Historically, the Canadian economy and its capital markets have been highly correlated to those of the United States. Similarly, Canadian interest rates prior to 2015 were over 90% correlated with those of the U.S. This is not surprising given how intertwined the Canadian and U.S. economies are, with approximately 75% of Canadian exports going into the United States. (Figure 1)
Today, however, we are seeing a divergence. The U.S. economy is growing at twice the pace of the Canadian economy. This deviation has led to the current monetary environment where the US is tightening its monetary policy by raising interest rates while Canada is loosening theirs.
When assessing recession risks in Canada it is worth noting that Canada has never had a truly “Made-In-Canada” recession without being accompanied (Figure 1) by recession in the United States.
Though the Canadian economy is highly correlated with that of the United States, as an oil producing country, the effects of lower oil pric-es has a profoundly different effect on our economy. In Canada’s oil pro-ducing provinces, in particular, the impact has started to materialize with a notable rise in unemployment rates in Alberta and Newfoundland, and slowing or even declining prop-erty prices. (Figure 2)
The impact of lower energy prices has also resulted in a significant shock to Canada’s terms of trade, pushing Canada’s monthly trade balance into deeper deficits.
Although lower oil prices also hurt U.S. oil and gas producers, they benefit the U.S. consumer in terms of increased savings and dispos-able income. The U.S. consumer
accounts for 70% of U.S. Gross Domestic Product (GDP), rendering the United States a net beneficiary when oil prices decline.
In anticipation of the impact to Canadian household incomes and jobs from lower oil prices, the Bank of Canada lowered interest rates twice in 2015. Importantly, this was in stark contrast to the market’s anticipation of the interest rate hike from the Federal Reserve in late 2015, its first since the global financial crisis in 2008. The effect was to put significant downward pressure on the exchange rate, with the Canadian Dollar depreciating to C$1.4690 (US$0.6808).
The weaker currency in Canada was intended to help revive some of the country’s non-energy sectors, particularly manufacturing. So far, however, evidence of a rebound in non-energy exports has been limit-ed. (Figure 4)
We believe this is partly the result of Canada’s relatively high unit labour costs versus its major export com-petitors such as the United States and Mexico.
In addition, almost all of the currency adjustment since mid-2014 was in the form of U.S. Dollar appreciation versus many currencies, rather than Canadian Dollar depreciation. Although this adjustment still helps Canadian exporters versus domestic competitors in the United States, the Canadian Dollar has not significantly depreciated when compared to its other major trading partners such as Mexico or Europe. (Figure 5)
However, there are some signs that a weaker currency and an ongoing recovery in the United States is helping the overall labour market in Canada. In 2015, Canada added more jobs in total than in the prior two years. And importantly, jobs growth that had previously come from Alberta was supplemented by solid jobs growth in Ontario and, for the first time in three years, decent jobs growth in Quebec. (Figure 6)
We follow the Canadian labor market particularly closely due to the level of household indebtedness in Canada. Unlike the United States, Canada never really went through a household deleveraging as a result of the global financial crisis. In fact, household debt to disposable income continued to rise to record highs in late 2015.
The growing level of household debt poses a significant risk to financial stability in Canada, something that the Bank of Canada has frequently referenced in its Monetary Policy Reports. (Figure 7)
Our view is that this risk, albeit significant, is not necessarily imminent for two reasons. First, low interest rates mean that, despite high indebtedness, households remain able to service those debts. Second, the Canadian labour market has remained relatively firm in 2015. There are limited signs outside of Alberta and Newfoundland that the effect of lower oil prices has impacted the labour market; in fact there is some evidence that a weaker Canadian Dollar may be providing a boost to manufacturing sector jobs in Quebec and Ontario.
