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Monthly Economic Letter

September 2018
Feature article

Canadian entrepreneurs remain confident despite trade turbulence

Entrepreneurs have been bombarded of late with news about potential trade disasters and actual natural disasters, including forest fires, earthquakes and hurricanes.

Despite all the turbulence, business owners remain in a confident state of mind, according to a recent BDC survey.

Close to 80% of owners of small and medium-sized businesses we surveyed* saw stable or increasing sales over the past 12 months, even after considerable growth in the first half of 2017. As well, the majority of respondents expect sales to improve further over the next 12 months.

This positive outlook led many of the entrepreneurs to say this is a good time to invest in their business. As the accompanying chart shows, the most compelling reason for believing that now is the right time are the opportunities that entrepreneurs see for growing their business. BDC research shows that by growing their business, entrepreneurs achieve economies of scale and productivity gains that help them generate greater profits margins, which they can reinvest, creating a virtuous cycle of improvement and increased competitiveness. Business investment for the first half of 2018 has been solid, up 7.6% compared to the same period in 2017.

Notwithstanding rising interest rates, two-thirds of business owners see stable financing conditions.

When asked about their perception of conditions for their competitors, their region and the Canadian economy generally, business owners were a little less optimistic. However this is probably human nature speaking. Often, as the distance increases from what people know well, in this case their own business, their optimism declines.

In addition, it’s not surprising that business owners might be less optimistic about what’s happening around them given the negative news cycle, especially trade tensions with the United States.

However, negotiations with NAFTA may be drawing to a close soon. At the end of August, the U.S. and Mexico agreed on the important issues related to trade between their two countries, including contentious rules of origin for autos. Canada re-joined the discussions and it appears that an updated NAFTA may be concluded this autumn, however a key sticking point could be the dispute resolution chapter which Mexico agreed to eliminate, according to some media reports. A new agreement on NAFTA would reduce uncertainty for many firms and give some support to the Canadian dollar.

Still, there could be more risks lurking around the corner. The U.S. will impose 10% tariffs on US$200 billion worth of Chinese imports effective September 24, and the rate will increase to 25% at the end of the year. The U.S. administration has threatened it is ready to impose tariffs on another US$267 billion of Chinese imports as well as on autos and auto parts from a variety of countries, including Canada.

Impacts from trade tensions are modest so far

The U.S. has already imposed steel and aluminum tariffs on many trading partners, as well as a raft of other tariffs on Chinese imports. Tariffs on China now total US$50 billion with the imposition of a second tranche on US$16 billion worth of goods that came into effect in August. Many trading partners have countered with retaliatory tariffs against the U.S., but the overall impact to date has been modest. While world trade contracted in June, after a strong increase in May, volumes remain near historic highs.

Inflation has risen in both Canada and the U.S., but it does not yet appear to be the result of recently imposed tariffs. The consumer price index in Canada rose by 3.0%, and in the U.S. by 2.9%, compared to last July. In Canada, the increase is due mainly to higher energy prices, while in the U.S. increases in the cost of shelter (rent or mortgage) were the main driver. In the U.S., tariffs on metals and lumber are hurting profit margins, forcing some businesses to modestly raise prices for consumers, according to Federal Reserve district bank reports.

In Canada, tariffs do not appear to be affecting producer prices—a measure of various commodities including fruit and vegetables, chemicals, lumber, metals, machinery and equipment. Over the past year, energy and other commodity prices have pushed the Canadian producer price index higher. Interestingly, since the imposition of steel and aluminum tariffs, those product categories have not seen a price rise, though aluminum prices did increase earlier in the year on the expectation that President Trump would follow through on his promise to impose tariffs.

Of the firms surveyed by BDC, over 50% trade with the U.S. and about three in 10 expect the trade tensions to hurt their business (either directly or indirectly). The most common expected impact is a rise in prices for goods or services.

In the face of the turbulence, Canadian firms are using strategies such as re-focusing their efforts on local markets, developing trade with other countries, agreeing to partnerships, and investing in research and development and innovation to become more competitive.

What does it mean for entrepreneurs?

  1. While U.S. trade protectionism will not disappear in the near-term, Canadian companies can weather this storm by continuing to focus on existing customers while seeking out new markets. A BDC study found that diversification correlates strongly with financial success.
  2. Investing in innovation to develop new products or processes will improve your competitive position and possibly allow you to charge higher prices if your margins are being squeezed by higher input prices.
  3. When times are uncertain, it’s a good idea to keep a tight grip on your costs. Take the time in the next month to review all your expenses to see where you can find savings.

* We surveyed 951 business owners and business decision-makers from July 10 to 20, 2018.

Canadian economy at a glance

The Canadian economy shows stable growth

Canada’s economy grew a solid 2.9% annualized in the second quarter of 2018, in line with the Bank of Canada’s expectations.

Consumer spending picked up after decelerating in the first quarter, as did goods exports, which rebounded with 15% annualized growth.

Business investment, though still positive, slowed down after a very strong first quarter, and residential investment reversed its negative slide.

After impressive growth in 2017, the expansion appears to be stabilizing around 2%, a more sustainable pace for an advanced economy with an aging population.

Inflation picking up, but interest rates remain favourable

With the economy performing broadly as expected, the Bank of Canada held its key interest rate steady at 1.5% in early September. While consumer price inflation hit 3% in July—a result of higher gas prices and air transportation costs—it should come back closer to the Bank of Canada’s target of 2% as transitory factors dissipate. Indeed, the average of the Bank of Canada’s three core inflation indices is currently at 2%—right on target.

The Bank of Canada has raised the policy rate a total of 1% since it began a gradual tightening cycle last summer. Since then, banks have passed along about three-quarters of the increases to households and businesses. Most analysts anticipate that the Bank of Canada will raise its policy rate at least once more this year.

Slower pace of consumption expected

With higher prices and gradually rising interest rates, household consumption will likely slow down from its strong pace of 3.5% last year. So far this year, household spending has grown 2.4% compared to the first half of 2017.

This trend is also showing up in slower retail sales growth. Retail sales grew over 7% on a nominal basis in 2017 compared to 2016, while in the first half of 2018 they have grown only 3.2% compared to the same period in 2017.

But a stable labour market should be supportive for consumer spending

While the labour market results for August were disappointing, this data is notoriously volatile. The net decline of over 50,000 jobs last month brought the unemployment rate up to 6%. Year to date, employment growth is essentially flat. However, full-time jobs—which account for about 80% of employment—increased, while part-time jobs declined over the first six months of the year.

Wages grew at an average pace of 2.9% during the first six months of the year. While the pace varies considerably across sectors, with retail and construction wages growing more rapidly, overall, wages are just keeping pace with inflation, which means that real earnings (nominal wage growth less inflation) are flat. However, the fact that people have jobs and some stability in their lives should allow for moderate spending growth.

Indeed, this stability may be the reason why after decelerating for about six months, consumer credit grew more strongly in July. Consumers may be more comfortable taking on more debt to increase purchases after they slowed their debt accumulation in the first half of the year.

Confidence up despite uncertainty on NAFTA

And Canadians’ confidence improved in August compared to July according to a poll by Ipsos. Part of this optimism is likely coming from the fact that growth has been broad-based with all sectors of the economy contributing.

While there is much discussion about what will happen with the NAFTA renegotiations and this uncertainty can weigh on confidence, it seems plausible that Canada will come to a deal with the United States and Mexico by the end of September. The trade authority granted to the U.S. administration by Congress was for a new three-way agreement. The U.S. Trade Representative notified Congress on August 31 of a deal with Mexico with the possibility of adding Canada. That started a 90-day countdown to signing a pact. Sixty days prior to signature, the U.S. Administration must publish the text, which gives Canada until the end of this month to negotiate a good deal.

What does it mean for entrepreneurs?

  1. The Canadian dollar is unlikely to appreciate significantly against the US dollar until a NAFTA deal is achieved. This is positive for exporters not facing U.S. import tariffs.
  2. Interest rates are likely to continue to move up. Ensure your business is managing its debt load effectively. It may make sense to make productivity-enhancing investments sooner rather than later to take advantage of still low interest rates.
  3. If your business is operating in the retail sector, your margins are no doubt under pressure as wages are rising and revenues may be slowing. Consider where you can trim costs and take advantage of technology to improve efficiency.
U.S. economy at a glance

Is strong U.S. growth sustainable?

In the short term, robust growth in the United States looks on track to continue. However, as the dollar continues to appreciate against other currencies, growth may moderate. Longer-term, households spending may slow if wage growth does not strengthen further.

The U.S. economy expanded at an impressive 4.2% annualized pace in the second quarter, up from 2.2% in the first quarter. All sectors of the economy contributed, except for residential investment.

Consumer spending bounced back, accounting for 60% of the growth, as consumers spent more of their windfall from a tax bill passed last December.

Business investment slowed a little after a strong increase in the first quarter with the main drag being an inventory build up. Firms increasingly concerned about the reliability of suppliers, both domestically and overseas, stocked up on materials and intermediate goods last quarter.

Trade likely to be a drag on growth in the near future

Trade was a net positive for GDP growth as goods exports increased strongly. However, as the greenback appreciated, exports declined toward the end of the quarter and the U.S. trade deficit expanded. It’s currently at US$571 billion (total for the last 12 months).

This trend is likely to continue in the current quarter as firms import goods in advance of the U.S. import tariffs on another US$200 billion in Chinese goods, effective September 24. There are already import tariffs on US$50 billion worth of Chinese imports for which China has retaliated in-kind. China announced that as of September 24, it will impose 10% import tariff on US$60 billion worth of American goods.

The U.S. Federal Reserve is expected to raise the federal funds rate by another 25 basis points on September 26 and that will likely mean the U.S. dollar will continue to appreciate against the Chinese yuan and other major currencies.

Capacity pressures are beginning to bite

Consumer prices rose by 2.9% in July compared to a year ago, largely driven by higher rental and mortgage costs, due to higher interest rates. As well, energy prices have climbed over 40% since last year with retail gasoline prices at their highest level in four years, according to the U.S. Energy Information Administration.

As more companies face higher transportation costs, labour shortages and the effects of import tariffs, prices will likely continue their steady move upward, hurting demand.

Despite adding an average 200,000 jobs a month over the last 12 months, many companies continue to lack capacity to respond to the strong demand for their products and services. Instead of raising salaries though, they are choosing to pay for more overtime work. Indeed, overtime hours in the manufacturing industry are up 50% from two years ago.

Wages are increasing and employment costs are up even more, meaning workers are reaping some rewards from the hot economy. However, the pace is slower than when the economy has performed this well in the past.

Are the chances of recession rising?

Is the U.S. economy overheating and headed for a recession? It’s too soon to say, but one key forecasting tool suggests the odds are rising.

An inverted yield curve has been a signal of impending recession in the past, including in 2000 and 2007. Currently, the curve has flattened—a signal of investor concern about the economy's growth prospects—but not yet inverted.

The Federal Reserve Bank of New York forecasts recessions using the yield curve. At the end of August, their model suggested a 15% chance of a recession in the U.S. in the next 12 months, up from a 10% chance a year ago.

While the national savings rate remains high historically, it is largely due to higher interest and dividend earnings not wage income. The less well-off have a higher propensity to spend than the wealthy, but if their wages are not keeping up at least with inflation, it will be harder for the economy to keep growing as strongly.

What does it mean for entrepreneurs?

  1. The U.S. dollar is likely to remain strong, including against the Canadian dollar.
  2. Demand in the U.S remains strong and with capacity constraints growing, Canadian firms that are reliable suppliers will be valued.
  3. While President Trump’s tariff talk has not diminished, as U.S. firms increasingly face challenges, the administration may begin to relent. This would be positive for Canada’s economy.
Oil market update—September 2018

Global oil benchmarks are stable, but the price for Western Canada’s oil has declined sharply

Global oil benchmarks, such as Brent and West Texas Intermediate, have been relatively stable in the US$65-75 a barrel range over the past several weeks. News about the impact of U.S. sanctions on Iran, lower production from Venezuela, Mexico, and Libya, and higher production and refining in the U.S. and China have resulted in some fluctuations, but in general prices have been stable. This is not the case for Western Canadian Select, which is trading much lower, at US$40 a barrel.

There is always some discount for WCS compared to WTI because of the different quality of WCS. WCS is a heavier grade fuel and has more sulphur content, making it “sour”. It also costs more to transport it to the refineries on the Gulf Coast than oil coming from the Permian Basin in Texas or other parts of the U.S.

Between the end of 2014 and November 2017, WCS traded with an average discount of US$14 a barrel to WTI. When an oil spill was discovered on the Keystone pipeline and was forced to shut down, the discount doubled. While the discount narrowed to US$20 after a legal ruling in late March in favor of the Trans Mountain pipeline (which would bring Alberta oil to the west coast of British Columbia), since mid-July, the discount has widened again, averaging about US$27 a barrel.

Pipeline capacity uncertainty explains part of the widening discount

Last autumn, TransCanada Corporation was forced to alter its preferred route for its $10-billion Keystone XL pipeline, which is meant to travel from Hardisty, Alberta to Steele City, Nebraska, following a legal ruling forcing the company to move the pipeline from the plaintiffs’ land. Since then, a new route has been selected and in mid-August, a U.S. District Court Judge ordered an additional environmental study on the revised route through Nebraska. TransCanada must overcome this new regulatory hurdle before construction can begin. The further delay may be putting downward pressure on the price of WCS as there continues to be uncertainty as to whether the pipeline will actually ever be built. TransCanada initially proposed the Keystone XL nearly a decade ago.

Kinder Morgan has won a number of court rulings to get the Trans Mountain pipeline built, including a recent ruling by the Supreme Court of Canada dismissing an appeal by the City of Burnaby to prevent construction. While the federal government’s purchase of the pipeline, finalized on August 30, gives more certainty to the project to cross provincial borders, the most recent ruling from the Federal Court of Appeal has halted construction of the project. On August 30, the court ruled against the government on a case that combined nearly two dozen lawsuits, seeking the National Energy Board's review of Kinder Morgan Canada Ltd.'s project to be overturned. The court has ordered the government to redo its Phase 3 consultation. The federal government remains committed to the Trans Mountain project.

The significant discount is surprising given declining production in Venezuela and Mexico

While uncertainty remains regarding pipeline construction, demand from the U.S. remains strong. Declining production from Mexico and Venezuela—important producers of sour crude oil—means that Canada's oil can gain market share. U.S. refineries use heavier crude oil to blend with the lighter sweeter crude oil produced from shale oil to make diesel and gasoline.

New environmental regulations may be pressuring WCS

New marine fuel regulations are set to come into force on January 1, 2020. These regulations affect the fuel used by ships to transport 95% of the goods countries export and import.

Ten years ago, the International Maritime Organization adopted a regulation requiring that shippers use marine fuel with sulphur content of 0.5%—down from the current 3.5%. Using low sulphur fuel reduces the amount of sulphur dioxide released into the atmosphere. Sulphur dioxide causes respiratory problems, acid rain and acidification of the oceans.

The IMO estimates that these regulations will apply to more than 121,000 ships operating in international waters. As the implementation is fast approaching, market participants are concerned about the cost of switching to low-sulphur marine gas oil, which is more expensive than higher sulphur content fuels, like WCS. The consultancy, Wood Mackenzie, estimates that fuel costs could rise by 25%. The cost of fuel represents about 30-50% of total operating costs of a ship, according to Marine Insight—an Indian-based company providing resources and training to mariners. Vessels that do not have engines to support the lower sulphur fuel will need to install scrubbers to reduce sulphur dioxide emissions.

For Canada, as an important producer of higher sulphur content fuel, this new regulation could increase the discount western Canadian producers receive for their product. The Canadian Energy Research Institute modelled the IMO’s change and estimates that the discount for WCS could grow from the historical US$13/barrel to US$31-33/barrel.

However, according to Mike Priaro, a veteran of the Alberta oil patch, Canada’s oil sands are well placed to supply this growing market. One barrel of oil sands crude oil, or partially upgraded oil sands crude, or synthetic crude produces significantly more MDO (middle distillate oil) which is a low sulphur fuel, than one barrel of light sweet crude oil (such as Brent or West Texas Intermediate). The issue will boil down to capacity for complex refining to generate the required low sulphur product needed to meet the new regulations. If the refineries cannot transform Canada’s heavy crude oil into the needed marine fuel, then downward pressure will continue on WCS.

Bottom line

Western Canadian Select’s discount to WTI is likely here to stay until pipelines to get Alberta oil to global markets are finally built. While the discount may narrow as more certainty regarding construction materializes, we should not expect a return to historical levels soon.

Other economic indicators

Bank of Canada holds key rate steady in September

The Bank of Canada kept its key lending rate at 1.50% on September 5. Governor Poloz reiterated that although July’s consumer price index reading was 3%, the Bank’s core measures of inflation remain around the Bank’s target of 2%. The latest Canadian GDP growth estimate was below market expectations, however it was better than the Bank’s forecast by 0.1 percentage points. The Bank of Canada is also keeping a close eye on the NAFTA renegotiations. Most analysts anticipate that the Bank of Canada will raise the policy rate by 25 basis points in October.

NAFTA talks weigh on the loonie

The loonie gained against the greenback over August due to optimism surrounding NAFTA talks but has lost some ground since then. The Canadian dollar traded in a range of 76.0 cents to 77.4 before closing the month of August at 76.6 cents. Factors such as the Federal Court of Appeal’s decision to halt construction of the Trans Mountain pipeline and lower than expected GDP growth offset the impact of higher world oil prices, putting downward pressure on the loonie. The Canadian dollar seems to be increasingly sensitive to the NAFTA renegotiations. The dollar’s trajectory will likely continue to be highly dependent on new developments regarding trade talks with our southern neighbour over the next month or so.

The housing market is stabilizing

The B201 stress test and other province-specific regulations slowed the real estate market at the beginning of this year. However, the latest available data show the housing market to be stabilizing as borrowers and lenders have started to adjust to the restrictive rules. Residential sales activity picked up for a third consecutive month in July despite running below the 10-year average. Prices in the Greater Toronto Area changed very little over the summer bringing more stability to the home price index on a national level. As seen in the graph below, prices in the most significant markets appear to be converging around a more sustainable growth rate.

Credit conditions are getting tighter, but remain relatively favourable

Credit conditions remain relatively favourable for households and business owners. Financial institutions have not yet fully passed on the Bank of Canada’s July interest rate hike. Households and businesses were facing an effective rate of 3.8% and 3.6%, respectively, at the end of August. The increases represent half of the 0.25% hike from July. While the Bank of Canada did not raise its rate at its last meeting earlier this month, most analysts suggest it will likely to do at least once more this year.

Key indicators–Canada


1. The Office of the Superintendent of Financial Institutions (OSFI) introduced in January 2018 a new guideline requiring banks to test that borrowers with uninsured mortgages demonstrate that they can afford payments based on the greater of the Bank of Canada’s five-year benchmark rate or their contract mortgage rate plus two percentage points.

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