Canada’s beleaguered export sector is putting the brakes on Canada’s economy. Domestic demand — spending by consumers, businesses and governments — remains strong, so only a few industries and communities are feeling the pain. Even on Main Street Ontario, which is in a recession, the pain is focused on areas with crumbling auto production.

In fact, this is a slowdown that’s easy to take. Unlike their U.S. counterparts, Canadian banks are still lending money, the housing market is healthy despite some cooling, and the unemployment rate in most regions is low by historical standards and expected to climb moderately higher.

Canada is also a major beneficiary of high oil and metal prices. Even if oil and metal export volumes decline, producers’ profits are high — and that translates into jobs and higher wages.

“Even though commodity prices have come down,” says Dawn Desjardins, assistant chief economist with Royal Bank of Canada in Toronto, “they are still elevated and provide a good boost to national income.”

That doesn’t mean Canada is out of the woods. It is still very dependent on the U.S., which has real problems. The subprime mortgage crisis is pulling down growth in consumer spending and has caused the collapse or near-collapse of major financial services institutions. (See page 8.) Only the U.S. export sector is buoyant. If the U.S. economy weakens further, Canada’s economy will inevitably be affected by dropping exports to its major market.

There are three main scenarios that could cause the U.S. economy to weaken further: the resumption of rising oil prices, a U.S.-dollar crisis and a significant retrenchment in U.S. consumer spending caused by a lack of confidence in the financial system.

It is the last possibility, of course, that has taken precedence recently, as once mighty Wall Street firms collapse. The markets, however, are obviously heartened by the U.S. government’s announcement, Desjardins says, of a US$400-billion rescue plan.

Clement Gignac, chief economist and chief strategist with National Bank Financial Ltd. in Montreal, is even more positive. “The balance of risks,” he says, “has turned positive for equities for the first time since the bursting of the U.S. housing bubble in 2005.”

In fact, most economists don’t expect any of those three scenarios to occur. They agree U.S. growth will pick up as U.S. banks gradually ease lending requirements and make more loans. But there is less agreement on how fast this will happen. Some think U.S. growth could reach an annualized rate of 2.5% as early as the second quarter of 2009, while others say it could take longer — in which case, it may be 2010 before healthy growth resumes.

What could be in store:

> The Optimists. Royal Bank forecasts that the U.S. will report growth of about 2.5% by late next year, with Canada growing a little faster. The bank is still finalizing its forecast numbers, but Desjardins suspects Canada’s real GDP will be about 2% for all of 2009, with the U.S. significantly slower earlier in the year.

Royal Bank economists assume oil prices will average US$90 a barrel in 2009. Because the Canadian dollar is a petrodollar and tends to follow oil prices, the C$ should come down to about US88¢ by the end of next year.

The optimists also expect slightly higher interest rates in 2009. As soon as central banks are sure their countries’ economies are not at risk of becoming weaker, they will move today’s historically low interest rate up to more normal levels. Desjardins believes the U.S. Federal Reserve Board will be sufficiently convinced that the U.S. is on its way to recovery by the third quarter of next year that it will raise the Fed funds rate by 75 basis points to 2.75% for the last half of the year. The Bank of Canada will raise rates in the first quarter of 2009, Desjardins says, but increase them by only 50 bps to 3.5% from 3%.

Neutral rates that should preclude higher inflation would be about 4%-5%.

The main driver of the recovery in the U.S. will be consumer spending. Desjardins expects very weak growth over the next six months, with spending growth bouncing back into the 2.5% range next fall.

Housing construction — which Royal Bank economists estimate will be 20% lower in 2008 vs 2007 — will pick up in 2009; but 2009 construction will still be down modestly from 2008 levels.

@page_break@In contrast, Royal Bank economists don’t expect growth in Canadian consumer spending to fall much below its current 3% pace; in the April-December 2009 period, they expect annualized growth of 3.3%-3.5%.

Housing construction in Canada is expected to remain relatively flat both this year and next.

For Canada, it’s the change from modest drops in export volumes this year to some growth in 2009 that will fuel our recovery.

Royal Bank economists expect little growth in Canada’s unemployment rate — to an average of about 6.5% in 2009 vs 6% in 2007. Over the same period, the U.S. jobless rate will jump to about 6% from 4.6%.

Conditions will vary across Canada. Royal Bank economists expect Ontario’s and Quebec’s economies to grow by less than 1% this year, while the Prairies’ economy will continue to grow at a healthy pace. New Brunswick and Nova Scotia are in the middle, with 2% growth. Prince Edward Island can expect growth of about 1%. Newfoundland and Labrador is expected to have a very weak number this year; that’s deceptive because the province had 9.1% growth in 2007.

All provinces should do better in 2009, say the optimists, and this is reflected in the relatively small increases in provincial jobless rates from 2007 to 2009. Indeed, Royal Bank economists are forecasting a drop in unemployment rates in Saskatchewan, Newfoundland and Nova Scotia, while Manitoba’s should remain unchanged. Even Ontario’s unemployment rate is expected only to edge higher, to about 7% from 6.4%.

In Ontario and Quebec, personal disposable income is expected to increase by about 5% both this year and next. The gain will be higher in the West and lower in the East.

> The Less Optimistic. Bank of Nova Scotia economists expect the U.S. economy to grow by only 1.7% this year and just 0.9% in 2009, while Canada’s economy will be up by 0.7% this year and by 1.4% in 2009.

Given such sluggish growth, Scotiabank economists think the Fed will need to lower the Fed funds rate to 1.5% from the current 2% in the first quarter of next year —and leave it there for the rest of the year. Scotiabank senior economist Adrienne Warren expects the BofC likewise will lower its rate to 2.75% in the fourth quarter and to 2.5% in the first quarter of 2009.

Warren thinks the U.S. jobless rate will average more than 6% next year but doesn’t expect much change in the Canadian unemployment rate. Indeed, her forecast of 6.5% unemployment for 2009 is similar to Royal Bank’s.

Warren expects consumer spending to increase by 2.2% in Canada next year and only 0.6% in the U.S. She also forecasts drops in residential construction of 2% and 5.5%, respectively.

On the export side, she assumes an increase of just 0.5% in Canada’s exports in 2009 and a rise of 4% in the U.S.

Oil prices are expected to average US$105-US$110 a barrel, which isn’t high enough to put economic recovery at risk and which will keep the C$ a little below par with the US$. In Warren’s view, it would take oil prices of US$150 to create a major risk of a serious and prolonged recession.

Scotiabank economists expect no growth in Ontario this year and just 0.8% growth in 2009; Quebec will be almost as weak, at 0.4% in 2008 and 1% in 2009. Their predictions are similar to Royal Bank’s, except for Newfoundland, which Scotiabank economists think will do better.

The weakness in manufacturing in Ontario, Warren notes, is being offset by increases in construction activity and consumer spending, which should put the rise in Ontario’s unemployment rate at 7.1% in 2008, not that much higher than 2007’s 6.4%.

Scotiabank economists see drop-ping unemployment in Sas-katchewan, Newfoundland and, marginally, Manitoba. Increases in the unemployment rate in other provinces will not be significant, except for New Brunswick, where it will be 8.6% in 2008 vs 7.5% in 2007. IE