Monday, August 30, 2010

Canada’s growing trade deficit; an early warning system?

Is the drop in Canadian export an early sign of a big slowdown in American consumer demand (PCE), and is the U.S. economy slipping back into recession (or very low positive growth) and will set the stage for additional quantitative easing?

Statistics Canada released revised current account data for Q1/2010 and new data for Q2/2010.  The results conform to Canada’s continued economic health (at least in the first half of 2010), and the continued weakness abroad.  The "bright lights" in the numbers revolved around equipment & machinery import – which speaks volume about future potential increase in labor productivity (although since manufacturing is only 25% of GDP…the overall impact on labor productivity will be limited).  

Source: StatsCan

It would seem that foreign investors have finally quenched their appetite for Canadian assets.  There appears to be a marked slow down in investment: of course this data predate the offer by BHP to acquire the assets of Potash Corp.  On an amusing note most Canadian newspapers highlighted the fact that Canadian direct investment abroad rose to $9.7 billion in the second quarter.  But didn’t make much hay over the fact that although this is higher than 2009, it is still below the level achieved in 1996 – an indication that Canadian investors still see Canada as their primary target of investment, following a net repatriation of funds in the first quarter.

There is a sense that the international investment community has enough of “All things Canadian” which is a good think, because the inflow was becoming unsustainable, account for nearly 6% of GDP over the past 9 months.

Source: StatsCan

Some Canadian economist (BMO I’m looking at you) take the view that Canada has benefited mightily from foreign stimulus:  "The peak impact that the stimulus-fuelled rebound in global growth has had on demand for Canadian products is beginning to fade, leaving in its wake a more subdued, but ultimately more sustainable, growth rate of exports."  Personally, I suspect that the “transfer” from the US to Canada has been minimal (except in the energy area).  More troubling for Canada is if we assume a return to historical norm for U.S. consumption of 64% of GDP (compare to around 53% in Asia) instead of today’s 70%, the U.S. consumption will be much lower going forward.  That could have a tremendous impact on Canada – especially with regards to vehicles.  


This is where reality gets interesting:  In Q2/2010, PCE amounted to $9.3 trillion (down by 15% from its 2007 peak) out of a $13.2 trillion economy (70% on the nose).  Should the US return to a 64% level of consumption to GDP either:

(a)        Consumption has to fall a further $802 billion (6% further drop), or
(b)               GDP has to rise by 9%, while consumption remains unchanged – in other words exports need to rise.  

However, exports account for 12% of GDP – or $1.6 trillion, which would mean that US exports would have to rise 48% -- that’s a big hill to climb.  The long term impact on Canada’s must therefore be negative, first as America’s largest trading partner (with an appreciating currency).

In these condition is becomes more difficult to be bullish about Canada’s economic prospect.  In a sense, Canadian industry heavy capital investment may well translate into a productivity increase that will reduce the impact of a strong currency, but there is little doubt that 2011 will be a challenging year for Canada.

We projected 3.2% GDP growth for 2010 – consensus is apparently for 3.5%, but our view of 2011 has worsened from 3.2% to only 2.5%.  Depending on what happens to our American neighbors.

P.S.  Reviewing my post of last week, it seems that I am far more bearish than I was just 5 days ago.  I must note that I made an error in my model (changed a protected cell) making the correction to this error has increased the numbers back to the same levels as last week, but GDP growth may well be at 2.5% in 2011 (new figure) from the 3.2% level (I should have shown before)

Friday, August 27, 2010

The ending of the Bush tax cuts is equal to 2% of the US GDP. What is the impact of the non-renewal on Canada’s economy?

As a strict monetarist I believe that deficits do matter, that has always been my position, government should, like everyone else, live within their means.  That means that borrowings are OK, as long as they are repaid out of the revenues they have created (eg a new bridge or power station -- these thing generate economic activity). It’s not OK to use deficits to pay for healthcare or teachers salary; these are general expenses and as such should come out of tax revenues.  Government will operate in deficit during recession, but it should be a rule that as the economy recovers, the government seek to reduce these deficit (yes I know that this is recessionary).  

Over the past few days I have spoke to 4 bank economists in three institutions (don’t ask) and they all came across as optimists on the Bush tax cuts!  All their base models assumed that the Obama administration will “continue” to Bush tax cuts for another 3-4 years.   At first, I wondered if there was something that I missed, but then it dawned on me, these guys are all equity bulls… every one of them looks at the economy and sees a return to the “normal” of the Bush years.Rose tinted glass in my opinion. 

A bit of realpolitiks should be included here.  First the Republicans are speaking for their master – these are the ultra wealthy and right wingers who believe that less taxes is always better – cutting entitlements is the solution (medicare and Social security).  The Tea Partiers now being selected – and probable winners in November will never strike a deal with Obama’s White House, who they consider as traitors anyway.  You can bet that a witch hunts will ensue following the November elections:  Black Panther party, Birther, Appointment, Accorn.  Everything under the sun will be used to stop and destroy Obama’s legislative “successes”. 

There is almost no way for the Obama White House to agree to the Bush tax cuts if they remain as drafted today, and there is no way for the Republican who will probably control both the House and Senate to agree to substantive changes (see Tea Party reference above) that would focus tax cuts to the “middle class” and away from the very wealthy.  Since the WH and Congress will not agree to change the tax cuts these will naturally expire.  In a revenge move Congress will slow/stop the financial reform, health care, and will stall the WH agenda (a reprise of the mid 90’s “Contract with America efforts) -- thereby reducing the Federal government's deficit (and increasing the hardship for millions of Americans).

Now the meat:  $250 billion, which is equivalent to about 1/3 of the current federal budget’s deficit and about 2% of the US total GDP will disappear in 2011 as taxation takes revenues out of the system.  This will generate further economic contraction – it’s simple math!  The results:
(1)               Anemic GDP growth – in the 1.5% to 2.0% for 2011 and 2012
(2)               Stronger U.S. dollar as the Feds will need to borrow less (impact on U.S. exports)
(3)               Further job losses as local, state and Federal government has to lay-off staff because of budget constraints.

For Canada the impact of low U.S. growth in 2011 and 2012 is mixed.  Already in 2009, OECD and emerging economy each consumed 45bbl/day.  OECD oil demand growth was near zero, rest of the world growth rate around 20%, producing a blended increase in oil of about 10%.  In 2011, global oil demand is expected to rise to 89.3 bbl/d [above the 2007 peak demand of 87.6  bbl/day (oil prices had risen to $147 at that time).  An American recession would in the past have lead to a fall in oil prices, but the changing dynamic of oil demand maybe permanently changing the pricing picture.

Currently, 70% of all Canadian exports are destined to the U.S.  About 1/3 of this total is energy (mostly synthetic oil and gas).  Canada is extremely dependent for its export markets on the U.S.

Our second largest exported goods are vehicles – the North American car industry is fully integrated and has been for decades.  It is expected that even in a weak U.S. recovery demand for vehicles is unlikely to drop substantially below the current 10 million units per annum (which is about 20% below the “replacement” level).  As such Canada’s two core U.S. exports are considered largely safe.

Further weakness in the U.S economy will affect the Canadian economy, especially since many of the internal growth factors in Canada have peaked (housing and infrastructure spending).  Canada’s growth rate is therefore likely to suffer slightly form continued U.S weakness caused by the removal of the bush tax cuts, but is unlikely to hamper the Canadian dollar or the broader Canadian economy.  At most further U.S. weakness will trim between 0.5% and 0.75% to Canada's growth prospects.  We still anticipate that Canada's 2011 GDP growth will exceed 3% -- forecast for 2010 is still around 3.2%.

Two caveats, a weak U.S. economy will have no room to maneuver in the event of an exogenous chock; Iran/Israel conflict, failure of one or more European state or some other unknown event could be a tipping point for the U.S. economy from stagnation to recession. 

Second should the U.S. economy face a depression like scenario all bets are off on Canada.  Our economies are closely related, an American depression would severely damage Canada’s economy.  A continuation of the U.S, recession will reduce Canadian growth, but our position as a large exporter of materials and energy will endure with the rest of the world keeping up demand.

Thursday, August 26, 2010

Economic Data points to BoC restraint -- maybe!

The news out of the U.S. continues to be dismal, yet the market feels like celebrating!  Up here in Canada the news is OKish.  The big date is September 8th when the BoC will have another chance to raise interest rate from 0.75% to 1.0%.  For Carney and friends the incentive to raise rates is high because it would provide the BoC with some ammunition in the event that the Canadian economy starts to tank again.

The reasons for not raising rates are numerous:

(1)                                       Canadian inflation is already in the lower target range:  Core CPI at 1.6% and total CPI at 1.8% -- Canada’s interest rate range is between 1% and 3%. – Inflation was affected by the introduction of consumption taxes in three provinces.
(2)                                       Housing “seems” to have slowed down – although the hard data points back to June (National Bank Teranet Index) July and August “sale” data is much lower than it has been in the past few months.
(3)                                       Corporate profitability of Canadian firms is down
(4)                                       The American economy appears to be slowing down – it may even return to recession levels

Inflation: Last week’s headline inflation figures were distorted by the introduction of consumption taxes in Nova Scotia, British Columbia and Ontario. This explains in part why total inflation jumped more in some provinces than others. However, core CPI, which is not affected by sales taxes, showed a 1.6% inflation rate on a twelve-month basis. So far in third quarter inflation is below the Bank of Canada target forecast level of 1.8%. Canadian inflation is still comfortably positive – unlike in the U.S. who appear to be heading towards deflation.

For the BoC more good news on the real estate front where it would appear that the Canadian housing “bubble” seems to be deflating (its not so much a bubble when trending house price against income growth).  It’s impossible to forecast where inflation will be heading; right now energy prices are falling as are house prices (two critical components of the inflation index), but how much of a fall is hard to estimate.  The Canadian dollar – as a petro currency takes away some of the energy price movements, as for housing, it is still largely a balanced sector.

Canadian corporate profitability has dropped for the second quarter.  Two segments were to blame: Oil & Gas and Insurance.  However, the rest of the corporate landscape saw an 0.8% increase in profitability -- not great but still positive.  Worse was that the source of the weakness was generalized as both domestic and foreign demand were weak.  Overall profits for Canadian companies are still only 92.7% of their pre-recession level.  One sector that has done remarkably well is manufacturing, which both at the operational level and bottom line level has reached the pre-recession level.  However since manufacturing only accounts for ¼ of Canada’s GDP…. 

The Bank of Canada will have a difficult task on the 8th, the odds are 50-50 that the BoC will raise rates by another 0.25%, but few now would argue that further raise are considered, especially with America's economy slowing.

Monday, August 16, 2010

Data Points in a slow week:

A very quiet beginning of the week, with no news until Thursday and Friday.  As I often stated my “thing” is Canada and its progress/failure in progressing as an economy.  First the bare facts:  Canada is by historical standards in poor shape, but compared to almost everyone other OECD country else we are doing amazingly well.  Historically, our oft cited weaknesses (strong industrial and mining basis) are today considered strength.  No doubt that in a resource challenged world (where demand increase but were supply are becoming constrained) being a resource rich one is attractive.  However this richness is not a quality, it’s a state of being, quality arise from the human element:  peace, rule of law, little corruption, well educated population with interesting demographics.

Ok end of preaching!  The rest is stuff which has been accumulating in my inbox:


Interesting statistics on Gold producer, as the price rises the impact on the share price (throughout history) has been very positive, with a 2:1 increment in the value of gold stocks (i.e. if gold price go up by 1 unit, stock prices go up by 2 units).  That’s not my work; the chart below just confirms the trend.  

More amusing, the UAE authority in Dubai no longer test “Gold” in provenance of Africa.  According to UAE official its always 100% fake – you have been warned

TIC Report & China (ok not Canadian..)

From today’s TIC report:  Chinese Treasury holdings dropped to a 1 year low of $843.7 billion, following reductions in both long-term and short-term treasuries. China now has almost $100 billion less in US Treasuries compared to the peak of $940 billion in July 2009. One wonders what China is buying with the sale/maturity proceeds?

The Chinese authorities are also pushing down the Yuan rather aggressively – consider that China has just hit its biggest trade surplus…

Canadian Housing:

Canada’s housing market stalled in July as sales sank 30 per cent from the same month a year earlier (Canadian Real Estate Association). Prices edged up 1 per cent from July 2009, though slipped 3.5 per cent from June, with sellers finding far fewer buyers willing to step into the market.  The country's largest cities led the annual decline, with Vancouver posting a 45 per cent drop.

Housing has been a huge economic engine for Canada over the past 12 months, with massive increase in supply.  It would appear that Canadians are worried… it probably has something to do with the U.S. , our immediate neighbors!  The reality is that most Canadians live within 140km of the U.S. boarder, so Canadian are greatly influenced by the U.S. evening news

That is all.

Thursday, August 12, 2010

Trade: Bumpy road ahead

Watching Mark Mobius this morning was somewhat surreal; in effect Mark was saying that if the economy tanks, the U.S. government will prime the pump with stimulus II or QE II, and if the economy is OK, then its OK, so in a nutshell Mark’s prediction is that its all positive for stocks, even if the news is bad, it will be good because of Keynesian intervention by the U.S. government (and China I presume).  Funny enough Mark was not challenged, possibly because the numb nuts permabull cheerleaders in CNBC don’t know what to say to a money manager who is always such a bull.

Trade numbers came out yesterday for Canada, and the number were poor, the market anticipated a reduction in the trade deficit in the range of $300 million instead the trade deficit rose by $700 million, a $1.1 billion expectation gap.  Exports dropped more quickly than import.  The only good news from the report was the rise in impost of machineries – a potential sign that productivity will continue to rise…. (Again, our bias is 20th century manufacturing capacity – still there are few other outward appearance of potential productivity improvements).

The trade numbers have a dramatic consequence on GDP growth.  We continue to hedge down towards an annualized GDP growth for Canada of 3.2% -- I may still be right (great…).  It looks like the revised GDP growth numbers for the second quarter will be around 2.5% (after the trade numbers), which is short of the BoC target of 3%.

The reason I raised Mark’s comment about the U.S, economy (Mark is already convinced that the Chinese are about to embark on their own stimulative package anyway) is how this will impact the demand for Canada’s primary exports:  energy and raw materials.  One thing is certain, the world will continue to require the things that Canada produces.
Consequences & Predictions:
(1)               Canadian dollar remains in the 0.96 -1.01 range (against the USD).  Canadian dollar exchange rate is highly correlated to oil prices (90%) and the direction of the S&P 500 (94%) [causal???]
(2)               Inflation will remains subdue – around 1.6% to 1.8% for the rest of 2010 – excluding the adjustment for GST in September
(3)               Interest rates may rise another 0.25% to bring the BoC rage to 1.0%, bit with weak employment and a housing market that seems to have rolled-over there will be little pressure to increase interest rates beyond the September 8th review date

Tuesday, August 10, 2010

Canada -- a Great story according to the data

This morning, David Rossenberg provided interesting insight as to what is "turning foreign investors on" in Canada.  The entire document is worth a read, but there are two diagrams that say it all:

Only the Netherlands and Germany have a lower cyclically adjusted budget deficit -2.7% and Canada has by far the lowest level of net debt at 32.6%.  The second issue is that Canada not only is a better risk, but its risk is mis priced, it offers better yield premium than the US.

Finally, and this is just chart porn, since there is no honor in being "Natural Resources rich", Saudi Arabia is not a better people or economy because they sit on great oil and gas properties.  This in fact, has always been a Canadian weakness, we are not so good in trans formative industries we are good at extraction.  This implies that the value added is created elsewhere.

However, for foreign investors looking to increase their exposure to natural resources, Canada is an obvious investment destination.  In fact foreign investors have been flocking to Canada, investing more than $121 billion into the country (or 7% of Canada's GDP) over the past 12 months.

Monday, August 9, 2010

Canadian Dollar, Interest Rate and Economic Growth

The Canadian dollar is back near parity, it’s been all over the place over the past few weeks, down to 0.92 and all the way up to 0.97 today.  Why the currency gyrations?:  First, we are in the middle of the silly season, there is little depth to the markets, second the market is looking for good news, even when it doesn’t exist, and finally oil price are on the war path again – around $81/bbl.  The Canadian dollar is heavily correlated to oil prices (around 90%).

I always worry when the Wall Street Journal starts having articles about Canada – and over the past few months the number of articles (rarely do they get their facts right) have been written – first our banking system, now its our taxation system with Canada: the Land of smaller Government.  First, insisting that Canadian corporate income tax 18% (don’t worry its not) then making the point that all budget cut initiative have been initiated by “Liberal” administrations), and finally, to say that Canada is the land of smaller government is a gross mischaracterization of Canada’s economic model.

Getting to economic data over the past few weeks, the numbers are far rosy than they were in the first and second quarter.  
(1)                                       Unemployment rose in June (up 12k), but it easy to forget that Canada has created more than a ¼ of million jobs over the past 9 months, which is massive),
(2)                                       Inflation is clearly tame, falling both in general and the core rate (1.7% and 1.8% respectively).  Inflation from foreign price is falling and will continue to fall for at least another year.  
(3)                                       Capacity utilization appears to be nearly full, which implies that Canadian companies will soon have to invest in plant and equipment (although uncertainty about the economy has slowed this process down).
(4)                                       Housing seems to have hit a speed bump.  After rising for the past 12 months, and now at a new peak, the Canadian market seems to be moving towards surplus capacity

Last week’s job report was poor, but then so many jobs were created in Canada over the past six months, it was to be expected.  This will be a problem for the Bank of Canada’s objective of further raising interest rates.  The dollar is not a component of the BoC’s interest rate fixing policy, but economic growth (and inflation) are.  Growth appears to have dropped off over the past few months, the Canadian short term rate now stand at 0.75%, and may rise further to 1.0% by the end of August, but in view of the slowing US economy, it would seem that the BoC’s offorts to raise rates are nearing the end.

Foreign investors’ interest in Canadian economy are dominated by the direction of the Canadian dollar, economic health and interest rate policy as barometer for their decision to invest in Canada or increase (or reduce) their holdings.

First, the BoC never takes the strength of the Canadian dollar in their interest rate setting process.  As far as the BoC is concerned, the strength of the currency is an output, over which they can have no lasting impact (someone should have told this to the SNB trying to hold the Swiss franc).  Inflation is still key factor, and Canada faces two different sources (more so than other economies), when natural resource prices rise, the Canadian dollar tends to rise – as such the inflation impact on Canada is initially mitigated, and Canada also faces inflation from the endogenous elements such as labor market and excess capacity (or the lack thereof).  Canada’s manufacturing base shrinks on an annual basis, accounting for nearly 1/3 of economic activity in the early ‘90s today it accounts for les than a ¼.  This shift is common to any advanced economies, but it poses problems when the BoC attempts to evaluated the level of spare capacity in the system. Canada’s various governments remain committed to cutting their operating deficits, both by raising taxes and by controlling expenditures.  

The current federal administration is minority conservative government, which will probably call the election in two years – facing a divided opposition (three parties), and remains committed to lower taxation and smaller government (all Canadian governments face the same rapid natural shrinkage of their labor force as a large number of functionaries are looking at retirement over the next 5 years).

Chart Porn: