09/13/2011 03:54 EDT | Updated 11/13/2011 05:12 EST

Canada Recession: Economic Headwinds Could Make Canada First To Stumble

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OTTAWA - Canada could be the first economically advanced country to stumble into another recession, the Bank of Nova Scotia says in one of the more stark warnings about the gathering gloom ahead.

Scotiabank economists say Canada could in fact already be in a mild downturn, given that the economy retreated 0.4 per cent in the second quarter and is at risk to come in negative in the third quarter, which ends Sept. 30.

While he is not predicting a recession, "nobody can say with total confidence GDP is going to come in the black in the third quarter," said Derek Holt, vice-president of economics at Scotia Capital.

Holt notes that job growth, a previous strength, has been flat the past two months.

He said a recession at this time would be mild, given that the second quarter was near zero and the third quarter is unlikely to be much below the line.

But it would undercut Canada's claim to be a leading wave of the global recovery and could exacerbate the current malaise by further shaking business and consumer confidence.

A recession is defined as two consecutive negative quarters of growth and usually leads to higher unemployment, flat or lower household incomes and tight money across the economy.

The deep 2008-09 recession that began almost three years ago lasted three quarters and led to the loss of more than 400,000 jobs, many in the manufacturing sector in central Canada. By May of this year, it appeared Canada had regained at least as many jobs but employment growth stalled in July.

While no other forecasting group has come as close to warning of a slump, two other big Canadian banks — RBC and TD — recently downgraded their forecasts for the latter half of this year and 2012.

The two banks both cited the growing strength of headwinds hitting Canada's economy, adding that a so-called double-dip slump can no longer be ruled out.

The most likely trigger for such an outcome is if the U.S. falls into a recession next year, said TD Bank chief economist Craig Alexander. He places the odds of a U.S. downturn at 40 per cent.

"A U.S. recession would drag Canada down," he explained. "If it was mild, the Canadian economy might stall instead of contract. But, we are dealing with semantics. The odds of negative quarters in Canada might be less than in the U.S., but not by much."

The other possible mechanism is a Greek default on its national debt — even if it involves a partial debt forgiveness — followed by market pressure on Italian and Spanish sovereign bonds.

BMO Investments head Serge Pepin said a Greek default would have few direct impacts on Canada, but added he was concerned about the impact on already shaky global business, investor and consumer confidence.

While the foreign difficulties are serious, Holt believes not enough attention is being paid to weakness in the Canadian domestic market.

The latest indicator was new data Tuesday showing Canadians fell deeper into debt, and lost household wealth during the difficult second quarter.

The period saw stock markets tumble, eroding the value of Canadians' investments and undermining the so-called wealth effect that underpins consumer confidence.

Statistics Canada said household net worth fell 0.3 per cent to $184,300, the first decline in a year. Meanwhile, household debt to income rose.

The situation likely got worse in August, when financial markets suffered an even bigger setback from growing unease over European and U.S. deficits and debt.

Two expected sources of economic strength — business investment and exports — show recent signs of weakening, Holt said.

"The domestic picture is very solid in certain respects, but how much longer can we keep running at record high home ownership, record high leverage, record high house prices, record renovation spending, record high total consumer spending?" he asked.

Holt said Canada's long-term prospects are still good, given its resource riches, solvent banks, relatively small government deficit and debt position, and cash-rich corporations. In the short term, he said, the risk of a setback is real.

By Julian Beltrame, The Canadian Press