06/20/2011 01:19 EDT | Updated 08/20/2011 05:12 EDT

Slowing U.S. Economy a Warning to Canada

Policymakers in Canada must hope that the elephant next door has nothing more than a case of the sniffles. Unfortunately, the diagnosis looks more serious.

In a 1969 address delivered to members of the Press Club in Washington, D.C., Canadian Prime Minister Pierre Trudeau described living next to the United States as akin to sleeping with an elephant: "No matter how friendly and even-tempered is the beast... one is affected by every twitch and grunt."

More than 40 years later, this analogy still holds true and the twitches and grunts currently reverberating through the U.S. economy could soon make their presence felt north of the 49th.

The U.S. buys more than 70 percent of Canada's exports each year -- mainly crude oil and other commodities. On the "imports" side of the ledger, America provides roughly 60 percent of all goods imported into Canada.

So in times of U.S. growth, Canadian exporters may count on greater demand (and, therefore, sales). But when the U.S. economy falters -- as it's doing now -- export sales decline, dragging profits down as well.

Policymakers in Canada must hope that the elephant next door has nothing more than a case of the sniffles. Unfortunately, the diagnosis looks more serious.

All Signs Point to a Faltering U.S. Economy

Consumer spending fuels the U.S. economy, so it makes sense that weaker-than-expected "retail therapy" figures were the first hint of a stalled economic recovery. In April, consumer spending fell to 0.4 percent from 0.5 percent the previous month. After adjusting for inflation, the real increase in consumer spending was a mere 0.1 percent.

The employment outlook has also worsened based on figures released in the recent Non-Farm Payroll report (the most-watched employment report in the markets). It was expected to show that 160,000 new jobs had been created in May. The actual number was a less-impressive 54,000 -- too low to offset the jobs lost during the month. U.S. unemployment rose from nine percent to 9.1 percent in May and the trend may continue.

U.S. recovery is simply impossible without considerable improvement in both consumer spending and employment. With such weak indicators, the Federal Reserve has silenced any talk of a return to higher interest rates before the end of the year.

All this should have the alarm bells ringing in the halls of the Bank of Canada. Just the threat of a pullback in the American economy is enough to send investors to the sidelines on fears that demand for Canadian exports could weaken. Commodity prices have softened in recent months and the TSX has lost almost 10 percent since the beginning of April; the Canadian dollar meanwhile, has lost more than two cents to the U.S. dollar.

Planning Ahead

During an address to the Canadian Club in Ottawa last month, Bank of Canada Governor Mark Carney warned that exports to the U.S. could suffer "for some time". Carney also cautioned that a higher Canadian dollar could further hurt export sales by making Canadian goods more expensive for foreign buyers.

Canadian exporters have made efforts to expand their customer base by cultivating stronger ties with the emerging Asian markets. China in particular is anxious to buy Canadian resources such as nickel, copper, and minerals used in the production of fertilizer. Heavy machinery is also in demand as the Chinese build up more infrastructure and urban centres.

Still, the American market remains the primary destination for Canadian exports and any significant or prolonged slowdown in the U.S. will be felt in Canada.