U.S. slowdown could hit Canada, TD warns

By Steven Lamb | March 22, 2006 | Last updated on March 22, 2006
4 min read

While the opening months of 2006 have seen a rebound in both the U.S. and Canadian economies, the second half of the year could see a mid-cycle slowdown south of the border with ripples affecting Canada’s growth, according to a report from TD Economics.

While a deceleration in late 2005 was caused by isolated incidents, TD Bank Financial Group senior vice president and chief economist Don Drummond says there are now a number of risks to American growth looming on the horizon.

Current interest rates can no longer be considered “stimulative,” Drummond says, and he predicts only a single 25 point rate hike by both central banks before the credit cycle turns. That would mean an overnight rate of 4% from the Bank of Canada and a Fed rate of 4.75% in the U.S.

“Last summer, we noted that housing market strength and household indebtedness in the U.S. was simply unsustainable, and that it would give way to an economic slowdown in the second half of 2006,” says Drummond. “Evidence is mounting in support of this view.”

While new and existing home sales have slowed, construction has continued, creating an oversupply in the market. As house values fall, the so-called “wealth effect” is expected to evaporate, trimming consumer spending not only on housing related items, but in all non-essential sectors.

Since the U.S. is Canada’s largest export market, sagging consumer spending and slower GDP growth will have an impact north of the border. But the Canadian economy is generally in better shape, according to Drummond.

“Since Canada has neither the same degree of housing imbalances, nor as much tightness in monetary settings, it should fare slightly better than its U.S. counterpart,” he says.

Still, the TD Economics team is not predicting an outright recession in the U.S., with GDP growth remaining positive at around 2.3% through the 2006 and into 2007. That’s about 1% below its long-term trend rate. In Canada, the long term trend is lower at about 2.8% and the economy is expected to only slightly underperform.

“Virtually everything that matters in our forecast flows from two key assumptions,” Drummond says. “First, the U.S. experiences an economic slowdown; second, the economic weakness proves to be mild and relatively short-lived.”

So far, both central banks have managed to stave off inflation by raising rates in anticipation, rather than in reaction, to rising inflation. This gives both the Bank of Canada and the Fed room to cut rates rapidly should the respective economies hit a soft patch.

Given the prediction that there will be no spike in interest rates, there should also be little harm to the heavily-indebted consumer and spending should only moderate, rather than fall off a cliff. Strong corporate balance sheets should help to sustain businesses through the rough spots and employment is expected to remain strong.

While the above is considered most likely, the bank assigns only a 40% likelihood to this scenario. There is a 30% chance the next 12 to 24 months could be much better, with an equal chance that it will be worse.

“There’s a 30% chance that the U.S. economy will plow through its vulnerabilities and expand at a 3.5% annual rate, similar to the performance in recent years,” Drummond says. “This, in turn, would provide support for major trading partners, especially Canada.

“But, there is an equal 30% probability that the U.S. economic weakness will be longer and deeper, gravely impacting Canada.”

One of the greatest dangers facing the American economy is that the housing market will not gently plateau or slide gracefully lower, but will instead suffer a hard landing. Drummond assigns only a 15% chance of this happening, but the crater caused by this impact would probably plunge the U.S. into recession. The Canadian economy would struggle, but likely still grow at about 1 to 1.5%.

TD assigns a 10% chance to an intense energy shock, but points out that as a net exporter, Canada as a whole would fare much better than many industrial economies. Still, growth would be concentrated in the oil patch economies of the western provinces and Newfoundland. Manufacturing economies like Ontario and Quebec, on the other hand, would suffer the consequences of higher input costs, softer demand and the competitive constraints of a strong petro-dollar.

The least likely problems, with a 5% likelihood, are that the U.S struggles with its current account deficit or that a global flu pandemic strikes.

“The Canadian economy looks to be fundamentally healthy, but befitting of our status as a relatively small, open economy, the driving force over the next year or so will be from developments abroad” Drummond says.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com


Steven Lamb