November 8, 2012
The world and Canadian economic outlooks
In the fall of 2012, the outlook for the world economy continues to be uncertain. There is more than one reason to doubt whether fragile growth can be sustained.
The European debt crisis continues to fester. Two of the Euro region’s bigger members, Spain and Italy, may need financial assistance.
The U.S. is headed towards a “fiscal cliff”. Approximately $600 billion in government support for the economy will automatically disappear on January 1 2013 unless Congress takes action.
Bush-era tax cuts will expire and spending will be reduced across the board. This is the penalty for failure. A super-committee comprised of both Republicans and Democrats failed to reach a compromise on how Washington might bring its deficit under control.
As a result of weakness in its two major trading partners, Europe and the U.S., China’s output advance is proceeding at an uncharacteristically slow pace.
Double-digit GDP growth has dropped to around +7.5% in the latest quarter, with a similar rate of increase expected through the next couple of quarters as well. Inventories of consumer goods and raw materials are accumulating at factory sites and on dockyards.
Canada has been caught up in the global downdraft. This nation will be lucky to achieve a +2.0% GDP advance this year, with the figure rising a little higher next year.
A major drag on our national output since the recession has been the merchandise trade account.
Prior to late 2008, Canada traditionally ran monthly surpluses of $40 to $80 billion annualized. Since early 2009, this nation’s trade balance has hovered near zero, with more months of deficits than surpluses.
A particular soft spot for Canada can be found in generally weaker global commodity markets. With a few notable exceptions — e.g., agricultural prices on account of the worst drought in nearly 50 years in the U.S. — many raw material prices have eased back from their previous peaks.
This hurts the returns of firms in our natural resource sector and has thrown some mega project construction activity into doubt.
The foregoing may be putting too negative a spin on the current situation. There are plenty of positives to report about the world economy.
Central bankers have seized the initiative. Ben Bernanke has been especially aggressive with monetary policy at the Federal Reserve. First, he set interest rates close to zero percent, then he launched two rounds of quantitative easing (QE), a fancy phrase for printing money.
When Mario Draghi replaced Jean-Claude Trichet as head of the European Central Bank (ECD), a more active monetary stance was adopted “across the pond” as well. Super-Mario, as he’s known overseas, has altered the tone of the dialogue.
He’s been aided by some leadership changes among the member states — in Greece, France, Spain and Italy. More practical solutions are being tried to deal with the region’s financing problems.
Germany is the holdout, wanting austerity from its undisciplined partners at every turn. Others have been quick to point out the flaw in this approach — nothing but belt-tightening doesn’t offer much hope of economic improvement.
Germany’s Chancellor, Angela Merkel, has finally been persuaded to allow a different approach.
Mr. Draghi has said he will do “whatever it takes” to support the Euro. He is prepared to make unlimited purchases of short-term bonds from distressed nations.
He wants to burn speculators and lower borrowing costs. The debt of badly indebted nations not only carries a normal risk premium, it bears an additional charge based on speculation the Euro might collapse.
He’s trying to make it clear this won’t happen. Rates on long-term Spanish and Italian bonds have fallen substantially, for the moment at least.
There are conditions. If nations want the ECB’s help, they must ask for it. Then they will be subject to tight monitoring to ensure they are indeed proceeding with the structural changes and budgetary measures necessary to improve their balance sheets.
Ben Bernanke, Chairman of the Fed, has taken a leaf from Mr. Draghi’s book. He has cranked up the rhetoric. In the latest interest rate pronouncement from the Fed, determination was expressed to lower the U.S. unemployment rate from 8.1% to a more acceptable level, probably 7.0% or lower.
The Fed will buy $40 billion in mortgage-backed bonds monthly for as long as it takes. In essence, this is a QE3 program. It will also continue with Operation Twist to the end of this year — an innovative course of action that sees short-term notes sold to buy more long-term bonds.
Raising the demand for bonds lowers their yields, providing a more favorable long-term interest rate environment for the business community.
The Fed has also extended the period of time it will keep its official interest rate, the federal funds rate, in a range of 0.00% to 0.25%. The termination date has been moved back from mid-2014 to mid-2015.
With such a distant horizon, the hope is that interest rates will stay low for a considerable period of time even after the economy comes more fully back to life.
In China, the monetary authorities have both lowered interest rates and reduced reserve requirements at local banks. Beijing has also indicated a willingness to proceed with another round of infrastructure spending. There will be projects in transportation, nuclear power and steel production.
Further details remain sketchy due to political events. Later this year, the Chinese Communist Party is expected to undergo its once-each-decade change in leadership.
Politics are playing a role everywhere. In Canada, the separatist-leaning PQ has been elected to a minority government in Quebec. The degree to which new Premier Pauline Marois can implement radical policies will be limited by her need for support from either the Liberals or the CAQ.
In the U.S., the direction of economic policy awaits the outcome of the Presidential election on November 6th.
The Democrats advocate a combination of spending cuts and tax increases, the latter to be targeted at the wealthy. They’ll want to maintain a substantial government presence to provide a base level of activity and employment as the economy fights its way clear of the bramble.
The Republicans want nothing but tax cuts. They believe entrepreneurs should be rewarded for risk taking and that a less rigid regulatory environment will spur on the corporate sector.
Canada is closely tied to two sectors of the U.S. economy. One has recovered nicely since the recession. The other is showing signs of leaving its sick bed.
The auto sector south of the border has climbed out of a deep scary ditch. Two of the Detroit Three — General Motors and Chrysler — barely escaped financial ruin in 2009 when they were rescued by large infusions of cash from the public purse.
Changes in ownership and a restructuring of legacy costs (e.g., pensions and health care for retirees) have helped to turn the sector around. Also crucial has been a strong pick-up in sales.
Canadian auto factories have benefited from both improved domestic sales and the even faster rate of advance south of the border. Much of Canadian production is destined for American customers.
The second notable sector is housing. U.S. residential building permits and starts have gradually increased to levels not seen in years. Existing home sales are on the rise. Prices for both new properties and resales are up year over year.
The residential real estate sector still has a long way to go before returning to “normal”, but the journey will benefit both construction employment and consumer confidence.
The Canadian and U.S. economies aren’t always in phase. The improvement in the U.S. housing market is coming at a time when Canadian homebuilding activity is in danger of turning in the opposite direction. This will be discussed in the next section.
Housing starts in Canada have been above 200,000 units, seasonally adjusted and annualized, in 12 of the past 14 months. That’s a remarkably strong performance.
Over the same time frame, employment has risen by 185,000 jobs. That’s close to the long-term pattern. There are indications the jobs advance may be stalling. In the past four months, the net improvement has been only 19,000 new jobs.
The worst of the recession in late-2008 and early-2009 ushered in an era of ultra low interest rates in both the U.S. and Canada.
In the U.S., the recession was partly caused by the collapse in housing starts. In the early to mid-00s, adjustable-rate “teaser” mortgages attracted a rash of low-income home-buyers who were subsequently unable to maintain their monthly payments. A speculative surge in home prices in 2005-2006 that was followed by a bust also contributed to the sector’s woes.
Debt instruments were issued that included a sub-prime mortgage component. These proved to be worthless, bringing down a house of cards. Rating agencies lost their credibility. Investment banks went under and the nation’s largest mortgage-providers needed government bailouts.
The ensuing credit crunch has kept U.S. housing starts buried in a trench almost to this day. Thankfully, there are signs of an imminent pick-up in the works.
Canada has not shared the U.S. housing experience. Home prices both for new and existing properties have steadily increased, although some weakening is now apparent. Only a few locations, most notably in Victoria and Vancouver, have demonstrated sticker tags far out of reach of the rest of the country.
The strength of the condo building markets in Vancouver and Toronto has inspired the federal government to gently apply the brakes. Measures have been introduced to slow demand.
The amortization period for an insurable mortgage has been reduced in stages to 25 years. First-time homebuyers are finding approvals harder to come by. Home starts are expected to moderate from 215,000 units this year to 185,000 in 2013 and 190,000 in 2014.
In non-residential building markets, one would expect commercial and industrial work to show early signs of improvement. That’s how cyclical recoveries usually unfold. Office-based employment improves, vacancy rates fall and there is a need for more high-rise towers.
At the same time, better retail sales lead to construction of more warehouse, store and shopping centre square footage. An influx of U.S. retailers into Canada will also play a role in spurring on some retail construction activity.
A 2.0% GDP growth rate, plus uncertainty about the employment outlook, however, will inhibit some of the investment that might otherwise occur.
There are a couple of commercial sub-categories that should see significant improvement in the next couple of years nonetheless.
The demand for hotels is on the rise, with a lengthy list of upcoming projects. Niagara Falls will receive a disproportionate amount of the attention.
Sports facilities are another growth market. From football stadiums in Regina and Hamilton to hockey arenas in Markham and Quebec City, the quest for the casual and rabid fan’s entertainment dollars is readily apparent.
The new football stadium in Hamilton will first welcome soccer matches as the Toronto region hosts the Pan and Parapan American Games in 2015 and there are other venues and sites that are either underway or about to start for those events.
In institutional construction, there will be an ongoing need for more medical facilities to provide care for seniors over the next several decades. This was the kind of work that was brought forward during the government’s infrastructure stimulus program in 2009 and 2010.
On the heels of that big push, there is the inevitable letdown. The “aftermath effect”, combined with the current emphasis on austerity, is pushing hospital and school projects back somewhat in public-sector short-term planning.
Industrial work is being impeded by the rise in value of the Canadian dollar. Not least among the causes is the fact the U.S. — through its quantitative easing programs (i.e., printing money) and low interest rate policy — is consciously lowering the value of the greenback.
Foreign exchange traders are betting on Canada as a safe haven for their investment funds.
Canada’s auto sector is making solid sales gains, but future investment dollars will depend on how pleased the Detroit Three firms are with their latest union wage agreements. Pay scales for both seasoned veterans and new hires, reductions in “legacy” costs and quality of work will all figure in such an assessment and help determine how much investment will take place here as opposed to other international sites.
A great deal of manufacturing activity is tied to the housing sector. Renovation work will hold up pretty well, but with new home starts retreating, the demand for some building materials will be kept in check.
The resource sector component of industrial work awaits an improvement in global commodity prices.
The same can be said for much of engineering construction. One difference is that engineering work is heavily weighted towards oil and gas activity. The world price of oil, hovering near $100 U.S. per barrel, remains high — thanks to geopolitical risk in the Middle East and North Africa — justifying major projects in the Oil Sands and off the coast of Newfoundland.
For natural gas, a depressed price level inhibits investment. This may be about to change.
Hydraulic fracturing of shale rock has greatly increased the reserves of gas that can be recovered. More supply means lower prices, but it also lifts demand. Home and industrial usage is on the rise, plus nuclear and coal-fired power stations are giving way to natural gas-fired units.
Emerging economies are also eager to buy low-cost natural gas. That’s the incentive behind major liquefied natural gas (LNG) project proposals not only in Canada but in Qatar, Australia and even the United States.
There are some mega hydro-electric power projects that will be getting underway shortly in Canada. All the necessary agreements have been signed between the Newfoundland and Nova Scotia governments for the Muskrat Falls station on the Lower Churchill River in Labrador to begin this fall. There will eventually be a sequel, a Gull Island station, which will be even bigger.
Manitoba and B.C. are two other provinces where hydroelectric projects are inching towards start-ups. Low natural gas prices are creating some political fallout. Opposition parties are pointing out that electric power export sales are no longer as assured as in the past.
Canada may find it harder to export hydro-generated power if the U.S. brings on a host of new electricity plants based on gas-fired generators.
Alex Carrick, Chief Economist, CanaData
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