FORUM magazine - January/February 2012

Canada emerged from the global economic downturn of 2008-2009 relatively unscathed, and today its economy remains strong compared with other nations. But how immune is Canada to the economic uncertainty facing Europe and the United States? With the possibility of another global economic recession, how will Canada be affected, and will it be different this time? Three leading Canadian economists weigh in

Meet the participants:

Craig Alexander is the senior vice-president and chief economist at TD Bank Financial Group.

Peter Hall is the vice- president and chief economist at Export Development Canada.

David Rosenberg is the chief economist and strategist at Gluskin Sheff.

FORUM: If the world enters into another global recession, what are the chances of Canada entering another recession? And would the recession be worse, not as bad, or the same as the 2008-2009 downturn both globally and in Canada?

Craig Alexander: If the world enters another global recession, Canada would likely be pulled into an economic contraction as well. Exports represent more than one-third of the Canadian economy. Canada is also a major commodity exporting nation, and commodity prices would fall significantly if a global recession occurred. If Europe loses control of its fiscal crisis, leading to a banking crisis and a global financial crisis, the economic and financial environment could be similar to 2008 in many respects.

Peter Hall: Being a trading economy, Canada would not be able to dodge the bullet. The severity depends on what kind of recession occurred. If we are talking about a situation where a major European domino falls, then we would not be able to escape the indirect financial fallout — and the knock-on effect on global and Canadian GDP would be severe. If the recession were a mild one, tipped off by some unforeseen event (for example, a natural disaster somewhere in the world), then we might be able to get off lightly. Any near-term recession would be difficult for the world to handle given the sluggish rate of overall growth, heightened uncertainty and greatly diminished policy options. A key element that differentiates today from the 2008-09 debacle is the lack of policy options.

David Rosenberg: Canada has so far shown resilience to the global economic and financial market volatility that has been plaguing other parts of the world, in particular the U.S. and Europe. What Canada has going for it is that it is among the few developed countries that has its fiscal house in order, has a stable and pro-business government, and [has] a growing economy with strong exports — particularly energy and other resources. The Canadian dollar’s relative strength over the past few years is a testament to how investors feel about Canada … Canada [now has] additional spending power abroad to upgrade technology and infrastructure to be more competitive.

More recently, however, signs of a downturn have been emerging, most notably in employment, where manufacturing jobs in particular have declined. This is a symptom of the hurdles Canadian producers face from the weakening global economy and the still-strong Canadian dollar. Unless productivity growth accelerates dramatically, the likelihood of economic contraction will increase. Today’s data is a shot across the bow for the consensus “we’ll muddle through” viewpoint. Keep in mind that Canada, which is very similar to Australia and South Korea, who are also struggling, is a play on the global economy.

FORUM: Recent economic data and corporate earnings indicate the U.S. isn’t about to slip back into recession. Do you concur?

CA: I do concur. During the summer, there was a lot of worry that the U.S. economy could stall and go back into recession. A key worry was that the financial market volatility might undermine consumer and business confidence. And, if consumers and businesses cut back on their spending — or in the case of businesses cut back on their hiring — it could lead to a renewed period of weakness. While confidence did decline, the U.S. economy grew by an annualized two per cent in the third quarter, and our tracking for the fourth quarter is for growth of close to three per cent.

PH: Momentum appears to be rising in the United States. Consumer confidence measures dipped to an [alarmingly low] level in October … but fortunately it was temporary. Actual spending trends run counter to this pessimism: real spending is rising at a respectable rate. The same appears true of the business sector. The Purchasing Managers Index (PMI) data indicate an increase in pessimism among U.S. businesses. However, factory orders have been rising at an 11 per cent rate since the beginning of the year, and the latest data indicates continued strength. Orders represent business that has been booked but has yet to be processed, and is a great indication of activity that is yet to occur. Orders are a strong signal that near-term deceleration of the economy is not in the works.

DR: Those who have been following my forecasts and predictions well know that I have been calling for a recession in the U.S. for a while now. More recently, with some of the U.S. numbers looking “less awful” the question I’ve been getting is, “Why aren’t we there yet?” Make no mistake: This has been and remains a fragile, post-bubble deleveraging economy, and corporate earnings are no longer going to derive tailwinds from rapid overseas growth, a cheap U.S. dollar, contracting unit labour costs and ongoing tax benefits, as has been the case during this two-year rebound phase.

From my lens, the world is as fraught with uncertainty as it was in the third, second and even the first quarter. The only change has been the length of time it has taken the world to show its stripes in the form of still-high unemployment, still-weak consumer spending, a still-moribund housing market, and a few rather large still-unknowns — namely whether Europe will find a way out of its troubles and whether the U.S. can figure out how to [reduce] a $1.2 trillion deficit without sending the economy over the edge. But numbers are numbers. As such, I think it will be the first quarter of 2012 when many of the problems come to roost. [This will be] when the traditional lag from the tightening in financial market conditions to the real economy starts to kick in, when the deepening European economic downturn begins to materially affect U.S. exports and global supply chains, and when intense fiscal drag kicks in. If any of the goodies passed last year are not extended — including jobless benefits, payroll tax relief and bonus depreciation allowances for companies’ capital expenditures — [then we can likely expect another U.S. recession.]

To quote Alan Greenspan at the height of the Asian crisis back in 1998: “It is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress.”

FORUM: How will the current economic instability in the U.S. and abroad affect our financial markets over the short and long term?

CA: The heightened risks and high degree of uncertainty about the future is likely to mean a continuation of dramatic volatility for equity markets. If Europe avoids the worst-case scenario, the North American economic fundamentals should support mid-single to high-single digit growth in corporate profits, which should be supportive to equity valuations. However, it could be a very rough ride in getting those equity gains. The economic backdrop is also likely to keep interest rates low for a long time.

PH: Instability in Europe is a far greater concern than in the United States. Canada does not face a great amount of direct exposure to the most affected sovereigns; where we as Canadians do face risk is in the indirect exposure we have through linkages to affected European financial institutions that themselves have strong ties to distressed sovereigns. If any large European dominoes fall, it will be hard for Canada to avoid the fallout. The instability in some respects is actually working in Canada’s favour. We have attracted attention and investment as a result of our relatively strong domestic economy, well-managed fiscal policy and prudent financial sector.

DR: For some time, we as a firm have been advocating strategies that are constructive in a volatile and uncertain environment: hedge funds that have the ability to be both long and short in different kinds of securities and sectors, and fixed income and credit — particularly corporate bonds, where companies with strong fundamentals and solid balance sheets will, in the end, pay their bond holders first, with interest and coupon. We are also in favour of so-called premium income holdings — investments in well-known and liquid stocks and other securities that pay income and dividends. These are part of what we call “S.I.R.P” (Safety and Income at a Reasonable Price) strategies, which we expect will continue to be the place to be through the medium term. As for the broader markets, my expectation is that volatility will remain the dominant short- and medium-term factor.

FORUM: The Canadian economy is strongly tied to commodities. What is your forecast for commodities and how do you see this affecting the Canadian economy?

CA: My crystal ball is predicting that commodity prices will dip in the coming months in response to slowing global economic growth. Economic growth is slowing in many emerging markets while Europe is heading back into recession. The real issues are how much commodity prices will fall and how long the lower prices will last. I think the pullback will be limited, and I don’t believe it will last too long. The world economy is going through a fundamental shift. Twenty years ago, the advanced economies represented two-thirds of the global economy while the developing nations accounted for one-third. Today, the split is almost even. Two decades from now, I am convinced the ratio will have inverted — developing nations will account for two-thirds of the world economy and they will need commodities for their economic development. This means that commodity prices will remain supportive to the profitability of the commodity sector and the Canadian economy over the coming decades.

PH: The commodity price correction that occurred mid-year has generally persisted. We believe that this was more of a return to fundamentals than a reaction to weaker world growth. Excess liquidity in the global economy has made its way into commodity markets owing to their relative resilience. However, speculative plays are expected to diminish significantly as global growth resumes, chann-eling liquidity back into more normal activity and initiating a flight from commodities. Even so, oil and base metal prices will remain much higher than historical norms, accounting for the increase in emerging market appetite for these products. As such, the exploration, production and export of commodities is forecast to remain strong over the long term, and will increase Canada’s penetration into emerging markets.

DR: Commodities are more sensitive to what is happening in Asia in general — and China in particular — than the U.S. or Europe. In this light, it is encouraging to be seeing inflation peak in this part of the world now so policymakers can make the shift from restraint to stimulus. Insofar as the economic clouds in that part of the word begin to fade, one should expect to see commodities back on their secular uptrend. Considering that about half of Canada’s equity market is made up of resources, and that we have triple the exposure that the United States has in terms of exports, this should prove to be a constructive underpinning for both our capital markets and currency.

FORUM: What is your forecast for the Canadian dollar and how would a stronger or weaker loonie impact the Canadian economy?

CA: When one thinks of the outlook for the Canadian dollar, you have to remember that what you are really asking is, what will happen to the value of the Canadian dollar relative to the U.S. dollar? I think there is scope for the Canadian dollar to fall when financial markets are worried about the global economy and global financial markets. Fear makes people run to the U.S. dollar, and that weakens the Canadian dollar. When people are worried, commodity prices often soften, and that too weakens the Canadian dollar. However, barring a global financial crisis, I don’t see the Canadian dollar dropping below 90 U.S. cents. I also believe that once the fears abate, the Canadian dollar will bounce back. The U.S. government is facing a huge fiscal challenge, and I believe that will lead to the Canadian dollar averaging above par over the next five years.

PH: From US $1.03 this year, down to US $0.98 in 2012. This will provide exporters modest relief in 2012.

DR: The Canadian dollar has been caught in quite a broad range since this current period of investor risk aversion took hold last summer in response to the spreading European debt crisis. Be that as it may, the loonie has [fared] better in this period of global crosscurrents than it did in 2008-09, and that is because global investors know more about Canada today than they did back then — a well-capitalized banking system, political stability, reserves in the ground that China needs, and a prudent central bank that has not engaged in money printing as have many of its counterparts. As with commodities, I believe that the Canadian dollar is locked into a secular or long-term upward trajectory, and this is going to create both winners (importers, consumers) and losers (exporters, tourism) for the economy.

FORUM: What are your predictions for economic growth in Canada in 2012?

CA: My base case outlook is for the Canadian economy to post moderate economic growth of close to two per cent in 2012 and close to 2.5 per cent in 2013. The main risks to the outlook are the European fiscal crisis and the fragility of the U.S. economy.

PH: We predict 2.4 per cent. We are at the high end of the consensus.

DR: I think we will see GDP growth of between one and two per cent for the year, largely reflecting the struggles in the U.S. and in Europe, which will undoubtedly impinge on export growth. It will be another tough year, but less tough than our G-7 competitors will experience. We just don’t have the same imbalances — at least not to the same extent.

FORUM: What are your predictions for the Canadian housing market for 2012? Can you comment on the regional differences across Canada (i.e., Vancouver, Regina, Calgary, Toronto)?

CA: I expect a relatively flat housing market in 2012. I expect home sales to drop a bit, but listings to increase. As a result, most real estate markets will be fairly balanced, supporting low single-digit price increases. The real issue is going to be when the Bank of Canada eventually starts to raise interest rates. Right now, the Bank is clearly on hold. At some point down the line interest rates will rise, and when they do I think it will be a real shock to many households. I believe Canadian real estate is currently overvalued by 10 to 15 per cent. So, when interest rates rise by a couple of percentage points, I expect a real estate correction — but this is likely a 2014 story. The overvaluation in Canada is not spread evenly. The markets with the most risk are Vancouver and Toronto, particularly condos in the latter.

PH: We forecast that housing will soften from current levels by 10,000 to 15,000 units. Activity has been in excess of long-term sustainable levels and will return to the 160,000 to 165,000 pace in the next few years.

DR: I think that so long as Canada remains a beacon — as it has for foreign capital inflows and immigration — the housing market nationally should remain quite firm. Interest rates are also more likely to go down than up. There is still nary an indication of a major supply problem, at least in the single-family sector. Vancouver is supply-constrained, but pricing has moved far too high relative to rental rates and underlying income growth. I am concerned about the Toronto condo market, which is going through a massive building boom right now. The number of cranes in the sky is eerily reminiscent of what we experienced in the late 1980s.

FORUM: How would you describe Canadian investor confidence today?

CA: I would say investor confidence is fragile. I think there is a lot of uncertainty, which is a fair assessment of the economic and financial environment. I think the real challenge is that investors still have to invest for the future. Cash investments are losing money because they are offer a return lower than inflation. Bonds are now playing the old role of cash as capital preservation vehicles. Wealth creation is likely to come from equities, but it could be a very volatile market for some time.

PH: Cautiously optimistic.

DR: Canadian investors are increasingly focused on capital preservation and strategies that reduce volatility and ensure income growth is a critical part of their overall return. We are finding tremendous interest in hybrids, corporate bonds and hedge fund (long-short) strategies that actually can generate significant risk-adjusted returns in the current and prospective volatile market environment.