U.S. slowdown could affect Canada

(June 28, 2005) The Canadian economy should continue to perform well through 2005, but imbalances in the U.S. economy could take a toll north of the border in 2006, according to the latest forecast by TD Economics.

“A number of major imbalances have developed in the U.S. economy that are likely to come home to roost in 2006. And, given Canada’s heavy reliance on exports to the United States, any moderation in U.S. economic growth would weigh on Canada’s economic performance,” said Don Drummond, senior vice president and chief economist of TD Bank Financial Group.

Canadian growth is expected to pick up in the second half of this year, as manufacturers shrug off the remaining effects of the rapid appreciation of the Canadian dollar. Annualized growth for 2005 should total 3%. Despite this modest growth rate, the Bank of Canada is expected to raise interest rates again in the fall, as there appears to be very little spare capacity in either the job market or in plant utilization.

TD predicts full year growth rates of 2.8% for 2005 and 2.9% in 2006.

“If the U.S. and Canadian economies do weaken as we expect next year, there will no doubt be accusations that the Federal Reserve Board and the Bank of Canada should not have raised rates,” Drummond says. “But, given the nature of the shocks to the economies and the limited tools at their disposal, a more reasonable perspective is that the central banks will have handled things quite well.”

Among concerns south of the border, the report cites the usual suspect — high consumer indebtedness — along with “frothy” housing markets and high dependence on foreign savings.

On the other side of the scale, U.S. consumers and businesses still enjoy low borrowing costs and rising incomes, on both the household front and the corporate balance sheet. These factors are expected to maintain the current upward momentum for a few quarters to come, and TD predicts 3.5% annualized growth for the remainder of 2005. After that, the picture is less rosy.

The Federal Reserve is expected to continue tightening credit, drying up the excess cash supply and giving consumers pause before taking out another home equity loan. TD is calling for a “mid-cycle slowdown,” rather than a screeching halt and economic growth should still ring in at around 3.1% in 2006, despite a predicted dip to below 2.5% in the fall of next year.

“It should be stressed that this represents quite a mild slowdown by historical standards,” Drummond says. “However, given financial markets’ apparent dissatisfaction with the U.S. economy’s current tracking of 3.5% growth in the first half of this year, there is a real risk that they will not take the deceleration in stride.”

Drummond points out that the “recession” of 2001 turned out to be remarkably mild and short-lived and suggests that the rapid recovery since could indicate a trend that future business cycles will be “shorter and shallower” than in the past.

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