Monthly Economic Letter
How the war in Ukraine will affect Canada’s economy
After two years of pandemic, Canadian entrepreneurs were finally beginning to see the light at the end of the tunnel. Provincial authorities across the country have finally announced a cessation of health restrictions in the coming months.
Now, a new source of uncertainty is hitting the economy—the invasion of Ukraine by Russia. Beyond their concern about the human tragedy unfolding in Ukraine, many businesspeople are wondering how this war and the sanctions imposed on Russia will affect the Canadian economy and their company.
While Canada's trade relationship with Ukraine and Russia is limited, a careful analysis of the situation suggests there will be both negative and positive impacts for Canadian businesses and the economy.
Will customers affected by trade sanctions turn to Canada?
The trade relationship between Canada and Russia is too small for restrictions to have a significant direct impact on the Canadian economy. Exports total just over $600 million a year to the Russian federation, or only 0.1% of Canada’s total merchandise exports of $600 billion.
Obviously, for the few companies that trade with Russia, the impact will be significant and immediate. Even if their sales are not restricted by sanctions, the Russian economy has taken a hard blow with the ruble already having fallen by about 30% against the Canadian dollar and even more against the U.S. dollar since the conflict broke out.
Upward pressure on commodity prices is among the most notable economic effects of this war. Russia is the world’s third largest energy producer and of vital importance to Europe in particular. President Vladimir Putin's country supplies about 40% of Europe's natural gas, more than half of its coal and is also a main supplier of crude oil.
At a time when the energy markets are already tight, the invasion has driven crude and natural gas prices much higher. An expected slowdown in grain and metal production has also been reflected in rocketing prices in those markets.
Although driven by a horrific situation in Ukraine, these price increases could prove to be a boon for Canada, whose commodity production is very similar to that of Russia’s. Canadian agricultural and mining companies could seize market share from Russia in the event it is shut out of markets. Already, Canadian companies are benefitting from spiking prices for commodities.
Pressure on supply chains to remain
The COVID pandemic and subsequent reopening of economies created significant imbalances between global supply and demand, putting pressure on supply chains and highlighting major international logistical problems. As we know, these imbalances have resulted in an inflation surge, the likes of which have not been seen for decades.
Recent signs of improved delivery times and some easing of supply chain problems had been expected to slow price increases in the coming months. Now, tightening commodity supplies as a result of sanctions on Russia will heighten problems throughout the production chain with large spillover effects globally.
On the other hand, a halt in exports to Russia could allow supplies of some key products to be redirected to other markets. For example, the United States and Japan have already blocked shipments of computer chips to Russia that may now go to countries in desperate need of semiconductors.
Central banks will respond to rising consumer prices
Households in Canada and other developed countries were already facing staggering price increases at the pump and at grocery stores created by those imbalances. The turbulence generated by the war means rising prices for oil, metals and agricultural products will continue and consumers will likely see no relief anytime soon.
The Bank of Canada, like the U.S. Federal Reserve, was already on the verge of starting its fight against inflation before the war broke out. Despite this new element of extreme uncertainty for the global economy, central banks may be pushed to raise their policy rates even more quickly to control inflation, before pausing their tightening cycles.
Inflation and the accompanying rate hikes will undoubtedly hit consumers' wallets and they can be expected to adjust their spending accordingly—meaning, consumption will be lower than what was expected prior to the conflict.
Newcomers and an immigration boom
Another element that could mitigate the economic impact for Canada is a potential surge in immigration and refugees from Ukraine. Canada's Ukrainian diaspora is the second largest in the world after Russia, which should help the integration of newcomers.
The Canadian government is committed to facilitating the movement of immigrants and refugees from Ukraine. Immigration is the engine of Canada's population growth and an important source of workers. This would be an advantage for businesses in context of the current labour shortage.
The impact on your business
- As a medium-sized, open economy, Canada depends on healthy international trade and a stable geopolitical climate. The outbreak of war in Ukraine and the economic and financial sanctions against Russia are a source of significant uncertainty for global growth. The impact on Canada’s GDP will be mitigated by soaring need for Canadian commodities export.
- Trade sanctions against Russia will be reflected in Canada primarily through accelerating inflation and another impetus for higher interest rates, which, together, will reduce the purchasing power of Canadian consumers. Canadian demand and consumption will continue to grow compared to 2021, however at a slower rate than initially expected.
- The longer the war in Ukraine goes on, the more displaced Ukrainians can be expected to arrive in Canada, contributing to the country's workforce.
New global risks will require resilience from the Canadian economy
The Canadian economy started the year on a good footing as it recovered from the Omicron variant, according to Statistics Canada's first estimates. However, it now appears the war in Ukraine could reduce the strength of the rebound going forward.
An unexpected end to the year for the economy
Canada seems to have finally learned how to live with COVID. The proof is in the pudding. The economy grew at an annualized rate of 6.7% in the fourth quarter of 2021, the best quarterly performance for the year. It was well above the Bank of Canada's forecast, bringing GDP growth in 2021 to 4.6%.
Unsurprisingly, economic activity was driven last year by strong household consumption and record residential investment. Elsewhere, extraordinary government programs to deal with the various waves of the virus were reflected in public spending, which also contributed strongly to growth in 2021.
By contrast, business investment was tepid. In the face of economic uncertainty stemming from the pandemic, entrepreneurs preferred to replenish their inventories.
The year-end momentum continued into January, according to Statistics Canada's preliminary data. Growth came in at 0.2% for January, after treading water in December despite Omicron-related health restrictions. It’s important to note, however, that customer-facing businesses once again suffered through a more difficult first few months of winter than other sectors of the economy.
Investment will be critical for growth in 2022
Behind the economy’s solid performance in the last quarter lies a further decline in labour productivity. Hours worked once again increased faster than growth in domestic output. This phenomenon was observed even though the health restrictions between the third and fourth quarters were similar.
This decline in domestic labour productivity likely reflects worker fatigue in the face of the pandemic and related restrictions. Nevertheless, it highlights a key issue for Canada’s future economic prospects. As noted above, the economic recovery to date has been supported largely by robust consumer spending and a hot residential housing market, meaning demand is driving economic activity.
While the growth has been welcome, it’s inflationary in nature. As demand runs up against capacity constraints, prices are rising. More than ever, private (and public) investment is necessary to ensure balanced and, therefore less inflationary, economic growth.
Fortunately, private investment is expected to return to 2019 levels this year. Projected spending on machinery and equipment is forecast to continue at the same growth rate as in 2021—6.4%, while construction spending is expected to reach 8.9% growth in 2022. This means that more than $180 billion will be invested in the Canadian economy by private companies. However, the uncertainty resulting from the war in Ukraine could undermine this outlook.
Employment rebounds strongly after Omicron
January's job losses (-200,000), while significant, were quickly regained in February. 336,600 jobs were created during the month, an increase largely attributable to the easing of health restrictions.
Significant gains were made in industries that were once again hardest hit by health restrictions: accommodation and food services (+114,000), and information, culture and recreation (+73,000).
The overall employment picture in Canada remains very positive despite the setback due to Omicron. The unemployment rate is near its all-time low of 5.4%, standing just 0.1 point above it. In February 2022 there were 370,000 more wage earners in Canada than before the pandemic lockdowns began two years ago. The speed with which employment has recovered from the various waves explains in large part the strong performance of the Canadian economy in the face of the pandemic.
Between higher inflation and interest rates, consumption will be put to the test
Household disposable income fell for a second consecutive quarter at the end of 2021 and will have brought the savings rate down with it. With the various government support measures no longer as necessary, household finances continue to return to normal. Still, several indicators remain above 2019 levels and will continue to support growth in the coming months, but headwinds are on the horizon.
As expected, the Bank of Canada raised its key interest rate by 25 basis points earlier this month. This was the first move to address rising inflation in Canada, but certainly not the last. More rate hikes are expected in the coming months as well as the start of quantitative tightening by the central bank to further reduce stimulus to the economy.
The effect of this first increase has already been reflected in some channels, such as variable mortgage rates. But it usually takes 18 to 24 months for a policy rate adjustment to be fully felt throughout the economy.
The war in Ukraine will further mitigate the effectiveness of monetary policy in responding to the various price spikes that are expected to continue over the next few months. (For more details, see this month's main article).
The impact on your business
- Even if new headwinds arise, including those caused by the war in Ukraine, the Canadian economy is expected to remain resilient this year and continue to prosper.
- Supply chain problems will take longer to recover from potential shortages of many commodities that typically originate in Russia will further complicate the already difficult situation worldwide. Canadian companies should also expect higher prices and longer delivery times.
- Despite an increase in interest rates, they remain very low relative to the past. The good performance of the labour market and still enviable financial situation of households will continue to support economic activity.
- Consumption should continue to increase at a good pace nonetheless, lower than what was expected before the war in Ukraine.
U.S. economy stands up well to COVID, but what about war?
Several indicators suggest the U.S.’s capacity to meet strong demand was improving in January, a good start to the year and a sign the economy is adjusting to the effects of COVID.
The economy’s positive performance in the first few months of the year should provide a cushion against the risks that lie ahead, especially those brought on by the war in Ukraine. Employment rose by nearly 700,000 in February on top of upward revisions for recent months. The unemployment rate fell to 3.8%, a mere three-tenths of a point above its pre-pandemic low.
The strong performance of the U.S. labour market continued to support consumption early in the year. Consumer spending in January more than offset December's losses with growth of 1.5%, net of inflation. These gains were driven notably by vehicle purchases.
Shortages began to ease despite Omicron
Port congestion continues to ease, and delivery times reported by manufacturers are significantly improved from last summer's peak. Backlogs of orders also suggest a reduction in supply chain stress.
However, these improvements don’t mean that shortages are a thing of the past or that the supply of goods has increased significantly. Indicators tracking supply chain performance still remain well below their pre-pandemic levels. Further improvements are unlikely at this time considering the recent turbulence in international trade.
On the demand side, we have not seen signs of a normalization in spending on durable goods yet. Considering the magnitude of demand for these goods during the pandemic and the subsequent impact on supply chains, further increases in durable goods will likely put more pressure on already soaring prices.
In the automotive market, imports of semiconductors—a key component in vehicle manufacturing—remain at an all-time high and production is struggling to catch up.
Now, the conflict in Ukraine has begun to slow European car production, and some observers are concerned about the impact on U.S. supply chains. However, since the U.S. industry sources most parts from Canada and Mexico and also uses Asian and Latin American components, its production is much less vulnerable than Europe’s.
Oil prices: No relief in sight for U.S. inflation
Although crude oil prices have rocketed to 2008 levels, the energy profile of the U.S. economy has changed since then. Oil production in the U.S. has surged, reducing its dependence on the international energy market. The energy sector's share of the S&P 500 has also declined significantly to just 4%. Therefore, the impact of oil price increases will be mostly felt in higher inflation.
Americans were struggling with record price increases even before the Russians started the war in Ukraine and a sharp rise in gasoline prices was already responsible for much of the latest inflationary surge in the United States.
Now, the price at the pump is expected to rise somewhere between US$4.50 and US$6.00 per gallon depending on the region. Obviously, the purchasing power of Americans will decline more than had been anticipated at the beginning of the year.
Inflation faced by our neighbours to the south is undermining consumer confidence. Despite a sizeable decline in new COVID cases, confidence deteriorated further in February to a level rarely seen outside of recessions.
Thus, inflation fears appear to be outweighing the strong performance of the economy and the labour market. With war in Ukraine, high oil prices and stock market volatility, the situation is not expected to improve in March.
The Fed raises its rate, but will remain cautious
With inflation breaking recent historic records and employment continuing its post-pandemic momentum, the Federal Reserve went through with a 25-basis point increase to its trend-setting rate. Fed Chairman Jerome Powell noted that while the economic implications of the war in Ukraine are highly uncertain, monetary policy will be tightened further this year, albeit carefully.
The impact on your business
- Growth will continue in the U.S. as several core economic indicators have started the year well. However, growth was already expected to moderate in 2022 compared to last year. While runaway inflation will be further fueled by rising crude prices due to the conflict in Ukraine, the overall impact should be moderate on the U.S economy.
- Supported by the strong performance of the labour market, the Fed raised its key rate in March by 25 basis points to counter inflation. Subsequent rate hikes are expected to counter inflation that will exceed the 2% target for several more months due to the conflict in Ukraine.
- The Canadian dollar has weakened as uncertainty sends investors to their favorite safe haven—the U.S. dollar. The U.S. economy is still on solid footing. Therefore, this is a good opportunity for Canadian exporters to take advantage of the competitive advantage a lower loonie brings against the greenback.
How high will oil prices go?
In just a few days, the oil market has gone from wondering if prices could reach US$100 a barrel to trying to figure out if US$200 is a possibility.
At the time of writing, the price of the world's leading price benchmarks had reached session highs last seen in July 2008. Brent at US$139.13 and WTI at US$130.50 before closing at $123.21 and $119.40, respectively. Of course, increases are quickly being reflected in prices at the pump, which surpassed $2 per litre in some locations across Canada.
The reason for the meteoric rise in the crude oil market is obvious: the war between Ukraine and Russia.
Russian oil by the numbers
Russia is the third largest oil producer in the world, behind the United States and Saudi Arabia, and the largest oil exporter.
As of January 2022, Russia was producing 10 million barrels of crude per day (b/d) and 1.3 million barrels of other oil products. This production represents more than 10% of total world oil demand, so it’s not surprising the war is causing such a stir in the markets.
Uncertainty pushes the risk premium higher
The United States has banned Russian oil and natural gas imports, but Europe's energy dependence is too great for it to follow suit, at least for this year.
U.S. imports of Russian petroleum products are currently around 670,000 b/d, so the ban should not create a significant imbalance in the markets. However, other restrictions on Russia and the uncertainty that accompanies them are being reflected in the markets by a huge increase in the risk premium.
Some oil buyers are shunning Russian production and major companies have ceased their participation in operations in that country. This is the case for BP, Shell and Exxon Mobil.
OPEC, a substitute for Russian oil?
According to OPEC Secretary General Mohammad Barkindo, the cartel's production would not be able to counterbalance a full Russian production embargo.
It should be remembered that although Russia is not a member of the organization, it is among OPEC's allies included in the so-called OPEC+ group and participates most of the time in the various production adjustment agreements to influence prices.
In fact, the organization and its allies (including Russia) has ruled it will continue to gradually bring barrels back into the market, up to an additional 400,000 b/d each month. This pace of recovery, agreed to last July, has not changed, even though gross prices have increased by more than 30% (about US$40 per barrel) since the agreement was reached.
Some hope from the potential end of other sanctions
While American shale producers are still reluctant to increase their production, Washington is evaluating the possibility of lifting sanctions from other oil-producing countries, including Venezuela.
Meanwhile, talks in Vienna on the future of a nuclear deal with Iran have resumed. The completion of a deal would mean an end to U.S. sanctions on Iranian oil and the release of 1.3 million "new" barrels per day almost immediately.
The volume of crude oil stored in Iran is estimated to have jumped by 30 million barrels since December alone. This would put the inventory of Iranian crude ready to enter the market at 103 million barrels.
The situation in Ukraine and the restrictions imposed on Russia are changing by the hour. The result is growing uncertainty in the oil markets that translates into an elevated risk premium in prices.
Both Brent and WTI have reached significant highs, and quickly. Crude supply has been tight since before the conflict between Ukraine and Russia broke out. Thus, prices are expected to continue to increase, but several factors remain highly uncertain. Depending on which scenario you favour, crude prices could peak anywhere between US$150 and US$200.
Even though crude oil prices have fallen on the markets in recent days, the price at the pump remains high because they generally adjust more quickly to price increases than to decreases.
As expected, the Bank of Canada raise its policy rate
As expected, the Bank of Canada raised its key interest rate to 0.50% on March 2. Canada has managed to weather the latest wave of COVID-19, but in addition to the evolution of the pandemic, the conflict in Ukraine is a major new source of global economic uncertainty, the main effect of which will be reflected in high inflation. While this is the first-rate hike by the Bank of Canada since the beginning of the pandemic to tame price increases, it certainly is not the last.
The loonie is losing some ground
The Canadian dollar has been revised downward over February and at the beginning of March. After reaching US$0.79 in January, at the time of writing, the loonie stood at US$0.78 and should continue to hover around that level over the course of the month. The war taking place in Ukraine has rekindled investors' risk aversion and with it the demand for safe havens like the US dollars. Major price increases on numerous commodities, including oil, resulting from the conflict, make the terms of trade still favourable for the Canadian dollar.
Business confidence bounced back after Omicron
The Canadian Federation of Independent Business (CFIB) Business Barometer's long-term index bounced back to 62.5 in February, the level it reached in December just before Omicron hit Canada. The long-term index captures the expectations of small business leaders over a 12-month horizon. Obviously, easing of health restrictions across the country over the course of February explain the optimism. The index will probably go back down next month because of the war in Ukraine and the uncertainty it’s creating in the global economy. However, it should remain above the 50 marks, meaning more companies will expect to do better relative to the last 12 months than those who don’t.