Canadians Start 2016 with Some Trepidation

Canadians start 2016Canadians Start 2016 with Some Trepidation

Guest post by Norman Mogil

Trepidation is often defined as a worry or fear of what is going to happen. This best describes the feeling manyĀ Canadian investorsĀ have regarding the Ā economic outlook for 2016. It all started with the dramatic collapse of world oil prices in 2014, theĀ continuedĀ decline through 2015 andĀ  then Ā intoĀ January 2016.Ā  To get a better appreciation of why there is growing concern for 2016, let usĀ review the basic developments of 2015 and how they may impact on developments in Ā 2016.

Table 1 identifies some of the key economic developments of 2015 that are now weighing on our minds as we launch into 2016.

Canadians start 2016

  • Economic growth. The year 2015 started off badly as the economy contracted, and, by the summerĀ GDPĀ Ā had fallen for two consecutive quarters, technicallyĀ a recession. TheĀ Q4 will likelyĀ beĀ slightlyĀ positive, but for the year as a whole,Ā observers expectĀ GDP will beĀ nearĀ 1%. Not a good handoff to 2016
  • Unemployment. The unemployment rate crept up during 2015 from 6.8% to 7.1%. More significantly, the quality of job creation leaves a lot to be desired.Ā In December,Ā  for example,Ā Ā the economyĀ created 23,000 additional Ā jobs;Ā  however there was a loss ofĀ  17,000 full time payingĀ jobsĀ againstĀ a gain of 40,000 self-employedĀ  workers.
  • Inflation.Ā Ā The rate of price increases slowed considerably, largely inĀ reaction Ā to the fall in gasoline prices. This isĀ a mixed blessing for a country that relies so heavily on oil exports.
  • Terms ofĀ  Trade. TheĀ  prices we receiveĀ for ourĀ exports have fallen relative to the prices of imports,Ā resulting in a decline in national income.Ā  The Bank of Canada estimates that the decline in the terms of trade has resulted in a loss of $50 billion a year or $1,500 per person per year.
  • Oil Prices. TheĀ  continued slide in oil prices has had a dramatic effect on capital investment, especially in the Oil Patch. ThisĀ Ā has resulted in significant job losses in western Canada which continue to this day. The industry mantra regarding prices is ``lower and longer``; the question is how much lower will prices fall and for how much longer. Already January's price decline of 10% is roiling the financial markets everywhere.
  • Canadian Dollar. In the wake of the strong upward movement of the USD, the CDN has fallen sharply over the year, forcing Canadians to make unwanted adjustments in the purchase of imported goods (especially food) and in international travel. Consumer confidence has been hurt by the dollar's almost free fall.

Essentially, the drop in oil prices is now reverberating throughout the whole country. As the Governor recently admitted, "the forces that have been set in motionĀ  simply must work themselves out"(1). It is no wonder that the mood in Canada is subdued and there continues to be a feeling that we areĀ powerless Ā in dealing,Ā  in the short run, withĀ a deteriorating economic situation.

The Canadian stock exchange, the TSX60Ā  is heavily weighted in energy and bank stocks. The resultant 12% decline in 2015 was one of the largest in recent memory.Ā  This trend continues in theĀ first week of January 2016 when the index fell another 7%, adding to investors' woes. Recently, a Bank of CanadaĀ surveyĀ of business conditions, revealed that business respondentsĀ  predicted a further decline in investment plans for 2016. The commodity bust is now starting to seep into other sectors of the economy.

With deflationary forces well entrenched, short and long term interest rates fell significantly during 2015. TheĀ  Bank of Canada lowered its rate twice, dropping the overnight rate from 1% to 0.5% in response to the deteriorating domestic Ā economic conditions. Housing was the only bright spot in 2015. Nationally, the average home price increased by 10%; although Ā the market was heavily skewed to the very lofty prices in Vancouver and Toronto, the rest of Canada experienced modest price increases ( Table 2).

Policy Responses

In a recentĀ speech, the Governor of the Bank of Canada,Ā  adopted a 'made -in-Canada' monetary policy. This policyĀ  diverges from that of the US where the Federal Reserve is on track to raise short term rates Ā over the course of the next 12-18 months. The Governor stated "we will continue to conduct an independent monetary policy in response to our own economic circumstances in order to meet our 2 percent inflation target"(1).Ā He cited a range of conventional and unconventional tools that are available to promote growth. In fact, many analysts expect the Bank to lower its rate later this year in effort to boost growth, further entrenching the theme of divergence in monetary policy.

Benjamin Tal of the CIBCĀ claims:Ā "It's becoming very obvious that monetary policy is not the solution. The Governor admitted thatĀ a low currency is our only hope but the benefit of cutting rates in order to get another cent or twoĀ out of the dollar fades relative to the damaging impact on household leverage" (2). In other words, there is a concern that dropping short term rates will only fuel the housing market-- a market that some consider to be overheated consideringĀ household debt levels. This bringsĀ us to the most controversial aspect of the Canadian environment: will housing prices finally crack under the weight of a deteriorating economy?

There are many ways to measure the vulnerability of housing prices to household leverage. For American readers this topic also resonates, having endured one of theĀ largest housing collapses in modern historyĀ starting in 2007.Ā Ā In a recent study by the staff of theĀ  Bank of Canada, summarized in Table 3,Ā debt ratiosĀ are compared between Canada in 2012/4Ā with those in the U.S. in 2007. Canadians are not nearly indebted todayĀ as the Americans were in 2007.Ā Ā For example, Canadian households with debt service ratiosĀ of 40% plusĀ (a major threshold level) comprise onlyĀ 36% of all household, compared toĀ  71% of US households in 2007.

Given the limitations on monetary policy, we haveĀ to look to fiscal policy to improve the economic climate. The Federal Government will introduce a budget in February whichĀ is expected to featureĀ  infrastructure spending across the nation. The remaining hope is for a stimulus package. Meanwhile, Canadians continue to feelĀ Ā a degree of vulnerability. We start the new year with considerableĀ unease.

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(1) January 7, 2016
(2) CIBC newsletter, January 11, 2016

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