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As Australia stumbles, will Canada follow suit?

Predictions of a hard landing for the resource-rich Australian economy have Canadians wondering whether our economy will share the same fate. The answer is likely not, although for investors a painful transition may be ahead.

Former Morgan Stanley economist Andy Xie presented a compelling argument that Australia was on the verge of a hard landing. Mr. Xie argues that, just as in Canada, the sharp increase in Australian GDP over the past decade is a direct result of capital inflows from China, the vast majority of which relates to resource exports. He believes the current slowdown in Chinese growth will see a reversal of this process:

Any foreign capital-inspired asset bubble bursts when the flow reverses. It causes the monetary system to contract. As the central bank replaces the outflow with new money, the currency value drops, which frightens Asian retail investors who hold Australian dollar deposits. Their flight causes the currency to tank more and liquidity to tighten.

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The property market will fall with the tightening liquidity and capital flight, which frightens away more foreign capital in the property market. The new equilibrium is defined by a much lower currency value and property price. In this new equilibrium, the currency value could be half of its peak value.

The Canadian economy's ties to the United States will likely save the domestic economy from Mr. Xie's doomsday scenario for Australia. Canadian businesses are positioned to benefit from strengthening U.S. economic growth, evidenced by Friday's stronger-than-expected GDP growth report – while Australia's is not. The makeup of Canadian economic growth, however, may change in ways that are highly inconvenient for investors.

A slowing China has caused lower commodity prices which are already depressing profits for domestic mining and energy stocks that dominate the S&P/TSX composite. The Canadian sectors that benefit from U.S. growth are barely reflected in the stock market. Autos, for instance, are less than 1 per cent of S&P/TSX market cap but 10 per cent of the domestic economy.

Further slowing of the global economy will hit Canadian equities hard. The underlying economy will fare much better, although this may be hidden from the equity markets.

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