Warren Jestin, Senior Vice     President & Chief Economist

INTERACTION MET WITH WARREN JESTIN TO LEARN ABOUT CURRENT MARKET VOLATILITY, IMPLICATIONS OF U.S. AND EUROPEAN FINANCIAL SYSTEMS RESTRUCTURING AND WHAT LIES AHEAD FOR THE CANADIAN ECONOMY.

IA: How has the deterioration in global economic activity impacted Canada?

WJ: The Canadian economy has lost considerable momentum since the summer, as the combination of rapidly weakening U.S. economic activity and the sharp drop in commodity markets hit export sales, earnings and employment. While Canadian households are in better financial shape than their U.S. counterparts, growing concern about the economic outlook is cutting into big-ticket purchases. The Canadian housing market has softened in many areas across the country, with prices posting year-over-year declines for the first time since 1998. With global growth poised to weaken further during the first half of 2009 in both developed and emerging nations, economic conditions in Canada will remain challenging in the months ahead.

That said, our economy will continue to perform better than the U.S. because our financial and fiscal fundamentals are much stronger. Canadian financial institutions are among the strongest in the world, and our households have less debt leverage and more equity in their homes. The longer-term broad-based commitment of Canadian governments to balanced budgets is also an important strategic advantage, which allows policymakers on this side of the border much greater leeway for providing economic stimulus without jeopardizing their longer-term fiscal health.

IA: Have the actions of the central banks and governments helped?

WJ: The U.S. Federal Reserve, the Bank of Canada, the European Central Bank, the Bank of England and others have taken unprecedented action to support their financial systems and unfreeze credit markets. Many central banks have reduced their key interest rates to historic lows, with the Federal Reserve virtually adopting a zero interest rate policy with respect to its key overnight borrowing rate. U.S. and European governments also have taken ownership positions in some of their key financial institutions, providing capital to instill more confidence in investors. While these extraordinary actions have helped stabilize markets, it will take considerable time to restore investor, business and consumer confidence, particularly now that weakening sales and financial deleveraging are undercutting earnings and triggering widespread layoffs.

IA: Do you think we will experience a recession?

WJ: The National Bureau of Economic Research has indicated that a U.S. recession began a year ago. The European and Japanese governments have acknowledged that their economies are also in a recession. Despite our financial and fiscal advantages, Canada will not buck this trend. Our economy has weakened substantially since September and will probably experience a slide in output through the first half of 2009.

On a regional basis, stronger fiscal fundamentals and public infrastructure projects will provide support in Western Canada. Newfoundland will lead the Atlantic Provinces in overall performance, although economic conditions have already begun to weaken significantly. The greatest challenges will be faced in Central Canada, particularly Ontario, because of the importance of manufacturing – particularly the auto sector – and the strong orientation of exporters to the U.S. market.

IA: How long do you think this period of adjustment will last?

WJ: This economic setback – both in Canada and other countries – will be long remembered for both its duration and for its intensity. Measured by output, sales and employment, the period of declining economic activity will probably last the better part of a year and my guess is that we are not yet at the half-way mark. The recovery phase, when growth resumes but conditions remain uneven and uncertain, is expected to stretch through the first half of 2010.

By then, financial markets should be on a much stronger footing with investors displaying renewed confidence in the outlook. However, even then, investors will likely be confronting a legacy of day-to-day volatility in equity, bond and exchange markets. During this period, I expect governments will be pursuing a significant re-regulation of financial institutions, both in their countries and on a broader global front. The world financial system will operate differently in the years ahead as regulators adjust capital requirements and gain greater control over risk practices.

IA: How does the demand for Canadian commodities in growing markets like Asia come into play?

WJ: Resource prices have come down sharply because emerging powerhouses such as China – which have been a driving force in commodity markets – are experiencing a large and sudden slowing of export and domestic demand. Once these economies move back into higher gear, something I don’t expect much before 2010, Canada’s advantage as a resource-rich country in a resource-short world will come back into play. Enjoy lower prices at the pumps while they last, because once global growth resumes, energy and many other commodity prices will move up significantly.

IA: What parts of the Canadian economy will be hardest hit in 2009?

WJ: Even with the recent swoon in the Loonie, exporters will face very challenging times in the first half of 2009. Tourism and service industries plugged into global business networks also will experience weakening markets and bottom-line pressures. Rising unemployment will inevitably dampen household purchases of postponable, big-ticket items, particularly autos. Residential construction and sales activity is already softening, although renovation activity should have greater resilience.

Weaker demand will reduce sticker prices and improve bargaining power for consumers who opt to keep shopping. Similarly, investors with a longer-term view and greater risk tolerance also will find very attractive valuations. Interest rates also are likely to come down further in the months ahead – good news for borrowers, but not for investors looking for fixed income.

IA: How will the Canadian dollar perform in 2009?

WJ: The longer-term fundamentals are positive for the Canadian dollar and negative for the U.S. currency. Even as our governments move into deficit in the months ahead, we have one of the world’s strongest fiscal positions, and our financial system is the envy of many nations. Canada will continue to enjoy a trade surplus, driven largely by commodity sales. All of these strengths will become more positive as the global economy improves beyond 2009.

At the same time, U.S. fiscal deficits are going into orbit and will average $1 trillion or more over the next two years. Heavy reliance on commodity imports also has locked the U.S. into large trade deficits. These chronic twin-deficits pose long-term risks for the U.S. dollar against major currencies, particularly if global investors opt for more diversified portfolios and reduce heavily overweight U.S. asset positions.

In the here and now, however, the quest for safe and secure investments has pushed the yield on U.S. short-term treasury bills close to zero and longer-term yields to historically low levels. This trend has bolstered the U.S. dollar against a broad array of currencies. At the same time, lower commodity prices and weakening fiscal positions have caused the Loonie to fluctuate widely and, on balance, to move towards 80 cents (US). I expect our currency to continue moving very erratically in the months ahead, both above and below this threshold. We probably won’t see a sustained move back above 90 cents (US) until the more positive longer-term Canadian – and more negative U.S. – fundamentals begin to influence investment decisions beyond 2009.

IA: What is happening to economic growth in China and India? What are the implications for Canada?

WJ: Over the next year, we’re looking for growth in China to move to 7% – down from more than 11% – and for the trend in India to fall below 6%. As I mentioned earlier, the slowing trend in these economies will have a big impact on the demand for, and the price of, commodities produced in Canada. We still believe that the domestic fundamentals in these very powerful economies and their competitive edge in global markets will allow them to retain their title as world growth leaders. Both in good times and bad, we also expect many other emerging nations to outperform the traditional developed nations in North America, Europe or Japan by a substantial margin.

IA: How would you sum up Canada’s overall position in the global economy?

WJ: On a relative basis, our economic circumstance compare very favourably with most other nations. A year from now, hopefully the Canadian and global economies will be into a recovery mode. It may not be as fast as we’d like because the U.S. will still have problems and global financial markets will be prone to volatility. However, for the average person on the street and for investors, the move back into economic recuperation and expansion will be very welcome news.

It is common sense that businesses and consumers should be cautious in the months ahead, but the extreme skepticism that has led to dire predictions about our economy and financial market is unfounded. The important thing is to be cautious about your finances and prudent in your economic management because that’s the best way to weather this particular storm.