This morning we learned that Canadian GDP contracted by 0.3% in the first quarter of 2008. This came as a substantial downward surprise to many analysts and the Bank of Canada itself who had forecast 1.0% growth during the quarter. It was the first contraction in Canadian GDP since Q2 2003.

In addition to a negative Q1, there was a downward revision to the previously reported Q3 2007 GDP which was reduced from 3.0% to 2.3%. As a result the output gap (demand over our potential) in Canada is now likely closed and has done so a few months sooner than the Bank of Canada had expected.

The momentum heading into Q2 is also very weak, and likely to bring a second quarter of below potential and possibly negative growth. This makes it highly likely that the Bank of Canada will continue to cut rates into the next couple of meetings. It also means that our unemployment numbers are likely to rise over the coming months.

I have been saying for several months that I believed the US entered into a recession in the last quarter of 2007. Typically the Canadian economy has lagged the US by about 8 months, so a decline in Q1 is the first part of a slowing story that will likely be confirmed in Q2 and continue in Canada for the next few quarters.

Meanwhile the US Q1 GDP number updated this week revised US reported growth to a slightly positive .9% versus the earlier guesstimate of .6%. The barely positive read came courtesy of a substantial inventory build (stuff made but not sold) and an understated inflation deflator of 3.5% . Had a more accurate inflation estimate like 5% or even 4% been used, the extent of the US contraction would have been more accurately reflected in the official headline. As usual, it is almost certain that the official numbers will be revised again in the future with the benefit of more retrospection.

Already Canadians are feeling high levels of concern about the months ahead. While it is popular to bash US consumers for wanton spending and over-leveraged housing, Canadians too have some skeletons in our closets. We have over-spent and under-saved for the past several years as well. Our debt levels are at multi-decade highs and not surprisingly our consumer confidence is near historic lows. All of this makes us now collectively less immune to economic headwinds over the months ahead.

Canada is likely about to learn once again that we are in fact still heavily tied to the fate of our southern neighbour. And with commodities and energy now accounting for more than 50% of our stock market composite, the ongoing aggregate demand correction, coupled with recently announced regulatory crackdowns on speculative loop-holes in commodity markets now threatens to hit us harder than many have so far dreamed possible.

It is true we have hard assets and resources that the world wants to consume, but even strong secular demand cycles can and do correct as a normal part of the economic cycle. Just a casual glance at an Andex chart since 1950 shows any that will see it that Canada and our stock markets have never been immune to a downturn in the US and the rest of the world.

Even where Canada has escaped following the US into outright recession as we did in 1953, 1960, 1974, and 2001, our market corrections have always been nothing short of stunning. We can hope that this time will be different. The odds do not however, favour such hopes.