Economic & Investment Outlook
Global economic growth has slowed as the effects of tariffs and continued uncertainty regarding future US trade actions have affected business confidence and investment. There have been notable declines in manufacturing and industrial production across major developed and emerging economies.
The Canadian economy expanded at an annualized pace of only 0.4% in the final quarter of 2018. This was the weakest quarterly growth since the summer of 2016. Consumer spending, exports and business investment were all below expectations. However, growth rebounded in January and rose 0.3%, fueled by a multi-year high in manufacturing activity.
The oil production curtailment plan imposed by the Alberta government acted as a drag on growth in January, but has produced the desired effect of higher prices for Canadian oil. The price increase has prompted the Alberta government to partially decrease production restrictions ahead of schedule.
Residential construction is showing signs of slowing. In February, home sales fell 9.1% and new housing starts dropped by 16.3%. Statistics Canada data showed that national home values decreased last year for the first time in three decades. This adds to the mounting evidence that rising interest rates, declining affordability in some major markets and new restrictive lending rules, have resulted in a broad-based slowing in the housing sector.
Despite slower economic growth, the Canadian labour market continues to produce solid gains. 122,700 new jobs were created in the first two months of this year. This two month gain is the best start to a year since 1981. Canada’s economy has added 290,000 jobs since last August, the largest six-month increase since the early 2000's. These ongoing gains in employment will continue to support consumer spending and assist in maintaining positive economic momentum.
US economic activity grew by 2.2% in the final quarter of 2018. Consumer purchases weakened sharply at the end of last year, as uncertainty regarding the record long Federal government shutdown affected confidence and spending power. The shutdown lasted 35 days and furloughed 800,000 workers and stopped payments to nearly 4 million contractors. According to the Congressional Budget Office, the shutdown cost the economy $11 billion in lost activity.
Consumer spending was a key contributor to US economic growth last year and was supported by higher wage gains, tax cuts and a robust labour market. Although US retail sales stabilized in January after the sharp decline in December, it is likely that overall spending will decline this year from last year’s elevated levels.
US construction spending increased for a third straight month in February, boosted by gains in both private and public construction projects, while sales of new and existing homes increased to 11-month highs. This provides some evidence that lower mortgage rates are starting to have a positive effect on the housing market.
Despite the Trump administration assertion that trade wars are easy to win, the tariffs that have been implemented to date are negatively affecting the US economy. According to the Federal Reserve Bank of New York, tariffs are reducing US income by $1.4 billion per month by increasing the cost of targeted products. Additionally, uncertainty over trade policy is causing problems in corporate supply chains, resulting in $165 billion of trade being lost or redirected by company efforts to circumvent tariffs.
Although markets appear to be focused primarily on progress in the trade dispute between the US and China, there are other trade related issues that are still outstanding. The new agreement between the US, Mexico and Canada to replace NAFTA still faces ratification challenges as Canada and Mexico have indicated that steel and aluminum tariffs need to be removed prior to giving their final approval of the agreement.
In addition, a US Department of Commerce report investigating whether European automobiles constitute a national security threat to the US has been completed. The US administration is expected to make a decision in May on whether to impose new tariffs on automobile imports. If implemented, these new tariff costs will add further downward pressure to global trade.
The risk that the UK leaves the European Union without a negotiated agreement has increased. The European Union agreed to extend the original
Equity markets produced a sustained recovery from last year’s declines.
Although recent economic data has indicated decelerating growth, support from lower bond yields
March 29th exit deadline to April 12th after the negotiated withdrawal agreement was rejected by the UK parliament three times. The UK parliament has failed to find a majority of support for eight different pro-posed alternative options to this defeated withdrawal agreement.
The UK now has three options: leave the European Union without a negotiated agreement on April 12th, call a general election as a prelude to a second referendum, or attempt to negotiate a longer extension with the European Union in the hope that a better compromise solution will eventually be agreed upon.
It is estimated that the uncertainty surrounding Brexit has cost the UK economy 2.5% of its economic potential or £19 billion annually since the referendum was held in June 2016. The potential for further economic losses increases with further delays to the final out-come of the negotiations.
Equity markets produced a sustained recovery from last year’s declines.
Although recent economic data has indicated decelerating growth, support from lower bond yields has produced stability in the global economy and supported the rise in equity prices.
Returns in local currency and Canadian dollar terms were:
The slowdown in global economic activity produced a sudden reversal by some key central banks toward pausing further interest rate increases.
The most consequential change was the US Federal Reserve signalling no further interest rate increases at all this year, after they had projected two increases as recently as December of last year.
With five interest rate increases since 2017, the Bank of Canada was one of only a few central banks that has implemented a sustained rate hiking cycle. The Bank is now indicating potential rate increases are on hold pending the outcome of future economic data.
The European Central Bank also pledged to keep interest rates on hold throughout 2019. The decision came just three months after the Bank halted its quantitative easing program and signaled it may raise borrowing costs later this year.
Global government bond yields reacted quickly to the news, with Canadian and US yields reaching 15 month lows, while yields on both the German 10-year bonds and Japanese 10-year bonds traded down into negative yields. The amount of debt with negative yields has now grown to more than $10 trillion, a level last seen in 2016.
Although lower global bond yields have been a catalyst for the recovery in equity prices, they may also now reflect an overly negative view of the economic environment. Better economic performance may partially reverse these declines, which will then require higher levels of corporate earnings to move equity prices meaningfully higher from current levels.
The Bottom Line
As the first quarter drew to a close, there were some preliminary signs that many of the largest developed economies may be stabilizing from the recent period of slower growth.
The pivot by central banks to pausing interest rate increases has assisted in the recovery from last year’s global stock declines. The appearance of poor economic data or renewed trade tensions may again reignite global economic uncertainty. However, there is also a positive potential outcome in which lower interest rates now act to extend the economic cycle that is widely viewed as being in its final phase. As a result, we believe that the odds of a recession beginning in Canada or the US this year are still low.
We continue to expect that equity and fixed income markets will experience periods of volatility this year. This argues for some degree of caution, but will also add the potential for buying opportunities as the unfolding economic environment becomes clearer. We will continue to monitor economic conditions and relative asset class valuations to make adjustments to portfolio holdings as required.
Canada's Tech Emergence
Over the past several years, Canada has seen a remarkable increase in technology sector employment. In February alone, 18,300 new science and technology related jobs were created.
Toronto was the city with the fastest-growing North American technology job market in 2018, according to CBRE Group. Toronto’s technology sector created more jobs than San Francisco, Seattle and Washington, D.C., combined last year. There are now 241,000 workers employed in the city’s technology sectors, marking a 52% increase over the last five years.
This employment increase is largely the result of Canada’s approach to immigration. Unlike the US which has moved to limit the immigration of skilled workers under the Trump administration, Canada has moved to expedite the immigration process for these types of workers and also foreign students.
Canada’s targeted immigration approach has been a boon for tech companies and continues to be a primary supporter of economic growth.
Canada received 425,245 immigrants last year, which is the largest annual gain since 1972. The majority of these individuals had some form of post-secondary education. This influx helped Canada’s population grow by 1.4% which is the fastest pace since 1990 and the strongest among Group of Seven countries.
The debt load of Canadians continues to grow while the cost of servicing this debt is rising. On a seasonally adjusted basis, Statistics Canada reported households borrowed $21.2 billion in the fourth quarter of last year. Total credit market debt, which includes consumer credit, mortgages and non-mortgage loans, now totals $2.21 trillion. According to Bloomberg News, this is the highest debt load in the Group of Seven economies.
The household debt service ratio (interest and principal as a share of disposable income) increased to 14.9% in the final quarter of 2018, meaningfully higher than the 14.1% level reached in 2017. The proportion of income that is now required to service interest costs, increased to 7.3% up from 6.7% over the same period. The debt service ratio has increased for five consecutive quarters and reached the highest level in nine years.
Debt growth continues to outpace income. On average, Canadians now owe $1.79 in credit market debt for every dollar of household disposable income. It is noteworthy that the previous time the debt service ratio climbed to this level was in 2007, when the Bank of Canada policy interest rate was meaningfully higher than it is currently (4.5% vs. 1.75%).
The credit monitoring company Equifax Canada, reported that consumer delinquencies climbed higher in the fourth quarter of 2018 and warned that rising delinquency rates are likely to continue to increase this year. A total of 31,900 Canadians filed for bankruptcy in the last quarter of 2018, which is the highest number of filings since 2010. Debt issues are also affecting younger Canadians, as almost 40% of insolvency filings last year in Ontario came from individuals between the ages of 22 and 37. Key contributors for these bankruptcies were student loan and credit card debts.
It will take a long period of household incomes outpacing credit growth to deliver meaningful reductions in either the total amount of debt owed or improvements in the debt service ratio. Until this happens, Canadian households with high leverage are increasingly susceptible to higher levels of interest rates or to an economic downturn.