Canadian economy on rough road

The U.S. slowdown has sunk its hooks into the Canadian economy, new economic data suggest. The question now is whether the high-flying commodities sector can keep the Canadian market afloat.

The weakening U.S. economy contributed to Canada’s economic growth taking an unexpected drop in the first quarter of 2008. The national growth rate is forecast to slow to 1.4% for 2008, according to the latest economic report from RBC.

“Going forward, Canada’s economy will continue to be hampered by flagging U.S. demand for exports, but domestic demand will more than offset the drag this year,” says Craig Wright, senior vice-president and chief economist, RBC. “The surprise economic contraction will be short-lived as growth prospects for the remainder of the year should brighten, with financial market pressures starting to ease, the U.S. economy getting a boost from the issuance of tax rebate cheques, and commodity prices remaining historically high.”

Commodities have been a rallying point for the Canadian economy since there is still pent-up demand in markets other than the U.S. Wright says there is still solid demand from emerging markets such as China. Over the past five years, Canada’s gross domestic income has outpaced gross domestic product by an average of 1.2 percentage points, also providing steady support for government revenues, corporate profits and the labour market.

High commodity prices are a dual-edged sword, however. Real GDP growth has been flat, largely as a result of high energy prices. Real GDP did rebound slightly in April, but a report from BMO Economics does not predict sustained growth.

“Indeed, the economy has managed to produce no growth, on net, over the past six months, as weak a stretch of activity as seen over the past decade,” writes Douglas Porter, deputy chief economist of BMO Capital Markets. “We continue to look for GDP growth of just under a 1% annual rate in Q2 following the small dip in Q1, and not much better in Q3. If anything, the risks for second-half growth in North America remain squarely tilted to the downside amid rampaging oil and gas prices.”

Regionally, the situation remains dire for central provinces heavily reliant on the U.S. market for exports.

A study released by BMO Economics Thursday showed that the Ontario economy is struggling against the undercurrent of a strong Canadian dollar, high energy costs and a U.S. downturn. Real GDP growth was a moderate 2.1% in 2007, but BMO expects that the manufacturing sector will likely drag down growth to 0.2% this year before rebounding in 2009. RBC expects economic growth in Canada to stick around 0.7% for 2008 — the weakest growth for the province since the last recession in the early 1990s.

By comparison, the Western and Atlantic provinces look strong since they are the country’s key commodity producers. But even there, cracks are starting to appear.

For example, BMO says Canadian housing market activity has cooled sharply in 2008, particularly in the formerly strong West. BMO says existing national home sales were down 13% year over year through May, with nine out of 10 provinces seeing sales below year-ago levels. The most pronounced declines have been in Alberta and B.C., with Saskatchewan also starting to lose momentum.

Consumer spending is also on the decline, according to a TD Economics report released on Wednesday. Canadian consumer spending has been buoyed by strong gains in employment and disposable income and by double-digit capital gains on financial and real-estate wealth. Consumer spending has been supported by low inflation, the strong dollar and improving terms-of-trade.

Although remaining relatively healthy, these factors are expected to decline, pointing toward weaker spending. TD expects commodity prices to continue to appreciate, but the report notes that gains over the past several years are “unlikely to be reversed, and the level of prices will continue to be supportive of a high level of national income.”

Maybe the most telling of how far things have fallen is the fact that even commodities can’t seem to sustain the S&P/TSX Composite Index from deflating. Despite record-high oil prices on Wednesday, the market still dropped more than 400 points.

“It wasn’t that long ago the TSX Composite Index hit new highs, but we’re seeing damage within that to stocks that are levered to the U.S. economy or to the health of the financial system itself,” Avery Shenfeld, senior economist with CIBC World Markets, told Advisor.ca in an interview. “The commodities aren’t the whole story for the equity market. In the near term, we may find it’s difficult to make headway while there are all these doubts about other sectors and the implications for them because of a U.S. slowdown.”

Shenfeld believes the Canadian markets can tread water long enough to avoid dropping into the bear market territory — defined as a 20% drop — that the Dow Jones Industrial Average and S&P 500 entered yesterday.

“There is enough weight in energy and materials and some randomly scattered stocks to offset the bruising some of the sectors exposed to the financial market turmoil and the U.S. slowdown are already feeling,” he says. “If you look within the TSX, there are certain sectors that are going to mimic what’s happened in the U.S. equity, even if there are some points of refuge within the markets as a whole that prevent the overall index from doing as poorly.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(07/03/08)

Mark Noble