Caution, economic uncertainty ahead

2016 brought a magnitude of tumultuous times – it was … “interesting” … to say the least. But to move forward, we can’t forget where we came from. As we review the year that was, starting with our 2nd annual Economic Forecast breakfast, featuring BMO’s Douglas Porter, it’s more important than ever to stay informed and understand the context of what’s going on in the markets, in politics and beyond.

To look ahead, join us for the 3rd annual Economic Forecast breakfast in Toronto on Tuesday, January 31st, and in Montreal on Wednesday, February 1st. This year’s event features the 2017 forecast by Benjamin Tal, Deputy Chief Economist at CIBC World Markets Inc.

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Richter had the pleasure of hosting Mr. Douglas Porter, Chief Economist of BMO Financial Group, at events in both the Montréal and Toronto offices recently. Over breakfast, the Richter team and special guests gained insights as to what the future of the economy holds for investors and businesses alike.

Global financial markets are moving forward with caution, and Canada is no exception. Looking back on 2015, the Toronto Stock Exchange (TSX) entered into bear market territory at one point and many equity markets around the world were maintaining similar fashion. The start of 2016 also continued in the same direction as commodity prices and the Canadian dollar fell, oil hit $30/barrel, and bond yields plummeted globally. In fact, just recently, 10-year Canada Government Bond yields fell to 1.00% - the lowest they’ve been in history (even lower than during the Great Depression), while Japanese and some European bond yields entered negative territory. When global yields are this low, it’s safe to say that the future can look uncertain.

Given the economic fluctuations from last year, the growth rate of the 11 major world economies was wide ranging. India and China grew very quickly, the industrial economies (Australia, UK, U.S. and Japan) and Mexico followed with slow but stable growth, while Russia and Brazil lagged substantially. Europe, notably, has been able to grow faster than Canada which is a point worth mentioning, given the amount of troubling events and banking difficulties the continent experienced in the last year. Overall, global real GDP growth was near 3%, well below the long-run average and below what was expected a year ago. At best in 2016, global markets are expected only to maintain this pace.

In North America, the most interesting story of the past year was the divergence between Canada and the U.S. Typically, there is very little separation between the two in terms of GDP growth: most often if the U.S. grows, so too does Canada. Now, however, the U.S. weathered 2015 quite well, with roughly 2% year-over-year growth, while Canada’s growth was cut in half over the previous year, and much uncertainty exists, looking forward.

Why is this departure suddenly so prevalent? A one-word, simplified answer: oil. The Canadian economy is still very dependent on oil exports. Even though U.S. oil production has increased in the past few years, the country still imports a large amount of it from other countries and benefits from lower oil prices, while Canada does not. In turn, this then is, and will continue to affect Canada’s unemployment rates drastically. In terms of unemployment rates, Canada and the U.S. are predicted to diverge further. While the U.S. unemployment rate is forecasted to drop to 4.9% for 2016, Canadian unemployment is expected to be around 7%. If the U.S. achieves an unemployment rate of 4.9%, it will be the third lowest rate in the world. To put this in context, Spain and Greece forecast unemployment rates of 20.8% and 24.5%, respectively. 

Delving further into the crude oil market and what’s ahead, it’s important to look back at how prices have changed over the years. Averaging the price of crude oil from 1970 to present day, in today’s dollars, the average price is 55 USD/barrel. While historical price is no certain indication of future expectations, this does help put the recent oil price collapse into perspective. According to Mr. Porter, if oil production can be restrained, an optimistic outlook could assume that oil will average 40 USD/barrel this year, and roughly 50 USD/barrel next year; representing a modest recovery over the next few years from current levels. 

Even with this optimistic outlook, oil prices will continue to impact regions throughout Canada very differently in the next three to five years. While crude producing provinces like Alberta, Saskatchewan, and Newfoundland and Labrador have been leading the country in retail sales, employment, and GDP in the last 10 years, the tables have now started to turn. It’s predicted that these crude-reliant provinces will slip in their standings in terms of GDP growth while other provinces will see modest growth, creating a very uneven picture for the coming year. British Columbia and Quebec are expected to see a modest surplus of 0.1% and 0.4% growth in real GDP respectively, whereas other provinces will see a deficit. The hardest hits are of course expected to take place in the crude-reliant provinces of Alberta, and Newfoundland and Labrador. To put things in a fiscal context, adding up the debt of the Canadian provinces almost equates to the debt at the Federal level now. This is due to the Federal debt falling over recent years, while provincial debt has been steadily climbing. Overall, it is expected that Canada will see a deficit in growth for 2016.

To help weather the economic challenges, the Federal Government has campaigned to help stimulate the Canadian economy. The Liberal fiscal plan has indicated that they are willing to employ a modest short-term fiscal deficit of less than $10B over the next few years to help deal with the challenging economic landscape. Some banking institutions and other organizations are calling for even more government spending than what has been indicated by the Federal Government, implying the Federal deficit could reach $20B, to possibly even $30B. Putting this in perspective, $20B represents roughly 1% GDP, which, as pointed out by Mr. Porter, is a seemingly manageable ratio.

Looking at the regional level, the housing market is another topic of keen interest in 2016. Mr. Porter noted he has fielded many questions over the last few months as to whether the housing market will “calm, correct, or crash” in the coming years. Since 2008, major institutions have predicted that Canada’s housing bubble will burst. Yet, the surprise has actually been how strong and resilient the market has been since 2008. However, that strength has been diminishing to fewer and fewer cities over the years, and now remains primarily in the country’s two biggest markets, Vancouver and Toronto. Looking beyond these two cities, most cities’ markets are well-balanced as housing prices rise by 2 – 3%; except for “oil cities” like Saskatoon and Calgary, where prices are falling. The two outliers of Vancouver and Toronto are another story completely. The average price of a detached home in Vancouver reached $1.8M in January, 2016. According to Mr. Porter, it’s predicted by various sources that both may face a correction, however because interest rates are so low, this correction trigger is not on the horizon just yet – in fact, more people than ever before are moving into these two cities (from within the country and immigration) so it’s not yet certain when nor whether this correction will occur.

Another growing concern is rising debt loads. Largely due to mortgage debt, household debt is now at an all-time high and is continuing to grow. Canadian household debt is even higher than that of the U.S. now, which is unusual from a historical perspective. However, despite historic Canadian highs when compared to the rest of the world, these levels are still not that extraordinary. There are other developed economies (Denmark and Norway for instance) that have similar or higher household debt levels than Canada. U.S. household debt levels are lower than the global average. 

According to Mr. Porter, to deal with these economic challenges and help lead the economy over the next three to five years, Canada must rely on exports. In addition to government infrastructure spending, exports are primed to help Canada maintain its course in the coming years. With the drop in the Canadian dollar, exporters now have a better opportunity to compete.

As Mr. Porter explains, the Canadian loonie fell 30% in the last three years, attributed to three factors: 1. oil prices, 2. a strong US dollar, and 3. the Bank of Canada’s sensitivities to the challenges facing exporters and manufacturers. Overall, BMO’s February economics publication forecasted the loonie to trade at 71 US¢/CAD by the end of the year, and rebound to 75 US¢/CAD by the end of 2017. As warned by Mr. Porter, despite these forecasts, there is a chance the Canadian dollar will weaken over the next six months. Richter publishes a monthly summary of bank currency and interest rate forecasts which may be subscribed to here.

There will be winners and losers as a result of the weak Canadian dollar. The “winners” will be those sectors that compete internationally, with tourism leading the way. Technology, and some producers and manufacturers will generally benefit over time, as well. However, broadcasters, utilities and sports teams tend to see more pressure as a result of the weak dollar. There is a mixed impact on Canadian consumers, although benefitting from lower energy prices, they may also be impacted significantly due to the rising price on imports and travel.

Consumer prices have risen 1.6% in the last year, well above the U.S. and most of the industrialized world. Fruit and vegetable prices have led this trend, increasing 13% year over year. In the U.S., these prices are only up 0.4% in the last year, implying that the Canadian dollar is a major cause of this increase. In addition, prices of cars, clothing, books and insurance are also on the rise. Conversely, gas prices are beginning to decrease, along with goods relying on similar inputs, such as airfare, sporting and home entertainment equipment. Overall, the inflation rate is roughly 1.5%.

According to Mr. Porter, the current growth and inflation rate seem to indicate that there is a reasonable chance the Bank of Canada may cut interest rates once again. While there is a possibility of negative interest rates, currently it seems unlikely. Negative interest rates would only be necessary in extreme circumstances, such as those seen in 2008, of which the economy is not facing currently. Further, it is predicted that the Federal Reserve would raise interest rates in the U.S. once, or twice at most, over the next year.

In summation, economic challenges can be observed globally. By the end of the year, the S&P 500 is predicted to remain flat on the year, while Mr. Porter explains that the Toronto market may present some opportunity despite recent struggles. He emphasizes that while this global volatility is chipping away at U.S. export performance and investments, the negativity in the equity market has been overdone to some extent. However, given that, it is possible that the weakness in equity markets may spill over into consumer and business confidence. This can lead to softening and further concern in relation to the global economic outlook. The above being explained, the best outlook for the coming year is one of caution.

The above represents insights and observations gained by Richter, as presented by Mr. Douglas Porter, at the time of presentation. The article was not reviewed by Mr. Douglas Porter.

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