More downside is in store for the Canadian economy and a recovery of financial markets is farther off than investors expect, said David Wolf, head of Canadian economics and chief strategist at Merrill Lynch Canada Inc., on Wednesday.

Speaking at the Toronto CFA Society’s annual interest rate forecast, Wolf cautioned that on the global landscape, Canada’s economy faces more downside than many other countries around the world. He pointed to the country’s open economy, with exports that account for 35% of GDP; the enormous dependence on the struggling U.S. economy; and the damaging impact of falling commodity prices.

“The domestic landscape is really quite vulnerable,” he said. “I think there’s going to be a hit far greater ahead than the consensus and more forecasters believe with respect to the Canadian economy and financial markets.”

Merrill Lynch expects nominal GDP to decline by 2.8% this year, and predicts that the unemployment rate will surpass 8% by year’s end.

As a result of the dire economic outlook, Merrill Lynch expects the Bank of Canada to cut interest rates by 50 basis points later this month, followed by another 50-basis-point cut in March. Later in the year, rates could fall to zero, Wolf said.

The shrinking economy will cause corporate earnings to fall substantially, by at least 35% in 2009, Wolf added.

“Corporate cash flows are going to come under tremendous pressure in Canada over the next several months, and they are going to see a very substantial contraction in earnings,” he said. This could lead to further hits to corporate bond markets and equity markets through their connection to corporate cash flows, he said.

The Canadian housing market will also worsen in the year ahead, according to Wolf. He said that while demand has already weakened in the market, more growth in unemployment will further drive away prospective buyers.

“There is a huge supply overhang,” he said.

Although a recovery will inevitably set in eventually, Wolf warns Canadians to be patient.

“Don’t lose sight of the fact that we still have yet to see a visible bottom,” he said.

American citizens, meanwhile, are facing the worst recession since the Second World War, according to Edward Friedman, a senior economist at Moody’s Economy.com.

Similar to Wolf’s outlook for the Canadian economy, Friedman said a rebound for the American economy will take time.

“It will not be a quick recovery,” he said. “There’s been too much damage done to the private sector.”

He said the economy would continue to suffer throughout the year as banks remain hesitant to engage in lending, home prices continue to fall and more jobs are lost. The American housing market will ultimately witness a 30% peak-to-trough fall in prices, according to Moody’s, and the unemployment rate is set to hit a peak of 9%.

The looming stimulus package from the U.S. government, however, will help to reduce the extent of the economic damage, Friedman said. Without stimulus measures, he said unemployment could soar as high as 11%.

“The stimulus will arrest the recession,” said Friedman.

The government aid will also help prevent widespread deflation from setting in, Friedman added. He noted that since prices in many services categories are not yet falling, nor are wages, deflation is unlikely.

IE