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Bay Street Week Ahead: An ailing US could make Canada sick

TORONTO (Reuters) - Cracks in the U.S. economy could become major safety hazards for Canadian investors before the year is out.

A flagging economy in the United States -- as some analysts are warning -- could yank the Toronto Stock Exchange's main index down to 10,500 over the next year, a good chunk lower than its recent record highs around the 12,000-mark.

"The performance of capital markets over the next 12 months will depend on what type of landing is in store for the U.S. economy and on the direction of oil prices, among other factors," National Bank Financial's chief economist and strategist, Clement Gignac, said earlier this week.

Gignac's 12-month target of 10,500 for the S&P/TSX composite index represents one of the lowest forecasts on Bay Street, although it's up from his previous prediction of a chilling 9,900.

Most see the market's main index making a decent gain this year, but not repeating the eye-popping 22 percent rise it achieved last year on the back of surging energy prices.

The Toronto Stock Exchange's key S&P/TSX composite index <.GSPTSE> hit a record 12,012.66 on Wednesday, but has since eased from that level, finishing the week at 11,937.62.

Gignac thinks there is a 60 percent chance there will be a period of prolonged sub-par economic performance in the United States, which could see its gross domestic product growth fall below 2.5 percent in 2006 and 2007.

He has two other scenarios painted as well. He assigns a 15 percent chance to a "Goldilocks" economy: not too weak and not too strong. That would take the TSX index to 13,500.

He also sees a 25 percent chance that a steep slowdown in the United States turns into recession, which could set the stage for the TSX to fall drastically to 8,500.

"In two of our three scenarios, the performances of the U.S. and Canadian stock markets are likely to diverge in 2006. The reason is simple: the two markets need inverse catalysts to rise," he wrote in National Bank's monthly Equity Monitor.

Easing oil prices will help the U.S. economy and corporate profits, and also give consumers some relief. But in Canada, the energy sector, which makes up about a third of the TSX index, will take a hit, and haul down the whole equity market.

And as income trusts become fully included on the index this March, Gignac estimates more than 30 percent of the index will be tied to energy sector.

"This highly uncertain environment calls for a defensive approach and we remain very comfortable with our current asset mix, which generally underweight North American equities but overweight foreign markets," the report said.

National Bank is positive on non-cyclical sectors such as consumer staples and health care, and would also be overweight in information technology, which underperformed last year.

The thinking about a slowing U.S. economy could also set the stage for the Bank of Canada to cut rates at year end, though it's difficult to predict rate cuts when recent economic numbers are pointing to further hikes.

Convention has it that rates should soon be near neutral levels, where they are no longer as stimulative as they are now.

Among Canada's 14 primary securities dealers, Toronto Dominion Bank is with the majority and sees at least two more quarter-percentage-point hikes in the near term.

Where they're alone is that they say rates will fall at the end of the 2006 -- after peaking around 4 percent -- as the effect of U.S. monetary tightening slows that economy, and also restrains Canadian growth.

There are other dealers that think the overnight rate won't rise past 3.75 percent this year. The Bank of Canada's key rate now stands at 3.5 percent.

By all measures, TD Securities' chief fixed income and foreign exchange strategist, Marc Levesque, is "very optimistic" on the Canadian economy in the near term, it's the U.S. economy that he's worried about.

U.S. growth could slow to the point that it will give the U.S. Federal Reserve the flexibility to ease rates, he said.

If that's the case, Canada will likely feel the effects since the U.S. is its biggest trading partner by far.

"I think the Bank of Canada has every reason to continue to tighten over the course of the year. However, once we move into the tail end of 2006, with the U.S. economy slowing, just as a precautionary measure, you will see the Bank of Canada start to ease," said Levesque.

The U.S. central bank raised its fed funds rate 25 basis points to 4.5 percent this week and shifted its tone to say more credit tightening "may be" needed.

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