Monthly Economic Letter
Brexit: Monumental change for Europe, but limited disruption for Canada
Britain has entered a new era. Four and a half years after a referendum to break from the European Union, Brexit was finally concluded in December.
After years of stalled talks to avoid an abrupt rupture, the British government and the EU reached a last-minute agreement on future trade on December 24.
Fortunately, these important changes for Europe are likely to have a limited impact on the Canadian economy.
Trade agreement with the European Union
The United Kingdom officially left the EU trading bloc on January 31, 2020, although a trade agreement had not yet been signed. Fortunately, the two parties agreed to extend the talks until December 31, 2020.
In recent years, markets have feared a hard Brexit (no-deal Brexit). In the absence of a free trade agreement, Britain’s trade with the EU would have been governed by the World Trade Organization, and this would have led to higher tariffs for a large number of sectors. The aviation, automotive and financial services industries would have been particularly hard hit by such an outcome.
The terms of the new deal between Britain and the EU are generally favourable to continued free trade between the two. However, regulatory differences will complicate exports of certain goods, particularly food production, where more restrictive standards in continental Europe could complicate trade.
Some British sectors, such as finance and construction, will have more limited access to the European continent and its public markets and will face more bureaucracy when they want to operate in the 27 nations of the European Union.
Additionally, the border between Ireland and Northern Ireland will remain fluid, forcing customs controls between Northern Ireland and the British mainland—another complication for British companies.
Limited impact on Canada
The vote in favour of Brexit took the world by surprise. The day after the June 23, 2016 referendum, the British pound depreciated drastically against international currencies, including the Canadian dollar. The value of the loonie against the pound sterling has since remained around C$ 1.70.
Following the referendum, economists expected Brexit to have a limited impact on the Canadian economy because trade with Britain is relatively small and concentrated in certain industries. It seemed likely a bilateral agreement could resolve issues without too much damage to the economy.
The Comprehensive Economic and Trade Agreement (CETA) between Canada and the European Union was negotiated and is now in force. The terms of this transatlantic pact will continue between Canada and the United Kingdom on an interim basis until a new bilateral agreement is agreed upon. This new, more focused agreement could be even more beneficial to Canadian exporters than CETA.
Brexit will nevertheless have a negative impact. A large volume of Canadian goods transit through the United Kingdom on their way to continental Europe. Thus, Brexit has meant logistics disruptions and cost increases for several Canadian exporters who have had to redirect their deliveries.
The United Kingdom remains our third largest trading partner, after the United States and China, accounting for 3% of our exports and 1.5% of imports. Trade totalled $19.8 billion in 2019 ($9.2 billion for imports).
Canadian exports to Britain are not very diversified. In 2019, minerals (mainly gold and silver) accounted for 72% of the total value of these exports and mineral fuels were in second place, at 5%. This is followed by products for nuclear reactors (3%), air/space navigation equipment (2%) and wood products (2%).
What it means for entrepreneurs
- As a medium-sized open economy, Canada depends on strong international trade. The vote in favour of Brexit in 2016 was part of a protectionist trend that has grown since.
- The agreement between the United Kingdom and the European Union assuages many of the concerns associated with a hard Brexit. While both economies will be negatively impacted in the short- and long-term, the December 24 agreement means the break-up will have more limited effects than the worst-case scenarios feared in 2016.
- Trade between the United Kingdom and Canada will follow the CETA model. This agreement, which eliminates tariffs on 98% of products exported to the UK, will remain in place until a new Canada-British pact is signed.
Canadian economy at a glance
The economic recovery wanes as the second wave accelerates
Another round of lockdown restrictions in Canada, and elsewhere in the world, to address the second wave of COVID-19 infections are hampering the economic recovery.
Immunization has only just begun, and it will be a few quarters before there is any hope of a return to normalcy.
A winter slowdown
Real GDP increased by 0.4% in October compared to 0.8% in September as measures to counter the second wave began to multiply across the country. According to preliminary data from Statistics Canada, GDP growth in November was also 0.4%, confirming the slowdown in the last quarter of 2020.
Food services, where output fell 4.5% in October compared to September, and accommodation (-2.1%) were again particularly hard hit. These sectors, which were slow to rebound last summer, are now down for a second consecutive month, reaching only 73% and 59% of their pre-crisis level of activity, respectively. In each case, this represents a decline of three percentage points compared to the summer.
For these sectors, the winter will be harsh. Activity could approach the lows seen last spring, although many restaurants have since adapted their business model to boost take-out sales.
The manufacturing sector (-0.8%) was also down in October, with wide variations among sub-sectors. For example, aerospace was down 4.4% while wood product manufacturing was up 2.8%, thanks to sustained demand for building materials.
The agricultural sector (+1.6%) continued to perform well due to strong growth in cannabis production (+7.1%). The output of this agricultural sub-sector had doubled in two years.
Second wave hinders retail sales growth
Retail sales increased by 0.4% in October compared to 1.9% in September. This was due to slower sales in Quebec (+0.2%) and Ontario (-0.4%). Fear of catching the virus and restrictions to fight the epidemic caused retail sales in Ontario to decline for the first time since April.
Nevertheless, retail sales in Canada were still up 7.5% year-over-year—one of the few sectors to show a V-shaped recovery.
The next few months may show limited gains for retailers. Google's mobility data indicates a reduction in traffic in the last few weeks of 2020. This is bad for brick-and-mortar stores but should help online sales.
Employment falls in December
Employment fell by 62,600 in December, the first decline since April. Therefore, the economic recovery of the last few months will not have been enough to make up for historic job losses recorded in the spring.
To date, 636,400 jobs remain to be recovered, or 21% of the 3 million jobs lost during the first set of lockdowns. We will probably have to wait until 2022 to see the number of jobs return to pre-crisis levels.
Job losses have been concentrated mainly in Quebec (-16,800), Ontario (-11,900) and Alberta (-11,900). These figures are as of mid-December and therefore do not take into account new restrictions imposed in Quebec and Ontario. The January data could therefore show more significant job losses.
The unemployment rate rose from 8.5% to 8.6%, ending six consecutive months of declines. For the third consecutive month, employment in accommodation and food services was down in December (-56,700).
By contrast, employment in the manufacturing sector held steady and has increased by 15,000, returning to its pre-crisis level.
What it means for entrepreneurs
- The next few months will be difficult. Despite the start of vaccination campaigns, lockdowns will remain in place at least until spring. The return to normal will take place very gradually in the hardest hit industries.
- Teleworking and online sales will remain important survival strategies for many businesses in 2021.
- Although the economic recovery is likely to be slow in the first quarter of 2021, growth should accelerate with the arrival of spring.
U.S. economy at a glance
The blue wave becomes a reality
As economic data deteriorates, the new political landscape comes into focus
A victory by two Democrats in Georgia's runoff elections means President-elect Joe Biden’s party will control both houses of Congress for the next two years.
In the short term, this result will likely lead to a more aggressive COVID-19 support package than the one approved by Congress and the outgoing President in December.
In the longer term, Biden’s agenda calls for an imposing environmental plan and additional investments in health and education. This should support GDP growth. Tax increases are also possible, but the need for agreement from more conservative Democrats makes them less likely at this time.
Meanwhile, the United States has been unable to curb the rise in COVID infections, with new cases continuing to reach new highs. A new, more contagious variant of the coronavirus, initially detected in the United Kingdom, represents an additional risk of new outbreaks. Cases related to this variant have been reported in both the U.S. and Canada.
The new administration could encourage more restrictive lockdown measures in a few weeks, which would have an impact on the economy in the short term.
The job market disappointed at the end of the year, when 140,000 net jobs were lost in December. In total, 56% of the 22.2 million jobs lost at the beginning of the pandemic have been recovered. The unemployment rate ended the year at 6.7%.
Initial unemployment claims remained high at the beginning of the new year, close to 800,000 per week. A tightening of measures to counter the spread of COVID-19 could contribute to a further deterioration of the labour market in the coming months.
Expenditures down in November
For the first time since the start of the economic recovery, consumer spending declined in November (-0.4%). In particular, households cut back spending on clothing, cars, and food services.
This drop was partly due to lower incomes (-1.1%), a slowing labour market and uncertainty about the federal government’s COVID support plan. (A $900-billion program was finally adopted at the end of December).
These factors led to a drop in the Conference Board’s index of consumer confidence, which fell to a level comparable to that reached at the beginning of the pandemic.
Good news on vaccines and the support plan could provide a boost to U.S. consumption. Households have also built up considerable contingency funds since last spring, with the savings rate remaining above 10% since March.
Business confidence on the rise
Despite the uncertainty of recent months, business confidence indicators remained surprisingly robust in December.
The ISM indicator for the manufacturing sector rose from 57.5 to 60.7, a peak dating back to the summer of 2018. An indicator above 50 indicates that businesses expect increased volumes. In particular, sub-indicators related to production (64.8) and employment (51.5) were rising.
The ISM indicator for the services sector reached 57.2, a monthly increase of 1.3. It should be remembered that this sector is more vulnerable to the vagaries of the spread of the virus.
The impact on Canada
- A Democrat-controlled Senate is expected to have a positive impact on GDP in the short term. President-elect Biden will have the votes needed to implement more expansionary policies. A more generous COVID support plan could also boost U.S. household consumption and have a positive impact on Canadian exports.
- The U.S. dollar continues to depreciate against a majority of currencies, including the Canadian dollar. The Canadian dollar reached a two-year high of US$0.79 at the end of 2020.
- Businesses remain optimistic, which bodes well for Canadian cross-border supply chains.
Oil market update
Vaccine hopes and production cuts push oil prices higher
Oil prices continued to rise at the beginning of the year, as vaccination campaigns began and Saudi Arabia announced a significant reduction in production for the first quarter. The Saudi decision caused prices to jump to their level of last February.
Between December 1 and January 6, the price of West Texas Intermediate (WTI) rose from US$44 to US$51 per barrel. Western Canadian Select (WCS) increased more moderately, from US$33 to US$35.
Demand recovery on hold
Lockdowns to slow the spread of COVID-19 are again increasing around the world. In Europe, the United Kingdom has imposed stringent restrictions due to the spread of a new coronavirus variant, which is suspected to be more contagious. Germany is also extending its restrictions, and many other countries, including France, are re-imposing curfews.
Year-end celebrations and fears of the spread of the British variant were behind these decisions. Teleworking and travel restrictions will therefore continue for several months, slowing demand for oil until the positive effects of vaccine distribution are felt, likely in the spring.
The International Energy Agency (IEA) expected at the beginning of December that oil demand from OECD countries in the first three months of 2021 would stagnate at 91% of its pre-crisis level. This forecast could be revised downwards, given the deterioration of the health situation. Note, for example, that individual mobility was in sharp decline at the end of December, as shown in a graph in the section on Canada.
By contrast, demand for oil in China has rebounded quickly. The IEA even anticipates that Chinese oil demand in the first quarter of 2021 will represent 105% of its pre-crisis level.
This increased demand is reducing oil reserves, which had reached historic levels last spring, as storage facilities approached their maximum capacity. The reduction of these stocks should support a price recovery.
Saudi Arabia cuts production
In early January, Saudi Arabia announced a production cut of 1 million barrels per day in February and March to keep pace with slowing demand in the first quarter.
This cut represents an 11% drop in their recent production, and 1% of world supply. This reduction should limit the risk of stocks building up to the levels observed in the spring of 2020. According to the IEA, OPEC member countries are producing about 20% less oil than their 2019 average level.
The IEA also expects the recovery in U.S. production to slow and remain at 93% of its 2019 average, at least for the first half of the year. U.S. production will not return to historical levels until 2022, at the earliest.
The election of Joe Biden may have an impact on U.S. production as the President-elect defended the importance of the transition towards renewable energy during his election campaign.
The bottom line
The outlook for the Canadian energy sector has improved as oil prices now exceed the cost of production for the sector as a whole.
While the demand outlook has deteriorated in the near term, the acceleration of vaccination campaigns in North America and Europe is expected to limit lockdowns later in the year, allowing demand to approach previous peaks towards the end of 2021.
The reduction in Saudi supply will also benefit Canada. Alberta's production is expected to return to pre-crisis levels in 2021, according to the IEA.
In the longer term, several uncertainties remain, including the attitude of the new U.S. administration towards the oil and gas industry. Tensions between Persian Gulf countries and Iran could also represent a risk for the oil market.
Other economic indicators
The Bank of Canada maintains its overnight rate at 0.25%
The Bank of Canada says its key interest rate will remain at its floor value of 0.25% until annual inflation returns to the target of 2%, which it does not foresee occurring before 2023.
Meanwhile, the central bank's quantitative easing program continues at a rate of at least $4 billion of asset purchases per week. In a briefing note, Deputy Governor Paul Beaudry explained how the program works and its objectives.
The Bank of Canada will make its next interest rate announcement on January 20 when it will also release new forecasts for economic growth and inflation.
Loonie ends the year at a 2020 high
After hitting a low of US$0.69 during the first wave of the pandemic, the Canadian dollar recovered and ended the year at US$0.79, a peak not seen since 2018.
Rising oil prices, as well as the decline of the U.S. dollar against most currencies, explain the year-end strength of the loonie. The Canadian dollar should remain in a range of US$0.76 to US$0.80 in 2021.
Entrepreneurs' confidence rises
Confidence among managers of small and medium-sized businesses as measured by the Canadian Federation of Independent Business (CFIB) was up in December, despite tighter lockdowns in several provinces.
The CFIB’s outlook for the next 12 months was up 2.5 points to 58.2, a level similar to ones reached over the summer. Good news about COVID-19 vaccines contributed to this longer-term confidence.
However, short-term optimism (3 months) deteriorated to 31.5—a level comparable to the ones registered during last spring’s lockdowns. A score below 50 indicates that entrepreneurs expect a contraction in economic activity.
Inflation reaches the 1% mark
Prices posted an annual growth rate of 1% in November, the highest rate since the beginning of the pandemic. This corresponds to the lower end of the Bank of Canada's target range (1–3%).
Price increases for housing (+1.9%, year-over-year), food (+1.9%) and health and personal care (+2.0%) were higher than average. Clothing and footwear (-2.3%) and transportation (-0.1%) remained in deflationary territory.