The lethal combination of weak U.S. demand, a high Canadian dollar and tighter credit conditions will continue to put downward pressure on the domestic economy this year, said TD Economics in its quarterly forecast released today.

“The U.S. troubles will continue to wash onto Canadian shores in very visible ways, contributing to modest 1.1% economic growth in 2008,” wrote Beata Caranci, TD’s director of economic forecasting.

The report notes that a rigid credit environment will stall investment by raising the cost of funding and restricting investment for some Canadian companies. Caranci predicts export growth will contract outright in the first half of 2008, due to a lack of demand from the U.S. and the strong loonie.

This will also ramp up the east-west divide among the provinces, the report notes, as the weakness in the trade sector will hit Ontario the hardest, while Saskatchewan will outperform national growth by nearly threefold, buoyed by its commodities exports.

“Since the U.S. recession is consumer-led, related shipments will be hardest hit within the provinces, particularly auto and forestry products,” said TD’s chief economist Don Drummond. This explains TD’s expectation that Ontario will only eke out 0.5% growth in 2008, its worst showing since 1992.

According to the bank’s quarterly report, domestic spending levels are holding strong, but it is “unreasonable” to expect them to be completely immune pressures on provincial export sectors. Unemployment rates are expected to increase slightly by the second quarter in eastern and central regions, leading to consumers spending less on goods and real estate.

As far as goods shipping out of the country, energy, agriculture and other non-forestry exports are scheduled to hold up reasonably well for the year, said the bank.

The problem at the center of the weakness, namely the struggling U.S. economy, will sink into recession this year, the bank now forecasts. “We believe the history books will log 2008 as a recessionary year for the U.S. economy,” the report reads. “Canada will only narrowly miss entering into a recession itself.”

Until recently, TD said, economic data indicated that the U.S. economy could conceivably squeak by the recession hole without falling in, but the bank has changed it’s tune in light of broad-based job losses since January. The 6-month annualized change in private sector employment dropped to 0.1% and the bank said this has never happened without a recession following.

Adding fuel to the fire is the fact that home prices have fallen for an unprecedented 18 months and high inventories mean this likely won’t change soon. In 2007, the amount of equity that Americans had in the homes they owned sank below 50% for the first time since the Second World War. “This presents several threats to the economy and consumer spending,” said Drummond. “Among them is the rise of the so-called ‘mortgage walker’ who can afford their payments but decides not to pay.” This action would increase loan losses among financial institutions, he added, which would lead to more cautious lending behaviour.

TD’s positive outlook for 2009 tempers all these grim forecasts a little. “The adjustment underway in the U.S. is a necessary evil that will allow lenders and homeowners to work through oversupply, stagnating home prices, and the excesses of past lax lending standards,” said Drummond. “This will lead to fewer restraints in consumer spending and lending behaviour.”

Here at home Drummond emphasizes that Canadian economic woes are minor relative to those in the U.S. Pointing to a thriving housing markets, strong income growth and the already-visible affects of past fiscal stimulus. “These factors won’t come apart at the seams in 2008, especially when an additional 150 basis points in monetary stimulus of central bank cuts is added into the equation,” reads the bank’s forecast. “As such, Canada remains fundamentally sounder than the U.S.”

But of course, there’s always the chance things could go awry. The bank’s positive outlook for 2009 is contingent on more stable—if not necessarily perfect—growth in the last half of that year. Without this the U.S. could suffer from a “double-dip recession” when the effects of fiscal stimulus dissipates. This worst-case scenario, according to the bank, would probably make Ontario “unlikely to withstand the recessionary pressures from the U.S. without falling into the same predicament in 2008 and 2009.”