Canada: Growth improving, but uncertainties persist

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1 Jan-15 May-15 Jul-15 Nov-15 In Focus: Canada Treasury Research Group For private circulation only Canada: Growth improving, but uncertainties persist Canadian growth on an improving clip, but Bank of Canada flags uncertainties associated with trade. Divergence between US and Canada government bond yields has sharply widened over the past couple of months. The Canadian Dollar s trajectory will be determined by the way different factors play out, with overarching influence of risks emanating from the US. Chart 1: Growth continues to improve (% YoY) Source: Bloomberg; ICICI Bank research March 28, 217 GDP Growth Sumedha DasGupta sumedha.dasgupta@icicibank.com Please see important disclaimer at the end of this report Overview: The Canadian economy has been growing at an improved clip since the second half of 216, as the improved performance of several economic indicators show. However, Canada is now faced with challenging times ahead, as US President Donald Trump remains unmoved on trade policies, in particular the renegotiation of the North Amercan Free Trade Agreement (NAFTA), which could be to Canada s detriment. Growth recovering on most fronts: After averaging ~.7% YoY in H1 216, GDP growth rose significantly to 3.2% YoY in H Other indicators of the health of the economy have been largely improving in recent months. GDP growth has improved to average ~1.2% YoY in 216 from a ~.9% YoY growth seen in 215. This was only slightly below the Bank of Canada s forecast of 1.3% YoY in 216. Manufacturing PMI has risen steadily since September 216 (from 5.3 to 54.7 in February 217). The economy posted its first trade surplus after a gap of 25 months in November 216, and has continued to post trade surpluses ever since (CAD.8 bn in January 217). The current account deficit has narrowed significantly to CAD 1.7 bn in December 216, arresting the trend of increasing deficit between June 215 and September 216. The labour market appears to be gaining significant traction, with the unemployment rate dipping to a 25-month low 6.6% in February 217 from a high of 7.2% in January 216. Jobs additions increased manifold to 165K in H2 216 from 64K in H1 216, and has continued at a steady pace in 217. However, some other indicators have room for improvement, namely, Headline retail inflation crossed the Bank of Canada s 2% target in January (2.1% YoY), before dipping to 2.% YoY in February, and has risen significantly from ~1.3% YoY seen in H This was due in part to carbon pricing measures introduced in Alberta and Ontario. However, core CPI pressures remain subdued (1.3% YoY in February vs. ~1.8% YoY in H2 216). Wage growth pressures still remain muted, with average weekly earnings averaging ~.6% YoY over H2 216, as compared to ~.4% YoY over the first half of 216. Business investment, which plunged along with oil prices in late 214 and 215, has not rebounded in kind. Business investment in non-residential structures fell by 5.9% QoQ (ann.) following the 3.5% QoQ (ann.) growth in the third quarter, which was partly due to a large one-time investment in the Hebron offshore oil project. Bank of Canada held rates while emphasising risks: In its latest meeting on March 1, 217, the Bank of Canada (BoC) maintained its overnight benchmark interest rate at.5%, in line with expectations. Governor Stephen Poloz continued flagging uncertainties including the Brexit fallout, China s economic transition, and US President Trump s policies. The BoC expects solid consumption, exports and government spending to underpin growth in 217.

2 The Bank said that the recent improvement in economic data for the Canadian and international economies was consistent with its projection. However, it flagged subdued wage growth, emphasising persistent economic slack in Canada as compared to the US. On the inflation front, the Bank remained bearish, stressing that the common measure of inflation remained well below its target of 2%, pointing to excess capacity in the economy. Regarding export growth, the BoC elaborated on the headwinds to export competitiveness emanating from a persistently strong Loonie. Additionally, the outlook for exports remains a hazy field for the BoC currently, given the grey areas surrounding a reworked NAFTA. Outlook: The BoC s cautionary tone, in contravention of robust economic data, is largely intended to keep the Loonie from appreciating further and longerterm interest rates from rising. Canadian growth will accelerate in 217 as the economy benefits from stronger US growth, higher oil prices on an annual basis and public infrastructure spending by the Government. Potential headwinds arising from its southern neighbour include lower corporate taxes in the US, the imposition of a border tax on automobile exports from Canada, and the renegotiation of NAFTA. Since the US accounts for ~75% of Canada s exports, and ~65% of Canada s imports flow from the US, any protectionist stance from the US has a very real possibility of plunging Canada back into a recession. Chart 2: Trajectory of the Canadian Dollar against the greenback over the past year USDCAD Source: Bloomberg, ICICI Bank Research Bank of Canada meeting Oil price drops below USD 5/bbl Currency: After starting this year on its best note since it became a floating currency in 197, the Canadian Dollar has seen severe gyrations based on different events in the first three months of 217. The CAD strengthened by ~2% against the Dollar over January-February 217 as oil prices remained robust, and the US Federal Reserve kept rates on hold. Following this, the Loonie depreciated sharply in early March, as the Bank of Canada maintained the overnight policy rate, and over-emphasised risks to the economy. In mid-march, further weakening was seen in the wake of an expected rate hike by the US Federal Reserve, and a decline of oil prices below USD 5/bbl, as US stepped up production, offsetting OPEC cuts. The currency continued to see depreciation pressures in March as oil prices declined to three-month lows. The Bank of Canada has continued to specifically mention headwinds to exports stemming from the strength in the domestic currency. However, a number of factors will likely engender weakness in the Candian Dollar in the days to come: The Federal Reserve is on a tightening cycle, and the ensuing US Dollar strength, though not likely to be as much as anticipated earlier, will nonetheless weaken the Loonie. At the same time, the Bank of Canada is expected to remain on hold with regard to rates till mid-218, given their current tenor, which will put further pressure on the Loonie. Additionally, concerns regarding NAFTA and its ramifications for Canadian exports will also weigh on the Canadian currency. While compliance with OPEC production cuts seem to be betterthan-usual, US shale production has proved to be remarkably resilient, and a sharp step up in the same has been constantly weighing on oil prices. This will further weaken the Loonie. The currency is expected to gradually depreciate to the range of CAD /USD in H After NAFTA talks start among concerned parties (likely to be held in June), the Loonie is likely to see additional depreciation pressures, taking the USDCAD currency to ~1.36 levels by Q The principal risk to our view is the movement in oil prices, which will continue to have overarching impact on the Loonie. 2

3 Jan-15 May-15 Jul-15 Nov-15 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Manufacturing has seen steady improvement....but underlying inflation pressures are still muted (Index) Manufacturing PMI (% YoY) Headline CPI Core CPI (common) Trade surpluses are being recorded Current account deficit may be turning the corner (CAD bn) Trade Balance (CAD bn) Current Account Deficit Employment gains volatile, but largely positive Unemployment rate at two-year lows (') Net employment change Unemployment Rate Divergence between US and Canada bond yields steadily rising over time as monetary policies diverge Canada 2Y govt bond yield US 2Y Treasury yield 14 bps 55 bps Canada 1Y govt bond yield 4 bps US 1Y Treasury yield 78 bps 3

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