little sign of letting up, suggesting the Fed will have to do more to pass along the intended benefit of monetary stimulus to households and businesses. For instance, in spite of the aggressive 300 basis points in rate cuts by the Fed over the past six months, the fixed and variable mortgage rates have barely budged relative to the magnitude of the cuts.(2)

Meanwhile, existing home prices have fallen for an unprecedented 18 months and high inventories suggest a reprieve is not in sight, especially with record levels of foreclosures dumping more supply onto the market. To make matters worse, for the first time since the Federal Reserve started tracking the data in 1945, the amount of debt tied up in American homes is exceeding the equity homeowners have built, which was just below 48% in the fourth quarter of 2007. This presents two threats to the economy and consumer spending. First, the risk of so-called “mortgage walkers,” or homeowners who can afford their payments but decide not to pay, rises as home values depreciate and equity diminishes. This action would increase loan losses among financial institutions, which, in turn, would lead to more cautious lending behaviour. The Federal Reserve’s Senior Loan Officer survey released in early February indicated that the consumer borrowing environment was already becoming prohibitively restrictive. Banks have pulled back the reins for residential mortgages to the point where credit conditions are the tightest on record (1990), and other consumer loan products are sharing in a similar experience. Second, falling home equity limits a household’s ability to refinance their mortgages or draw on existing equity to shore up consumer spending.

The list of bad news on the housing front goes on and on, but the message is clear: the housing slump will extend through 2008. This, in combination with broadening job losses and a volatile financial environment, leaves consumer spending in a precarious situation. Although tax rebate cheques will boost expenditures in the second and third quarters of the year, the impact will be temporary and there is little the government or monetary policy authorities can do in the near-term to influence domestic spending.

While consumer spending will slump in 2008, the outlook for 2009 is promising. It is all too easy to get bogged down in the negative news from near-term economic indicators, but the adjustment that is underway in the U.S. is a necessary evil that will allow lenders and homeowners to work through oversupply, stagnating home prices, and the excesses of past lax lending standards. Likewise, the current deep wariness investors have to U.S. and international short-term lending markets will eventually ease. By the end of this year, we hope there won’t be any major new news to flush out with regards to counterparty risk between financial institutions. The gradual normalization of risk aversion will allow more favourable interest rates to be passed on to consumers, especially since we believe the Federal Reserve will be taking rates to an ultra-low 1.00% by August 2008. This, in combination with massive past liquidity injections, should start to gain traction, as central banks around the world continue to work towards new solutions. By 2009, the housing market, consumer spending and lending behaviour in general should face fewer constraints, allowing consumer spending to sustain a convincing recovery by the fall of that year. Likewise, by the tail-end of 2009, U.S. real GDP growth is expected to return to a healthy 3.1% quarterly pace.

The U.S. troubles will continue to wash onto Canadian shores in very visible ways, contributing to modest 1.1% economic growth in 2008. The nation as a whole is already feeling the effects from the credit crunch that originated in America, evident by the Bank of Canada having to repeatedly inject liquidity into the financial system. Even though the central bank has cut rates by 100 basis points since December, we calculate that the credit crunch is exerting the equivalent of about 50-75bp of implicit monetary policy tightening. Since the broad economy has only seen the benefit of perhaps one-quarter to one-half of the monetary stimulus, the central bank will have to work harder to get the desired monetary stimulus to shelter Canadians from the U.S. downturn, especially in light of two direct linkages between the two countries.

First, the current tightness in the credit cycle will act as a speed bump to investment by raising the cost of funding and restricting investment for a number of Canadian companies. An IMF study estimated that close to one-quarter of financing by Canadian corporations is raised south of the border. So the direct impact of tighter credit conditions there, in addition to the spillover into Canada, raises the cost of capital for domestic corporations.

Second, the lethal combination of a high Canadian dollar and weak U.S. demand will continue to drag export growth. A deteriorating net trade balance will be the primary source of downdraft on GDP growth in 2008, shaving almost 3 percentage points from annual growth. In fact, exports are expected to contract outright in the first half of the year extending the massive loss in shipments that ended 2007 in dramatic fashion. Between November and January, real Canadian auto exports declined 23%, the biggest drop off since the end of the 1982 U.S. recession. Meanwhile, exports of other consumer goods fell by 14% over that period, the worst showing in almost three decades.

With corporations facing impediments to financing alongside a battered and bruised export sector, the Bank of Canada is expected to respond by slashing rates 150 basis points over the next three meetings. This would bring the overnight rate to rest at 2.00%, providing the monetary kick to help heal Canada’s economic wounds in 2009.

The east to grow the least

The weakness in the trade sector over the forecast horizon will not be evenly distributed among the provinces and the pattern will reinforce the east-west divide that Canadians have become all too familiar with in recent years. The province of Ontario is slated to absorb the biggest negative trade impact. The economy is expected to eek out 0.5% growth in 2008, the worst showing since 1992, and there’s a significant risk that Ontario will experience a mild recession. At the opposite end of the spectrum, Saskatchewan will outperform national growth by nearly threefold.

A mismatch in regional economic performances is not a new development – different parts of the country have always tended to move to the beat of different economic structures and resource endowments. And with that, regional trading blocks have formed. The emergence of free trade with the United States in the late 1980s and the persistence of trade barriers at home has been a catalyst for developing north-south trade routes rather than east-west. As the adjacent graph indicates, the U.S. export share of GDP by province ranges from a high of 40% in Ontario to a low of 18% in British Columbia. As a rule of thumb, central Canada is the most closely tied to the U.S., followed by eastern Canada.

The degree of export reliance only tells part of the story. The sector mix is equally important. Since we expect a consumer-led recession in the U.S., related shipments will be hardest hit within the provinces, particularly auto and forestry products. Not surprising, Ontario is expected to post the worst economic performance in large part because one-third of its total international exports are attributed to shipments of automotive products. In contrast, even though British Columbia has a high share of its exports in forestry-related products, the impact on that provincial economy is mitigated by its relatively low overall reliance to U.S. trade. Declining U.S. forestry demand will impact New Brunswick and Quebec, but again, their exposure is relatively low at 6-7% of total exports.

In contrast, some export areas are likely to hold up relatively well in 2008, including energy, other non-forestry commodities and agriculture. This is partly why Saskatchewan will be at the top of the leader board in 2008. It shares the distinction, along with four other provinces, of having a heavy export tilt towards energy and/or refined products: N&L (70%), Alberta (68%), New Brunswick (59%), Saskatchewan (34%), Nova Scotia (17%) and B.C. (8%). Saskatchewan, along with Manitoba, also has 10-20% of their total exports in non-energy minerals. And, as a final clincher, just under one-third of Saskatchewan’s total exports are related to wheat and oilseeds crops, which are areas that will reap the rewards of strong price conditions this year.

Putting it all together, the western region remains in the best shape to weather the headwinds of the U.S. recession, while Central Canada – and notably Ontario – is in the worst position. Although domestic spending in all provinces will continue to receive support from falling interest rates, rising home wealth, and sturdy income growth, it is unreasonable to expect domestic spending to be completely immune to the growing pressures on provincial export sectors. By the second quarter of this year, employment in central and eastern Canada is expected to flatten out, leading to some increase in unemployment rates and some easing in consumer spending and housing activity. As a result, Ontario will barely keep its head above water in 2008, while expansions in the rest of the eastern provinces fare slightly better at 1-2%.

Although the western regions won’t be immune to slower growth, Saskatchewan is likely to stand out as the only province to both experience faster overall growth and a real GDP gain of 3% on the back of strength in its resource sector.

Our economic outlook for a return to more stable growth in the latter half of 2009 on both sides of the border is conditional on some greater stability – but not necessarily perfection or even full restoration – in financial-credit markets. Should this not occur, a double-dip recession could be in store for the U.S. after the impact from the fiscal stimulus dissipates at the end of 2008. At this stage of the current cycle, it is difficult to quantify what the full impact of this uglier scenario would be on the Canadian economy. The obvious statement is that the provinces most vulnerable to the U.S. would be in the worse shape, with Ontario unlikely to withstand the recessionary pressures from the U.S. without falling into the same predicament in 2008 and 2009. Suffice to say that the negative impact on Canada as a whole would be deeper and more extended.

Beata Caranci
Director of Economic Forecasting
416-982-8067

(1) For further details see TD Economics special report, “The Five Finger Guide: Economic data that provide a heads-up to a U.S. recession, January 17, 2008"

(2) For details see TD Economics special report, “U.S. Homeowners Not Getting Much of a Break on Mortgage Rates” March 2008