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Monthly Economic Letter

October 2018
Feature article

The new trade deal with the U.S. and Mexico: Good for business

For entrepreneurs, the new North American free trade deal represents stability, lifting a cloud of uncertainty that has hung over the Canadian economy for the past year.

The agreement in principle maintains largely tariff-free access to a market of 450 million people. Less uncertainty should lead to greater confidence and encourage entrepreneurs to invest in their businesses.

New deal is largely about stability

One important aspect of the agreement is the duration of the pact and its review by the three countries. Originally, the U.S. had pushed for it to be terminated after just five years, opening the door to continuous uncertainty. In the proposed deal, the agreement terminates in 16 years with a review every six years. That’s much more positive for business investment decisions because 16 years is sufficient time for many investments to be fully paid back.

In addition, the independent dispute resolution mechanism remains in place. It allows Canada to bypass the U.S. judicial review process (which is considered expensive and slow) to send trade disputes to an independent, binational panel of five arbiters, agreed upon by both parties. These panels have ruled every time in Canada’s favour when the U.S. government imposed antidumping and countervailing duties on Canadian softwood lumber imported into the United States.

Auto sector is protected

The deal also lifts the threat of the U.S. imposing tariffs on the auto sector, a potentially devastating blow, especially to the Ontario economy, which represents about 40% of national GDP.

Canada exported $74 billion in autos and auto parts to the U.S. last year—equivalent to 3.5% of our GDP. The new rules are more restrictive and complicated, requiring that:

  • 75% of a vehicle’s content originate in North America, up from 62.5%
  • at least 70% of a vehicle’s steel and aluminum be sourced from within the trade zone
  • 30 to 40% of total content must be attributable to factories that pay their workers at least $16 an hour

The last rule should put Canadian production at lower risk of being moved to Mexico. In addition, the U.S. has agreed not to impose tariffs under the guise of protecting its national security on the first 2.6 million vehicles shipped annually. Since this cap is 44% above the amount Canada shipped last year, it’s unlikely to have a tangible impact on Canada’s auto exports.

While the threat of national security tariffs appear to be effectively removed for the auto sector, the Trump administration has retained its right to impose them on other products. However, under the new trade pact, Canada and Mexico will be exempt from those tariffs for the first 60 days to allow them to try to negotiate a reprieve.

Consumer benefits are minimal

The increased competition from U.S. and Mexican exports in the dairy, egg and poultry sectors may lower prices for Canadian consumers. While supply management will continue in Canada, roughly 10% of the market is being opened to imports under the combined effects of recent trade agreements. The new North America pact provides 3.6% access to U.S. producers and agreements with the European Union and the Pacific Rim countries provided similar amounts.

Consumers will also be able to purchase up to $150 worth of goods from U.S. e-retailers before facing duty charges. However, it is only for items that are shipped by express couriers—not by post. According to C.D. Howe Institute, nearly 80% of e-commerce purchases from the U.S. are shipped by mail. This means that U.S. competition is unlikely to hurt Canadian retailers as originally feared.

However, drug patent protection will rise from eight to 10 years. This means brand-name drugs will face less competition from generic drug manufacturers and likely to result in higher costs for consumers.

Recognition of the importance of SMEs

A new chapter aims to increase cooperation and trade investment opportunities for small and medium-sized enterprises (SMEs). However, beyond establishing a committee on SME issues, there is not much else to report. The chapter is an acknowledgement of the important role entrepreneurs play in expanding trade. Stay tuned.

In a further nod to the growing importance of e-commerce, the new deal includes a chapter on digital trade. Countries are prevented from imposing fees or duties on the import or export of digital products transmitted electronically (such as e-music and e-books). Canada gave up its requirement for local presence for data centres. While this may lower costs for business, it could create privacy issues.

Unfortunately, the opportunity to expand the list of professions eligible for business visitors and temporary worker visas was missed. Professions that did not exist when NAFTA was signed, such as in information technology and environmental science among others, are thus not eligible.

Where do we go from here?

The countries are expected to sign the agreement on November 30. Canada’s and Mexico’s legislatures are then expected to ratify it.

For U.S. ratification, trade rules require an economic analysis, and this could take up to 105 days, bringing a congressional vote to March 2019. The November midterm elections could have an impact on whether and when the agreement will pass Congress.

Overall, eliminating trade uncertainty is a huge plus for entrepreneurs who already are benefitting from a strong economy. However, the Bank of Canada is now more likely to raise rates at the end of October to cool the economy, increasing borrowing costs and crimping household buying power.

Renewed stability on the trade front and the prospect of higher interest rates are two good reasons for business owners not to delay in moving ahead with investment projects.

What does it mean for entrepreneurs?

  1. The new trade deal will encourage greater stability in the Canadian dollar against the greenback, making importing and exporting less volatile.
  2. Higher interest rates are on the way, so invest now while interest rates remain relatively low.
  3. Consider how your business can sell its services in the U.S. and Mexico. With tariff-free access, digital trade is expected to continue strong growth.
Canadian economy at a glance

The Canadian economy is operating at capacity

The Canadian economy is operating at capacity as labour is scarce and salaries are increasing. The new trade agreement among North American partners bodes well for the Canadian economy. The housing market remains strong in most parts of the country but the retail sector shows some signs of slowing down. While the economy is not overheating—as inflation is still on target at around 2%—most analysts expect a 25 basis point increase in the Bank of Canada's policy rate later this month.

NAFTA 2.0 will have a positive impact on the Canadian economy

The new United States–Mexico–Canada Agreement (USMCA) should support Canada’s economic growth, lifting consumer and business confidence and encouraging investment.

The Canadian dollar jumped by 1% the day after the Canada-U.S. trade announcement (see this month’s feature article for details of what’s in the USMCA). The reduction of trade uncertainties provides support for the loonie at its current level of around 77 U.S. cents in addition to the prospect of higher interest rates south of the border, among other factors.

GDP growth is on track to hit 2% this year. With inflation trending close to the Bank of Canada’s target of 2%—it reached 2.2% in August after removing volatile elements such as gasoline—most analysts expect the Bank of Canada to lift its policy rate by 25 basis points on October 24, bringing it to 1.75%.

Job market is strong and salaries are increasing

Demand for workers remained strong as we headed into autumn. The Bank of Canada estimated that there were 462,000 job vacancies in Canada in September. Growth in vacancies has increased the most in manufacturing as well as in transportation and warehousing (+14,000 in both cases) over the last two years. Demand for digital workers is also hot as openings in the computer system design sector jumped by 8,000 during the same period.

Total employment increased by 222,000 (or 1.2%) from September 2017 to September 2018, entirely the result of gains in full-time work (+224,000). Over the same period, total hours worked increased 0.7% and the unemployment rate declined 0.1 percentage points to 5.9% last month.

The tight labour market led to salary increases. From July 2017 to July 2018, average weekly earnings grew by 3%. Growth was particularly strong in arts, entertainment and recreation (+9.2%), retail trade (+8.6%), and in real estate and rental and leasing (+6.3%).

Housing still hot, but new construction declines

Home resale activity continued to increase in most Canadian markets in July, especially in Ontario. However, residential construction was down by 1.5%, the largest drop since a strike-influenced decrease in May 2017. The latter confirms that a soft landing in the housing market is going on. However, together, these two factors contribute to keeping housing prices elevated in several urban markets.

The retail sector shows some signs of a slowdown

The vehicle and parts sector was down by 1.9% in July, the third drop in four months. Health and personal care services and general merchandise stores also declined. Improvement in food and beverage stores and clothing stores were not enough to offset these drops and, as a result, retail trade slowed by 0.1%, following a 0.3% decline the previous month.

Other sectors are mixed

Meanwhile, the manufacturing sector was up 1.2% in July, its strongest growth since November 2017, mainly due to a 2.4% increase in the production of non-durable goods, such as food.

Following four months of growth in the first half of 2018, the mining, quarrying and oil-and-gas extraction sector contracted for a second consecutive month, down 0.3% in July. This was due to the decline in non-conventional oil extraction, resulting in part from maintenance work at a production facility.

In tourism, the high season started on a positive note with accommodation and food services jumping 0.7% each month on average from May to July.

What it means for entrepreneurs:

  1. As labour is scarce, implementing proactive human resources strategies are a prerequisite to remain competitive. Check out our labour mismatch study for some ideas.
  2. Interest rate increases should be gradual and the cost of borrowing for new investments remains affordable for a while.
  3. With a deal in place, trade with the U.S. should largely continue as before. However, diversifying your export market is a good strategy as some protectionist policies are still in place.
U.S. economy at a glance

U.S. economy shows strength despite escalating trade tensions with China

The U.S. economy continues to perform well, leading the Federal Reserve to raise the federal funds rate on September 26 by 25 basis points, bringing it to 2.25%.

High consumer and business confidence is supporting investment, strong job growth and rising wages. Most analysts expect the Fed to continue its hiking cycle by raising its rate by 25 basis points in December, followed by at least another 75 basis points over the course of 2019 to bring the fed funds rate to 3%. This is considered close to a neutral rate of interest—when monetary policy is neither stimulating nor restraining the economy.

The impact of the Fed’s hikes to date, and its guidance that they will continue, are reflected in the rising yields in the accompanying chart. The pick-up in the yield of the 10—year note could also reflect the increasing sales of the Fed’s treasury bonds—reversing quantitative easing needed during the financial crisis—and concerns about higher inflation to come, possibly from rising trade tensions with China.

Will trade tensions with China force the Fed to stop raising rates?

Tariffs can have two opposing effects on monetary policy. They can reduce trade and investment, slowing growth. Slower growth would likely mean that the Fed would slow its cycle of interest rate hikes.

On the other hand, because tariffs are essentially a tax—raising costs for business—prices could increase as businesses pass higher costs on to consumers. If prices rise quickly, then the Fed could raise its key interest rate faster than anticipated to keep inflation under control.

The Fed is hearing from business leaders who are worried about the impact of US$250 billion of tariffs imposed on Chinese imports since July. The effects include disruption to supply chains, rising materials costs and loss of market share in China. This could lead to higher inflation and lower growth—not a good combination.

So far, however, inflation data is not showing significant upward pressure. The consumer price index hit 2.7% in August while the Fed’s preferred measure of inflation hit 1.96%—just below the Fed’s 2% target.

Costs from the first round of tariffs in July were small and likely absorbed by producers. However, the latest round in September was four times the size, and about 40% is on consumer goods, such as furniture, vacuum cleaners and suitcases.

Growth does not seem to be affected yet

Overall, it seems unlikely that U.S. growth would be sufficiently affected by the tariffs on China to slow the Fed’s rate hiking cycle.

The total value of Chinese imports for the first half of this year amounts to less than 3% of U.S. gross domestic product. Part of the reason the figure is small is because the U.S. is not very open to international trade—imports and exports represent only 27% of GDP. By contrast, the same indicator for China is 50% and for Canada, 64%. Thus, because the U.S. economy’s exposure to trade is limited, the tariffs it has imposed on Chinese imports is unlikely to slow its growth, at least not in the short-term.

Furthermore, China’s currency—the reminbi—has been depreciating this year against the U.S. dollar. With the U.S. dollar up 6% against the reminbi, part of the import tariff cost has disappeared meaning American companies still have access to competitively priced Chinese imports. Chinese depreciation will mean higher inflation in China. Eventually that could lead the People’s Bank of China to lift interest rates, but, so far, the Chinese are stimulating the economy by increasing credit to business and local governments.

What does it mean for entrepreneurs?

  1. Rising interest rates in the U.S. will have an impact on Canada. Anyone borrowing in U.S. dollars will see their interest costs rise, including banks that borrow in the wholesale market. Banks will likely pass these higher costs on to Canadian businesses and consumers borrowing in Canadian dollars.
  2. The loonie will likely depreciate against the greenback because the interest rate differential between the two countries has widened. Canadians exporting to the U.S. will be more competitive, but Canadian firms face higher costs for importing goods and services from the U.S.
  3. Global financial conditions are gradually tightening as the US dollar appreciates. If you have suppliers or buyers in other countries that have U.S. dollar debt, they may be getting squeezed.
Oil market update—October 2018

U.S. sanctions on Iran affecting the price of oil

Oil prices are back up as the market anticipates a reduction in the supply of oil as U.S. sanctions on Iran come into force.

Sanctions on Iran will likely reduce supply

U.S. sanctions on Iran will come into effect on November 4, 2018. This means that firms that deal with Iran will be locked out of U.S. capital markets. Already in August, a number of countries, including France, Spain, Italy and Japan began limiting their purchases from Iran, whereas others such as China and India purchased more oil. However, as of September, China and India seem to be limiting their purchases.

How much oil will be out of the market?

Iran produces close to 4 million barrels a day of crude oil, of which it exports about 2.5 million barrels a day. The question most analysts are asking is how much of those exports will be removed from the global supply. The estimates range from about 500,000 to 2 million barrels a day. The wide range comes from uncertainty as to whether Iran will be able to get its product to market. Iran could sell to partners outside the U.S. banking system. For example, India will use rupees to pay for oil from Iran, according to The Times of India. Another option could be for Iran to ship its oil via Iraq, according to a report by Reuters.

Could oil go to US$90 a barrel?

The reduction in supply from Iran is partly what is keeping prices elevated, especially Brent which is trading around US$80 a barrel. The other factors are the continued declining production levels in Venezuela, which produced only 1.24 million barrels a day in August, down from an average of 2.4 mb/d four years ago. Furthermore, the decision at the end of September by members of OPEC+1 not to increase production will also keep prices elevated.

To manage the possible shortfall in coming months, the U.S. government will release 11 million barrels of crude from its Strategic Petroleum Reserve for delivery from October 1 to November 30. This is part of its process of drawing down the SPR. Other factors though that will increase supply are the continued strong production in the U.S., which is averaging about 11 mb/d.

Uncertainty also affecting prices

Trade tensions between the U.S. and China are creating uncertainty for the global oil market. If trade declines, less fuel for shipping will be needed. The International Energy Agency estimates that if global trade drops by 5%, demand for shipping fuel oil would decline by 180 kb/d. Demand for diesel would also fall as it is the fuel used for moving goods from ports to stores.

Also due to the trade tensions, there are certain oil products for which China has imposed tariffs on U.S. imports. The retaliation for the $16 billion in U.S. import tariffs included propane, butane, naphtha, and jet fuel as well as various petrochemicals. With China being the fastest growing market for U.S. petrochemicals, these tariffs will hurt U.S. suppliers. China will source petrochemicals from other countries. In the latest round of tariffs, China added liquefied natural gas, but not crude oil to its list of products targeted for tariffs. China accounted for 14% of total U.S. LNG exports, and 21% of US crude oil exports in the first half of 2018.

Western producers not benefitting from high global prices

The run-up in global prices however is not translating to Western Canadian producers where the benchmark for Western Canadian Select continues to trade at a significant discount to West Texas Intermediate. See last month’s article for more information about the reasons behind the discount.

Bottom line

Global oil prices are likely to stay elevated over the next few months as sanctions against Iran take effect and other countries do not fill the gap. However, the discount on WCS is unlikely to shrink anytime soon.

1. The Organization of Petroleum Exporting Countries plus the following 10 other countries: Azerbaijan, Bahrain, Brunei Darussalam, Kazakhstan, Malaysia, Mexico, Oman, Russia, Sudan, and South Sudan.

Other economic indicators

A rate hike is coming

Most analysts anticipate that the Bank of Canada will raise the policy rate by 25 basis points on October 24, bringing it to 1.75%. The latest data points towards good GDP growth for the third quarter and a rise in the Bank of Canada’s core inflation measure—two factors that the Bank monitors closely when setting monetary policy. The uncertainty over trade with the United States has been lifted, which reinforces the likelihood of a policy rate increase this month.

Loonie hits a 4-month high on the announcement of a trilateral deal

The Canadian dollar gained against the US dollar over the course of September amid optimism surrounding NAFTA talks. The loonie traded a little under US$0.75 at the beginning of September but closed higher at US$0.77 at the end of the month. On October 1, the loonie hit US$0.78, a high not seen in the past four months, following the announcement of the United States Mexico Canada Agreement (USMCA). With trade tensions between Canada and the United States largely behind us, the Canadian dollar should stabilize at a slightly higher level.

Business confidence is down as labour shortages weigh on the outlook

Canadian business confidence dropped slightly in September. The CFIB Business Barometer Index fell by 0.2 points. Quebec and Prince Edward Island remain the most optimistic provinces. Ontario’s confidence bounced back by 3.6 points, the strongest gain among all provinces for the month. The agriculture and natural resources sectors’ indexes increased by more than 6 points each, but both sectors displayed some of the lowest confidence overall. In other sectors, including retail, hospitality and information and arts confidence declined. Business owners are still facing labour shortages that are limiting their capacity. If you are struggling with labour shortages, check out BDC’s latest study on labour shortages, titled Labour Shortage: Here to Stay to find out how you can manage the issue.

Credit conditions are becoming less accommodative with each rate hike

Credit conditions are becoming less accommodative with every interest rate hike by the Bank of Canada. The widely anticipated 25 basis point hike on October 24th will likely continue to put some pressure on credit conditions for the rest of this year. At the end of September, households and businesses faced effective interest rates of 3.80% and 3.65%, respectively, which are low from a historical perspective.

Key indicators–Canada