Outlook 2009 (Canada): Bad, but...

Canada's economy looks like it has slipped into recession, which we expect will continue in early 2009.

A difficult year lies ahead for Canada’s economy. Not only will exporters face soft demand as our largest trading partner struggles through a deep recession, but domestic demand will likely weaken as well. The financial market crisis has seriously damaged confidence. Consumers worry about their jobs and their savings. Financial institutions fret about the risks of lending to each other. Businesses face rising borrowing costs in debt markets, and are anxious that demand for their goods and services may dry up. Canada’s economy looks like it has slipped into recession, which we expect will continue in early 2009.

Growing incomes have been critical to Canada’s strong economic performance over the last six years; they supported consumer, business and government spending — the lifeblood of Canada’s strong economic performance in the face of deteriorating exports. The sharp decline in commodity prices from their summer peaks, however, means incomes will grow more slowly going forward. Because Canadian consumers also face rising debt-to-asset ratios and less access to credit, they will likely curtail their spending. Businesses are also likely to pare back investment. And residential construction activity will decline as Canada’s housing market experiences a cyclical downturn following six years of blockbuster sales.

While this all sounds gloomy, we believe the aggressive actions taken in recent months by the Bank of Canada, in conjunction with other global central banks and governments, will eventually ease pressures in credit markets. You can see some improvement by looking at the three-month London Interbank Offered Rate (LIBOR), the interest rate at which financial institutions lend money to each other. It fell by about 175 basis points from the recent high. Lower LIBOR rates mean that the cost of funding for financial institutions is easing, and that usually flows through borrowing rates throughout the economy. LIBOR needs to fall further, however, before the effect of the Bank of Canada’s 300 basis points of rate cuts is fully reflected in borrowing rates for households and businesses. Its recent decline is encouraging nonetheless, as it may signal that we have seen the worst for financial markets.

And there’s another piece of good news. “Terms of trade” measures the prices of Canadian exports relative to Canadian imports. While commodity prices (which comprise much of Canada’s exports) have declined from recent highs, they’re still running at about the average level of the past five years. Unlike during other downturns, we forecast that Canada’s favourable terms of trade will provide residual support for its economy.

The financial market storm came on quickly and ferociously. In contrast, the recovery will be slow and deliberate. We expect the LIBOR will continue easing in the months ahead, leading to lower borrowing costs. Lenders should make more capital available for loans. The prospect of a substantive fiscal stimulus package arriving early next year also suggests that Canada’s economic malaise will be relatively short-lived. Meanwhile, the Canadian dollar’s sharp depreciation augurs well for a pickup in Canadian exports once the U.S. gets on firmer footing. These developments will spur a moderate recovery in consumer and business investment in the second half of 2009 and pull Canada out of recession. Additionally, we look for commodity markets to stabilize and expect prices for energy products — a key export — to rebound modestly.

In sum, Canada’s economy is forecast to eke out a mild 0.3% gain in 2009. That’s even slower than this year’s tepid 0.6% increase. Even so, this weak showing would mark a solid accomplishment when compared to many other industrialized economies that are likely to contract next year. The U.S. economy, for example, is forecast to contract by 1% in 2009.

All things considered, we remain relatively optimistic. Several threats, though, can’t be ignored. Credit spreads might fail to narrow, or emerging economies could suffer a deeper downturn, keeping commodity prices under downward pressure. Either scenario would mean a longer, deeper recession for Canada next year.

Dawn Desjardins is assistant chief economist at RBC.