Bonne chance, Mr Trudeau. That's the takeaway from HSBC Bank Canada Chief Economist David Watt for Prime Minister-in-waiting Justin Trudeau after an election centred on Canada's economy. The oily tide has gone out, the economist warns, and now the nation's drivers of growth - or lack thereof - have been laid bare for all to see.
"Until Canada overcomes its productivity and competitiveness hurdles, it will continue to feature cyclical behaviour similar to those of emerging-market economies," Watt writes.
For equity investors, Watt's comparison will come as no surprise. The S&P/Toronto Stock Exchange Composite index has tracked the movements of the MSCI Emerging Markets index fairly closely.
But it's an odd time for renewed pessimism over Canada's prospects. Oil prices have stabilised, the economy booked back-to-back months of strong growth in June and July, the incoming government has pledged to boost infrastructure spending, and domestic demand in the US - the world's largest economy and Canada's biggest trading partner - is buoyant.
On trade, however, the economist says this time it's different.
In his report, Watt joins some of his peers in arguing that an economic acceleration south of the Canadian border doesn't pack the same punch it once did. Bank of America Merrill Lynch Canada and US economist Emanuella Enenajor has detailed how Canada's sensitivity to US domestic demand has been on the decline, while Steven Englander, Citibank's global head of G-10 currency strategy, has connected the subdued performance of Canada's non-energy exports to the ascendance of Mexico in US manufacturing. Mexico now benefits handsomely from its proximity to the US and enjoys its position as an integral part of many supply chains.
Canada's weakened currency has helped the nation increase its cost competitiveness with the US, Watt acknowledges, but hasn't significantly shifted the calculus. Generally speaking, HSBC economists have found little evidence of exchange rate depreciation fuelling export growth since the financial crisis. And some contend the weak exchange rate actually impedes productivity growth. The increase in competitiveness through lower labuor costs masks productivity shortcomings, while the soft domestic currency makes importing such materials more expensive, the thinking goes.
The Canadian economy is expected to rebalance towards non-commodity tradeable goods and the continued development of the services sector, but this won't be a seamless or swift transition. It will come amid "a negative terms of trade shock that will weigh on disposable income and wealth", Watt writes. "This will feature a lower demand for labour in the commodity-producing sectors of the economy, reduced spending on imports and weaker demand for non-traded goods, services, and housing. These adjustments have only just begun."
HSBC expects Canada to return to growth in the second half of 2015, but observes that every economic green shoot seems to be attended by a gray cloud. And if cashing in on external demand looks difficult, squeezing growth out of domestic drivers could be even harder. Canadian households can hardly be expected to make sizeable contributions to growth, with debt service ratios above historical norms and debt-to-income ratios at a record high. The erosion of purchasing power from lower oil prices, which prompted the Canadian dollar to decline in tandem, certainly doesn't help. Housing-related spending looks poised for a cyclical slowdown, Watt says.
"Residential investment (including investment in new construction, renovations, and costs related to the transfer of existing homes) in Canada at around seven per cent of gross domestic product is near a record high," Watt writes. "Such a threshold had been hit just prior to disruptive housing corrections in Canada in the late 1980s and in the US in the middle of the last decade."
Meanwhile, the collapse in oil prices will continue to adversely affect the economy for an extended period, according to HSBC.
Corporate profits have displayed a close relationship with oil prices throughout the new millennium, Watt observes, and a deterioration in this area implies soft investment growth. That's one portion of the Canadian recovery that's been conspicuous by omission, particularly once the oil patch and residential construction are excluded from the equation.
Canadian oil sands producers can't expect improvement soon. The shale revolution has spurred the growth of supply with a radically different cost structure from oil sands mining operations, and the ability to bring oil to market considerably faster. As oil prices rise, the marginal producer is much more likely to be a US fracker than a Canadian miner. The energy sector doesn't make up a massive chunk of the Canadian economy, but has contributed a substantial amount to the growth in investment since the recession. Watt says oil patch investment could drop off by more than 40 per cent as firms ratchet down their long-term estimates for crude prices.
The incoming prime minister certainly isn't responsible for these dynamics, and has limited influence over how they evolve over time. But how he navigates these challenges will likely define Canada's economic trajectory over his tenure and, in turn, his political longevity and legacy.
The good news for Trudeau is that he's not fighting these battles all alone, Watt notes. HSBC expects the Bank of Canada to cut interest rates by another quarter of a percentage point before the end of the year, in an attempt to provide further support for the economy.
© Bloomberg
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