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Monthly Economic Letter

July 2018
Feature article

Protectionism on the rise

The U.S. administration’s trade policies are aimed at increasing exports

Protectionist actions have become a predominant focus of the U.S. administration—from strict immigration enforcement to erecting tariff barriers against countries around the world.

Since assuming office, the Trump administration has said it wants “fair trade” with the rest of the world. For Trump and his trade officials, this seems to mean a sharp reduction in trade deficits with other countries.

The administration has imposed tariffs on steel and aluminum imports from a variety of countries, including Canada. It is also imposing heavy tariffs on imports from China. And, it has opened the North American Free Trade Agreement to renegotiation, withdrawn from the Trans Pacific Partnership, and put trade agreement negotiations on hold between the U.S. and Europe.

The Department of Commerce has also significantly increased the number of antidumping and countervailing duty investigations. It could impose import tariffs if the investigations prove products are sold at a value lower than what the U.S. judges is their true cost. Canadian firms have been the target of some of these investigations (softwood lumber, newsprint and Bombardier aircraft).

U.S. import tariffs on trade partners incites retaliation

In March, the U.S. administration imposed import tariffs on Chinese steel and aluminum, and announced other countries would be similarly affected unless they agreed to various U.S. demands.

Some countries met the U.S. demands, but Canada, Mexico, the European Union and others did not and import tariffs of 25% on steel and 10% on aluminum from these countries went into effect on June 1.

Canada hit back with $16.6 billion in retaliatory tariffs on U.S. imports that went into effect on July 1. These tariffs include 25% import duties on steel and 10% on aluminum and a wide range of consumer products.

Mexico and the European Union also imposed retaliatory tariffs on various U.S. exports including bourbon, pork and motorcycles as well as steel and aluminum. Many of the items selected by both Mexico and the E.U. were chosen for their political impact, targeting goods from strongly Republican states.

Canada, Mexico and the E.U. separately filed complaints to the World Trade Organization against the American steel and aluminum import tariffs on their legality under international trade law.

Then, in early July, the U.S. imposed 25% import tariffs on US$34 billion worth of Chinese exports and an additional $16 billion worth of U.S. import tariffs will come into effect later this summer. China has retaliated with import tariffs on U.S. exports of the same magnitude.

The impact to date is relatively small, but unevenly distributed

The impact of the import tariffs on Canadian exports of steel and aluminum appears to be relatively limited. Steel and aluminum exports represent only 0.8% of Canada’s GDP and 2.5% of total Canadian exports. Canada’s economy is growing moderately well, and these tariffs should not compromise it, especially considering the strong U.S. demand.

Even if the tariffs translate into a reduction in shipments to the U.S., the negative impact on Canada will be the equivalent of a small decline in real GDP, about 0.11%, according the C.D. Howe Institute. However, the impact will be felt most acutely in Ontario and Quebec where most steel and aluminum is produced. Producers’ profit margins will likely fall if they are unable to pass on the full cost of the tariffs. With higher costs, Canadian producers will also likely lose U.S. contracts and market share.

Canada’s retaliatory tariffs will mean higher prices for Canadian importers of steel, aluminum and any of the products included in the list of products and this will hurt companies’ profit margins. Some of the products subject to the retaliatory tariffs may not be produced domestically in Canada, so companies will need to find substitutes. Consumers will likely see higher prices for various goods.

In the U.S., many industries use steel and aluminum as production inputs. The steel-consuming industries are a much larger share of the economy than the steel producers. Construction, autos and machinery manufacturing comprise 80% of total domestic steel consumption. As their input costs rise, jobs in those sectors could take a hit. According to the Conference Board of canada, there is limited scope for immediate American import substitutes—particularly for Canadian aluminum.

At the same time, the counter-tariffs imposed by trade partners will hurt U.S. exporters because substitutes for many U.S. products appear to be readily available.

We know from history that protectionist measures, such as import tariffs and quotas, hurt everyone, especially poorer consumers. Less competition may lead to higher profits for some select businesses in the short run, but ultimately makes companies less productive.

Product selection will become more limited, and businesses will suffer when less technology is transferred between countries through trade. Overall, consumption and production will fall as a result of imposing such measures, and this will hurt the U.S. and global economy if they remain in place at the current high levels.

If the tariffs are a bargaining chip in trade negotiations to create a level playing field and open countries for fair trade, including better working conditions for workers, and reciprocal access to markets, then these tactics could ultimately prove beneficial for the global economy. However, if they remain in place for an extended period, it will be negative overall for the global economy.

What does it mean for entrepreneurs?

  1. U.S. trade protectionism is not going away in the short-term. However, as the cost to consumers and businesses begins to bite, the administration may have to moderate its course. Stay optimistic but vigilant for ways to weather the storm if your company is threatened.
  2. Diversify your business by finding new suppliers and developing new products and services to sell internationally. Investigate the trade agreements Canada has signed with the European Union (CETA) and with many of the Pacific Rim countries (CPTPP).
  3. If you import goods subject to Canadian import tariffs and then re-export them, you can apply to the Canadian government to get an 80% rebate on the duty paid.
Canadian economy at a glance

Economic growth is slowing to a sustainable pace

Economic growth in Canada slowed in April to 2.5% year-over-year, a slower pace than in February and March. The Bank of Canada remains bullish on the economy and expects growth in the second quarter to be around 2.5%, and in line with that view, they raised the policy rate by 25 basis points to 1.5% this month.

The manufacturing, public and utilities sectors contributed the most to the increase in GDP in April. The increase in manufacturing output spanned multiple sub-sectors with the largest increase coming from machinery manufacturing. Strong export demand and higher commodity prices are driving the growth in manufacturing output.

The retail sector took a hit as households are getting squeezed by higher interest payments

The retail, construction, mining and oil-and-gas sectors were a drag on GDP growth, with each sector’s output falling compared to March, although the latter two sectors had higher output than at the end of 2017. The retail sector, however, has declined compared to the end of 2017 as growth slowed in the first quarter and declined significantly in April. As households scale back spending because of higher interest rates and tighter mortgage lending guidelines, the retail sector will face increasing challenges.

Household income continues to show a steady rise, growing 5% in the first quarter of 2018 compared to a year ago. However, interest payments have grown at twice that pace, forcing borrowers to slow principal payments compared to the fourth quarter. The high level of household debt, though beginning to decline, is the driver in the 10% upswing in interest payments despite interest rates rising only 1% in the past year.

Whether labour shortages will provide the necessary push to drive up wages remains to be seen

In a number of provinces, particularly Quebec, British Columbia and Ontario, wages have risen above the historical trend, but the pace could be slowing. Wages increased as one method to deal with the rising labour shortages, but also due to higher minimum wages, in particular in Ontario.

As businesses find it increasingly difficult to find the right qualified labour, they may be choosing to invest more in technology. Last month’s article discussed the important investment increase, including machinery and equipment, in the last quarter.

Another factor playing on slowing wage growth could be an increase in job seekers. The unemployment rate rose slightly to 6% as more people, particularly those 15-24 years of age, looked for work.

Should wages not pick up more strongly for workers, household income, especially at the lower end of the income distribution will not grow significantly, and this could reinforce the retail sector’s challenges.

The purchasing power of households will also stagnate as inflation continues its slow steady rise, hitting 2.5% in June from a year ago, above the 2.2% pace in both April and May.

What does it mean for entrepreneurs?

  1. If you’re affected by the labour shortage, think about how you can make your business more attractive to prospective employees. This could include thinking about why a talented person would choose to work for your company. Build on these strengths to improve retention and help attract new hires.
  2. If you are hitting capacity constraints due a labour shortage think about automating tasks previously completed by people. Invest sooner rather than later given that interest rates are increasing.
  3. If you are in the retail sector, households’ purchasing power is likely not increasing by much. Consider developing products that are more affordable for your buyers.
U.S. economy at a glance

The U.S. expansion is expected to continue

In June, as widely anticipated, the U.S. Federal Reserve raised its key policy rate another 25 basis points to 2%. The interest rate tightening cycle is in line with a steadily strengthening economy that showed moderate inflation of 2.2% in May. GDP grew 2.0% (annualized) in the first quarter of 2018, a slight downward revision from last month’s estimate of 2.2%.

Despite headlines on the latest trade actions, and businesses reporting to the Fed that protectionism will dampen investment, the latest data shows that business investment continues to be relatively robust.

As reported last month, first quarter growth was largely driven by increased business investment. This is excellent news for growth to continue. Companies are finally investing in plants and equipment as well as intellectual property after a long period following the Great Recession when they mostly held cash or bought back shares. Now that firms are investing in increased capacity, we should see higher productivity growth, and this should be positive for wages and jobs. However, for the time being, wages have been growing only at a pace of about 2.7% over the last year. This is because there appears to be a lot more people still waiting on the sidelines to join the labour force.

Wage growth could stay tepid as more people rejoin the labour force

Indeed, the recent data appears to bear this out. Although the unemployment rate rose marginally to 4% in June, it was partly due to an increase in labour force participation, including about 200,000 people who re-joined the labour force. The other reasons the unemployment rate rose, however, were less positive. About 200,000 people lost their jobs, many in the retail sector, and the number of the long-term unemployed edged higher by nearly 300,000 people.

Slow wage growth may be holding back stronger consumption growth

While businesses took advantage of the tax cuts implemented at the end of 2017 to increase investment, households have not yet done so. Despite a rise in real disposable income of nearly 4% in the first quarter (annualized), household spending grew only 0.9%. Households may be waiting for an improvement in their wages before increasing their spending.

The tax cuts for individuals were largely skewed toward the higher income segments of society. The highest individual bracket was cut to 37% from 39.6%, and the threshold at which it is applied was raised to $600,000 from $480,000 (for joint filers).

Wealthier households tend to save more than lower and middle-income households. It remains to be seen whether consumer spending will rise next quarter, though we should see some pick-up given the summer holidays.

What does it mean for entrepreneurs?

  1. The U.S. economy is performing well and the expansion should continue. While trade policies are capturing many headlines, the economy’s exposure to trade is about half the size of Canada’s making it more insulated from fall-out of the protectionist measures the administration is imposing.
  2. Interest rates will continue to rise with the strengthening economy, and global financial conditions should begin to tighten more. The U.S. dollar will appreciate further against the loonie.
  3. If you are in the retail sector, you might consider segmenting your products by household income. The less-affluent segment of the population, which has a higher marginal propensity to spend, will value lower-priced goods.
Oil market update—May 2018

Global oil prices remain elevated in July

OPEC agreed to raise supply to satisfy strong global demand

The Organisation of Petroleum Exporting Countries (OPEC) began to increase production at the end of June. While the countries have agreed to continue to keep 1.8 million barrels a day out of the global market, they will be more flexible with the individual country targets. Over the past many months, there has been “over-compliance” with the agreement, i.e. there has been a withdrawal of about 600-700 kb/d more than the 1.8 million barrels a day. Thus, the new agreement of June 22nd will permit those countries with capacity, such as Russia and Saudi Arabia, to pump more and make up for those pumping less, such as Venezuela, Mexico, and Libya. Saudi Arabian and Russian oil exports will also likely replace the oil exports from Iran following the re-imposition of U.S. sanctions.

U.S. production picks up at the same time as the rise in OPEC production

With the new agreement in place, Saudi Arabia pumped more, raising production by 500 kb/d for the month of June. Meanwhile, U.S. production hit a new record last month, averaging 10.9 mb/d, higher than Saudi Arabia’s annual production in 2016, the year it recorded its highest production.

Despite rising production, prices trended upward

West Texas Intermediate has averaged US$68/barrel and Brent US$74/barrel over the past month—an increase of 50% and 60% respectively from a year ago. Even with rising production by OPEC, prices climbed a little higher, mainly because markets had expected a more significant increase in production.

Global consumption is the driver

The bigger reason prices have continue to trend upward is that global consumption remains strong. Global growth is expected to hit 3.9% this year, up from 3.7% in 2017, according to the IMF.

The U.S. economy continues to perform well and the recent upsurge in business investment is a sign the expansion should continue. Refining activity has been strong, fueling other sectors of the economy such as industrial chemicals, construction and wholesale trade. Household consumption of gasoline is set to rise as the summer driving season gets underway. All these components are drawing down crude oil inventories, which are now below 2015 levels.

Emerging markets are also supportive to the global consumption of crude oil. India and China, with anticipated GDP growth of 7.3% and 6.6% this year respectively, are important consumers of petroleum products. While the removal of fuel subsidies in India during the oil price downturn is likely to see demand growth slow down given the strong rise in prices, the country’s economic development will continue to demand petroleum products, and this will support prices.

It is too early to tell if the latest protectionist trade actions will dampen demand and oil prices

While the latest tariffs that the U.S. and China have imposed on each other’s imports at the beginning of July are significant, it is too early to tell what the impact will be.

Trade is an important driver of oil prices. The IEA estimates that if global trade drops by 5%, demand for shipping fuel oil would decline by 180 kb/d. Demand for diesel would also decline as it is the fuel used for moving goods from ports to stores. China has been an important buyer of U.S. oil exports for the last two years. However, its import duty list includes U.S. crude oil exports. This will put pressure on US producers to find other markets.

Bottom line

The increase in oil prices has not yet relented despite a rise in supply. While demand growth has slowed in the first quarter of 2018, the strong growth in the U.S. as well as some important oil-consuming emerging economies appears to be supporting continued price rises. Strong fundamentals remain supportive to benchmark prices in the range of US$60-70/barrel.

Other economic indicators

Bank of Canada raises policy rate to 1.5%

The Bank of Canada raised its key lending rate to 1.5%, as anticipated by many analysts. The Bank noted that despite trade protectionism threats to the strong global economy, Canada’s economy is growing close to capacity and the inflation rate remains near the Bank’s 2% target. Recent tariffs on steel and aluminum by the U.S. on Canada’s exports are judged to have a modest impact on Canadian growth and inflation.

The loonie remains low as protectionism rises in the U.S.

The loonie depreciated against the greenback during June as protectionist sentiment ramped up in the U.S. The Canadian dollar averaged US$0.76 for the month, falling nearly 2% compared to May. The rising interest rate differential with the U.S., where the policy rate is now 2%, kept the loonie low.

SME confidence remains positive overall, but regional variation is wide

Canadian entrepreneurs’ confidence barely moved in June, according to the CFIB’s Business confidence survey, but the regional variation is wide. Prince Edward Island and Quebec remain the most optimistic provinces, each up about 4 points, followed by Nova Scotia. Ontario declined this month by 2.3 points. Saskatchewan, which dropped 4 points, is considerably below 50 points—a level at which more business owners expect a weaker performance in the next year than those who expect stronger performance. Other provinces did not move much.

Results vary by sector too. The natural resource sector lost over 10 points in June (after falling 12 points in May), and the sector is now below 50 points. The sector with the brightest prospects, according to business owners surveyed, is professional services.

While firms are doing well now, business owners are concerned about capacity constraints. Labour shortages (both skilled and semi-skilled) as well as space and cost of inputs are the most common limitations to production growth.

The good news is that the share of business owners reporting their business is currently performing well is at an all-time high.

Credit conditions remain favourable

Canadian businesses continue to see favourable credit conditions. The business effective interest rate reached 3.49% in mid-May but dropped to 3.40% at the end of June. While higher mortgage interest rates pulled up household borrowing rates earlier in the year, they did not budge in June. Business and household effective rates have picked up over the last year as the Bank of Canada has raised the policy rate by 1%. The latest increase, on July 11, will likely show up in higher borrowing rates in the coming months.

Key indicators–Canada