Economy Battles Strong Headwinds Modest growth ahead

As 2011 got underway, the global economic recovery seemed broadly on track. But, as time has passed, so it has seemed less secure. A throng of economic troubles—the rise in energy prices following the Arab Spring uprisings, disruptions to global supply chains caused by Japan’s earthquake, the political stalemate over the U.S. debt ceiling and Europe’s deepening sovereign debt crisis—put a chill on the global economy.

Canada has fared relatively well. Its sound banking system, comparatively better fiscal position, resilient housing market and strong corporate balance sheets have steered the economy through turbulent waters. There is also a large dollop of good fortune behind Canada’s hardiness. It produces many of the commodities (e.g. crude oil, minerals, base metals and lumber) sought after by the world’s fastest–growing Asian economies.
While many of Canada’s economic advantages remain intact, ample headwinds will constrain growth in the year ahead. Many of these are blowing in from abroad.

The European sovereign debt crisis remains the most urgent matter facing the global economy. The crisis can send shockwaves across the Atlantic and hit the Canadian economy directly and indirectly through financial, trade and confidence channels. Indeed, the crisis has led to a decline in the prices of equities and other risky assets and has pushed credit spreads higher in Canada, albeit less so than in most other countries.

A challenging external environment will also weigh on Canadian exports. Modest economic growth in the U.S. and a still-strong loonie are expected to hold back the performance of Canada’s export sector, as will cooling demand in emerging-market economies. Shipments to the euro area are likely to remain weak as the region is in the grip of recession.

On the domestic front, global uncertainty has shaken consumer and business confidence. Canadians are growing more cautious in their spending habits and businesses are more guarded when it comes to hiring. 

With these headwinds at play, Canada’s economy (i.e. real Gross Domestic Product) is projected to grow a modest two per cent in 2012, down from an estimated 2.3 per cent rate in 2011 and 3.2 per cent in 2010.

Canadian consumers are tapped out

The pace of consumer spending has moderated, growing by just 1.2 per cent in the third quarter of 2011. This is a far cry from the 3.3 per cent average pace recorded in 2010. The steady drumbeat of negative global economic news and heightened volatility in stock markets have taken a toll on consumer confidence.

Additionally, employment growth has stalled since mid-year, a sign that employers are more cautious in hiring new workers given the uncertainty in the economic environment.

Going forward, high household debt levels are likely to keep growth in spending relatively modest compared with the rapid pace seen during the recovery. Canadian households owe almost $1.53 for every dollar of disposable income. As well, growth in personal disposable income will remain subdued, while the pace of hiring is anticipated to remain slow. Finally, there is not much pent up demand in Canada, especially for big-ticket items.

Housing activity is poised to moderate

Canada’s housing market has been surprisingly resilient. Low interest rates will continue to underpin home sales activity, but some easing is expected in the coming quarters due to tightened mortgage regulations, high household debt levels, slower jobs growth and a heightened degree of economic and financial uncertainty. With housing demand retreating, housing starts are also expected to recede.  

Governments spending restraint will weigh on economic performance

Fiscal fuel fired up the economic engine at a time when it was sputtering and contributed significantly to growth since the onset of the recession. Governments have now begun to rein in spending growth to balance their books. Central Canada and Atlantic Canada are likely to feel the biggest drag due to relatively large deficits as a share of GDP.

Net exports are expected to remain a source of weakness

Export sales will likely remain soft in 2012 reflecting sluggish foreign demand and ongoing competitiveness challenges, including a still-strong Canadian dollar and weak labour productivity growth.

Consumer spending has picked up in the U.S. recently but seems unlikely to serve as a major engine of growth. Although U.S. households have made some progress in repairing battered balance sheets, many still face elevated debt and reduced access to credit. Additionally, high unemployment, lack of real income growth and concerns about the possibility of further declines in home prices will continue to weigh on U.S. household spending.

Growth in emerging-market economies is moderating but remains relatively strong. And with the euro area in recession, expect Canadian exports to face growing headwinds.

On the other side of the ledger, imports are expected to grow modestly reflecting the expected moderation in Canadian household spending.

Business investment will remain a strong support to growth

Canadian businesses have made critical investments in plant and equipment to improve their productivity and competitiveness. Investment in machinery and equipment (M&E) has been particularly robust. 

A number of factors support increased capital investment going forward. These include low borrowing costs, high corporate cash balances, the elimination of tariffs on a range of M&E, a favourable business tax environment and development of new production capacity in the natural resources sector. The high Canadian dollar will also stimulate investment as most of the cutting-edge M&E employed in Canada is imported, primarily from the U.S.

Inflation Expectations Are Well Anchored

Consumer price inflation, as measured by the year-over-year per cent change in the All-items Consumer Price Index (CPI), has hovered above the Bank of Canada’s operational target range (one per cent to three per cent) for most of 2011, elevated by food and energy prices.

The core rate of inflation, which excludes the most volatile components of the CPI (like food and energy), is more subdued reflecting the persistence of excess supply in the economy, modest growth in labour compensation and the past appreciation of the Canadian dollar (which reduced prices for imported goods).

Moderate economic growth should keep inflationary pressures in check going forward. 

The Bank Of Canada Is Expected To Stay On The Sidelines Until Early 2013

In early December the Bank of Canada announced that it was keeping its benchmark overnight rate at one per cent where it has been since September 2010.

The Bank said “conditions in global financial markets have deteriorated as the sovereign debt crisis in Europe has deepened.” Offsetting this, “growth in the United States has been slightly more robust than anticipated” while “indicators in Canada suggest that growth in the second half of this year is slightly stronger” than projected.

The Bank of Canada has also cautioned that a prolonged period of low interest rates may encourage imprudent risk-taking.

Reflecting all these factors, we believe Canada’s central bank will wait until early 2013 before raising interest rates.

Canadian Dollar Is Down As Negative Market Sentiment Prevails Over Fundamentals

The Canadian dollar reached a new four-year high of US$1.06 US on July 26, 2011. Since then it has slipped below parity with its U.S. counterpart as investors nervous about Europe’s debt problems have sought safety in the U.S. dollar.

The ongoing turmoil in Europe and investor concern about the outlook for global growth will benefit the U.S. dollar in the near term. Consequently, the Canadian dollar is expected to trade around the US$0.95 US level in the first half of 2012. Canada’s stronger fundamentals—a relatively low level of government indebtedness, a strong banking system, firm commodity prices and a triple-A credit rating—should continue to underpin the loonie.

As risk aversion dissipates, and in anticipation of rate hikes by the Bank of Canada, the Canadian dollar should strengthen and migrate towards parity by year-end 2012 and above parity in 2013.

In Conclusion

Needless to say, these are very uncertain times for the global economy, and the risks to our outlook and forecasts are significant. 

Failure to contain the crisis in Europe is the most serious risk facing the global and Canadian economies. The Bank of Canada said “should the crisis deepen and spread further to the larger European economies, transmission to Canada could become more severe, through the credit and funding channels.” Most of

Canada’s banks have limited direct exposure to Europe. Indeed, according to a report by ScotiaMcLeod, the disclosed exposure appears to be fairly manageable against a backdrop of strong capital ratios, diversified revenue streams and relatively conservative investment practices.

On the domestic front, the major risk relates to household debt. Because of high debt loads, Canadian households—especially low-income Canadians—are more vulnerable to rising interest rates, job loss and asset price declines than in the past.

Of course, not all of the risks to the outlook are on the downside. The recovery in the U.S. may be stronger than anticipated resulting in higher demand for Canadian exports. Additionally, borrowing by Canadian households may continue to exceed income growth providing a greater impetus to domestic demand than expected. Finally, if European fiscal problems are addressed, Canadian economic growth could be significantly more robust.

Tina Kremmidas is the Chief Economist of the Canadian Chamber of Commerce

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