Trade war darkens economic forecasts for Canada

Two big banks cut Canada's growth forecasts on rising trade tensionsthis week, and others could follow suit if the new U.S. tariffs against Mexico are implemented next week.

Economists at Bank of America Merrill Lynch revised Canada's growth forecast from 1.5 per cent to 1.3 per cent for this year, and made an even bigger cut to their growth estimatefornext year from 1.8 per cent to 1.3 per cent.

"We had already marked downside risks to our GDP growth forecast for 2019 given lower oil prices and risks of trade war escalation," economists said in a note on Tuesday.

"With the U.S. threat of tariffs to Mexico, trade wars have effectively escalated, and uncertainty over global trade increases, which is negative for Canadian investment and exports."

U.S. President Donald Trump reaffirmedin a news conference in London on Tuesday that he would likely order new tariffs on Mexican exportsnext Monday, because ofa high number of Mexican migrantsentering the U.S.

The economists also said they believe that it isnow "unlikely" that the new trade deal between the U.S., Canada and Mexico will be approved this year, because of the new tariffs.

"In our new numbers we are using our estimate that a 10 per centdrop in Canadian exports would reduce Canada's GDP by 210 basis points," the reportsaid.

"Strong domestic demand in the first quartershows that there is some upside risk to our forecasts. But, lower oil prices and further escalation of trade wars imply that there are downside risks as well."

'Hit to commodity prices'

Despite a strong start to the year the price of benchmark U.S. oil,West Texas Intermediate,has fallen almost 20 per cent after hitting ahighin April this year Western CanadianSelect oilhas plunged even more, down almost 30 per cent from the high in April.

Added to that, weaker than expected growth in the first quarter has prompted National Bank of Canada to cut their growth forecast for this yearto 1.4 per cent from 1.6 per cent on Monday.

Krishen Rangasamy, senior economist at National Bank, said solid job gains, stabilization of the housing market, the removal of U.S. steel and aluminum tariffs and a weaker Canadian dollar are all reasons to be optimistic about economic growth. But the escalation of the trade war between the U.S. and China presents new risks.

"The U.S.-China trade war can only be beneficial to Canada if it doesn't escalate beyond a certain point," said Rangasamy in a note.

"Such a large exposure to one trade partner (i.e. the U.S.) makes Canadian exporters more vulnerable to U.S. economic cycles The resulting hit to commodity prices and negative spillovers on the U.S. economy, won't be good for Canada."

Canada's economy grew at annualized pace of0.4 per cent in the first three monthsof this year falling below expectations, and just slightly above the 0.3 per cent growth in the previous quarter. They were the country's weakest back-to-back quarters of growth since 2015.

Export volumes dropped one per centmarking for their first quarterly decrease since 2017.

Other banks could follow suit

Meanwhile, other Canadian banks are also keeping a close eye on developments on the global trade front as they review their forecasts.

DougPorter, chief economist at BMO Capital Markets, said the bank's growth forecast for Canada is already at the lower end of market consensus at 1.4 per cent, but if U.S. tariffs on Mexico are imposed next week, they are set to "retool" the entire forecast.

Brian DePratto, senior economist at TD Economics, said the bank was in the middle of reviewing its growth forecasts, and will publish the outlook next week.

"While I can't say too much about specific numbers this early in the process, certainly developments of late suggest the risks tilt towards less growth than might have otherwise been the case," said DePratto.

Meanwhile, Royce Mendes, senior economist at CIBC Capital Markets, alsosaid the bank was reviewing its North American forecasts as global risks like the U.S.-China trade war and Brexit moved closer to materializing in May.

"For a small open economy like Canada, these situations could be significant either via direct trading links, or indirectly through financial markets and confidence," said Mendes."The increased uncertainty regarding these global risks likely more than offsets any positives from the removal of U.S. steel and aluminum tariffs."

However, he added that the latest economic data doesn't look "particularly weak" with growth likely to rebound in the second quarter from the weak start to the year.

"At this point, central bankers are satisfied staying on the sidelines. However, should the data deteriorate more than they expect, don't be surprised if they jump into the game and pull the trigger on rate cuts," Mendes said.

"Monetary policymakers are keenly aware that they lack downside room to offset a full recession, so are likely to erron the side of providing too much stimulus rather than too little."