• Slower GDP growth in October and November is consistent with our forecast for a 2.5% annualized decline in fourth-quarter GDP – the sharpest quarterly contraction since the 1991 recession. The weakening tone in the fourth-quarter data points to the economy having slipped into recession in late 2008.
  
• Employment dropped abruptly by 70,600 in November after a net increase of 117,000 jobs during the past two months. This was the sharpest monthly employment decline since June 1982 and is consistent with an economy that is gearing down after a modest acceleration in growth in the third quarter.
  
• Weak retail sales in October, the decline in employment in November and the likely sharp drop in U.S. economic activity support our view that the Canadian economy will likely decline 2.5% in the fourth quarter, thus marking the entry point into recession for the Canadian economy.
  
• Housing starts resumed a downward trend in October, dropping 3.1% in the month to an annualized 211,800. So far this year, housing starts are down a modest 4.7% from the same period last year. This is in stark contrast to the United States where starts are down 29.8% in the first nine months of this year compared to year-ago levels.
  
• The merchandise trade surplus came in at C$3.8 billion in October. The narrowing in the October current dollar surplus reflected increases in both exports and imports, which rose 2.5% and 4.1%, respectively. However, a sharp drop in constant dollar imports (3.6%) in October outpaced the decline in export volumes (1.6%), thus reducing the size of Canada's real trade deficit.
  
• The downward movement in the topline inflation rate has fallen to 2% from the recent high of 3.5% in August due to tumbling energy prices. With the economy slipping into recession, we expect the downward pressure on prices to fan out.
  

Dawn Desjardins
dawn.desjardins@rbc.com

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Financial markets ...View full report (PDF)
Financial market crisis shows limited signs of abating

The financial market crisis showed limited signs of abating in November, with Canada’s stock market dropping about 5% and the U.S. benchmark S&P off 7.5%. Commodity prices swooned and credit spreads remained wide. Investors continued to run for cover, buying safer government bonds — the U.S. Treasury market posted a huge 5.4% total return and Government of Canada bonds rallied. Yields on government securities fell to the lowest level on record. LIBOR rates continued to move cautiously lower but are still elevated compared to official policy rates as the sting from the Lehman Brothers’ bankruptcy keeps financial institutions worried that one of their counterparties could suffer a similar fate. The relatively high level of interbank funding rates is preventing borrowing rates from falling. For the economy, the spinoff continues to be that businesses and households face both a high cost for capital and limited access to funds, which is hampering spending activity and resulting in recessions in both Canada and the United States.

U.S. recession deepens

• The U.S. economy is falling deeply into recession. Real GDP is expected to contract at much faster pace in the fourth quarter and the likelihood is growing that these recessionary conditions will persist through the first half of 2009. We now project the U.S. recession to run from the third quarter of 2008 to the middle of 2009, resulting in real GDP falling by 1% on average next year following this year’s tepid 1.3% growth rate.
• As the economic news worsens and commodity prices slide, worries about a steady rise in the headline inflation rate have quickly switched to concerns about a generalized decline in prices. We expect the U.S. headline inflation rate to continue to fall in 2009 partly due to the rapid drop in energy prices, but also reflecting a steady slide in core prices.
• The prospect that the economy will remain in a recession in the first half of next year is likely to see the Federal Reserve keep priming the pump through an additional interest rate reduction. We anticipate that the Fed will cut the policy rate by another 50 basis points to 0.50% on December 16 and to hold the policy rate at this level throughout next year.

Canada on course for recession

• Canada, while somewhat insulated by a solid financial system, now faces a number of negative factors. With commodity prices slumping, the positive growth momentum in Canada’s domestic economy will be challenged by an erosion in the terms of trade that will dampen income growth next year and the recent widening in spreads and tightening in lending standards argue for slower household spending and a cut in business investment.
• As a result, we now expect Canada’s economy to contract in both the fourth quarter of 2008 and first quarter of 2009. On average, Canada’s economy is still expected to eke out mild growth next year of 0.3%, half the pace of this year’s estimated 0.6% increase and much slower than the 2.7% pace of 2007.
• We expect price pressures to continue to ease; the headline inflation rate is forecast to average 1.2% in 2009, one-half the estimated 2008 rate. The Bank of Canada’s core inflation rate, which did not climb alongside the headline measure in 2008, is expected to hold steady at 1.6%.

Dawn Desjardins
dawn.desjardins@rbc.com

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• The dramatic worsening in financial markets since mid-September and the attendant credit tightening are expected to impede global growth from the remainder of this year and going into 2009.
• Commodity prices dive.
• Inflation concerns recede as worries about health of the global economy dominate outlook.
• Central banks aggressively ease monetary policy.
• Fiscal stimulus packages from around the globe have been announced with more on the way.
• Tentative signs that illiquidity in some financial market strains are starting to ease.
• Investor confidence in tatters.

U.S. economy slipping off the brink

• U.S. recession deepening.
• Fed and U.S. government aggressively responding to crisis.
• Fed cuts funds rate to lowest level on record with quantitative easing to increasingly provide more of the stimulus.

A rocky road for Canada

• U.S. downturn and high cost of capital to lead to Canadian recession.
• Slowdown in Canada to be less severe compared to other countries.
• Inflation rate to fall temporarily below Bank of Canada’s lower limit of 1%.
• Overnight rate cut to 50-year low and policy expected to remain accommodative throughout 2009.
• Eventual easing in credit spreads to support recovery late next year.

Paul Ferley
paul.ferley@rbc.com

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The two months since our last provincial outlook have been very turbulent. With the unrelenting financial crisis sustaining tremendous stress in global markets, damage to the “real economy” has mounted, prompting further unprecedented actions by governments and central banks around the world. Events in the past two months have been disappointing; we had expected financial conditions to show clear signs of healing and the weight of the crisis on the North American and other world economies to lighten. The persistence of the financial market maelstrom means that the economic downturn will undoubtedly be more severe than we previously thought, with the United States now in the throes of a fairly deep recession and Canada no longer able to avoid a short period of contraction. This bleaker context will have widespread negative implications for provincial economies. Performance is now expected to be weaker from coast to coast and, thus, we have revised growth forecasts lower for all provinces.

• Directly in the storm’s trajectory and already facing serious challenges, Ontario is expected to be hit the hardest. The province’s economy is forecast to contract in both 2008 and 2009 for the first time since 1990-91. Given tremendous uncertainty about the fate of key players in its auto industry, downside risks will remain elevated.
• Newfoundland & Labrador is also projected to contract slightly, although this will stem more from a drop in oil production unrelated to market conditions than as a consequence of the global crisis.
• While still carrying some forward momentum entering 2009, Quebec’s economy is nonetheless about to gear down. Significant weakness in the economies of its principal trading partners and the unsettling impact of the global crisis on consumer and business confidence are expected to completely offset the positive contribution of increased spending on infrastructure projects, causing Quebec’s real GDP growth to evaporate in 2009.
• The chill that has brought significant discomfort to British Columbia’s external trade sector during the past two years is making its way into the domestic economy, slowing real GDP growth to 0.6% in 2009 from 0.8% in 2008. Activity in the province should get a meaningful boost in 2010, however, when the world gathers in Vancouver for the 2010 Winter Games.
• A fair amount of steam is seeping out of Alberta’s economic engine as cracks appear in the province’s energy, housing and consumer spending sectors. Nonetheless, at a downwardly revised 2.1% next year, the province’s real GDP growth will remain among the fastest in the country.
• While not entirely immune to the global downturn, the economies of Saskatchewan and Manitoba will continue to carry substantial momentum during 2009. Saskatchewan is still projected to lead all provinces and Manitoba should remain in the top tier. Both provinces are still riding the wave created by the strong demand and prices that prevailed until recently for their key commodities.
• Completion of major capital projects and delays in the construction of new ones will weigh on New Brunswick’s and Nova Scotia’s economic performance, although growth is forecast to remain positive in both provinces in 2009.
  

Robert Hogue
robert.hogue@rbc.com

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• Canadians have watched with amazement for nearly two years now at the collapse of the housing sector in the United States, the United Kingdom and other countries that experienced overvalued housing prices with the sense that markets in this country stand on much more solid ground. After all, the sub-prime business never represented more than a marginal phenomenon here; Canadian households, while carrying heavier debt loads than in the past, were not financially overstretched; Canadian banks emerged islands of stability amid the global financial storm; incomes remained well supported by steady job creation and a strong domestic economy; and the influence of speculation — especially on new construction — was deemed to be subdued.
• Then, late in 2007, red-hot Alberta markets began to slide, followed earlier this year by British Columbia’s markets. Most recently, Saskatchewan, last year’s hotspot, and areas in Ontario joined the weakening trend. All of a sudden, Canada no longer appeared immune to a generalized housing downturn. In fact, the souring of economic conditions, eroding consumer confidence and, in some instances, past excesses are creating a downdraft that the majority of Canada’s housing markets will be hard-pressed to resist.
• As a sluggish economy threatens income growth and makes households much more skittish about major financial commitments, issues of affordability are coming to the fore. Much of the market correction taking place in British Columbia, Alberta and, now, parts of Saskatchewan can be traced to very poor affordability levels in those provinces.
• However, high home ownership costs are not unique to western Canada. RBC’s affordability measures lie above long-run averages in all provinces and across all housing segments, which suggests that the downdraft will be felt widely.
• Still, the extent of “unaffordability” varies substantially by province, with measures running as high as 48% above average in the B.C. standard townhouse segment and as low as 6% above average in the Quebec detached bungalow segment. Overall, British Columbia, Saskatchewan and Alberta remain the least affordable markets in Canada (relative to their respective historical norms).
• While the Canadian housing sector is undoubtedly entering a cyclical downturn, the risk of experiencing a U.S.-style meltdown is remote. The supportive factors mentioned above are still mostly in play and should provide enough backing to prevent markets from spiraling down even as the Canadian economy slips into recession.
  

Robert Hogue
robert.hogue@rbc.com

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• Technological advances, globalization, the lessening of regulation and the high Canadian dollar have upped the ante for small businesses in a wide spectrum of industries during the past decade. These factors have exerted increasing pressure on small businesses to take steps to become more competitive - including combining with other organizations.
• Consolidation in the manufacturing sector has led to a generalized loss of small businesses. However, there is evidence that average firm size has grown in the majority of industries. A similar “bulking up” of firms is also found in sectors outside manufacturing.
• Small businesses in sectors directly exposed to foreign exchange, such as tourism, have been most affected. Suppliers of goods or services to larger, export-dependent organizations also felt the effects, but to a lesser extent, of the sharp appreciation in the Canadian dollar.
• Within the broad small-firm category, there appears to be a shift in composition towards larger organizations, suggesting that many “micro” businesses are taking steps to scale up their operations in the face of increasing challenges. Only the hardest-hit manufacturing industries, such as textiles and clothing, fail to show a gain in average firm size.
• While consolidation in the manufacturing sector has led to a loss of small businesses, there is evidence that average firm size has grown in most manufacturing industries. Through the challenging markets of the past several years, the decline in the number of small manufacturing firms might actually be a positive sign if it reflects a movement towards them becoming larger in size. Larger firms tend to be in better position to make the investments necessary to become or remain globally competitive.
• Whether this size expansion is a result of smaller firms becoming bigger, or larger firms gaining heft, or both, we see this as positive news for our economy. Productivity performance tends to get stronger the larger the size of enterprises.
• Looking ahead, the slower growth trend in the number of small firms is likely to persist as the “soft patch” in the economy dampens opportunities for new business formation in the near-term and the forces of consolidation and restructuring restrain any pick-up in the pace once economic activity re-accelerates. Similarly, the increase in average firm size is likely to continue.
• While definitive judgment will await the availability of more comprehensive data, the evidence to date is encouraging. Signs of small businesses in Canada gaining heft across the spectrum of industries underscore important, positive structural adjustments taking place in our economy, enhancing its longer-run prospects.

Robert Hogue
robert.hogue@rbc.com

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