Canada Playbook 2018: The Year of Uncertainty. Frances Donald, Senior Economist. ManulifeAM.com

Transcription

1 w Canada Playbook Frances Donald, Senior Economist February 2018 ManulifeAM.com

2 Executive Summary 2017 was a year full of surprises for the Canadian economy and almost all of them were unequivocally positive. Forecasters chased the trend, raising expectations for 2017 at almost every turn (see Chart A). Even the Bank of Canada (BoC) appeared to have made a fairly rapid policy stance adjustment, moving from the idea that a rate cut was still on the table at the beginning of the year to hiking twice by the end of the year (and again this past January). All said and done, Canada likely ended 2017 with a formidable 3% growth rate, besting every other country in the G7. 1 However, forecasting growth in Canada in 2018 will be a more difficult risk management exercise. Forecasters will need to balance a solid and broadening growth trend against a particularly uncertain outlook which is increasingly muddied by a growing list of risks that may or may not create headwinds to growth. Where 2017 was undoubtedly the Year of Surprises, I believe 2018 will be the Year of Uncertainty. CHART A: Canadian Growth Forecast Evolutions Forecasters Spent 2017 Chasing Canadian GDP Higher Bloomberg Consensus Expectation for Annual GDP (%) Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb Projection 2018 Projection Source: Bloomberg, Manulife Asset Management, as of February 6, Frances Donald Senior Economist 1 Bloomberg, as of January

3 Three Growth Themes for 2018 In my view, three broad themes will characterize the Canadian growth story in the year ahead: 1. Growth is Broadening Across Regions, Sectors and Industries Unlike the period, where strong growth in the non-energy economy offset the painful recession in the energy economy, growth in Canada is now solid across most provinces, sectors, and industries. Our calculations show growth accelerating in 95% of Canadian industries, and 41% of industries growing at faster than 4% year-on-year. 2 Specifically, growth is being supported across the board by consumers, businesses, fiscal spending, and trade. Its breadth makes Canada less vulnerable to sector-specific shocks and reduces the overall risk profile of the economy. Breadth of Canadian Growth Becoming Impressive Share of Canadian Industries 100% 80% 60% 40% 20% 0% Year-on-Year Growth > 0% Year-on-Year Growth > 2% Year-on-Year Growth >4% Source: Statistics Canada, Manulife Asset Management, as of November Crucially, Canada s energy sector appears to have fully recovered. Oil and gas made positive contributions to growth in every month in and will likely continue to be a tailwind to economic growth in Rising oil prices should also help to contribute to more stability in the region. Alberta has now recouped all of the jobs lost during its recession and growth is projected to exceed Ontario in A Slower Pace, But a Healthier Pace While economic growth is likely to be broader in 2018, it is also expected to accelerate more slowly than it did in That s ultimately a good thing as a trend growth rate around 2% is more sustainable than the 4% seen in the first half of A moderate pace of growth gives the Bank of Canada some flexibility in the current rate hike cycle fast enough to provide support for rate normalization, but not enough to force the central bank s hand. GDP Quarter-on-Quarter (Annualized) Percent (%) Q Q Q Q Canadian Growth Set to Slow to 2% Trend Q Q Q Manulife Asset Management Forecast Q Q Q Q Q Source: Statistics Canada, Manulife Asset Management, as of February 6, Manulife Asset Management, as of February 8, Statistics Canada, January 31, Statistics Canada: Labor Force Survey Estimates, as of February 2,

4 Bank of Canada Estimates: The Output Gap is Probably Closed Percent (%) Integrated framework methodology Extended multivariate framework methodology Source: Bloomberg, Bank of Canada, Manulife Asset Management, as of Q According to the BoC, Canada likely absorbed all of its remaining excess slack in 2017 and is now entering a period of excess demand. 5 A 2% trend growth rate (or, any growth rate above the Bank of Canada s estimate of potential GDP of 1.6%) will continue to push Canada into excess demand territory. This environment should be supportive of further job creation and business investment. It will, however, also bring about some underlying price pressures. 3. US Growth will Continue to be the Tide that Lifts the Canadian Boat While Canada s economic narrative has been largely dominated by domestic issues over past three years with a big focus on the energy and housing sectors, the country s economy remains underpinned by US growth: about one-fifth of Canadian GDP is directly generated from exports to the United States. As the synchronized global growth expansion continues, we expect US growth to be sustained at a solid pace, fueled by a strong consumer, a temporary sugar-boost from a US tax reform package, 6 and rising business investment. US manufacturing activity and business investment will be particularly important to Canada, as those drivers of the US economy have a more direct link to the Canadian economy than the US consumer and services sector. Canadian Non-Energy Exports Poised to Pick-up as US Manufacturing Activity Recovery Continues % 15% 10% 5% 0% -5% -10% -15% -20% -25% YoY % Change US ISM (Three-Month Moving Average) Canada Real Exports ex Energy Year-on-Year % (Three-Month Moving Average) Source: Statistics Canada, Manulife Asset Management, as of February 6, Bank of Canada: Monetary Policy Report (January 2018), January 17, Manulife Asset Management: Global Economic Outlook, December 18,

5 Uncertainties Abound The three growth themes for 2018 paint the picture of an economy that is much more resilient to shocks than it was in 2016 or even That s a positive because we believe the likelihood of shocks is rising. Where Canada-watchers are concerned, the biggest challenge this year is to work out how to acknowledge the strength of the current economy while balancing it against a growing list of uncertainties with wide a range of outcomes. In our view, there isn t one individual issue that could by itself derail the Canadian economy. In our view, there isn t one individual issue that could by itself derail the Canadian economy. However, we are concerned that the sum of the evolving risk factors could deter or defer business investment. While recent surveys show that business investment intentions remain elevated, the question is whether they might have been even stronger in the absence of these uncertainties. Canada needs businesses to invest urgently, as evidenced by the country s high capacity utilization rates and the reported inability to meet a surge in demand without further expansion. 7 Canada Needs Business Investment: Capacity Utilization Levels are High and Growing Q Q Q Capacity Utilization (%) Q Q Q Q Q Q Q Q Q Q Q Total industrial Construction Manufacturing Source: Statistics Canada, Manulife Asset Management, as of February 6, Statistics Canada: Industrial Capacity Utilization Rates, as of December 8,

6 Looking ahead, we see four major uncertainties that warrant careful consideration. UNCERTAINTY 1: The Impact of Three Rates Hikes, Already in the Bag, on an Over-Levered Consumer The Bank of Canada raised interest rates by a total of 75 basis points (bps) between July 2017 and January To be clear, the objective of rate hikes is to slow the rate of economic expansion and prevent inflation from rising too quickly. The challenge, however, lies in in knowing the extent to which these rate hikes will slow the economy, and particularly, how they will affect the consumer. Naturally, this is not the first time that the Bank of Canada has raised rates by such a magnitude in the space of six months the benchmark interest rate rose 75bps in 2010, for example. That said, it is important to note that Canadian household leverage has never been this high, meaning the economy is likely to be far more interest rate sensitive than it was eight years ago. Due to higher debt levels, it is likely that the net impact of higher rates on disposal income for the average household could be greater than it has been historically. In our view, the most important data point to keep an eye on is the household Debt Service Ratio (DSR), which tells us the share of income that Canadians must put towards the interest and the principle on their debt. For the past 10 years, households have been paying around C$14 out of every C$100 of disposable income towards their debt. The cost of debt, however, will rise as the Bank of Canada continues to raise interest rates and Canadians will need to set aside more money to pay their debt bill each month. That will likely result in households switching away from other forms of spending. It could also contribute to an increase in debt delinquency rates, though we expect these to stay manageable at the macro level. Canada s Share of Disposable Income Heading Towards Debt Payments Has Been Stable, Now Set to Rise Debt Service Ratio (%) Q Q Q Q Q Q Q Q Q Q Q Q Q Q We expect to have more clarity on how higher interest rates are affecting the consumer around mid-year. Until then, it remains a shock that we think is on its way but are unable to work out the extent of its impact. Debt Service Ratio (Interest Only) Debt Service Ratio (Interest + Principle) Source: Statiistics Canada, Manulife Asset Management, as of Q

7 UNCERTAINTY 2: The Rise in the Minimum Wage in Ontario Ontario s minimum wage rose 29% from C$11.40/hour to C$14/hour at the beginning of the year. It is set to rise again to C$15/hour on January 1, Over the longer-run, it is entirely plausible that the benefits of higher minimum wage (e.g. higher wages to lower income households) will outweigh the negatives (e.g. rising costs for businesses). However, given the magnitude of the change, it is likely that the rise in minimum wage could translate into a negative shock to the economy in the short term. First, it could lead to some job losses and/or a decline in total hours worked as companies adjust to the rising cost of labor. Second, we could see some upward pressure on consumer prices as businesses transfer some of the higher labor cost to the end consumer. According to the Bank of Canada, up to 60,000 jobs could be lost and prices could rise by 0.1 percentage points in 2018 as a result of the new minimum wage policy. This has also been highlighted as a likely outcome in the recent Winter Business Outlook Survey. 8 To put things into context this would only represent mild headwinds to economic activity in Ontario (which represents about 40% of the Canadian economy). However, we are wary of the potential for larger shocks and, as always, the possibility that some segments of business investment are being deterred as a result of uncertainty. Minimum wage in Alberta is set to rise again on October 1, This would be the final adjustment in a four-year long process, which saw minimum wage in the province jump from C$10.50/hour to C$15/hour. 9 Given the slower speed of adjustment, and an accelerating local economy, we expect the near-term headwinds to be minimal. UNCERTAINTY 3: Another Set of Mortgage Rules on Housing Canada s Office of the Superintendent of Financial Institution (OSFI) updated its B-20 guidelines for mortgages last October. 10 The guidelines were meant to tighten lending standards and, among other things, subjected all new mortgage applications to a stress test (previously, the stress test only applied to mortgages with low down payments with terms of less than five years). Assessing the impact of the new guidelines on the housing sector remains to be a challenge. On one hand, about 70% of originations are non-insured, so these revised guidelines will hit a larger segment of new mortgages than prior regulation targeted insured mortgages. However, these new rules do not apply to provincially regulated credit unions and mortgage seekers may switch towards those institutions. The combined effect of more stringent mortgage rules and higher interest rates makes it challenging to paint a positive picture for Canadian housing, particularly in the bubble regions of the Greater Toronto Area and the Vancouver/Victoria area. We continue to expect a deterioration to flat activity in housing as opposed to a major correction. It would be prudent, however, to be positioned for downside surprises given the growing list of pressures on the housing sector. 8 Bank of Canada: Business Outlook Survey Winter , January 8, Alberta Government: Minimum Wage, as of January OSFI: OSFI is Reinforcing a Strong and Prudent Regulatory Regime for Residential Mortgage Underwriting, October 17,

8 UNCERTAINTY 4: NAFTA and US-Canada Trade Negotiations 11 In our view, it is unrealistic to produce a simple (or single) answer to the question of what NAFTA negotiations mean for Canada: in the words of Bank of Canada Deputy Governor Carolyn Wilkins, there are still a wide range of possible outcomes, which could play out over many different timelines. 12 But there is, we believe, a helpful framework for thinking about developing trade negotiations and their impact on the Canadian economy which we provide here. Our research and thoughts can be summarized by three main points: 1. The impact of NAFTA negotiations is dependent on what it is ultimately replaced with. There are three general buckets of outcomes: (i) NAFTA stays but is altered, (ii) a snapback to the prior bilateral Canada-US Free Trade Agreement (FTA), or (iii) a return to WTO trading rules. Within each of these buckets there are many, many variations. 2. In our view, even the plausible worst case outcomes are estimated to create only a relatively minor drag on Canadian growth over the next 5 10 years, with no meaningful recession probability. What is far more difficult to quantify and likely to be a larger concern for policymakers is the net impact of (i) Canadian Dollar fluctuations and/or one-time adjustment and (ii) lost and/or deferred foreign and domestic business investment. Currency volatility and headwinds from investment are of particular concern if NAFTA negotiations are especially drawn out and unclear (see our Chief Economist Megan Greene s explanation of trade policy risks in the latest edition of Global Intelligence 13 ). 3. The impact that NAFTA negotiations will have on Canada s export sector is ultimately not a 2018, or even 2019, issue. Any impact on trade and growth (and associated spillovers) will take years to unfold and even longer to understand, particularly in an adverse scenario where potential GDP is also permanently altered. 11 This is a summary of a detailed analysis of the subject, which can be found here. 12 Bank of Canada: Monetary Policy Report Press Conference Opening Statement, January 17, Global Intelligence Outlook 2018: More of the Same, With Risks to Growth on the Downside, December 18,

9 What Does This Mean for the Bank of Canada? Amid growing uncertainty, the year ahead is poised to be very challenging for the Bank of Canada from a policy setting perspective. It will seek to find a balance between cooling an overheating economy with a growing list of downside risks. Given that we expect more downside pressure to manifest themselves in the second half of the year, we are of the view that the Bank of Canada will be able to raise rates only once more in The risk to that view, obviously, is that no significant shocks materialize and the BoC ends up moving ahead with two additional rate hikes this year (i.e. a total of three rate hikes in 2018). Like most developed market central banks, we believe the Bank of Canada is motivated to normalize interest rates to a more appropriate level for an economy that is growing above its long-term potential. While we do not expect Canadian inflation to rise above the BoC s 1-3% target band, we believe the downside risks to inflation from excess slack and weak growth have now abated. We continue to believe that the Bank of Canada will place considerable weight on the below three data points in particular when determining the pace of future hikes: 1. US growth and associated export activity. Better than expected export activity implies better cyclical growth but also supports the Bank of Canada s much hoped-for rotation away from energy (and increasingly, housing) towards trade. This contributes to a more resilient economy and will likely encourage more rate hikes in Domestic wage growth is accelerating. We wrote about this last September. 14 The Bank of Canada has developed a new metric to monitor wage pressure 15 which they continue to feel are underwhelming given the pace of the rest of the economy. Still, there is clearly momentum building in hourly earnings that could force the BoC s hand should it become too aggressive. 3. Business investment intentions a soft data but it is perhaps, in our view, the best metric available that the Bank of Canada can use to assess how uncertainties (particularly those related to NAFTA negotiations) could impact the economy in the short-term. So far, businesses are suggesting they are not too concerned about the cloudy outlook, but a sharp deterioration in business investment intentions would weigh heavily on the BoC and will more than likely slow the pace of hikes ahead. 8 See our most recent Bank of Canada analysis here. Canadian Core CPI Drifting Back Towards 2% Target Year-on-Year (%) Source: Bloomberg, Manulife Asset Management. As of November * Average of the BoC s 3 preferred measures of core inflation. Canadian core CPI* 14 Manulife Asset Management: A Key Trend Change in a Major Canadian Data Point Wages, September 12, Bank of Canada: Wages Measurement & Key Drivers, January

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