Subject: David Hale: The Outlook for the Canadian Economy
From: "Mark Zoff" <[email-masked]>
To: <[email-masked]>
Date: Wed, 8 Jun 2011 22:01:30 +0000 (GMT)

Dear Clients,

Please find attached our latest in-depth report, “The Outlook for the Canadian Economy,” which analyzes the recent performance of the Canadian economy and examines the key sectors and regions that will shape the country’s outlook in the years ahead. 

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Copyright 2011, David Hale Global Economics Inc. All rights reserved. Please do not forward the attached document to individuals not authorized by David Hale Global Economics to receive it. It contains confidential information and is intended only for the individual named. This document is not for attribution in any publication, and you should not disseminate, distribute or copy this e-mail without the explicit written consent of David Hale Global Economics.

The Outlook for the Canadian Economy
June 8, 2011 • Volume 08.06
By David Hale

The Canadian economy has been outperforming the US economy since 2008. Canada’s real GDP declined 3.3% during the 2008-09 recession whereas US real GDP fell 4.1%. It grew by 3.2% during 2010 compared to 2.8% for the US economy. The growth rate of domestic demand was twice as strong as the US growth rate. At the end of 2010, Canada had recovered all of the jobs that were lost during the recession and gained an additional 23,700. The US had recovered only 12% of its lost jobs. Household credit in Canada grew by 7% during the first six quarters of the recovery compared to a 3.5% contraction in the US.

Canada’s performance reflects the fact that it did not experience a financial crisis comparable to the one which struck the US economy during 2008. There was no boom-bust cycle in property. There were no bank failures. There was no upsurge of non-performing loans at Canada’s banks. Canada’s banks have among the highest capital ratios of the leading industrial countries. They were already at 7% and 10% for Tier 1 and Tier 2, respectively, when Basel II requirements were at 4.5% and 7%. Moreover, Tier 1 was required to be at least 75% common equity. Since then, Canadian banks have significantly increased their capital ratios. They are now into double-digit territory for both Tier 1 and total capital, well above the Basel III capital guidelines agreed at the November G-20 meeting in Seoul. There is also a rigorous supervisory regime overseen by the Office of the Superintendent of Financial Institutions, with clearly defined objectives and a principles-based approach to regulation as opposed to the rules-based approach in the US. As a result of these strong capital positions, the Toronto Dominion Bank has a triple-A credit rating while the other leading banks are double-A. Canada’s big six banks had a combined net income of $20.4 billion in 2010, exceeding 2009 net income by more than $6 billion and surpassing the previous record of $19.5 billion in 2007.

The resilience of Canada’s financial system has produced a more buoyant housing market than currently exists in the US. In 2010, Canada’s residential construction grew by 10% compared to a 3% decline in the US. After declining 13% during the recession, house prices are now 10% above their 2007 peak. The ratio of average resale prices to personal income was 14% above its long-run mean at the end of the first quarter, suggesting that the market is modestly overvalued. House prices eased in April after stricter mortgage lending rules were imposed, but are 8% above levels one year ago. In the nation’s hottest market, Vancouver, they are 21% above last year’s levels. The situation in the US is totally different. Home prices are 33% below their peak four years ago and are still declining. The Chicago futures market is projecting there could be a further 4.2% price decline by next February. Home prices are suffering from excess supply resulting from foreclosures. Developers have reduced inventory to low levels, but there are over two million homes still moving through foreclosure. As a result of weakness in the US market, Canada’s average house price of $373,000 is now 79% above US levels after three decades in which they closely tracked.

Canada’s economy grew at a 3.9% annual rate during the first quarter. Business investment rose 3.2% with increases in both non-residential structures (2.8%) and equipment (3.7%). Housing investment rose 2.2% led by renovation activity. Consumer spending on goods and services was flat as spending declined on autos and furniture. Growth in the second quarter could be subject to two shocks. The Japanese earthquake has disrupted shipments of auto components to factories in Ontario. As in the US, this could produce a 10% decline in auto output. Japanese companies account for 30% of auto output in the US. The uptick in oil and food prices has boosted inflation and is squeezing consumer income, depressing consumption. In March, real retail sales were only 0.5% above levels one year ago.

The economy’s strongest sector this year is non-residential fixed investment. It is likely to grow by 10% after a 5.2% gain last year. There was a 14% downturn of investment during 2008 and 2009, so firms are responding to a profit recovery by increasing outlays. They are also taking advantage of the strong Canadian dollar to purchase capital goods from foreign suppliers. Canadian operating profits rose by 8.1% during the first quarter as revenues grew 4.9% and margins expanded further. Operating margins have now recovered about two-thirds of the decline which occurred during the recession. Rising profits have also bolstered balance sheets, pushing cash to near-record levels compared to liabilities.

Canadians increased consumer spending by 3.4% during 2010 compared to only 1.7% in the US. The Canadian outperformance reflected job growth and the resilience of the housing market. Canada’s unemployment rate was 7.7% during the fourth quarter compared to over 9.0% in the US. Canadians’ ratio of net worth to disposable personal income has declined only slightly from 6.4 to 6.2, whereas in the US it has fallen from 6.4 to 4.9. Canadians have also been borrowing more aggressively than Americans. In the fourth quarter, household debt rose to 148% of personal disposable income (PDI) compared to 147% in the US. The uptick in the debt ratio provoked widespread concern that Canadians were becoming overleveraged. Economists pointed out that it is unfair to make comparisons based on PDI because Canadians pay for healthcare out of taxes, so PDI is income after taxes and healthcare, whereas Americans pay for healthcare out of income, so their PDI is income after taxes but before healthcare outlays. If comparisons are based on pre-tax personal income, Canada’s household debt ratio is 116% compared to 133% in the US. 

Canada’s most robust provinces this year are those with natural resources. Saskatchewan could be the leader with a growth rate of 4.0% compared to 3.8% for Alberta, 3.4% for British Columbia, and 3.9% for Newfoundland. Ontario and Quebec will have growth rates close to 2.7%. The mining industry in British Columbia increased its revenues by 13% to $7.9 billion in 2010, and could exceed its 2008 peak of $8.4 billion this year. The mining industry invested $1.25 billion in new projects last year, so the sector should benefit from both rising prices and increased output.

The federal government led by Prime Minister Stephen Harper recently submitted a new budget that is quite similar to the one it offered in March and whose rejection set the stage for the recent parliamentary election. The fiscal deficit is projected to be $32.3 billion in 2011-12 compared to $36.2 billion during the current fiscal year. The government intends to return to a surplus by 2015-16, but it could achieve the goal one year early because of the growth of tax receipts. The government is maintaining tight control on spending. It projects a gain of only 0.9% next year followed by 2.4% over the next three years, or numbers close to inflation. The government will promote investment by reducing the corporate tax rate to 15% and extending accelerated depreciation allowances until 2013. The government wants to promote more investment because Canadian productivity growth has greatly lagged the US during recent years.

Canada’s current account surplus rose to 3.1% of GDP during 2010 as imports grew by 13.4% while exports rose 6.4%. Exports plunged nearly 22% during the 2008-09 downturn and have since recovered only 13%. As Canada sends over 70% of its exports to the US, it is very sensitive to the growth rate of the American economy. The trade deficit widened to $137.0 billion at annualized rates during the third quarter of 2010 as US spending slowed while imports remained robust because of capital spending. The current account deficit could shrink to 2.0% of GDP this year as exports benefit from the commodity boom while import growth moderates. 

Canadian manufacturing firms are concerned about the strength of the Canadian dollar because they export half of their output. Some firms blame the strong dollar for the fact that Canada has lost one-half million manufacturing jobs since the exchange rate rose above $0.80 in 2004. The most vulnerable sectors are autos, clothing, and forest products because they already have very thin profit margins. The exchange rate has posed a challenge to metal producers, electronics makers, and chemical companies, but they have the advantage of higher profit margins. The tourism industry has also complained about the high exchange rate because it discourages American visitors while encouraging Canadians to head south. The Canadian dollar has been volatile during recent years because of its sensitivity to commodity prices. It peaked at $1.10 in late 2007 and then slumped during the financial crisis. It has rallied back above parity in part because of the strength of oil prices.

There is concern that Canada could succumb to the “Dutch Disease” because of the strong exchange rate, but the manufacturing sector has added jobs during the past year despite the rising value of the dollar. The challenge will be for Canadian companies to enhance their competitive position by reversing the recent decline of productivity. The strong exchange rate could help in this process by lowering the cost of capital goods imports. The government will also try to boost exports by seeking new free trade agreements and streamlining regulatory requirements at the US border.

One of the factors which could generate more export growth is the development of Alberta’s oil sands deposits. They currently produce about 1.7 million barrels per day and contribute over one-third of the 2.5 million barrels per day which Canada exports to the US. The Canadian Energy Research Institute projects that tar sands output will rise to 2.1 million barrels per day in 2015 and possibly as high as 4.9 million barrels per day by 2035. Transcanada Corp has proposed the construction of a 1,661 mile pipeline to refineries in Texas and the Midwest to accommodate these potential new oil supplies. There is opposition to the pipeline from environmentalists who oppose the oil sands project, and the State Department is conducting a review which will finally reach a conclusion late this year. As a result of the high oil prices which have resulted from recent supply disruptions in Libya, the odds are high that the Obama administration will approve the pipeline. 

The Bank of Canada raised interest rates three times during 2010. It is showing few signs that it is anxious to tighten policy again despite the fact that inflation has increased to 3.3% because of rising oil and food prices. The Bank is concerned about the strong Canadian dollar and perceives that there is still an output gap of 1.5%. The real effective exchange rate of the Canadian dollar has risen to 122 from 96 during 2009. There are also signs that retail spending could slow because of the debt burden in the household sector. The Boston Consulting Group has recently conducted a survey of households which shows a 6% increase—to 63%—in  Canadians who plan to reduce spending on non-essential items, compared with a 19% decline among Americans who plan to do the same. Governor Mark Carney may be concerned as well about the impact of rising commodity prices on the US economy. In a recent speech he discussed how Canada was not sharing as much as it should from the boom in emerging markets, but was vulnerable to their impact on commodity prices in the US economy. He said:
Since only 10 per cent of Canada’s exports go to emerging economies and our non-commodity export market share in the BRICS has been almost halved over the past decade, activity in Canada does not benefit to the same extent as in past commodity booms driven by U.S. growth. The current situation is more akin to a supply shock for our dominant trading partner, with higher commodity prices acting as a net brake on growth. With oil prices up 50 per cent since last summer, the effect is material. (Mark Carney, “Canada in a Multi-Polar World, May 16, 2011)

The OECD has called upon the Bank of Canada to raise interest rates in order to control inflation expectations. The shadow monetary policy committee of the CD Howe Institute has called for the Bank to tighten. The overnight index swaps market is now suggesting there is less than a 50% probability that the Bank will tighten in September whereas in March the market was discounting a rate hike by September. The Bank has a history of pausing for prolonged periods during tightening cycles. During the 2004-07 cycle, the Bank paused once for six meetings and then again for eight meetings. As core inflation is only 1.6%, Mr. Carney probably shares Ben Bernanke’s view that recent inflation shocks could be transitory. If Canada’s economy regains momentum after the supply shocks during the second quarter, the odds will increase of a rate hike during the fourth quarter. But the Bank will be highly sensitive to developments in both the US and Canadian economies.

The OECD has recently published a new quality of life index comparing thirty-four countries. Canada ranks number one or two in many of the survey’s eleven well-being indicators. Only Australia topped Canada.  The quality of life index, coupled with the benign performance of the economy, helps to explain why the Conservative Party was able to achieve a parliamentary majority in the recent national election. Surveys indicate that Canadians are far more optimistic about their economy than Americans. As 17% of Canada’s GDP comes from exports to the US, there is no way that Canada can significantly outperform the US economy, but its strong financial position and modest fiscal deficit suggest that it has the potential to modestly exceed US growth during 2011 and 2012. In 2011, the OECD projects Canadian output will grow by 3.0% compared to 2.6% in the US.

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©2011 David Hale Global Economics, Inc
All rights reserved. This document may not be quoted, forwarded, disseminated, distributed, or published without the express written consent of David Hale Global Economics, In