Thursday, December 23, 2010

Shifting Drivers of Canadian Economic Growth

When we last wrote about the Canadian economy  in October, we warned of a slowing pace of
expansion and posited that full year growth for 2010 would come in at about 3.0 percent and 2011
would see somewhat slower economic growth of about 2.5 percent. Since that time, we have
learned that growth did indeed slow in the third quarter (Figure 1). There have also been a
number of developments in the U.S. economy including additional quantitative easing measures,
the extension of the Bush-era tax cuts and a run of better-than-expected economic data.
Consequently, we have upgraded our outlook for the U.S. economy. Given the strong trade ties
between the two countries, it stands to reason that the brightening picture in the United States
will be a boost for Canadian exports. Trade has been a drag on growth in Canada for six straight
quarters as import growth generally exceeded export growth over that period. Imports surged
earlier this year, driving the Canadian trade balance to the largest deficit on record in July (Figure
2).  Looking forward however, net exports should exert less drag on the economy as softer
domestic demand keeps a lid on import growth and exports benefit from the stronger U.S.

The rest of our outlook for Canada remains  essentially unchanged.  Business spending will
continue to drive overall growth as corporations remain flush with cash. Consumer spending
growth should continue, though the pace may slow somewhat as Canadians begin to whittle down
debt. Finally, the boost from government spending will wind down as stimulus spending draws to
a close.

Disappointing Third Quarter GDP 
During the global recession, Canadian GDP declined “only” 3.3 percent on a peak-to-trough basis.
That number appears small only when compared to the experience of other developed market
economies, like the 5.3 percent decline in Eurozone GDP or the 6.5 percent plunge in the United
Kingdom. Since bottoming in the second quarter of 2009, the Canadian economy has grown
3.7 percent and real GDP is now higher than pre-recession levels.

That said, the pace of the Canadian recovery is slowing. The economy expanded at only a one
percent pace in the third quarter, which was weaker than the 2.3 percent rate registered in the
previous quarter (Figure 3). Although the outturn in the third quarter came as a disappointment,
a look at the components of growth presents a somewhat more favorable picture of the Canadian
recovery. Growth in government spending slowed in the quarter, which had been largely expected
as the Canadian stimulus program winds down. Growth in both consumer spending and business
fixed investment spending were quite strong and roughly in line with the pace of expansion in
previous quarters. Indeed, final domestic demand expanded at a 3.9 percent annualized pace. The
factor holding back growth was the 4.4 percentage point drag from net exports.

In September, the trade deficit widened to C$2.49 billion, almost matching the C$2.51 billion
level hit in July, which represented the biggest gap in the Canadian trade deficit since records
began in 1971. In the decade preceding the recession, Canada never ran a trade deficit. There are
two primary reasons for the reversal in trade in  this cycle: 1) Slower economic growth in the
United States has weighed on growth in Canadian exports; and 2) Growth in domestic demand in
Canada has been relatively strong. But both of those factors are about to change.

U.S. Outlook is Brightening 
In just the last couple of months the outlook for the U.S. economy has improved. In early
November the Fed announced that it would re-engage in quantitative easing by purchasing up to
$600 billion of Treasuries on a $75 billion per month schedule through June 2011. Although the
plan is not without its critics, it likely will provide a boost to growth in the near term. That said, it
also raises the risk level for inflation, which is why Kansas City Fed President Hoenig’s dissented
focusing on his view that the risks exceed the benefits of the easing.

The U.S. outlook for 2011 has also improved due to the tax compromise reached between the
Obama Administration and congressional leaders, which will extend Bush-era tax cuts including
lower tax rates on dividends and  capital gains. The deal also includes a temporary reduction in
“payroll taxes”, which may lift consumer spending during the first half  of 2011. The deal has
helped to reduce uncertainty within the financial markets. Indeed, since the original deal first
surfaced as a compromise between President Obama and Republican leaders in the first week of
December, the S&P 500 has rallied more than 5  percent. In the bond market, the “flight to
quality” trade seems to be unwinding as well, with the yield on the 10-year U.S. Treasury rising

roughly 50 bps at the time of this writing. The continued reduced tax rate on both firms and
consumers should also be supportive of a pick-up in U.S. hiring.

Developments in the U.S. economy have generally been better than expected and serve to
underpin our long-held view of slow growth while simultaneously diminishing the credibility of
the double-dip crowd. A stronger-than-expected retail sales report for the month of November
suggests that our forecast for a 5 percent year-to-year increase in holiday sales should be on track.
U.S. industrial production rose 0.4 percent in November with gains spread across many sectors
including consumer appliances, business equipment, construction supplies and materials.
Outside of motor vehicles, output was even stronger, up 0.7 percent on the month. This strength
is consistent with our expectation for sustained growth in business investment as a support for
continued growth.

Between the additional stimulus, the extension of tax cuts and a run of better-than-expected
economic data, consensus estimates for fourth quarter real GDP growth in the United States are
trending upward. We would not be surprised to see a sequential growth rate of nearly 4 percent. If
realized, it would be the second fastest quarterly growth rate since 2006.
Over the last decade, Canada has been gradually diversifying  its trading partners.

Whereas exports to the United States comprised 87 percent of all Canadian exports in 2000, that share had
shrunk to 75 percent in 2009 (Figure 4).That said, with three quarters of all exports destined for
the United States, Canadian growth remains very exposed to the economic cycles of its southern
neighbor. Consequently, stronger GDP growth in the United States is good news for Canadian
exporters. A pickup in demand from the United States could help offset the negative effect on
trade stemming from the strong Canadian dollar that makes Canadian goods more expensive to
most foreign buyers.

As discussed earlier, trade has been a drag on Canadian GDP growth. Consider the fact that total
domestic demand in Canada grew at a 4.9 percent pace in the third quarter boosted by strong
growth in spending by consumers, businesses and  the government as well a rise in inventories.
Yet after factoring in the drag from trade,  overall GDP growth was reported as a paltry
1.0 percent. Looking forward however, net exports should be less of a drag on the economy as
softer domestic demand keeps a lid on import growth and exports benefit from the stronger U.S.

Wind Down of Government Stimulus Spending  
As the world economy dug out of the global recession, one of the developing themes has been that
emerging market economies recovering faster than the developed economies of the world. There
are many reasons behind this development, but perhaps the most significant factor is that many
developed economies entered the crisis with a lot of debt and many developing economies did
not. The one developed economy that does not seem to fit the mold is Canada. An aggressive plan
in the 1990s to reign in government spending and balance fiscal budgets positioned Canada better
than many of its developed market peers. The Canadian economy boasted one of the strongest
recoveries among all developed nations, partly because it (like many emerging market economies)
entered the crisis on better financial footing.

The comprehensive stimulus spending program—the Action Plan—delivered a C$62 billion boost
to the Canadian economy in fiscal years 2009 and 2010.2

While the program was generally 
viewed as a success, Canadian Finance Minister Jim Flaherty aims to balance the budget again
within five years, which means the end of large scale government spending to boost the economy.
Over time, as stimulus is withdrawn, growth in government spending will slow significantly from

its Action Plan-induced surge. Fortunately, spending by consumers and business should be able
to pick up much of the slack.

Challenges for Consumer Spending 
The Canadian economy started the current year with significant momentum, expanding at an
annualized pace of 5.6 percent in the first quarter—the fastest pace of growth on a sequential
basis in at least a decade. Part of the reason for Canada’s success is that the government was not
as highly levered as other developed market economies. Similarly, the Canadian consumer was
also not as highly levered on the eve of the crisis. However consumer spending growth in the
second and third quarters failed to match the heady 4.1 percent pace registered in the first
quarter, and we suspect it may be some time before it does because at some point Canadian
consumers will need to pay down some of the debt they have taken on recently.

Household debt as a percent of GDP in Canada was substantially lower than it was in the United
States in early 2008 (Figure 5).  Consequently, consumer spending in Canada held up better
during the recession because Canadian households were not trying to de-lever like their American
counterparts. But the tide has turned; over the  last few years, American consumers have been
actively reducing their debt while Canadian households have taken on more leverage. As a percent
of GDP, total household debt in Canada has risen from 77 percent in 2008 to over 90 percent
through the third quarter of this year. In the same time period, U.S. household have gone from
more than 92 percent to 85 percent. The saving rate in the United States, which had dropped to
only 2 percent of disposable income in the 2006-2008 period, has risen substantially in the last
two years to roughly 6 percent at present. In Canada, the saving rate has come up only modestly
from roughly 3 percent to 4 percent or so in the last 18 months (Figure 6).

Because the Canadian consumer has become rather levered and the saving rate has fallen so
precipitously, we suspect that the Canadian consumer will eventually need to unwind some of this
debt. This de-leveraging will obviously present a major headwind to spending growth. If there is a
silver lining to slower consumer spending, it would be a corresponding dip in import growth,
which would be a positive for GDP in terms of the boost from net exports.

We would be remiss not to point out that there are solid fundamentals that should continue to be
supportive of growth in Canadian consumer spending as we head into 2011. Most notably, the
Canadian job market is still in rather good shape. The unemployment rate has dropped from the
cyclical high of 8.7 percent in August 2009 to 7.6 percent at present, and the economy has already
recouped all of the jobs lost during the recession.  The solid job market should continue to be
supportive of income growth, which in turn should help drive consumer spending. Still, we
suspect that the debt-fueled spending by Canadian consumer during the early stages of this
recovery has run it course. Debt repayment by Canadian households will likely act as a governor
restricting the pace of spending growth to less than 3 percent in the year ahead.

Growth in Business Investment Spending Should Offer Some Offset 
With slower growth in consumer spending and government stimulus winding down, a welcome
offset may come from a pick up in investment  spending in Canada’s business sector. The Ivey
purchasing manager index is notoriously choppy and the most recent reading suggests a slower
pace of expansion slipping from 70.3 in September to 56.7 in October. 3

Canadian factory sales jumped 1.7 percent in October, a larger gain than the consensus had
expected. Our positive outlook for healthy business sector spending is buttressed by the robust
3.0 percent gain in October factory orders. The  jump in orders brought the inventory-to-sales
ratio down to 1.33 from 1.35.  This ratio helps gauge the extent to which factories are deliberately
increasing inventories. The inventory-to-sales ratio rose in three out of the last four months
raising some concern that there was unintended inventory building in the industrial sector. The
decline in October diminishes those concerns somewhat.

Business fixed investment spending has expanded  at a pace of roughly 8 percent over the past
five quarters, and we see little reason why the business fixed investment spending would slow
significantly in the foreseeable future. In fact, spending could actually accelerate from here
considering our outlook for an increase in exports to the United States. Historically, periods of
strong export growth are associated with a corresponding increase in business fixed investment

Inflation and the Bank of Canada 
The Bank of Canada (BoC), has been ahead of other G7 central banks regarding the removal of
monetary accommodation. Between June and September, the BoC raised the overnight rate from
25 basis points to 1.00 percent. However the BoC has been on hold the past two meetings as the
Canadian economy has been expanding at a slower rate each quarter this year. The BoC remains
the only central bank from a G7 economy to have raised rates in this cycle.

The policy challenge for the BoC occurs when inflation is rising but economic growth is slowing.
The BoC’s only objective is to keep the CPI inflation rate in a range of 1 percent to 3 percent.
Because policymakers thought that inflation could eventually breach the top end of the target
range, they felt compelled to raise rates this spring and summer even as the sovereign debt crisis
in Europe sparked concerns about a slower global recovery. Fortunately, the latest price data

suggest that inflation likely will remain within  the BoC’s target range. The Canadian consumer
price index rose just a tenth of a percent in November, slowing the year-over-year growth rate to
only 2.0 percent—smack dab in the middle of the BoC’s target range. Excluding food and energy
prices, core CPI was flat for the month and the year-over-year increase in core consumer prices
was only 1.4 percent. With an economic recovery that has been losing some momentum in recent
quarters, and the inflation rate within its target range, we expect the BoC to leave its policy rate at
the present level until its meeting in July 2011.  If inflation concerns remain essentially a nonissue, we could see the BoC remaining on hold even longer.

Canada entered the financial crisis on solid financial footing. The government was not running
large budget deficits, which allowed the Canadian government to deploy the Action Plan to
stimulate growth, and consumers were not highly  levered, which afforded them the wherewithal
to rapidly increase spending at the outset of this recovery. The result was a swift and full recovery
that outpaced the recoveries in other large, developed economies.

We are at a turning point in the economic cycle and the dynamics have changed. The boost to
growth from government spending has run its course. The consumer has become rather levered
over the past 18 months or so. We suspect that personal consumption expenditures will decelerate
somewhat in the year ahead as consumers increase saving rates and pay down debt.

On a positive note, continued solid growth in business fixed investment spending will help pick
up some of the slack from deceleration in consumer and government spending. We also expect
that the drag from net exports on overall GDP growth will dissipate in the quarters ahead. The
lion’s share of Canadian exports still goes to the United States. Although slow economic growth in
the United States helped to hold back Canadian export growth, the U.S. economy may prove to be
an asset once again as the U.S. recovery picks  up  momentum  in  2011. We  project  that  the
Canadian economy expanded roughly 3 percent  in 2010, and in 2011 we look for continued
growth on the order of 2.5 percent.
Full report: Shifting Drivers of Canadian Economic Growth

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