06/27/2011 09:00 EDT | Updated 08/27/2011 05:12 EDT

Three-Pronged Risk to Canada's Economy

The Bank of Canada weighed in with a few of its own comments as to Canada's economic direction and, more importantly, the challenges facing it at last week's FOMC meeting.

While markets were fixated on the Federal Reserve's policy decisions and its outlook for the U.S. at this week's FOMC meeting, the Bank of Canada weighed in with a few of its own comments as to Canada's economic direction and, more importantly, the challenges facing it.

In a follow-up to its May 31 meeting, the Bank has re-affirmed its stance that the recent economic slowdown is going to be short-term in nature, and that second-half growth will accelerate. If the underlying assumptions to this view include a holding pattern (or decline) in energy prices and a more relaxed Loonie (somewhere under parity), then the Bank's expectations are probably valid.

Another key assumption, and one shared by the U.S., is that the production losses due to disruptive events like Japan will turn out to be temporary. The problem with that argument is that it ignores the fact that the overwhelming majority of both economies is represented by consumers, which have not cooled their jets recently because of Japan's repercussions, but because of the impact of gasoline prices and uncertainty surrounding the pace of job growth in this recovery. Which takes us back to the previous assumption of lower stable energy prices.

That doesn't address the debt issue that Canada itself faces and one which again was harped on by the BoC this past week. Bottom line, Canada's household debt-to-income ratio exceeds where the U.S. stood prior to the credit crisis of 2007 at around 1.5.

The caveat, which is often touted, is that Canada's banking sector is on more solid ground than the position of U.S. financials four years ago and therefore better able to withstand a debt shock. Indeed, stress tests have shown that another deep recession, this time with double-digit home price declines, would shave less off bank profits than what we saw south of the border. Repeat -- profits. Not even a return to, gasp, losses.

I don't suggest that stress tests should be followed like the gospel, but it would take a much larger domino effect in Canada to produce a U.S.-style experience. That's good news for the overall economy and for government coffers, in that bailouts would presumably be less likely as well. It doesn't mean a thing for bank shareholders.

Lesson one from 2008 is that the correlation between Canadian and U.S. bank stocks is tight and has been tight for many many years. It doesn't matter what the catalyst for a decline in U.S. banks is, the reality is that Canadian shares can get hit hard just the same. In the case of Canada's debt problem, the trigger would still likely come from abroad, but the catch-up correction in household asset values relative to the U.S. could easily make for Canadian banks to underperform the U.S. this time. That's not a forecast by any means, but a reality check.

Where this trigger event emanates from is unclear, but the two leading candidates would be an actual default by Greece or other European small-fry, which leads to a contagion wave through European financials and ultimately global capital markets. The other possible event would come thousands of miles away in the form of a Chinese real estate shock. In this case, Canada would initially suffer from a three-pronged impact -- a major correction in the general equity market, sharply weaker commodity prices leading to much slower growth in Canada's economy and the contagion through the housing sector if banks tightened credit conditions on capital concerns and/or U.S. banks started to unload their inventories of foreclosed properties to raise capital.

Now that's a really scary bonfire story.