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Monthly Economic Letter

July 2019
Feature article

How much will the trade war hurt Canada?

Trade tensions between the United States and China have been rising and now go beyond trade imbalances to encompass technology transfers and investment.

Since last July, the U.S. has imposed 25% tariffs on US$250 billion worth of Chinese exports. China has retaliated with its own tariffs on US$110 billion worth of American exports. In addition, President Donald Trump has threatened to impose 25% tariffs on the remaining US$325 billion in annual imports from China.

As more tariffs have been imposed and threats escalate, global uncertainty is increasing, hurting business confidence and resulting in weaker global trade and investment.

At the same time, China has halted imports of key Canadian agricultural commodities, alleging they’re contaminated. The Canadian government has said those claims are groundless, and many analysts believe the Chinese actions are in retaliation for the arrest and detention of Huawei’s chief financial officer as she awaits extradition to the U.S.

While the magnitude of the impact of these developments on the Canadian economy remains unclear, the risks of negative fallout from a slowing global economy appear to be on the rise.

Global economic growth is slowing

In the wake of these moves, global trade contracted 2.3% between October and April, according to the Netherlands Bureau of Economic Analysis. And the World Bank expects the global economy to grow by just 2.6% this year—the weakest pace since the financial crisis.

Should the latest U.S. tariff threat come to pass, the OECD estimates that annual growth will drop by 0.6% in the U.S. and 0.8% in China, by 2021. Slower growth in the world’s two largest economies will have knock-on effects on their trading partners, including Canada.

Three-quarters of Canada’s goods exports go to the U.S., compared to just 5% to China. Therefore, the impact of the trade conflict on the U.S. economy is critical. Last year, it was negligible, estimated at just 0.04% of GDP by the National Bureau of Economic Research.

Since then, however, the U.S. tariff rate has escalated from 10% to 25% on US$200 billion worth of Chinese imports. And, if President Donald Trump follows through on his threat to expand the action to all Chinese imports, the types of products targeted will be more difficult to find elsewhere, and pain in the economy will grow.

The only certainty is that the level of uncertainty is rising. And that means the cost of capital will likely increase, and consequently global investment will suffer.

Exports could pick up

Over the last few weeks, the Canadian dollar has been appreciating against the U.S. dollar—over 3% since the end of May.

However, if foreign demand starts to falter, especially in the U.S., there will be lower demand for Canadian products and this will mean less demand for the loonie in global markets, putting downward pressure on the Canadian dollar. A depreciating loonie is helpful for our exports and makes tourism more affordable for foreigners.

Another potential boost for Canadian exports comes from China’s retaliation strategy against the U.S. It has lowered tariffs on competing products it imports from other countries. For example, Canada’s lobster exports to China more than doubled after receiving a 3-percentage point Chinese tariff cut in 2018 versus a 70% decrease for American lobster exports after China imposed a 25% duty in July 2018, according to the Peterson Institute.

Chinese trade action hurting Canadian farmers

Unfortunately, Canadian exporters who are seemingly caught up in the dispute over the arrested Huawei executive aren’t doing as well.

China halted shipments of certain Canadian canola products in April, claiming they contained weeds. With 40% of our canola exports going to China, and roughly half of them affected by this issue, this is hurting Prairie farmers.

Then in June, China prevented imports of pork and meat products, stating they contain a substance banned in China—though permissible in Canada and the U.S. Exports of both products to China had increased significantly this year with Chinese pork production severely affected by widespread African swine fever.

Canola, pork and meat products accounted for 11% of Canada’s exports to China last year, but less than 1% of total Canadian goods exports. While China is an important market for certain producers in the Prairies and Quebec, unless this trade action morphs into a ban on all of Canada’s exports, they’re unlikely to be a significant drag on Canadian exports overall.

Conclusion

While the U.S. and China have agreed to resume talks, it’s unclear how a deal can be easily reached. Tensions have moved beyond trade imbalances into the contentious realm of intellectual property and technology transfer.

There is hope that President Trump will hold off on further tariffs for six months while seeking to get a deal. Unfortunately, Canada will remain a bystander in those talks, while continuing to try to resolve its own disputes with China.

On a global level, the longer tariffs are in place, the greater the market distortions and worsening outlook for trade, investment and growth.

Canadian economy at a glance

Oil and gas drive Canadian economic growth

After a decent showing in March, many sectors contracted in April, with 3% annualized growth coming almost entirely from a rebound in the oil and gas sector.

The Alberta government, which had mandated oil production cuts to push up prices, is allowing more oil to flow each month. Despite the cuts easing, the price for benchmark Western Canadian Select has remained stable, relative to its competitor in the U.S.

The other piece of good news for the sector is the federal government’s approval of the Trans Mountain Pipeline. (See the oil market update for more details.)

Information and communication technology and professional services were the other important contributors to growth in April. While these sectors account for just 5% and 6% of GDP respectively, they are growing and supporting productivity gains in other sectors.

Interest rate hikes hurting retail and construction

The retail sector has grown only 0.3% so far this year compared to 2018. Retail is facing various challenges including adapting to e-commerce and competition for foreign online retailers like Amazon. Increasingly, stores serving middle income customers are struggling as the market bifurcates into discount and luxury segments. Recent closures include Sears, HBC’s Home Outfitters and Payless Shoes.

Interest rate hikes are adding to the pressure because a growing share of households’ disposable income is going to service debt. Interest payments and obligated principal payments grew to 14.9% of disposable income in the first quarter of 2019, meeting the record high hit in the fourth quarter of 2007.

Interest rate increases have also affected the construction sector. Despite a small increase in April, it’s contracted 5% since April 2018. Many developers have been struggling to sell properties because the rise in interest rates last year, along with mortgage stress tests, have worsened housing affordability in many markets.

Notwithstanding falling house prices in some markets, such as Greater Vancouver and Greater Toronto, affordability remains a problem in these centres. In other markets, such as Montreal and Ottawa, where prices have steadily risen in the past year, affordability is deteriorating.

Although mortgage credit recently expanded at a faster pace in May than it has for the last few months, we’re unlikely to see a big improvement in construction given housing starts contracted by about 10% in May compared to April.

Manufacturing sector showing slow growth

The manufacturing sector contracted in April and for the year to date has grown just 0.6% compared to 2018. Transportation equipment is the main sub-sector dragging down growth, and part of the reason was due to atypical shutdowns in the auto sector, according to Statistics Canada.

Wood and paper product manufacturing has also contracted, in part due to greater competition from low cost international producers as well as the growing trend toward digital media at the expense of newspapers and other print media.

However, stronger growth is coming from machinery and computer manufacturing as well as the food and beverage sectors.

No interest rate hikes in sight

While inflation has picked up, climbing to 2.4% in May, the Bank of Canada’s core measures remain on target at 2%. Given rising uncertainty related to global growth, the Bank kept its policy rate at 1.75% this month and will likely do so for the next while.

What does it mean for entrepreneurs?

  1. Interest rates are unlikely to rise given uncertainty about global growth. With stable interest rates, consider how your business could become more productive by investing in technology.
  2. The retail sector’s long-term challenge of adapting to increasing foreign competition through e-commerce is not going way, nor is the difficulty for companies catering to middle-income consumers. If you are operating in this sector, you will have to strive to find ways to compete on factors other than price.
  3. Given households rising debt service costs, the housing sector is likely to continue to moderate. Suppliers to this sector are facing a challenging year. See how you can diversify to serve other markets where possible.
U.S. economy at a glance

U.S. consumers support solid growth in second quarter

While much of the world worries about a slowdown in growth, U.S. consumers have remained upbeat and continued to shop, keeping the U.S. economy growing.

Consumer spending kept up a steady pace in April and May, despite slower growth in disposable income. While consumer sentiment dipped a little in June relative to the 15-year high hit in May, it is unlikely to slow consumer spending in the short term.

Small businesses are upbeat

Optimism among small businesses has also picked up, according to the National Federation of Independent Business’s index. Firms reported increased sales and capital expenditure outlays. Businesses in transportation, construction, professional services and manufacturing are most likely to invest in the coming months. With small businesses employing half of the private-sector workforce, this is another positive for continuing growth of the U.S. economy.

With a trade war truce in place, financial markets are settling down

Over the last few months, concerns over trade tensions and global growth have pushed investors to seek the safe harbour of U.S. government bonds. The longer-dated U.S. Treasury notes, such as the 10-year note, have been most in demand, pushing up prices and dragging down yields.

Now, there’s a truce in the U.S.-China trade war as the two countries attempt to work out an agreement. While the thaw continues, bond yields shouldn’t slip lower.

The Federal Reserve is unlikely to lower its policy interest rate at the end of the month, given that the economy is showing steady growth and inflation remains low. Consumer price inflation slowed to 1.8% in May, and the core measure is considerably below the Fed’s target of 2% at just 1.6%.

Wage growth has not been contributing to rising inflation with the average hourly wages growing by just 3% in June. Although wage growth has been slow recently, it could pick up in coming quarters. Productivity rose 2.4% in the first quarter compared to a year ago, the best performance since 2010. Usually, wage growth follows productivity improvements.

What does it mean for entrepreneurs?

  1. The U.S. market continues to offer great opportunities for Canadian exporters in 2019, especially those supplying consumer goods.
  2. The Canadian dollar has appreciated in recent weeks against the greenback providing importers with a better exchange rate. (See the main article for more details.)
  3. Interest rates in the U.S. are unlikely to fall lower in the short-term, meaning borrowing costs have likely hit a low for now.
Oil market update

Slower global growth outweighs the impact of geopolitical tensions on prices

Global oil prices have been on a rollercoaster in the last few months with trade tensions and their impact on global growth being a key factor driving speculation in the market.

In late April, when confidence was high that a trade deal between the United States and China was imminent, prices picked up, with Brent hitting US$75 a barrel and West Texas Intermediate climbing to US$66.

At the end of June, however, they fell by about 10% as contracting global trade and lower global growth weakened demand for oil.

According to the International Energy Agency (IEA) and the U.S. Energy Information Administration, oil demand growth will drop to 1.2 million barrels a day in 2019, revised down from previous estimates of 1.4 million barrels a day. However, investment banks are even more pessimistic, with Barclays and Morgan Stanley, forecasting oil demand growth at 1 million barrels a day, and JPMorgan forecasting only 800,000 barrels a day.

Global trade slows

Already, global trade has slowed, contracting 2.3% between October and April, according to the Netherlands Bureau for Economic Policy Analysis. And this was before the higher tariffs in the U.S.-China trade war went into effect. On May 10, tariffs on US$200 billion worth of Chinese imports went from 10% to 25%. China retaliated, but less severely.

At this stage, price swings in the oil market likely reflect uncertainty associated with the trade tensions, rather than direct effects on demand growth. The IEA estimates the tariffs currently in place will lead to a decline in demand of just 70,000 barrels a day, out of the expected 1.2 million barrels a day.

However, if threatened tariffs on all trade between the U.S. and China are imposed and indirect effects—such as slower investment and a higher cost of capital—are included, then the impact on world oil demand growth could be five times larger, or 350,000 barrels a day less.

Sanctions on Iran helping Canada’s oil

Meanwhile, geopolitical issues affecting supply don’t seem to be driving global crude oil prices higher as they did in the past.

Since withdrawing from the nuclear agreement between Iran, France, Germany, China, Russia and Britain, the U.S. has increased its sanctions on Iran. Waivers the U.S. had granted to various countries expired in May, and Iran’s oil exports have plummeted to 810,000 barrels a day from 2.6 million barrels a year ago—effectively removing 1.7 million barrels a day of medium-heavy crude from the global market.

Asian refineries are important buyers of Iran’s medium-heavy crude as they have invested in equipment and processes that yield more diesel and jet kerosene from this quality of oil.

The displacement of Iran’s medium-heavy oil from the global market is providing some support for Western Canadian Select (WCS), given they are of similar quality. Over the past couple of months, despite a rising supply of Alberta crude oil as curtailment lessens, the WCS discount to WTI has remained stable at US$13 a barrel.

Bottom line

Until there is an agreement between the U.S. and China to remove tariffs, traders will continue to speculate on how low oil demand growth could fall, driving global prices lower. Meanwhile, WCS will likely continue to benefit from lower supply of similar quality crude to the global market.

Other economic indicators

The key rate remains unchanged

On July 10, the Bank of Canada announced that it would maintain its key policy rate at 1.75%. The forecast of weak global economic growth for the second half of 2019 and the uncertainty associated with international trade agreements explain this decision.

The loonie slightly increases

Over the last few weeks, the Canadian dollar has been appreciating against the U.S. dollar—over 3% since the end of May. This is largely a result of expectations that the U.S. Federal Reserve will cut interest rates due to trade tensions and weaker global growth. A stable discount for Alberta’s oil relative to its U.S. counterpart is also supportive to the Canadian exchange rate.

Positive month for Business confidence

The Business Barometer Index of the Canadian Federation of Independent Business increased by 1.8 points to a year-high of 61.5 points. This is the highest reading of optimism since last August. The latest improvement in confidence has been broadly based, improving in 9 of 10 provinces. Owners in Prince Edward Island (68.4) and Quebec (67.6) remain the country’s most optimistic by a wide margin, followed by those in Nova Scotia (63.9) and Ontario (62.6), which showed relatively little movement from May’s results. The most promising sectors are Professional and Enterprises Services (65.5), Hospitality (63.3) and Health and Education Services (62.0).

Modest improvement in business and household credit conditions

For households, mortgage lending conditions eased in Q2 2019, while non-mortgage lending conditions remained mostly unchanged, according to the Bank of Canada’s Senior Loan Officer Survey. The effective household interest rate decreased from 3.97% to 3.8%. For business, overall lending conditions eased slightly and the effective business interest rate decreased to 3.50% in June from 3.54% at the end of March.

Key indicators—Canada

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