Thursday, September 30, 2010

Impact of a trade war on Canada’s economy

My conclusion:  trade war will have very little if any impact on Canada’s trade position.  First, the Bank of Canada is one of the few central banks that has no real issue with the direction of its currency.  In fact, the BoC has made a point of not taking the direction of the currency in its analysis of the strength of the economy.  With this in mind, the idea that Canada is manipulating its currency is considered moot. 

Canada is part of one of the world’s greatest trilateral trade alliance, the NAFTA (North American Free Trade Association), which includes Canada, U.S. and Mexico, but already America has made some inroad in this alliance when in 2008, its infrastructure program made “Buy America” a precondition to any federally funded projects.  Although the impact on trade was limited, it was not inconsequential, and in reality Canada and the U.S. are the two largest trading partners (with each other) in the world.

What is interesting is the nature of Canada’s merchandise export/imports:

Merchandise Trade


Obviously from these figures, Canada has a trade deficit at the merchandise level, which is a new issue for Canada (over the past 2 years), Service trade is approximately the same size as merchandise trade.  However, generally, it is merchandise trade that is more affected by trade sanctions.

Breakdown the type of merchandise trade:

Breakdown by Types

Resources & Agriculture

Material & Industrial


It is rather evident, and not surprising, that Canada exports raw goods and imports manufactured items (automobile is a very large (1/4) of the manufactured trade).  What I intend to show here is that more than half of Canada’s exports are for raw material, where there is often little or no domestic competition – when China or Russia buys wheat they are not affecting their domestic supply, they are meeting a shortfall.  So the cores of Canada’s exports are unlikely to be subject to import tariffs.  

Canada’s first Reading of negative GDP figure

It seems that the Bank of Canada’s bet is not working out as planned (maybe), GDP growth that was expected to be more sluggish in the second half of 2010 is turning out to be downright terrible.  It is difficult to blame the BoC, but it remains that Canada’s economy appears to be decelerating rather dramatically, from a 5.8% GDP reading for the first quarter of 2010, to a negative reading of 0.1% for July.

The biggest negative contributors were manufacturing, retail and wholesale trade, construction and forestry.  Confirming that Canadians, although clearly out of recession, are still spending as if they were in a recession.  The sectors which did the best were mining and to some extent the financial sector.  It must be pointed out that the success of our resource economy has little or nothing to do with the health of Canada’s economy; these numbers are entirely driven by foreign factors. 

Manufacturing decreased 0.7% in July, with 11 of the 21 major groups retreating. Manufacturers of non-durable goods reduced their production by 0.9%, in particular those of pharmaceutical and paper products. Manufacturing of durable goods decreased by 0.5%, notably of furniture, metallic and non-metallic products. Increases in the production of food and beverages and motor vehicle parts tempered the decrease in the manufacturing sector.

In the first quarter of 2010, Canada’s GDP grew by 5.8%, followed by a second quarter performance of 2.0%, now the first preliminary results for the third quarter are beginning to emerge, and the performance for that quarter are beginning to look like a sub 1% performance (4th quarter GDP tends to be slightly stronger due to seasonality), still the first half contributed a GDP growth of 3.9%, while the second half is looking increasingly difficult to predict.  It is now possible that my 3.2% target GDP growth for Canada in 2010 may be a little to optimistic, especially if the third quarter stays around zero growth, which would imply that by the end of the third quarter’s Canada’s growth rate may be around 2.6% for the year….

This will have an impact on Canada’s trade deficit (reducing imports), but will have virtually no impact on the CAD, since the currency is now entirely driven by the price of oil.  On thing for sure the BoC’s next 0.25% increase in interest rates would appear to be on hold.

Wednesday, September 29, 2010

Canada – Out of the Woods, yet?

Today the Teranet National Bank Index came out, indicating that, across Canada, house prices were still rising, but the increase was decelerating (prices are rising more slowly). 

Canadians have never seen such low borrowing costs, the Bank of Canada has been raising benchmark short term rates from 0.25% to 1.0%, but at the same time, inflation expectations have abated so the yield curve has “flattened” (which means long term interest rates are falling while short term interest rates are either rising or remaining flat.  Bellow is a diagram of borrowing costs in Canada, which illustrates this point rather well.

 About 10 days ago, Tim Lane one of the BoC’s deputy governors made a presentation.  The highlights are:

  • Inflation is around the 2% target range, which is right were the BoC wants it.
  • Borrowing conditions for small companies are still tightening,
  • GDP growth forecast for 2011 onward is for a rate of 2% instead of 3%, we got in the past decade (a function of aging population)
  • Capital expenditures by Canadian companies is still way off the 2007 level, but government spending is about 10% higher than it was, and consumption is back to its pre-crisis level
  • Capital expenditure may be driven by exports, which are also 5-7% lower than they were prior to the crisis.  There is still some excess capacity in the system (hence the lower investments)
  • The Bank of Canada has withdrawn all of its liquidity facilities – the bank’s balance sheet is back to its pre crisis size

The question is how can Canada, a small open economy function when its major trading partner:  America seems to be slipping back into either a full blow recession or at the very least a very subdued recovery 0.5% to 1.0% growth rate.  As Martin Wolf in the FT stated in today’s Financial Times: 

In an era of deficient demand, issuers of reserve currencies adopt monetary expansion and non-issuers respond with currency intervention.

Canada’s path is far from clear, in the past when short term interest rates have diverged from those prevalent in America; Canada has had to reverse its track.  Already, Canada’s second quarter seems to be showing cracks as GDP growth appears to slip below 1%.  The only part of the economy which seems to be firing on all cylinders is the material extraction business, from oil, to copper via gold, demand for raw material is still growing, fueled by the emerging economies strong GDP growth, and their demand for raw material as they play the infrastructure catch-up game.

Thursday, September 23, 2010


Fascinating interview with Aaron Regent the CEO of Barrick Gold on CNBC (TSE:ABX).  He is one of the more interesting guys “running” Canada, honest about his company and his industry.  First and foremost, is the scope/size of the business, total market cap for all gold stocks, and gold ETF is around $600-700 billion.  Which is lots of cash, but if you consider this is one extraction business not that much.  So the arrival of new capital, even in reasonable amounts, can have a rather dramatic impact on the industry.

That gold trades near $1,300/oz gives firms like Barrick a tremendous amount of  free cash flow, and one of the more interesting comments from Regent was the fact that finding new reserves is difficult and bringing a new mine to a “exploitation level” can easily take a decade or more.  This is the interesting bit, Barrick’s legacy mines are high cost producers, the newer ones operate at lower costs, therefore balancing the equation.  However, Regent indicated that is reserve attrition is about 1% per annum, and he see’s little chance of turning that around in the short term (5 years) – in fact his comment was that reserve attrition was a fact of life in the gold mining industry going forward.

Why gold prices are rising is the result of several elements:  (1) governments which had been selling gold, at a rate of 400-500 tones per annum are now net buyers. (2) Countries such as China, which had almost no gold demand 10 years ago, are now large buyers.

One question (Jack Welsh) was what would prompt gold prices to falter as it had in 1987:  Regent though that only a major Chinese recession could cause a dramatic fall in price.  According to Regent gold price in terms of staple goods is well within its historical range:  against oil and copper in particular, it falls within historical boundaries.

Canada’s trade picture

In 2005, the U.S. accounted for 70% of Canadian total exports; in 2009 this had dropped to 63% -- in terms of volume, forgetting the impact of Canada’s stronger currency.  Trade with Europe and emerging markets, still small (each less than 1/6th the size of the US/Canada trade flow) is growing quickly.  China that was nowhere in 2000 as an exporter to Canada is now the third largest (after the U.S, and EU).  As a percentage of GDP trade is ¼ smaller than it was in 2000 at 30% instead of 40% of GDP, but a great portion of that drop is the result of the appreciation of the Canadian dollar – a monetary impact, not so much one in terms of economic significance.  Canada is the world’s ninth largest exporter and the tenth largest importer, and 20% of all Canadian jobs are related to trade.

Some overall characteristics of the Canadian export sector:

(1)               Canada export sector remains deeply reliant on the U.S. as an export market, despite the increased barriers the Americans have added after 9/11 on the exports of goods (services are another issue).  First and foremost the two economies are deeply intertwined – a fact made clear during the 2008 crisis when many US infrastructure projects needed permission to buy Canadian products because there was no American equivalent. 
(2)               Canada’s trade is rapid growth of raw material exports at the expense of processed good.  This is a growing issue for Canada, since the value added (after mining) is processing.  As an example it’s not the bauxite miner that makes the cash it’s the aluminum smelter.

Canada’s dilemma is although merchandise trade is a smaller portion of the GDP it remains an important component.  A world that appears to become more protectionist (see the recent action by China on rare metals) a country that is as open as Canada is vulnerable.  

Monday, September 20, 2010

Canadian Economic Data Today:

Two pieces of data of importance:  First, the cash keeps on flowing into the country, another $5.5 billion in July flowed in from non-resident, and Canadian liquidated $3.3 billion on foreign holdings during the same period.  Second, is Wholesale Trade’s headline numbers were down, dragged down by car sales (-0.6%). 


 The first is not a huge surprise; the average monthly inflow was around $9.7 billion (over the past 6 months) that includes April and May that saw $23 bn and $13 bn inflows respectively.  The trend seems to be “down”, probably because the “risk-on” trade is now attractive.  However, the Canadian market is maybe not see as a “risk-on” market for non-resident investors, since equity outflow were large again at $0.6 billion. 

Wholesale trade is a huge deal for Canada, because the auto sell shortfall is an indication that the North American economy (we mean America here) is slowing, in fact not only were wholesale sales off, inventory have been rising, and indication that the U.S. economy is slowing, which is very important for Canada, for 70% of our trade is with the U.S. 


Finally, manufacturing sales were off too!  I don’t count this as a major indicator, first because merchandise trade is now less than ¼ of Canada’s GDP, but more importantly, similar data can be extracted from the wholesale trade data, its more of a confirmation, and in fact the drop was almost 1.0% for the month of July.

Recap of Canada’s economy – David Rossenberg from Gluskin Sheff

  • Canada will be the top GDP growth performer among the G7 countries in 2010 and second in 2011
  • Significant exposure to natural resources (over 40% of total exports)
  • Largest sectors of the S&P/TSX Composite Index:
    • Financials = 30%
    • Energy = 23%
    • Materials = 24%
  • Very active capital formation in the resource sectors. Extensive choice of small, mid, and large cap companies
  • Arguably the strongest banking system in the developed world (low leverage ratios, high dividend yield/growth, recourse loans)
  • One of the few countries with a AAA-rated balance sheet
  • The Canadian dollar (the “loonie”) is a resource-oriented currency and is in a secular bull market
  • Stable, parliamentary democracy — pro-business/pro-markets government; no election until 2012-2013
  • Risk of Quebec secession has disappeared

On a YoY basis virtually all material prices are up, energy prices are down for both oil and gas (7% and 28% respectively), and Zinc, Lead and Aluminum are either down or flat, but Copper, Nickel, Gold, Silver, Palladium and Platinum are all up 15% or more for the past 12 months.  These are tremendously positive factors for Canada.  Despite a slow down in manufacturing and wholesale trade (driven by the American economic problems) the money markets are pricing further interest rate rise out of the Bank of Canada (its important to note that the value of the Canadian dollar is not considered by the BoC when setting interest rates).

“Investors are increasingly seeking yield and especially among solid credits, and again in Canada, even with the Bank of Canada signaling a pause in the tightening cycle, they can pick up a 100 basis point premium at the front end (2-year note) of the Canadian government curve over the U.S. treasury market. Not only that, equity investors can pick up a similar premium in the domestic stock market because, at around 3%, the Canadian dividend yield is very nearly 100 basis points higher than what you can garner in the S&P 500. Yields above zero and resources below the ground, hence the fact that year-to-date, the Canadian equity market (the TSX Index) has outperformed the U.S. (the S&P 500) by well over 500 basis points (on a Canadian dollar basis) on top of last year’s 2,400 basis point outperformance. Look for this divergence to continue, as it has with near consistency for about a decade now” (Rossenberg).

Wednesday, September 15, 2010

Canadian Manufacturing & Productivity – a mixed bag

First the good news:  Canada’s industrial capacity utilization rose in the second quarter of 2010, still well below its peak, but any increase is good news (although a 0.2% increase is not exactly something to write home about).  The low of 68.1% was reached about a year ago, and the high of 83.1% was reached in Q1/2007.  The BoC anticipates that the capacity utilization for Canada’s manufacturing will continue to rise, but with the weak American economy its recovery will be slow.  Another bright signal was the increase in Canadian productivity, whereas the market was expecting a 0.5% decline the “reality” was of a 0.5% increase in productivity (there are real issues in measuring productivity – especially for services). 

Now the bad news:  Canadian manufacturing sales “unexpectedly” declined by nearly 1% in July according to StatsCan.  The market had expected a 0.2% rise and was therefore off by 1.1%.  The biggest “fail” were unsurprisingly vehicles sales and furniture (two sector greatly affected by U.S. demand). Looking forward the news was even worse, with new order decline of nearly 4% -- again core “fail” sector was the automobile sector….

So the news is mixed, on one side productivity rose (employment growth – see last post is clearly slowing) and the “real economy” data is off a little.  The Japanese action on the currency market overnight could be a one-off, but these things rarely are.  Our firm’s best guess is that the USD will strengthen against most currencies (Euro,Yen, Yuan) and my guess that the material/energy complex will be off a little which “should” weaken the CAD, but again intervention by the BoJ makes the currency map had to read.

Tuesday, September 14, 2010

Gold Stocks:

I don’t usually write about stocks – I’m an ETF man myself (Go China…), but this morning it was pointed out to me that the main gold stocks (Barrick, Goldcorp and Newmont) were behaving strangely over the past few days --- down while the markets were up.

It seems that gold prices (the metal) continue their unending reach for the star program, with gold flirting around the $1270/oz level – which by the way is near an all time high (in dollar term – in Euro to but not in Yen, go figure).  Anyway, the stock prices have been moving rather a lot (go on Google finance to check for yourself).  Its important to note that yesterday was a “bit of a rally” on the market – its seems that Mr. Market decided that despite all the bad news, life really, was not that bad after all.  But gold got clobbered – no special news, no new views as to the problems with fiat currency.  (BTW I have no explanation as to why Gold stocks were off by nearly 6%, while the market was up by 6% since the beginning of September -- especially since gold price have been rising consistently.

Also ZeroHedge had an article about the U.S. market activity – apparently 20 stocks account for ¼ of all market activity; it would seem that this is proof that high frequency trading is taking over the market (they only function in ultra liquid market).  Actually 126 stocks accounted for 50% of all U.S. market activity.    It would seem that the law of unintended consequence is alive and well here.  Having made market making “illegal” at the beginning of the decade, the market now relies on HFT to generate market liquidity; it does but only for a very few stocks.  Thing about it, only ¼ of the Forbes 500 make the active stock list.   No bloody wonder that mutual fund redemptions are so important, Joe Average thinks the market is rigged (it probably is) against him.

I don’t have a particular point to make here, just an observation. 

P.S.  I own no gold stock directly or indirectly (ETF) I have no position on the market

Monday, September 13, 2010

The Dead Zone

In terms of economic news up in the Great White North (better know as Canada) things are quiet, the Chinese are buying more commodities – I guess to build more empty malls and empty homes, but also to sell stuff to those rare animals:  “Americanus Consumtor”, Canada’s balance of payment was again negative (in August), oil are back trading around $77 bbl (off their $72 floor) – which tells you something about the change in global market dynamics.  America and Europe are clearly still broken, but Asia is growing by 8-10% per annum – oil demand is growing by 25% per annum.

Materials as a store of Wealth

An interesting commentary from Michael Pettis (here) on what’s going on in China – he teaches out there and is rather smart fellow.  First and foremost China has a big “inflation” problem it will have to deal with, official price rises are tracking (in August), a 4.8% rise in the cost of living – workers are demanding higher wages revving the whole inflation machine.  One way of reducing inflation is to increase interest rates, but that has severe for China’s economy – the dominant Chinese companies today operate as break even operations.  Not really my purview here, but most borrowing today in China are from SOE (State owned enterprises) who generate no profits – increase in interest rates could be problematic.  However, my topic here is Canada, what if, as Prof. Pettis posits:  the Chinese tiered of fiat money are buying raw material as a store of value; the implication is that the “real” trade balance is much worse than the numbers suggest – because the Chinese are buying goods as a store of value.  His contention is that trade tensions are certain to rise – as a trading nation this has serious implications for Canada, then again we export raw material, its not like people have much of a choice.

Clearly, Canada benefits from higher raw material prices.  Some (based on sheer desire) are talking about gold at $3,000 an ounce – maybe but my guess is that at $3,000 an ounce the amount of counterfeit gold is bound to rise – Two months ago, the UAE’s central bank indicated that they no longer test “African sourced gold” as they expect 100% counterfeit, and that’s for gold at $1,200/oz.  About a month ago the CAD was trading around 1.07 (to the dollar), it’s now around 1.03 – especially after the BoC’s 0.25% increase in the short term interest rates.  However, it must be pointed out that the long end of the Canadian interest rates curve has flattened over the past few months.  A reflection of one factor:  inflation expectations have ratcheted down dramatically.  Short term movement in the CAD are to be expected going forward, it will gyrate between parity and 1.07 for the next few months. 

The global recession was very tame in Canada, employment numbers for August were positive, which is good, but private sector jobs growth was lackluster:  In the first half of 2010, Canada was creating 50,000 jobs a month, whereas in July and August the average is around 15,000 – the economy seems to be decelerating, which supports my thesis of 2.5% GDP growth in 2011 (not great but OK).

Green Rant:

America politicians are in Canada this week to visit the Atabasca oil sands region, to decide if they will allow the building of a second oil pipeline to the US.  The green movement is against America buying any “oil sands” generated oil because of the excessive pollution it creates – bottom line oil is fungible, if the American chooses not to buy Canadian oil, others will, this will weaken our political and economic alliance.  Under the terms of the NAFTA agreement, Canada has agreed to sell a specific percentage of its oil production to Americans, this clause would have to be revised (Canada produces very little natural oil – synthetic oil and gas is our core business – what natural oil we produce is heavy and requires a great deal of processing).  My educated guess is that if the Americans turn the project down (its an election year – the temptation will be great to do some grand standing) then Canada will probably begin building a new pipeline to the West coast…

An interesting note, China recently imposed export quotas on rare minerals, the Chinese’s position is that the extraction process is too polluting and therefore production will be reserved for Chinese companies (it is true that China has a terrible pollution problem).  This news is amusing because most of these metals used to be mined in America until the mid 80s when environmental pressures closed all American mines.  The funny thing is that to avoid the highly restrictive American pollution rules producers moved their production to a location which places little emphasis on pollution control (if any value at all – 75% of Chinese drink contaminated water) – therefore the green movement created more pollution (granted in China instead of America) – the law of unintended consequences.  More serious is the security implication that such quotas create.  Last year, Argentina imposed quota on the export of beef and cereal, this summer Russia imposed (for goodish reasons) a cap on exports of cereals after the terrible firestorms they suffered.  These are early warnings of a global economy that is coming to grips with shortage (real or perceived) and taking action.   It could be stated that the era of trade expansion is coming to an end – protectionism may be rearing its ugly little head, and as Prof Pettis said last week, everyone is counting on America’s trade deficit to continue (even to grow) to support their economic correction process.

That may not work for the Americans 

Wednesday, September 8, 2010

Today the Bank of Canada revised its interest rate policy to 1.0%

  • The Bank of Canada (“BoC”) raised its benchmark rate by another 25 bps this morning to 1.00%. .
  • Interestingly, since the BoC’s first rate hike (June 2010), the Canadian Swap curve has actually flattened. The 3-month CDOR rose by more than 40 bps while the 5-year swap rate declined by more than 80 bps.
 The Bank of Canada press release highlights:

  • In the United States, the recovery in private demand is being held back by high unemployment and recent indicators suggest a more muted recovery in the near term.
  • Economic activity in Canada was slightly softer in the second quarter than the Bank had expected.
  •  The Bank now expects the economic recovery in Canada to be slightly more gradual than it had projected in its July Monetary Policy Report (MPR), largely reflecting a weaker profile for U.S. activity.
  •  Inflation in Canada has been broadly in line with the Bank's expectations and its dynamics are essentially unchanged.
  •  Any further reduction in monetary policy stimulus would need to be carefully considered in light of the unusual uncertainty surrounding the outlook.
The rise in rates was widely anticipated by the market (although the odds of an increase had fallen slightly to 50/50 over the past few weeks).  The statement is far less bearish than I had anticipated; on the other hand the market is pricing a 20/80 chance of a further raise to 1.25% in November.

More interesting is the shape of the interest rate curve which has flattened dramatically over the past few months.  No economist predicts deflation in Canada, strong resources based economy should insure that things will continue on their current path.  Yet inflation is very tame, and is not expected to trend towards the upper boundary (3%).  However, inflation risks are abating (currently around 1.6%) and Canadian money growth is well within the bound dictated by economic growth of 3.2% for 2010, and 2.5% for 2011. 

As we can see, the Canadian swap curve has strongly flattened in four month.
(Canadian swap rate curve)


BTW I was wrong on interest rates, I really thought that the BoC would hold off on a 0.25% rise

Wednesday, September 1, 2010

Doom and Gloom

The Obama administration has been a real disappointment.  Unlike most politicians Obama kept on seeking Republican support for his bills despite them never, ever supporting his agenda.  In fact, this had led the American government to pass some of the most long winded and poorly drafted laws in the land – 2,000 page health care law is just insane (a normal bill in Canada will run 75 - 100 pages).

November is coming up, and the right has fomented its troops into a frenzy of lies and half truths about Obama.  The economy is a complete disaster and far worse than even the most pessimistic analyst ever anticipated – you can bitch about Goldman’s behavior in arranging sub-prime securitization, but the reality is that all securitization structures failed.  They picked the worse, but it would not have mattered.

Obama has failed to pass any social legislation, or even try to pass social legislation.  Had Obama forced the hand of congress on iImmigration reform, he would have lost, but the failure could have been set at the door of the Republicans.

Up here in Canada we’ve had a number of “street fighters” as prime minister; these bare knuckle guys were tough SOBs and were able to make a mark, Obama has spent too little time on that!  It now looks like November will be a route for the Democrats, their supporters are depressed and sulking and the Republicans are mad and ready to get some. 

Should the Democrats loose control over both houses, the impact on the U.S. (and Canada) economy will be serious.  Unlike the 1995 period went the U.S. economy was in faire shape the U.S. economy is in a dire condition.

The Republicans’ plan appears to be:

(a)                Make the Bush tax cuts permanent
(b)               Add new tax cuts to the rich (more than $200k) – Boehner announce 31/08
(c)                Reduce eliminate Medicare/Medicaid and scale back Social Security
(d)               Stall the White House with investigations
(e)                “Defund” all Obama initiatives (not sure Defund is a real word)

Needless to say that adding more tax cut will make the deficit even worse, but it will make the Republicans paymaster happy.  However, even if the Republicans have a majority it doesn’t mean that they will be able to impose their will, Obama has the ability to veto laws and will probably do so.  The net impact will probably be:

(a)                The Bush tax cuts will be repealed (GDP cost 2%)
(b)               Healthcare reform is dead (no cost yet 2012 implementation)
(c)                No new stimulus package
(d)               No TARP II (should the banking system get into trouble)

In a nutshell the systemic risk is rising in the U.S., and this has grave consequences for the Canadian economy (70% of Canada’s exports are to the U.S.).  The RNC is being outflanked on the right by various organizations vying for “blood”:  the Tea Party have a very different view of America than do the old school, Regan conservative and Democrats.  They ability or willingness to compromise is minuscule – they may overplay their hand and America ends up with a worse case scenario.

My guess is that a Republican congress will be look more towards military adventurism (get Iran etc), and harder at home.  The States (with the support of Congress) will assume greater power and a meaner and more radical America will emerge.

An interesting aside this morning on CNBC there was a discussion about the difference between Germany and the U.S.  Bottom line, German companies have worked hard are minimizing layoffs by reducing working hours (thereby reducing productivity), whereas in America – CEO are very well compensated for reducing operating expenses (revenues not so important).  Bottom line, aside from one participant (A.R. Sorkin), everyone on the show was for the American version – fire everything that moves, and deemed the German version of dealing with economic slowdown as “Un-American”, which turns out not to be such an insult since they were talking about Germany.  A country that “suffers” from: (a) lower unemployment, (b) lower budget deficits, (c) growing GDP.  That is all bad in the world of the talking heads!.