• The 0.3% decline in GDP in August dented July's strong 0.7% gain, making it likely that the economy expanded at a 1.5% annual rate in the third quarter, slower than our earlier forecast for a 2.5% increase.
  
• Employment in Canada rose 9,500 in October after the 107,000 surge in September. However, the strength was narrowly based in the public sector with a rise of 40,000 jobs that offset weakness within the private sector (private sector jobs fell by 20,000).
  
• Retail sales fell 0.3% in August in both nominal and real terms following gains of 0.6% and 0.1% in June and July, respectively. Sales excluding the volatile auto sales component for both new and used vehicles were also down 0.3%.
  
• 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.
  
• Net exports remained a significant drag on economic growth in the third quarter. The strong Canadian dollar and soft U.S. growth saw constant-dollar exports contract at a 4.4% annual rate while imports increased at a 1.1% annual rate.
  
• Consumer prices fell sharply by 1% in October with the year-over-year rate slipping to 2.6% from 3.4% in September, the largest monthly decline since June 1959. Going forward, weak growth will see the amount of slack in the economy grow, which will put additional downward pressure on prices.
  

Dawn Desjardins
dawn.desjardins@rbc.com

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Financial markets ...View full report (PDF)
Global initiatives piling up

• Global central banks and governments have been active in putting policies into place to combat the weakening in economic growth, supplementing aggressive cuts to policy rates by central banks as global players worked to weigh against the burgeoning global recession.
• While these measures have been aggressive, the reaction in financial markets has been positive, but muted. Still, there are some encouraging signs that the policy actions are getting some traction with global LIBOR rates coming off recent highs. Corporate bond spreads, however, remain sticky and there has not been a discernible increase in loan supply or demand.
• Equity markets are nervous and, although there are tentative signs of stability, it is too early yet to tell if the bottom has been reached.
• Co-ordinated efforts to cut policy rates are being followed up, with individual countries easing further as data confirm many economies have fallen into recession, including the Eurozone and the United Kingdom.

U.S. economy slips in the third quarter; bigger declines ahead

• The Fed has pushed the funds rate back to 1% and, even though policymakers left the door open to additional cuts, early signs that funding costs are easing may give the Fed the leeway to hold rates steady and concentrate on other easing initiatives.
• But, with financial markets still under stress, aggressive Fed easing will do little to mitigate the downside risks to the U.S. economy in the near-term.
• The U.S. recession likely started in the third quarter. We now expect the economy to contract at a 2% annualized rate in the fourth quarter, with another substantial decline likely in the first quarter of next year of slightly more than 1% at an annual rate. The peak-to-trough decline in U.S. GDP will be greater than in any other three-quarter period during the 1970s, 1980s and 1990s.
• We still hold the view that the eventual narrowing in credit spreads, combined with accommodative monetary policy, will result in a modest recovery in late 2009.

Canada’s economy gearing down and barely skirting recession

• Canada’s economy is slipping, too, and is barely skirting recession. We think that Canada’s economy will avoid following the United States into recession because the favourable terms of trade effect, while weakening, will still provide support to domestic demand and Canada’s financial stress has been more limited than in the United States, meaning that the toll on household and business will be less.
• We see slower growth in Canada later this year and into 2009 with the economy now expected to contract mildly in the fourth quarter and grow by less than one-half a percent in the first quarter of 2009 before picking up pace in the second half of next year.
• For this year overall, we are calling for a 0.7% increase in real GDP growth Canada’s economy and a modest acceleration to a 1% pace in 2009. The weak pace of growth and lower commodity prices have lessened concerns about inflation and we now forecast the inflation rate will average 2% next year.
• With the economy running at a sub-potential pace and inflation risks falling, the Bank of Canada will likely ease the policy rate again in December of this year to 2%.
  

Dawn Desjardins
dawn.desjardins@rbc.com

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• The dramatic worsening in financial markets starting in mid-September and the attendant credit tightening is expected to impede global growth for the remainder of this year and going into 2009.
• The U.S. economy is likely falling into recession and the U.K. and Eurozone economies are slipping.
• In response, central banks around the globe have been both pumping liquidity into the system and trying to shore up faltering financial institutions. The U.S. administration has passed an aggressive (US$700 billion) package to buy various distressed assets held by financial institutions — Troubled Asset Relief Plan (TARP).

U.S. economy headed for weaker second-half growth

• The U.S. economy was the second quarter’s growth leader, but momentum is fading fast as support from tax rebates wanes and the credit crisis takes its toll.
• Growth in the U.S. economy is expected to turn negative during the second half of this year, with declines continuing into the first quarter of 2009.
• TARP and other policy actions are expected to ease credit tightening, thus allowing positive growth to return during the last three quarters of next year.
• The U.S. housing market is showing signs of sales bottoming, although prices are declining at record rates.
• Consumers are hamstrung by falling net worth, high energy and food costs, and restrictive lending standards.
• Export growth has been a lifeline for the U.S. economy, but support will dwindle as trading partners flag and the U.S. dollar revives.
• Concerns about the high headline inflation rate are likely to dissipate as economic growth slows.

Canada's weak growth numbers mask firm domestic demand

• Canada’s weaker-than-expected overall GDP rate in the first half of 2008 masked continuing strong domestic demand.
• Early signs of moderating housing and labour demand have tempered the outlook for growth in second half but do not point to a recession ahead.
• However, the trade sector will continue to constrain GDP growth in the second half of 2008 as a result of the expected greater weakness in the U.S. economy.
• The first half’s disappointing growth performance, weakness in the U.S. economy and tight credit are generating clear downside risks to the economic outlook.
• Canada’s headline inflation rate doubled between April and August, but the core rate remained in the lower end of the Bank of Canada’s target band.
• The Canadian dollar is likely to remain range-bound for the remainder of this year before depreciating next year.

Paul Ferley
paul.ferley@rbc.com

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The recent dramatic turn for the worse in the year-long financial market crisis has clearly darkened the outlook for the provinces. The U.S. economy appears to have succumbed to a recession, with Europe, the United Kingdom and Japan also sinking fast. While Canada is in a better position with its financial sector less heavily impaired, overall economic growth will be substantially weaker than previously anticipated. This fast-deteriorating context will necessarily affect the economic performance of the provinces in the period ahead. Central Canada is quite possibly the most at risk given its close dependence on dwindling U.S. demand, although a negative impact will be felt across the board. Fortunately, some provinces — e.g., Saskatchewan, Manitoba, New Brunswick — will be able to count on other positive factors that are expected to provide powerful offsets.

Our forecasts are based on the assumption that the historic actions being taken by central banks and governments around the world will ultimately be successful in restoring investor confidence and bringing some normalcy to financial markets. The weight on global economic activity will, thus, be gradually lifted, setting the stage for a recovery during the latter part of 2009.

• With its economy firing on most cylinders, Saskatchewan is leading the way this year and we expect it to remain at the front of the pack in 2009. Manitoba will be close behind. Both provinces are riding the wave provided by the strong demand and prices for their key commodities.
• The boom in commodities and the attendant rise in capital investment are also fuelling growth in most of Atlantic Canada. Positive repercussions are being felt in the labour markets, migration flows, consumer spending and the housing sector, particularly in the case of Newfoundland & Labrador. The region’s economy should continue to display resilience against the unsettling turmoil raging elsewhere and sustain a moderate pace of expansion — except Newfoundland & Labrador this year where flat crude oil production will temporarily halt economic growth.
• Conditions in the most western part of the country are much less encouraging, at least compared to earlier expectations. While strong capital expenditures still form a solid base for economic activity, clear signs of cooling have emerged in other sectors. Eroding housing situations and rapidly slowing growth in consumer spending have prompted us to revise our growth forecasts for British Columbia and Alberta lower.
• As weak external trade continues to exert a toll on the economies of Ontario and Quebec, cracks are now showing in their domestic foundations. A softening in job creation, consumer spending and housing activity will have a notable slowing effect in these provinces. As the province most vulnerable to the U.S. vortex, Ontario will likely see its growth evaporate. In Quebec, strong capital investment (led by public infrastructure spending) should help the economy stay above water.

Robert Hogue
robert.hogue@rbc.com

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Canada’s housing market is showing signs of coming off the boil after a period of unprecedented strength when resale home sales hit record highs, prices racked up double-digit gains and housing starts ran at a faster than 200,000-unit pace for six consecutive years. Recent reports showing that sales and prices are starting to slow have raised concerns that Canada’s housing market boom is set to bust, mirroring the slump in the United States. To be sure, conditions are softening, but there continue to be many factors that point to Canada’s housing market avoiding a U.S.-style crash landing.

Low speculative and sub-prime exposure leaves Canada in good shape
From a structural perspective, conditions in Canada’s housing market are markedly different from the U.S. market, with very limited sub-prime mortgage activity, a relatively small speculative sector and no significant supply overhang despite the robust construction activity. Additionally, affordability is forecast to improve this year with the Bank of Canada having cut the overnight rate by 150 basis points since December, mortgage rate spreads showing some signs of narrowing and the pace of house price gains slowing.

More conservative lending practices stand Canadian banks in good stead
Canada engaged in much more conservative lending practices during this past cycle compared to the United States. Mortgage credit was extended, on average, to more capable buyers, leaving household balance sheets in good shape with mortgage quality strong and delinquency rates well below past cyclical peaks. The sub-prime mortgage market in Canada accounts for about 5% of outstanding mortgages, while in the United States, sub-prime mortgages account for roughly 14% of the outstanding mortgage market. Speculative investing is also much tamer in Canada. Investor-owned mortgages account for roughly 2% of all mortgages in Canada compared to about 10% in the United States and the United Kingdom.

Outlook this year
Current conditions in Canada’s housing market point to a year of slower activity, although both starts and sales are likely to remain elevated by historical standards. Price gains are likely to slow but, with market conditions having shifted away from a seller’s market and into balance, we anticipate gains to average in the low single-digits, a far cry from the double-digit decline posted in the United States.

Dawn Desjardins
dawn.desjardins@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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