A report published recently by TD Economics states the Canadian economy is already showing signs of distress from the U.S. economic downturn, and will continue to feel its affect throughout 2008 and 2009.
Specifically, Canada has direct exposure to the U.S. housing fiasco via the spillover of tightened credit conditions, and faces collateral damage to the export sector from a stagnating U.S. economy. Fortunately, this is occurring in an otherwise healthy domestic demand environment.

Highlights:
 - Canadian real GDP to post 1.0% gain in 2008, underperforming U.S. growth of 1.4%.
 - Multitude of shocks hitting the U.S. economy leaves forecasters divided on the 2009 outlook.
 - TD Economics is more aligned with pessimistic camp on U.S. outlook, expecting meager 1.2% growth in 2009.
 - Canadian forecasters are in greater agreement with 2009 predictions. Most project reasonably solid domestic performances, so differences in forecasts are generally contained to that portion of the economy directly exposed to the United States - credit tightening and export demand.
 - Canadian economy should post modest 1.8% recovery in 2009, giving Canada the upper hand relative to the U.S. economic performance.

According to Chief Economist, Don Drummond, "Canadians would be best advised to buckle up for the ride." The path of the Canadian economy will be greatly influenced by how the shocks surrounding oil, the credit crunch and the plunging housing market evolve in the United States. TD Economics believes the U.S. economy will not experience the snap-back that typically follows an economic downturn. Rather, the number and severity of the shocks occurring simultaneously in the economy argue for an extended period of economic weakness.

Credit crunch to financial munch
The greatest forecasting uncertainty centres around the credit crunch, for which there is little historical precedence. TD Economics believes the impact from tight credit conditions will linger on the U.S. economy, and weigh down investment and consumer spending intentions through 2009.
"When financial firms pay more or profit less in their lending activity, the knock-on effects to non-financial firms and consumers can be quite long lasting. The combination of rising lending rates, tightening credit conditions and a dwindling share of internal funds available for investment spells trouble," said Drummond. Credit problems of today can act as a financial accelerator, whereby a shock is amplified or becomes long lasting by restricting firms through swings in their balance sheets and spending intentions.

U.S. consumers face a full frontal assault
Mounting job losses will put downward pressure on household income in the year to come. Meanwhile, record deterioration in home prices alongside record oil and gasoline prices makes for a less inviting environment for consumer spending, especially now that the Federal Reserve is showing reluctance to provide any additional monetary stimulus due to inflationary pressures.
    
"Our belief is that instead of getting the traditional pent-up demand pop in consumer spending that typically follows a downturn, we will see a muted pace of spending through the end of 2009. The non-traditional number and magnitude of economic shocks assaulting the consumer don't suggest a traditional recovery," said Drummond.
   
The U.S. government will be sending out $117 billion in rebate cheques, which will boost real consumer spending by $60-70 billion annualized in each of the second and third quarters. However, this is a one-time impact. Once the cheques are spent, consumer spending will drop back to the status quo level, which means a negative quarter. The short-lived tax rebate won't change the view that annual growth in real personal income less government transfers will still be treading water at -0.4% by the final quarter of this year and remaining in the red through the first quarter of 2009.

Canada to be pulled along with the ride
Canadian exporters will continue to feel the pain from the lingering U.S. economic weakness. Real GDP will expand at a 1.0% pace in 2008 and a 1.8% pace in 2009. Both of these estimates are at the low end of consensus estimates because of a more pessimistic U.S. outlook, and hence greater secondary effects to the Canadian market. Meanwhile, domestic demand growth will gear down in response to the tighter credit conditions and a softer job market.

Specifically, like the U.S., the cost of funding has risen dramatically.
The Libor-OIS spread was blown out for Canadian banks following the credit turmoil that began last August. The wound has been healing, but slowly. The spread remained high at 20-40 basis points in June compared to a low and steady 3-5 basis point range in prior years. A sharp increase in medium-to-longer term funding costs has caused a tightening in credit conditions on this side of the border, which will have knock-on effects to investment and spending.
 
However, Drummond noted one critical distinction between Canada and the United States: "Canadians households have one good leg to stand on. They will not have to face deterioration in real estate wealth or a sharp slowdown in income growth. The same cannot be said of their American counterparts."

In particular, Canadian employers continue to churn out new job opportunities, providing a solid foundation beneath income growth. With five months of employment data already on the books, the die has largely been cast on this front. Employers have been averaging 24,000 new workers per month, with hourly wage growth of permanent employees averaging 4.6% - the highest on record since 1997. With inflation holding below 2%, workers have had the benefit of a tidy real wage gain. Even with the expectation for softer job creation in Canada going forward (averaging about 5,000 positions per month), it will merely serve to restore wage growth to historical norms. As such, consumer spending should prove more resilient in Canada, averaging a quarterly annualized pace of 2.7% over the forecast horizon.

Drummond also said that "Although inflationary pressures are the 'flavour of the month' worrying financial market participants, we see the continued weakness in the U.S. and Canada containing inflation pressures. Nevertheless, the next move by both central banks will be to hike rates, but only after along pause." The Bank of Canada and Federal Reserve are both expected to begin a tightening cycle in the second half of 2009.

TD Economics' Quarterly Economic Forecast can be found at
www.td.com/economics

What it means:

Buckle up for the ride? No kidding, just ask GM's and Magna workers soon to be laid off. And one can bet that this is just the beginning. A new US trend is also rearing its ugly head: According to the June 19th J.D. Power and Associates Powergram's,  "Surprisingly, the crowded compact CUV category, which includes the popular Honda CR-V, Ford Escape and Toyota RAV4, also saw a dip in average price that was lower than the industry's average price dip of 1.9%. Smaller CUVs sold in May for an average of $21,644 compared with $22,272 a year ago."
At a first glance, it may not appear to be significant, but think of it - it's the same process that started the demise of the SUV.

Inflation: Despite TD's optimism, the inflation seems to be a serious problem - just as Mr. Carney, BoC's governor. Of course, the issue is what is the real world inflation? The official numbers or the anecdotal evidence that suggests otherwise?  Even Statiscan's official numbers are now at 2.2% - Consumer Price Index in May rose to its sharpest monthly increase since January 1991.

Source: Statistics Canada 

Of note: May's Consumer Price Index was actually held by lower vehicle costs: "...The price to purchase and lease vehicles decline 8.1 percent between May, 2007 and May, 2008. The strong Canadian dollar and an increase in manufacturers' rebates on certain larger models of motor vehicles contributed to this increase", said Statistics Canada.