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Monthly Economic Letter

December 2018
Feature article

Expect more volatility for the dollar after a bumpy 2018

It looks like there will be no let up in turbulence for the Canadian dollar in 2019 after a year of gyrations driven by volatile oil markets, rising interest rates and trade tensions.

As we close 2018, the loonie has fallen to about US75 cents, down 5 cents from where it started the year.

While it’s challenging to forecast currency values, we expect the loonie to perk up somewhat over the course of 2019, moving to about 78 cents, thanks to firming oil prices and continued economic growth.

Oil prices have the most impact

Oil-and-gas production industries represent about 7% of Canada’s economy while energy products account for about 20% of exports. This is why fluctuations in demand for oil and gas, which are priced globally in U.S. dollars, explain a good deal of the volatility in the loonie vis-à-vis the U.S. dollar.

As the chart below shows, the dollar closely tracks movements in oil prices. When prices collapsed in 2014, the loonie also plummeted. However, the rebound in oil prices was not matched by as dramatic a rise for the loonie. Among other factors, uncertainty related to the renegotiation of the North American Free Trade Agreement weighed on the currency.

This year, oil prices have been on a roller coaster as the Organization for Petroleum Exporting Countries (OPEC) first limited supply and then Saudi Arabia and Russia boosted it on the expectation that U.S. sanctions on Iran would limit global supply.

Most recently, OPEC and Russia have agreed to reduce supply for 2019, meaning prices are likely to move higher, back to about US$60 a barrel for West Texas Intermediate. As oil prices move up, they should push the Canadian dollar higher.

Interest rate differential to continue to hurt the dollar

Meanwhile, U.S. tax cuts have stimulated economic growth south of the border and pushed inflation higher. The Federal Reserve has responded with multiple increases to its policy rate, currently at 2.25%. Next year, interest rates will likely continue to rise, though more slowly than this year.

Slower economic growth in Canada has led the Bank of Canada to go more slowly in raising its rate—currently at 1.75%. And with a recent drop in Canadian oil prices, interest rates may not go much higher next year.

The gap of 50 basis points between the two countries’ policy rates is creating downward pressure on the loonie, a countervailing force to higher oil prices.

Financial market volatility may hurt the loonie

In addition, volatility in financial markets has picked up recently. In part, this is due to rising trade tensions between the U.S. and China and concerns about the sustainability of global growth. Given the U.S. is Canada’s most important trading partner, accounting for over 70% of our exports of goods and services, this is another force for greater dollar volatility.

The bottom line

Many factors will influence the value of the dollar during the coming year, but we believe continuing growth in the Canadian economy and improving oil prices should help support the loonie to trade closer to 78 cents. However, it may have trouble breaking through the 80-cent level.

What does it mean for entrepreneurs?

  1. The bright side of a lower loonie is that Canadian exports are cheaper for U.S. customers. As well, tourism in Canada is more attractive to Americans while Canadians are more likely to stay in the country for their holidays.
  2. Examine inputs for your products. If you need to import inputs, evaluate whether you can wait for the loonie to appreciate.
  3. Both exporters and importers should plan for currency fluctuations. Consider how you can hedge foreign currency exposure.
Canadian economy at a glance

Canada’s economy is about where it should be

Canada’s economy is performing largely in line with the Bank of Canada’s expectations, growing 2.0% in the third quarter (annualized).

Growth is slowing down compared to 2017 as interest rates have steadily risen 1.25% over the past year.

Consumers are feeling the pinch, with household spending slowing to a pace of 1.2% annualized, compared to an average pace of 2.9% since 2000.

While retail sales grew 2% in September (on a real basis) compared to a year ago—the best monthly performance this year—it’s below the average pace of 3.5% of the past five years. Retail sales of healthcare products and services continue to see excellent growth, however furniture sales, building materials and garden supplies turned negative. This is not terribly surprising given that the volume of home sales at a national level are down 8% compared to last year, according to data from the Canadian Real Estate Association. Home prices have declined over the past two months, though they are still higher, on a composite level than the same time last year.

The latest consumer confidence readings from Bloomberg/Nanos do not suggest there will be a strong pick up in sales given the index has been trending lower over the past month. Current readings related to personal finances, job security, the outlook for the Canadian economy and real estate values are all below the average for the current year as well as the last ten years.

Despite these lower confidence levels, job creation in November was strong at 94,000 jobs. The vast majority of these were full-time positions in the private sector. This strong growth has lowered the national unemployment rate to a historic low of 5.6%.

New tax incentives should help investment grow

While business investment declined in the third quarter compared to the previous quarter, it is still stronger than a year ago. Given that the oil and gas sector’s investment is half what it was before oil prices fell in 2014—currently averaging about $40 billion/year vs $75 billion/year pre-price drop—investment levels are lower in comparison to that period.

The federal government’s recent tax changes should incentivize more investment as businesses can immediately expense qualifying capital goods.

For example, manufacturers and processors that buy machinery and equipment can use an accelerated capital cost allowance of 100% to completely write-off the investment. Clean energy investments qualify for the same treatment. Computer and software purchases are eligible for an Accelerated Investment Incentive to write-down those capital assets at a rate of 100%. Other types of capital goods are eligible for different deduction rates. See table below.

These new rules will help Canada be more competitive with the United States as an investment location of choice. The U.S. reduced its corporate tax rate in its budget last year and made it easier for businesses to write off capital investments. Canada’s rules will stay in place longer than the U.S. rules and apply to software, which is not the case in the U.S.

Interest rates steadily moving up

With interest rates steadily climbing higher, the government’s new incentives are coming just in time for businesses to invest.

While headline inflation rate rose to 2.4% in October from 2.2% in the prior month—mainly on higher auto prices, airfares and telephone services—the average of the Bank of Canada’s preferred measures of core inflation is exactly on target at 2%.

The Bank of Canada held off on a rate hike in early December noting that the recent drop in oil prices will have an impact on Canada’s energy sector. The Bank also noted concerns regarding trade tensions between the U.S. and other countries, particularly, China. The impact of these trade tensions on global growth and oil prices will affect the Bank’s decision for future interest rate increases.

What it means for entrepreneurs:

  1. Consumers will continue to slow or curtail big-ticket items that they would buy on credit, so retailers may need to enhance the value of their product offering to make those sales.
  2. Consider how investing today will improve your product and your efficiency to improve your margins.
  3. While interest rates are rising, they are still low, which means the cost of borrowing for new investments remains affordable for a while.
U.S. economy at a glance

Rising volatility not yet having a major impact on U.S. growth

Economic growth in the United States remains strong, with the third quarter growing at a pace of 3.5% (annualized). The majority of forecasters expect the U.S. to have robust growth next year as well, with the consensus forecast at 2.7%. Currently the U.S. economy is doing well as steady consumer spending offsets the effects of slower investment growth and rising volatility.

Consumer spending growth remains steady

Consumer spending, which accounts for about 70% of gross domestic product, continued to expand at a steady pace. Last December’s tax plan continues to benefit households and the 5% drop in gasoline prices over the quarter gave households more disposable income.

Growth in investment slows

The tax plan had a tremendous impact on U.S. business investment with very strong growth in the first half of the year, but it decelerated in the third quarter. Greater volatility in financial markets—in part due to rising trade tensions and concerns about global growth—may have contributed to a deceleration in business investment in plants and equipment.

Growth in residential investment has declined each quarter this year as steadily rising interest rates make buying a home more expensive for households. (See graph)

Trade tensions creating volatility

Despite the limited direct exposure of the U.S. economy to trade—imports and exports represent only 32% of GDP compared to 50% for China and 64% for Canada—trade tensions are creating more volatility in financial markets. The volatility is because the U.S. and China are the world’s most important economies and the longer the tensions remain unresolved the greater the likelihood of a slowdown in both countries with spillover effects for global growth.

Because the U.S. economy is operating beyond capacity, the U.S. trade deficit deteriorated further in October hitting US$603 billion for the last 12 months. Even though U.S. import tariffs on $250 billion worth of Chinese goods and tariffs on steel and aluminum imports from a variety of countries, including Canada, remain in place, American businesses and consumers continue to source some of their goods outside the U.S.

Trade tensions appeared to soften between the U.S. and China with the announcement on December 1 that the rise in the tariff rate (from 10% to 25%) on US$200 billion worth of U.S. imports from China would be postponed by 90 days to allow for negotiations between the countries.

The U.S. wants to increase its exports of agricultural, energy, and industrial products to China, but it is also seeking resolution to “structural” issues, namely the Chinese requirement that foreign firms set up joint ventures (JVs) with Chinese firms when investing in China. The U.S. argues these JVs force technology transfer between U.S. and Chinese companies.

While Beijing may be able to increase imports of American goods, it seems unlikely that China would be willing to change its policies related to technology and industrial subsidies.

Volatility is here to stay for a few more months

Although recent comments by the Chair of the Federal Reserve have shifted expectations lower for many more interest rate hikes next year, the possibility of a 25 basis point hike on December 19 remains high. This is because inflation is tracking close to target since wages are moving higher. The unemployment rate is at a historic low of 3.7%, and as such, companies are raising prices due to difficulties in hiring and for some firms, in particular manufacturing, higher costs from import tariffs.

Higher U.S. interest rates means tightening global financial conditions.

Volatility in financial markets will remain elevated due to the combination of tightening global financial conditions and China-U.S. trade negotiations likely to extend until March.

What does it mean for entrepreneurs?

  1. Rising interest rates in the U.S. are having an impact on global financial conditions. 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. Stronger growth in the U.S. compared to Canada means a weaker loonie. 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. Greater volatility breeds fear and can cause businesses to hold back their investment plans.
Oil market update

Over the last few weeks, global benchmark oil prices—Brent and West Texas Intermediate—have dramatically risen and fallen.

During most of September and October, prices of global oil benchmarks, Brent and West Texas Intermediate (WTI), rose on fear of lack of supply due the imposition on November 4 of U.S. sanctions on Iran, which could have removed up to 2 million barrels a day (mb/d) from global markets.

Then, in late October and November, prices fell as supply picked up more than the market anticipated.

Three forces conspired to increase supply

Contrary to expectations, the U.S. provided six-month waivers to various countries to continue to buy oil from Iran. China, India, Turkey, and Korea obtained waivers for Iranian oil purchases for at least 870,000 b/d according to the International Energy Agency.

The high oil prices incentivized Saudi Arabia and Russia to pump more oil, with each country hitting around 11 mb/d in October and November, adding roughly 500 kb/d to global markets.

Finally, U.S. producers are pumping more than ever--hitting 11.7 mb/d in November—and the growth has been stupendous--up 20% compared to a year ago. For 2019, the U.S. Energy Information Administration expects crude oil production to rise to 12 mb/d.

Canadian oil prices are falling too as production grows

Canadian oil prices, in particular Western Canadian Select, has not participated in the upswing, and its discount relative to WTI has widened significantly.

The key reason: production is greater than available pipeline capacity

Current pipeline capacity out of western Canada is 3.9 mb/d, while Canadian oil production is averaging 4.6 mb/d, up 400kb/d from 2017, and of which 90% is from Alberta and Saskatchewan. About half of oil production in Canada is heavy oil.

The other important reason for the recent blow-out in the discount between WCS and WTI is that U.S. refineries have been closed for maintenance, with 2.2 Mb/d of capacity offline in October. U.S. refineries buy a lot of Canada’s heavy oil. In fact, 80% of Canada’s oil exports are heavy oil. U.S. refineries invested significantly in complex processes to transform heavy oil into lighter, low-sulphur products that consumers and businesses need such as gasoline, diesel, and jet fuel.

The slump in prices is also due to questions about the sustainability of demand for oil

While growth in the demand for oil is expected to remain steady (1.4 mb/d for 2019) according to the International Energy Agency, it is more unevenly distributed, much like the forecasts for global economic growth.

Sentiment regarding global growth has softened recently. The International Monetary Fund and the Organization for Economic Cooperation and Development revised their forecasts downward for this year and next year, amid slowing trade due to tensions between the U.S. and China.

Historically economic growth has driven demand for oil. This will continue until the time when other energy sources become dominant.

To date, demand for oil in the United States and China remains robust. In the U.S., diesel is especially in demand by the trucking industry. Two major industries are keeping the trucking industry busy: retail and wholesale trade as e-commerce becomes more important in the economy, and the shale oil and gas industry where production is booming.

In emerging markets though it’s a different story. As local currencies have depreciated against the US dollar, demand for oil is slowing. This is because oil is priced in US dollars and as the US dollar appreciates, every barrel of oil becomes more expensive in local currency. India, Argentina and Brazil have been particularly affected. However, the recent slide in global oil benchmarks will help these countries afford the oil products they need to continue to grow.

Bottom line

Fundamental analysis of oil demand and supply puts global prices in the range of US$60 to $70 a barrel. When geopolitical factors become dominant in the market, prices become much more volatile, which is why the U.S. sanctions on Iran initially bid up prices, only to see them come back down when supply ramped up. With the latest decision by OPEC+1 to cut production by 1.2mb/d during 2019, prices will move back up somewhat from their current spot prices of US$53/b and US$61/b as of early December.

1. OPEC+ is the Organization of Petroleum Exporting Countries (Algeria, Angola, Ecuador, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Saudi Arabia, United Arab Emirates, Venezuela, Libya, Nigeria, Congo) and the “+” includes Azerbaijan, Kazakhstan, Mexico, Oman, Russia, Bahrain, Brunei, Malaysia, Sudan and South Sudan).

Other economic indicators

Bank of Canada holds the key interest rate steady

The Bank of Canada held the overnight interest rate at 1.75% on December 5. In its statement, the Bank noted the economy was expanding largely as anticipated but that the recent fall in oil prices, in particular western Canadian crude oil, would have an impact on activity in Canada’s energy sector. The Bank said the housing sector was adjusting to the interest rate hikes. It also noted that recent federal tax changes would be supportive to investment and exports as firms increase their capacity.

The loonie is dropping even further

The Canadian dollar depreciated against the U.S. dollar, hitting a new five-month low of US$0.75 for the month of November. The recent drop in world oil prices as well as a rising interest rate differential between Canadian and U.S. interest rates is putting downward pressure on the loonie. The uncertainty generated by global tensions is likely to contribute to further downward pressure in 2019.

Entrepreneurial confidence stagnates

The confidence of Canada's small and medium-sized business (SME) owners barely increased in November. The Canadian Federation of Independent Business (CFIB) Business Barometer Index rose by a negligible 0.7 points and stood at 61.2. The level of optimism among SMEs has deteriorated significantly in Quebec and Nova Scotia, where there is a decline of more than five points between November and October. Despite the recent fall in crude oil prices, confidence of Alberta SMEs did not worsen, though only slightly more entrepreneurs expect better results over the next 12 months than those who expect weaker performance. In Saskatchewan, more businesses expect weaker performance next year than stronger performance.

Credit conditions are slowly becoming less accommodative

Effective interest rates for businesses and individuals are currently about 4%. Canadians have not faced interest rates this high since spring 2009. Although interest rates continue to rise, credit conditions remain historically accommodative. Banks have not yet transferred all of the increases in the key policy rate to clients. Given the Bank of Canada’s statements to bring the policy rate to a neutral range, we expect further increases next year. Credit conditions will likely gradually tighten in 2019.

Key indicators–Canada