A sharp slowdown in the U.S. economy in 2007 is unlikely to drag the rest of the global economy down with it, although, Canada is expected to take a hit, says Merrill Lynch & Co. Inc. in a new report.

The firm’s economists expect U.S. GDP growth to slow to 1.9% in 2007 from 3.4% in 2006, but non-U.S. growth to decline by only half a percent (5.2% versus 5.7%). This decoupling is due to higher non-U.S. domestic demand, a rise in intra-regional trade and supportive macroeconomic policies in many of the world’s economies, it says.

Although some countries appear very vulnerable to a U.S. slowdown, one in five is actually on course for faster GDP growth in 2007, Merrill adds.

Asia, Japan and India appear well-placed to decouple from the U.S., though Taiwan, Hong Kong and Singapore are more likely to be impacted, it notes. European countries could feel the pinch, but rising domestic demand in the core countries should help the region weather the storm much better than in previous U.S. downturns. In the Americas, Canada will probably be hit, but Brazil is set to decouple, it predicts.

“The much-vaunted housing market correction, which has finally hit the U.S. economy, has the potential to pull the U.S. to the brink of recession by early 2007,” it says. “Judging by past experience, housing starts decline by 50% peak-to-trough and the correction lasts well over two years. This time around, the correction has the added twist that housing has become extremely overvalued – by 20% at least and perhaps as much as 40%. Merrill Lynch expects an outright decline in housing prices of about 5% next year.”

“The combination of the decline in home prices and the slowing in the growth of housing stock is expected to reduce housing wealth by more than U.S.$ 1 trillion in 2007. This, in turn, will likely mean that U.S. consumers will spend 1% less for most of next year and double that figure if house price falls are more severe,” it adds.

The only bright spot is business investment, which is set to be robust due to healthy profit margins, high productivity growth and strong corporate balance sheets, it says.

Japan appears better able to withstand a U.S. slowdown than any other country, Merrill suggests. “For the first time in over a decade, the country’s financial system is flush with capital, and banks are eager to lend to corporations and households alike. Japan’s export markets are far less reliant on the U.S. than they were in the 1990s, with 78% of its goods and services directed towards China and the rest of Asia,” it says. “In addition, managers are re-investing in their businesses for growth, which should sharply boost domestic demand. At the same time, Japanese companies are investing heavily in their workforce, forcing down the already low unemployment rate. Household consumption will probably be further boosted by low interest rates and a steady rate of income tax.

“The rest of Asia is more closely linked to the fortunes of the global economy. Taiwan and — to a lesser extent — Hong Kong and Singapore, could find it hard to escape the effects of a U.S. slowdown, it adds. “However, the relative robustness of the non-U.S. economy, coupled with supportive macroeconomic policies in the larger Asian countries, should help the region weather slower U.S. growth, especially if the U.S. capex cycle is resilient. Even China, where U.S. exports amount to 8% of GDP, could be resilient if its leaders opt for an aggressive policy response.”

Despite a strong historical correlation between the U.S. and the euro area’s business cycle, the region has a good chance of avoiding the worst effects of a U.S. slowdown, Merrill adds. “For one thing, the euro area’s GDP growth, though modest, is being driven by stronger domestic demand, not exports. Also, half of all exports are capital goods, which are expected to hold up more strongly than consumer goods. euro area GDP is set to slow from 2.6% to 2.1% during 2007, but this is because of the impact on domestic demand of tighter fiscal policy,” it says.

Slower U.S. growth would impact emerging markets in two ways, Merrill notes: through lower demand for EM products, and through weaker commodity prices and less abundant liquidity. “Mexico and Central America are the most sensitive to a U.S. slowdown and, if commodity prices fall, Venezuela, Chile and Ecuador would be hurt,” it says. “Brazil has a high chance of de-coupling from the U.S., due to its relatively low reliance on exports and its current account surplus.”

@page_break@In 2007, Merrill Lynch expects growth in supply for most major commodities to remain constrained and demand to expand further, albeit at a pace consistent with a deceleration in global economic activity to 4.4%, it says. “Inventories are still relatively low for some commodities, leaving only a limited cushion against unexpected changes in supply or demand. As a result, Merrill Lynch believes that commodity prices will stay high and volatile, providing a boost to commodity-exporting economies.”

Merrill Lynch economists expect a divergence in global interest rates. Japan and most European and Asian countries are expected to continue to raise interest rates. Australia, Canada and Britain are expected to keep rates steady. They expect the U.S. Federal Reserve to lower interest rates by 125 basis points in 2007.

“Broadly speaking Merrill Lynch would thus advise overweighting the fixed income markets of the U.S., Canada, Australia and Turkey and underweighting Japan, the euro area and Korea,” it says.