TORONTO, July 21 /CNW/ - Big doses of monetary and fiscal stimulus,
widespread official actions to contain mortgage defaults and unprecedented
injections of term liquidity by the Federal Reserve have had some success in
mitigating the heavy negative fallout from the sub-prime crisis, according to
Scotia Economics' latest flagship report, Global Outlook, entitled A Long and
Winding Road to Recovery. Despite a severe retrenchment in housing activity
and motor vehicle sales, the U.S. economy managed to stay on a modest growth
path during the first half of 2008.
    "Without another injection of fiscal and/or monetary stimulus, however,
recent economic resilience will likely give way to a broad-based weakening in
U.S. conditions by year-end," said Warren Jestin, Scotiabank's Chief
Economist. "The temporary palliative to consumer spending provided by
Washington's flood of tax rebate cheques will be followed by a relapse in
sales once this fiscal stimulus recedes."
    Adding yet another layer to this year's unprecedented fiscal boost may
forestall or even avert an outright double dip, but at the cost of catapulting
the federal deficit in FY2009 towards a new record above US$500 billion,
equivalent to 3.5 per cent of Gross Domestic Product (GDP). Further monetary
easing -- by lowering financial sector borrowing costs and by adding liquidity
to encourage lenders to make private credit cheaper and more available -- also
may help to prevent outright recession. However, such additional fiscal and
monetary measures will not resolve the structural imbalances underlying tight
credit conditions, depressed housing activity, domestic profit pressures, weak
equity markets, high energy costs and reduced growth momentum abroad.
    "These home-grown and global challenges point to lingering lethargy in
U.S. domestic demand," added Mr. Jestin. "Bottom line, we expect U.S. growth
in 2009 to be even weaker than this year's paltry 1.5 per cent advance."
    The report states that double-digit export gains and robust business
investment have helped to cushion the impact of weakening consumer spending on
U.S. growth, but these factors are likely to become less supportive. While the
depreciation of the U.S. dollar has boosted competitiveness, foreign sales
will be tempered as growth in Europe and Japan recedes further in 2009 from
this year's already lacklustre pace. The squeeze on corporate earnings from
rising input costs and slumping U.S. sales also will work to dampen domestic
investment at a time when buoyant offshore earnings provide a strong incentive
to divert strategic capital spending to rapidly growing nations in Asia, Latin
America and Eastern Europe."
    "While the pathways to prolonged economic lethargy vary across countries,
growth is unlikely to reach 1.5 per cent in Japan through 2008-2009 and is
expected to fall to this level in the U.K. and Europe over the next year,"
said Mr. Jestin. "The sudden shift from credit expansion to credit crunch,
widespread layoffs in financial services and the unwinding of excesses in real
estate activity are rooted in structural imbalances that will take years, not
months, to resolve. As in the United States, weak employment and output growth
will aggravate European and Japanese fiscal deficits."
    The report adds that weakening domestic demand in the major developed
nations will temper the pace of expansion in China, India, Russia, Brazil and
other emerging powerhouses. However, some offset will be provided as
hard-pressed North American and European households and cost-pressured
businesses search out and substitute lower-priced imports.
    As a result, the great divide in performance between the traditional and
emerging nations may actually widen as global growth recedes. China has
expanded at more than four times the average G7 pace over the past half
decade, but even if growth there drops by two percentage points towards nine
per cent next year, the growth multiple will jump to 6:1. Growth rates in
India and Russia are expected to be at least four times the average for G7
nations and a similar, though a somewhat more subdued, degree of
outperformance is expected for many nations in Latin America and Eastern
Europe.

    Canadian Outlook

    Canadian growth is being dragged down by weakening U.S. demand, the
loonie's return to parity and exceptionally high oil and natural gas prices.
While these factors have clouded prospects for many manufacturing and globally
focused industries such as tourism, the auto sector has been at the epicentre
of the adjustment.
    "The difficult ongoing adjustments in Canadian manufacturing must be kept
in perspective. Since the start of the decade, domestic manufacturing
employment has fallen by 11 per cent, only half the 22 per cent decline in the
United States," said Mr. Jestin. "In the euro zone, manufacturing employment
has dropped by close to 25 per cent since 1990."
    The report states that the loss in Canadian manufacturing exports has
been cushioned by a big run-up in commodity receipts, which now represent more
than half of the value of merchandise exports. Over the past year, Canada's
trade surplus in commodities totaled $117 billion, roughly one and a half
times the combined deficits in other trade categories. The dramatic rise in
commodity sales also has coincided with a diminution in Canada's reliance on
U.S. markets, which this year will absorb roughly 77 per cent of Canadian
exports compared with a peak of 84 per cent just over half a decade ago.
    Unlike U.S. households that increasingly relied on home equity
withdrawals to underwrite spending, Canadians have tended to build equity in
their homes over the past decade. The levering up of higher-risk households
that eventually precipitated the sub-prime mortgage crisis and credit crunch
was not replicated on this side of the border. While Canadian residential
construction is down about 10 per cent from the peak reached two years ago and
both sales and prices are likely to soften over the next year, residential
activity will continue to be much less of a drag on overall growth.
    "Canada's fortuitous position as a major commodity producer, its
strategic advantage in government finance and its legacy of household caution
with respect to leverage have helped to shelter domestic activity from the
gathering U.S. economic storm," said Mr. Jestin. "Canadian output growth will
probably not exceed the U.S. outcome in 2008, because inventory swings and
weather-related disruptions triggered a mild contraction on this side of the
border at the beginning of the year and massive fiscal stimulus is temporarily
levitating U.S. demand. Difficult adjustments in the auto sector also are
bound to impose a significant challenge in both countries."

    Financial Markets Outlook

    The juxtaposition of weakening demand in the United States, Europe and
Japan with multi-year highs in their headline consumer inflation rates
highlights the big influence emerging market demand for commodities is having
on global economic trends. While the inflationary impetus from commodities
should diminish in the months ahead, prices for many energy, industrial and
agricultural products will be supported by robust demand from powerhouses like
China, India, Russia and Brazil.
    "Looking ahead, sputtering European growth is expected to preempt further
European Central Bank (ECB) rate increases and will likely encourage the Bank
of England to cut rates by year-end," said Mr. Jestin. "In the United States,
risks to growth and financial market stability are expected to trump inflation
concerns, with the Fed once again adopting a bias towards lower rates over the
winter. With lower inflation on this side of the border, the housing market
entering a slump and export volumes weakening, the Bank of Canada will likely
follow suit."
    The Canadian dollar has been relatively stable in recent months, hovering
near parity against the U.S. dollar despite soaring commodity prices and a
high level of anxiety about U.S. economic and financial prospects. While the
loonie's glide path may be buffeted by slowing domestic and global growth in
the months ahead, Canada's enviable position as a resource-rich country in a
resource-short world and the associated revenues that support our twin trade
and fiscal surpluses are positive for the currency and point to further
appreciation. Against a background of U.S. dollar volatility and weakness, the
Canadian dollar is expected to have an appreciating bias and to average above
parity in 2009.
    The Global Outlook and other Scotia Economics publications are available
at www.scotiabank.com and on Bloomberg at SCOE.

    Scotia Economics provides clients with in-depth research into the factors
shaping the outlook for Canada and the global economy, including macroeconomic
developments, currency and capital market trends, commodity and industry
performance, as well as monetary, fiscal and public policy issues.