U.S. headed for a soft-landing: TD Bank

Canadian investors should brace themselves against the spin-off effects of an economic slowdown south of the border, according to the June issue of the TD Quarterly Economic Forecast.

“While high-flying energy prices and the lagged impact of Fed rate hikes will play a role in the U.S. economic slowdown, the main catalyst will be a cooling U.S. housing market and a diminution of the powerful real estate wealth effects that have been driving consumer spending in recent years,” says Don Drummond, senior vice president and chief economist of TD Bank Financial Group.

Drummond points to falling sales of both new and existing homes as well as rising inventories of unsold houses still on the market. Rising interest rates also dented mortgage refinancing, which could crimp consumer spending down the road.

After the Federal Reserve slashed interest rates to record lows, in response to the twin shocks of the bursting tech bubble and the September 11, 2001 attacks, consumers tapped into home equity to fund consumer purchases.

Drummond says falling demand in the housing market will erode the wealth-effect and could lead to “softer consumer spending, particularly on big-ticket and luxury items.”

The national average home price is not expected to collapse — in fact, the report predicts price growth will only slow or flatten, with the exception of certain overheated markets like California. But even a flat housing market could trim economic growth to just 2% for late 2006 and early 2007.

“The Fed may hike rates again in late June, but that should be the last rate increase and the central bank is likely to be easing policy by the end of 2006 and early 2007,” says Drummond.

Such a slowdown in the U.S. will inevitably have an impact on global growth, with Canada facing an exceptionally strong shock due to our economic reliance on the U.S.

On a global basis, an American slowdown could cut real economic growth from its current 4.6% rate to 4.0% in 2007. The TD report predicts that slower growth will diminish corporate profit growth and dampen investor appetite for equities.

“A slowdown in the world’s largest economy will impact commodity markets negatively,” says Drummond. “We think prices will pullback by 10% over the next twelve months, with the bulk of the adjustment coming from a more than 20% decline in prices for crude oil and base metals.”

Weaker global commodity prices and cooler U.S. demand will spell particular trouble for Canadian investors, who have been enjoying an incredible bull market focused in the materials sectors. The U.S. dollar is expected to soften in reaction to the anticipated moves by the Fed, which will hurt exporters of manufactured goods as well.

Canadian economic growth is expected to remain positive, but will likely fall from the 3.8% rate posted in the first quarter of this year, to 2.5% in the fourth quarter.

“Even with the expected correction in raw material prices, the high level of prices means that commodity-rich provinces will continue to experience robust economic growth, while central Canada will underperform the national average,” says Drummond.

He added the Bank of Canada’s tightening policy will be sidelined by the weaker economy in the near term and that the Bank likely will cut rates by early 2007. As a result, Canadian bonds are expected to rally in the second half, but underperform their American counterparts. Manufacturers may then see some relief as the Canadian dollar retreats to about 85 cents U.S.

“The main message is that consumers, businesses and investors should be braced for a period of economic and financial market volatility,” Drummond cautions. “However, the economic weakness is expected to pass relatively quickly.

“Equities may struggle as corporate profit slows, but remember that the stock market has a long history of being a leading economic indicator,” he added. “If the economies experience a soft landing, equities are likely to rally strongly in response to central bank rate cuts and once there is clear evidence that a hard landing will be avoided.”

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

(06/14/06)

Steven Lamb