The S&P/TSX Composite Index on Tuesday closed above 26,000 for the first time, marking its tenth straight day of gains, as valuations continue to expand despite trade uncertainties that threaten the economy.

However, this resilience in the stock market may soon fade as the effects of tariffs take hold and economic conditions deteriorate.

Toronto-Dominion Bank chief economist Beata Caranci warns that Canada will enter a recession this year, calling for negative GDP growth in the second and third quarters.

On May 15, I spoke with Ms. Caranci, who shared her outlook on the economy, tariffs and future potential trade deals.

You calculate current tariffs on Canada to be around 12 per cent and see the effective tariff rate falling to around 5 per cent by year end. In late 2026, you believe a new USMCA deal may be reached, lowering the average tariff rate to 2.5 per cent for Canadian exporters.

For Canada, the presumption is that companies will increasingly apply to have their products qualify under USMCA, which are exempted from tariffs right now. We have the current effective tariff rate with the U.S. of about 12 per cent because steel, aluminum and all non-USMCA compliant goods are at 25 per cent. So, as more companies put in the effort to get that paperwork in and qualify, the better it will be. That presumes USMCA qualified products will stay exempted, but we don’t know if that will remain the case.

If your tariff predictions are correct, what impact might they have on the Canadian economy?

We’re very worried that we’re going to be in a formal recession in the second and third quarters and that we can see perhaps another 100,000 jobs lost. We’ve already had over 70,000 lost in the private sector in two months.

So, the concern for Canada is that negative sentiment has directly correlated to the hard data, so sentiment is manifesting quickly in the outcomes. In the U.S., you see very negative sentiment, but the economy is holding up quite reasonably, and in Canada, that’s not the case.

The housing market is a good example. The housing market has always been Canada’s go-to when you want to stoke growth. You would not just get the sales bump but that would lead to purchases of household furnishings and other things in the retail sector, and it would lead to renovation activity. So, you would get this 1,2,3 economic push. We’re getting none of those drivers. Nothing’s coming through, even with 100 basis points of cuts, sales are going in reverse. You’ve had sales deteriorate, they’re down 20 per cent since November, even though the Bank of Canada has cut interest rates by 100 basis points.

You forecast Canada’s real GDP growth in the second and third quarters will be negative. Currently, your forecasts for real GDP are 1.3 per cent in 2025 and 1.1 per cent in 2026.

That was our March forecast, and I would say given our preliminary look at all the data, those numbers are coming down. I would say for Canada we’re probably going to be around 0.8 per cent for this year, and just north of 1 per cent next year. These are not great numbers. We think the middle of the year, the second and third quarters, are going to be deeper contractions than we initially anticipated based on what we’re seeing in terms of private sector job losses, the housing market not reacting to interest rates, consumers being cautious and sentiment being down - this is not a good combination.

Given your outlook for a potential recession, what are your rate cut expectations for the Bank of Canada?

That’s where it gets interesting because we only put in two more rate cuts, which takes the policy rate down to 2.25 per cent. Part of the reason why we haven’t gone further is because of what [Bank of Canada Governor] Tiff Macklem has acknowledged - there’s uncertainty over the effectiveness of the interest rate channel when a tariff policy shock creates a supply side shock. And the housing market is telling us the answer is no, otherwise it would be reacting.

Now, the flip side you can argue is that you have to go even further, you’ve got to do bigger adjustments but then you run the risk that let’s say a trade deal is reached and all of a sudden you have a housing market that comes rip roaring and then you’re in the pandemic situation where you get blamed for overstimulating.

So, the policy tools rest with the government. This is a supply side shock. This is a confidence shock. The interest rates in Canada are low relative to what you see in other countries - the U.S., Europe and elsewhere. It’s not enough to stimulate demand because people are not comfortable to invest in this environment or to purchase a house in this environment until they have clarity on their jobs.

In the Bank of Canada’s financial stability report, it stated, “In the medium to long term, a prolonged global trade war would have severe economic consequences.” When would a trade deal have to be made to avert such an outcome?

We think that we only have up until about the third quarter. If you don’t start to build out significant clarity and stabilization and tariffs, it’s a very difficult operating environment for businesses and the price impacts will really start to come through on the consumer side.

The U.S. also has a motivation to get some big deals done by the third quarter for its economy to gain momentum.

I think what we’ve seen is financial markets get excited about the tariff truce with China but there’s still no deal.

Speaking about the markets, the S&P/TSX Composite Index is near record levels. Equity markets are forward looking, and they seem to reflect optimism that major trade deals will be reached. Do you share that same optimism?

For Canada, we have that two-quarter recession because of the sentiment side but growth happens as we get to the end of the year and into next year because we’re assuming trade deals are done.

I think what we saw with China and the U.S. is that each country can pull themselves back from the brink. They had this massive escalation, and then cooler heads prevailed. But I think it’s going to be hard to get a deal with China so we might have a bumpy road ahead of us with optimism and disappointment because China plays a long game. China already reprimanded the U.K. over their agreement with the U.S. There was a line in their deal regarding making sure one of the reasons the U.K. is not paying 25 per cent on steel and aluminum is their agreement to ensure their supply chain was properly monitored, which was targeted at not allowing China to use the U.K. as a method in on steel and aluminum. China’s point is that when you have a trade deal with another country, it shouldn’t be targeting a third party, it should be between those two countries. So, China is going to be a hard negotiator. These are two big competitors going head-to-head.

I think the markets are optimistic in part because it’s been quiet once the truce was put in place, but we’ve got 90 days and that clock is ticking, and if we don’t get some really good news in 90 days, I think market angst starts to build up again.

People are waiting to see the two largest economies in the world, the U.S. and China, strike a deal.

Markets just need to see progress, just as you saw with the 90-day tariff reprieve. They don’t need to see the total outcome.

I think that negotiations will be carried out over many stages.

What we’ve braced our forecasts for is that the China-U.S. effective tariff rate will be around 40 per cent.

And what are the economic implications if that rate, 40 per cent, is accurate?

We have a pick-up of inflation happening around the third quarter you get this peak impact for the U.S. and Canada. It’s a one-time price shift.

In the near term, you’re going to be absorbing the inflation impact, and we heard it with Walmart. They think they’re going to have to start increasing prices by late-May. The Manheim Used Vehicle Value Index rose around 3 per cent in April compared to the prior month. It didn’t get captured in CPI in the U.S. because it takes a couple of months for the methodology to capture it, but that tells you by June or July, that inflation indicator in the U.S. is going to start rising as the new numbers come into that survey period. So, I think the ball is rolling in that direction.

And don’t forget, the de minimis rate with China is 54 per cent, which used to be zero. So, there’s still quite a bit of price pressures out there.

Given your expectation or rising inflation in the U.S. combined with decelerating economic growth, how do you believe the Federal Reserve balances these risks?

We have the Federal Reserve cutting interest rates. We think they might be able to get three cuts in - if deals on the tariff front happen by the third quarter.

You have to think of everything like a sequence of events that we need to see. The first sequence is that the tariff turmoil stops, that we get stability. Stability doesn’t mean a zero-tariff rate. It means clarity on where it’s going to settle so businesses can know their operating environment. Our base assumption is that this all happens around the third quarter.

It’s not going to happen with every single country but the ones that matter the most are China, the EU, Canada and Mexico because they’re the biggest trading partners to the U.S., and so we need some degree of negotiations and stability to be there.

If we get that, it opens the door for the Federal Reserve to cut rates because they will have clarity that any price increases will be falling out of the data next year, rather than continuing to escalate due to the uncertain environment. So, that opens the door for them to start cutting interest rates to address the weakening economy from everything that’s been happening. It’s almost like the first pillar that has to fall into place.

Otherwise, you need an economy to weaken to such a degree that they’re nervous about it, and they cut rates because of that - even if it means accepting higher prices.

The one thing that the Federal Reserve has kind of working in its favour is that the policy rate is very high at 4.5 per cent. It’s restrictive - it’s restraining the economy. So, they probably have the least amount of risk in cutting interest rates because even if they take 50 basis points off, it’s still going to be restrictive, so they can provide a little bit of relief into the economy.

Among the G7 nations, the U.S. has been a leader in economic growth. You recently revised your 2025 GDP forecast down to 1.5 per cent from 1.9 per cent. Do you expect the U.S. to maintain its leadership?

Yes, for sure.

I would say for the U.S. next year - because we’re assuming that we’re going to get these trade deals - I would not be surprised if growth comes in with a two handle, to see growth of 2 per cent.

In a recent report, you said, “U.S. tariff policy assumptions are the biggest wildcard” to your forecast. If we are on a path toward lower tariffs and an eventual new USMCA deal, that would remove tariff policy as a key risk. What do you see as the next major challenge for the Canadian economy?

The bigger challenge for Canada is not getting a tariff deal with the U.S. - that’s going to happen at some point - it’s what our economy looks like in five years.

To me, this is a shift in Canada that is on the scale of an economic wartime period. You’re trying to simultaneously reduce your dependence on the U.S., increase your domestic resiliency and increase your global presence. Any one of those is difficult to do. Now, you’re trying to do all three simultaneously.

When you look at the Liberals’ platform, the debt-to-GDP ratio rises. That’s going to happen because we’re going to be putting a lot of money behind many transformative initiatives. Will the rise in the debt-to-GDP ratio occur because you’ve actually succeeded in creating more growth opportunities for industries, jobs and companies? If so, it’ll pay for itself through the growth of the economy and productivity.

The concern is that every time we do big projects within infrastructure and other areas, it takes longer and costs more. We cannot have that. The Liberal government has to execute with a fair degree of precision. This is all about execution. So, they have big policy platforms like the East-West corridor and doubling the size of the amount of housing. These are really big initiatives that require strong execution on timelines and cost structure because taxpayers are going to be paying for it.

And there may be a deficit in the expertise and labour to do all these initiatives. They’re going to have to pick their priorities.

The risk is that you incur more debt relative to the growth you drive in the economy, so the debt-to-GDP ratio continues to worsen rather than stabilize and improve with time.

If you don’t get it right, you will be burdening future generations with higher taxes and potentially higher interest rates because Canada could end up getting a penalty imposed on it by international investors as a country that doesn’t look as attractive to put their money in.

Let’s talk about the housing market. This spring selling season, which is traditionally an active period, has been weak. We’ve seen sluggish home sales, especially in Ontario and B.C. You anticipate weakness in Ontario and B.C. will persist in 2025 with home prices forecast to fall 6 per cent in Ontario and decline 4 per cent in B.C. For 2026, you have Ontario and B.C. showing the lowest price growth compared to other regions in the country with less than 3 per cent growth in each province. What will help revive the housing market in these two large regions and when do you see that happening?

Well, one is you need confidence to come back into the market and right now it’s not there. Part of that weakness is related to the drop in immigration flows, which would have been a feeder pool into that market.

And the reason we have B.C. and Ontario, in particular, underperforming the rest of the country is specific to the condo market, especially in Ontario. That is an area that we think we can see a 15 to 20 drop in prices from the peak, of which 10 percentage points might be this year. It’s a market that is oversupplied when you look at the sales-to-listings ratio, it is very low. That market has to play through with prices going even lower before it starts to attract enough people into the market. And they’re still building, there’s still supply coming online, so this will not be the year for the condo market.

I think as you get confidence coming back, the job market improving, there’s a lot of pent-up demand, people who are waiting to get in, at some point, prices get attractive enough that people start coming in. I think it’s a next year’s story versus a this year’s story.

Do you see stagflation as a greater risk than a recession?

I would say they’re probably about even.

We’ll have to see just how much the policy environment evolves. Like I said, everything in our forecast is dependent on factors that are outside our control, it’s on tariffs and resolution as well as on government policy and execution.

The Canadian unemployment rate rose to 6.9 per cent in April. The unemployment rate in Ontario was above the national average at 7.8 per cent. How high might the unemployment rate rise to given the tariff uncertainty?

We think getting to 7.2, 7.3 per cent seems perfectly reasonable.

Like I said, we still think that we could see about 100,000 jobs lost between now and the third quarter.

Where it ultimately settles, I’m not 100 per cent certain because the labour force side is constraining it. The labour force weakness coming through the immigration channel actually helps constrain the unemployment rate.

Given that you see both the Federal Reserve and the Bank of Canada cutting rates further this year with two cuts from the Bank of Canada and potentially three cuts from the Federal Reserve, what are the implications for the Canadian dollar with a widening interest rate differential?

The interest rate differential between Canada and the U.S. is not what is driving our currency - it’s all about the risk.

What’s interesting is that the Canadian dollar has done better than we thought it would do in this environment, and it’s coming through the sentiment channel with the markets feeling a bit relieved that the U.S. is now starting to make progress on deals. This has taken some of the risk pricing off with the view that it’s possible Canada can get a deal done.

The Canadian dollar seems to have stabilized in the low 70’s. I think it holds in that area until we get a deal.

Lastly, where do your economic forecasts differ materially from consensus estimates?

So, with our downgrade on Canada’s real GDP growth, I think we might be below consensus now. I think we’re going to be at 0.8 per cent for Canada this year and consensus is at 1.2 per cent, right now.

And I know we’re an outlier on the other side of it for the U.S. For next year, we think the U.S. real GDP growth can get to 2 per cent and consensus is 1.5 per cent. I think we’re more optimistic on the U.S. than American banks when we look at Bloomberg consensus, and I think there are two functions to that.

One is we’re constantly redoing our forecasts so we’ve already incorporated the pause on the tariffs, and Bloomberg consensus probably has not picked that up yet. And two, forecasts are really assumption based right now, and our assumption is that these deals hit in the third quarter and then by the fourth quarter you go from growth inhibitors to growth accelerators. The inhibitors are tariffs and DOGE [Department of Government Efficiency] right now, and the accelerators will be the tax cuts and deregulation, and those become the prominent themes for the U.S. we think in 2026. So, what they’re doing is getting the negative news out of the way now, and then they’re going to have more positive news as they move into midterm elections.

This Q&A has been edited for brevity and clarity.